Margin of safety and risk aversion is Seth Klarman’s central
investment tenet. And risk aversion begins with defining a margin of safety for
your investments. In his book Margin of
Safety, Klarman outlines three of the best ways to build a winning stock
the risk and downside associated with the investment before focusing on
a bottom-up approach on individual companies while ignoring the industry and
its connections with the economic cycle as a whole.
how the company achieves its returns and research why revenues and profits have
increased or decreased year by year.
The key to downside risk protection
In the current financial market
environment, unprecedented things are happening with surprising regularity. This is as true for our preparations
for financial disaster as for any other kind.
And when the memories of disaster,
along with worry and diligence, dim over time, it leads to complacency in
investors. Complacent investors naturally focus more on benefits and the focus
on benefits will lessen the concern over what could go wrong. It
is important to prepare your investments for stormy times and one way to do
this is to consider the downside protection an investment offers. Downside protection starts with understanding the
risks associated with the investment. When
the risks are identified, then the best course of action is developing a plan
for protecting against those downsides. One of the most
popular forms of downside protection is investing with a margin of safety.
As Klarman writes in Margin
of Safety, "A margin of safety is achieved when securities are
purchased at prices sufficiently below underlying value to allow for human
error, bad luck, or extreme volatility in a complex, unpredictable and rapidly
when giving a margin of safety, drives towards investments that provide adequate
balance sheet cash and low-risk collateral.
margin of safety doesn't guarantee an
investment will generate high returns but it provides room for error in an investor’s
judgment. In particular, it provides a cushion against any miscalculations
that may occur.
no doubt, will be inevitable because an investment’s intrinsic value is subject
to various interpretations by investors, which affect how large a margin of
safety investors will choose to set. In general, the bigger the margin of
safety set by investors, the less likely investors will suffer losses.
Why use bottom-up approach
Bottom-up investing focuses more on analyzing a specific
company and less on the the financial markets and economy as a whole. With
bottom-up investing, a thorough review of the company is done, paying close
attention to factors like financial stability and the conduct of management. This approach is commonly used
during instances where we think that individual companies can do well in an
industry that is not performing well. They pose great opportunities for value
investors because these types of companies are ones most likely to be
overlooked by the average investor.
Most investors naturally choose top-down investing, a
strategy focused on investing according to the market cycles and economic
environment, which tends to be a better measure of how the stock market is
performing as a whole. However, economies and industries are often too complex
for investors to gain useful insight.
Bottom-up investors ignore the markets and focus on specific
dynamics to get ahead of the game. They evaluate factors like competitive
advantage and management reputation.
said the following to investors in his Baupost letter earlier this year: “Our
disciplined risk aversion throughout 2011 enabled us to avoid dangerous
temptations and remain focused on investments in our areas of strength and
competitive advantage.” Competitive advantage
comes down to two questions. Can the company raise prices for their products
while maintaining sales in a competitive environment? Can it continue to retain
customers as the business undergoes operational and technological changes? One
aspect for investors to keep in mind is that of technological change, a
constant threat to industries like retail stores and mobile communications. Best
Buy (NYSE:BBY) used to be the go-to place where customers could shop for electronic
appliances but internet retail took that away. RIM (RIMM) used to be a model
company that produced phones for email on-the-go but competitors like Apple
(NASDAQ:AAPL) and Google (NASDAQ:GOOG) upped the ante and took away the value of RIM’s
products. These kinds of circumstances show that keeping up with trends
on a regular basis is a vital part of bottom-up investing.
Management reputation explains a company’s business model, a
measure of how the business makes a profit while delivering value to its
there is one theme that continually runs through the public statements of
billionaire investor Warren Buffett, it is the principle that investors should
only consider investing in companies with managers of competence and integrity. Buffett explains
that he likes managers who stick to doing what the company does best. He
declares, “The best business returns are usually achieved by companies that are
doing something quite similar today to what they were doing five or ten years
ago.” On the contrary, Buffett suggests investors to avoid companies with
managers who pursue growth for growth’s sake and acquisitions for the sake of
owning more. Like Buffett, Klarman is a deep value investor who thinks more
bottom-up than top-down.
Develop a framework for decision making
Outstanding investment returns are, indeed, hard to achieve.
But once investors take care of the risks and understand a company better, it
is possible to develop a strategy for generating better returns. Investors can increase
their chances at bigger returns by gaining an idea on how much cash a business
is generating, where it is coming from, and whether its origin is sustainable. According to Klarman, a company's share price often
fluctuates significantly in the absence of fundamental developments, such as
when a sizeable seller needs cash quickly. So how can investors
determine the sustainability of cash within the business? Reading through the
financial statements, focusing on the line items that affect cash generation,
and trying to remember key statistical numbers are just a few of the key steps.
When investors find the information they need, they need to
dig deeper into those numbers by examining sub-statements and reports that say
something about the numbers. These steps, taken altogether, will form the
foundation of a unique investing strategy for each value investor. Over time,
Klarman discovered a great strategy that produced a top-of-the-line stock
Four of Klarman’s stocks include PDLBioPharma (NASDAQ:PDLI), Ituran
Location and Control (NASDAQ:ITRN), BP (NYSE:BP), and Microsoft (NASDAQ:MSFT). What these
companies have in common are annually increasing total revenues, annually increasing
cash flows, and gradually decreasing operating expenses and debt. Additionally,
they show a clear value focus with P/E ratios no greater than 15. And even when
stocks like these go through a troubling period brought on by a sagging economy
or major scandal, they have an ability to bounce back.
The following sums up what Klarman tries
to do at Baupost: “We are always long-term oriented. We never attempt to gauge
near-term market movements; we have no edge there. We strive to make long-term
investments that have truly compelling risk-reward characteristics. We are
never afraid to stand apart from the crowd. We stick to our game plan, and
focus on areas where we are skilled and experienced.”
An investment framework
like Klarman’s is necessary to develop a winning portfolio. The framework
should include principles through which ideas and decisions are filtered. A sound investment process, most of the time
will lead to a good investment result. But ultimately, investor success in the long term is
shaped by how well we can develop and utilize our skills over time to
understand companies better.
Margin of safety and risk aversion is Seth Klarman’s central