Seth Klarman (Trades, Portfolio) is perhaps one of the most direct writers and teachers when laying out his thoughts and techniques on investing. I have become fascinated by the following extracts from Margin of Safety, which are both illustrating and to the point.
The common thread among these quotes is the emphasis on emotional control, very much needed for successful investing. It is in avoiding both cognitive and behavioral errors that we may encounter an edge against the market. Just was Warren Buffett (Trades, Portfolio) once mentioned:
"You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ."
Now, here are some of Klarman’s sometimes cruel but unmissable quotes:
- “In all games the difference between the amateur and the professional is that the professional plays the odds, while the amateur, whether he realizes it or not, is among other things a thrill seeker. Investment, too, is part science and part a game, and just as in poker, you need to sort out your motives. The essence of the whole matter is buying a company in the market for less than its appraised value. Fortunately, most of the other investment players are quite emotional, so if you are thorough and patient, you can find good deals. However, they will rarely be easy, since many other people are looking for the same thing. Thus, to prosper in the investment game, as in any other, requires that you be right—so you’ll win—and different—so you’ll get attractive odds. I hope that this book will help you do that.”
Two key lessons from this statement. The first one is that valuation matters a great deal, it is the compass of every investment thesis. While valuation ranges may vary across the investing community, I personally like cases that I can understand and present limited downside with upside potential under adverse conditions. While infrequent, as Klarman mentions, patience to get the right pitch is key. The second lesson is that it is very hard to find attractive opportunities where everyone else is looking. I have come to realize that good opportunities usually are far from consensus, in beaten down sectors or industries. They generate some uncertainty because it's hard to let go of the crowding effect.
- “It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market—ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.”
The key lesson here is that the market is there to serve us, not to guide us, paraphrasing Buffett. It will present good opportunities to buy at low prices and sell at high ones, and that cheapness or expensiveness will be determined only by comparison to our intrinsic value estimates. Following the crowd can prove very costly, since without a clear range of value estimates, we are navigating the ocean without a compass.
- “Investors will frequently not know why security prices fluctuate. They may change because of, in the absence of, or in complete indifference to changes in underlying value. In the short run investor perception may be as important as reality itself in determining security prices. It is never clear which future events are anticipated by investors and thus already reflected in today’s security prices. Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.”
Prices are volatile but businesses and operations take longer periods of time to reflect their nature in intrinsic value. While we might get lost as investors in price quotations, we should always reflect and wait for business data to display and confirm (or reject) our investment thesis. Only after thorough analysis we might come up with a decision to sell, hold or buy, depending on what the data tells us. Sales, operations' expansion, inventory, ratios and trends are some of the things that will tell us how the business is really doing.
- “Unsuccessful Investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money buy only a few minutes to invest it. The same people would read several consumer publications and visit numerous stores before purchasing a stereo or camera yet spend little or no time investigating the stock they just heard about from a friend. Rationality that is applied to the purchase of electronic or photographic equipment is absent when it comes to investing.”
I like Klarman's example a lot, basically because it shows how different we are under slight changes in variables and conditions. When shopping we compare (sometimes exhaustively) using the internet, friends and other sources of information. When we invest, however, we sometimes go with our gut feeling. This discrepancy only reflects why the efficient market hypothesis will never hold 100% true, investors are not always rational.
- “Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally, greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.”
Making a quick buck is an idea that drives the markets constantly, but here Mr. Klarman states what the goal of investors should be: invest capital to earn a decent return. I think about Buffett mentioning that his #1 job is capital allocation, in line with the previous comments by Klarman.
Do you agree or disagree with the comments made by Seth Klarman?
