Although he doesn’t give many public appearances, Seth Klarman (Trades, Portfolio) has written extensively on the subject of value investing. His best known work is his book "Margin of Safety," which was published in 1991 and is now out of print.
Klarman has somewhat of a cult following, and with good reason. His Baupost Group has an enviable record, and he has amassed a personal fortune of $1.5 billion. In this article, I will examine some of my key takeaways from "Margin of Safety."
Why investing is like bridge building
As every value investor knows, there’s no point buying something at fair value. You need to purchase stocks at a discount to their intrinsic value. The importance of this practice is reinforced by the fact that as a value investor, you can never be really sure that you have correctly pinpointed fair value. In fact, you should embrace the fact that precision in these matters is unattainable, and instead you should aim instead for a "ballpark figure."
This is where the margin of safety comes in: if you determine that the fair value of a company is around $10 a share, then you probably won’t want to invest at $9.99 a share. As Warren Buffett (Trades, Portfolio) once said, “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it.” In investing, as in engineering and life, you need to account for human error and randomness.
Here is a an example that Klarman provided:
“To appreciate the margin of safety concept, consider the stock of Erie Lackawanna, Inc., in late 1987, when it was backed by nearly $140 per share in cash as well as a sizable and well-supported tax refund claim against the IRS. The stock sold at prices as low as $110 per share, a discount from the net cash per share even exclusive of the refund claim. The downside risk appeared to be zero...Ultimately Erie Lackawanna won its tax case. Through mid-1991 cumulative liquidating distributions of $179 per share had been paid ($115 was paid in 1988, returning all of a buyer's late 1987 cost), and the stock still traded at approximately $8 per share.”
Klarman recognised that the only foreseeable loss on the stock would be a temporary market price decline, a development that would only make the shares an even more attractive purchase. Importantly, recognizing this opportunity required some knowledge of tax laws and the regulatory structure underpinning the company’s refund claim.
This historical episode illustrates not only the importance of having a margin of safety but also how important it is to do proper research. In a world awash with data and high speed market movers, only those that are willing to do the legwork can outperform the average.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: Defining Your Investment Goals
- Warren Buffett: What Is a Board of Directors For?
- Chamath Palihapitiya: The Government Should Not Bail Out Mismanaged Companies
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