The third part of 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
Seth Klarman's Bite-Sized 'Margin Of Safety': Part 2
This installment will begin with one of Klarman’s famous comments on the bad behavior of Wall Street:
“If the behavior of institutional investors weren't so horrifying, it might actually be humorous. Hundreds of billions of other peoples hard-earned dollars are routinely whipped from investment to investment based on little or no in-depth research or analysis. The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance. Indeed, the short-term, relative performance orientation of many money managers has made "institutional investor" a contradiction in terms.”
Wall Street’s concern with short-term performance means most investors cannot compete (you could even argue Wall Street itself has arbitraged away any possibility of short-term outperformance). Thousands of well-paid, highly educated analysts on Wall Street are all trying to gain an edge over each other, which eliminates the possibility of taking advantage of mispricings. The best way to take advantage of this is to invest for the long term:
“There are no winners in the short-term, relative-performance derby. Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game.”
While a long-term focus will give you an edge, it means nothing without research. Spending time and effort on research in the first place is an investment in itself:
“Investment research is the process of reducing large piles of information to manageableÂ
ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat. The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market. In fact, often there is no immediate buying opportunity; today's research may be advance preparation for tomorrow's opportunity In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis.”
Warren Buffett (Trades, Portfolio) is a big advocate of using research to reduce risk, and Klarman is of the same persuasion. In fact, Klarman believes that most of the time, diversification is not needed and the more diversification you have, the higher the level of risk attached to your portfolio:
“Diversification is potentially a Trojan horse. Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky. Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.”
As I covered in parts one and two, Klarman is well aware that no matter how much research you do, the direction of the market is unknowable, which is why he advocates never building a full position at the initial time of entry. Instead, he recommends buying in gradually, leaving buying power in reserve if the stock price declines further and offers the opportunity to acquire more at a lower price.
“One half of trading involves learning how to buy. In my view, investors should usually refrain from purchasing a 'full position' (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to 'average down,' lowering their average cost per share if prices decline.”
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