The second of a two-part series on some of the best lessons contained within Seth Klarman (Trades, Portfolio)’s highly acclaimed book, "Margin of Safety."
Seth Klarman's Bite-Sized 'Margin of Safety': Part 1.
This second article continues from the first, which ended on the topic of selling stocks, specifically, when to sell if things aren’t going according to plan. Selling is one of the hardest parts of investing, and deciding when to sell is never a clear-cut decision.
Indeed, as Klarman describes in his book, loss aversion is a long-term goal, not a short-term one. Selling investments that have not gone to plan should be a part of your strategy:
"Warren Buffett (Trades, Portfolio) likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule." I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.”
One of the keys to avoiding substantial losses is to avoid getting tied up in speculative euphoria. Trying to time the market, or jumping on the same investment trend as everyone else, might pay off in the short-term, but timing the sale, getting out before the crash is all but impossible to time.
Investors want to make as much money as fast as possible. That’s understandable, but it’s not realistic and trying to follow this dream, rather than taking the long-term route, will more often than not lead to losses:
“While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome."
And if you want to achieve long-term profit, you should stay away from Wall Street at all costs:
"Wall Street can be a dangerous place for investors. You have no choice but to do business there, but you must always be on your guard. The standard behavior of Wall Streeters is to pursue maximization of self-interest; the orientation is usually short term. This must be acknowledged, accepted, and dealt with. If you transact business with Wall Street with these caveats in mind, you can prosper. If you depend on Wall Street to help you, investment success may remain elusive."
Sticking on the topic of Wall Street, I’m going to finish on this quote regarding Ebitda. This extract is shortened to concentrate on the most crucial part. Adjusted earnings figures and Ebitda or adjusted Ebitda is a waste of time. Most companies unfortunately now use these figures to report earnings to investors, but they are highly misleading.
Like Buffett, Klarman believes that investors should not use Ebitda because it only justifies higher valuations and presents a misleading picture of each company. Value investors should look to calculate the intrinsic value using the most conservative method, not the most optimistic. EBITDA has no place in value investing:
“It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company’s ongoing income stream. Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out. In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipated sharp reductions in capital expenditures. Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.”
“EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. This would be a clear case of circular reasoning. Without high-priced takeovers there were no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios. This would not be the first time on Wall Street that the means were adapted to justify an end. If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.”
Disclosure: The author owns no share mentioned.
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