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Margin of Safety by Seth Klarman book review

Book Review: Margin of Safety by Seth Klarman

Hi Investors. In this post, we are going to discuss the book review of Margin of safety by Seth Klarman (Originally published in 1991).

About the Author:

Seth Andrew Klarman is an American billionaire investor and hedge fund manager.

He is a graduate of Cornell University and has a business degree from Harvard Business School. Klarman is the founder of The Baupost Group, a Boston-based private investment partnership, that focuses on making value-based investments in the US public markets (founded in 1982). 

In the recent decade, Warren Buffett and his lieutenant Charlie Munger have voiced their support for his investment style and even went on to state that Seth Klarman would be one of their asset managers of choice to manage their personal portfolios. 

Besides, Klarman is also a close follower of the investment philosophy of Benjamin Graham.

Book Review of Margin of safety by Seth Klarman:

margin of safety -seth klaarman

The Margin of Safety by Seth Klarman covers a broad spectrum from providing sound education on the psychology of investing as well as developing the quantitative and qualitative aspects of value investing. It is sometimes said to be the most important book available on value investing after The Intelligent Investor by Benjamin Graham.

The book primarily explores three broad themes for the investor:

  • Firstly the futility of the efficient model hypothesis and the practice of finance professionals of over-relying on their models and estimates.
  • Secondly, it focuses on the concept of risk and the central role it plays in investment success
  • And finally on valuation and market opportunities for the retail investors

Klarman encourages investors to always assess their investments only after first evaluating the risks associated with a particular opportunity and then and only then the potential returns.

In his eyes, the key to a successful track record in investing comes not by achieving higher than average returns but by achieving below than average losses.

This strategy has seemingly worked for him and his investment fund, they have achieved a 19% CAGR for every dollar invested in them (despite maintaining close to 20% cash position in their portfolio for most of the years)

“The avoidance of loss is the surest way to ensure a profitable outcome. Loss avoidance must be the cornerstone of your investment philosophy” – Seth Klarman

The book illustrates this concept through the example of 2 people, say A and B, who invested in the market over a period of 5 years.

Assume A generate returns of 12% for 4 years while B generated only 10%. In the 5th year, due to a market downturn, A’s portfolio witnessed a drop of 10% while B witness a drop of 5%. Because of this significant drop in the down year in A’s portfolio, B ends up having a higher portfolio return in comparison to A.

Also read:

In the book, Klarman espouses that the value investment philosophy is based on three timeless pillars:  a bottoms-up approach to selecting investments one stock at a time, absolute performance orientation that enables one to buy and hold irrespective of short-term relative non-performance and paying attention to the real risk of capital loss, not beta (volatility).

Further, in the book margin of safety by Seth Klarman, the author consistently stresses on the need to focus only on one’s own analysis and to discard the market noise when making an investment decision.

Klarman also discusses the difficulty involved in the art of valuing a business and recommends arriving at a conservative but imprecise range of business value based on 3 or 4 techniques: Net Present Value of Free Cash Flows, Liquidation or Breakup value, and Stock Market Value.

(His book provides practical examples of his philosophy, we encourage our readers to take time to go through his work to improve their knowledge and skill in valuation)

“It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot” – Seth Klarman

Klarman closes his masterpiece with tips for retail investors on finding opportunities in the market namely catalysts, market inefficiencies, and institutional constraints, as well as then going on to provide detailed evaluation methods for thrifts and bankruptcy situations.

Also read: 10 Must Read Books For Stock Market Investors.

Bottomline:

In our view, Margin of Safety by Seth Klarman is a must read for all investors of all levels, besides strengthening foundations on the value methodology it also provides insights into how a seasoned investor stays apart from the chaos of the market to generate stable returns. Happy Investing.

Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.

The Intelligent Investor by Benjamin Graham Summary & Book Review COVER

The Intelligent Investor by Benjamin Graham Summary & Book Review

The Intelligent Investor by Benjamin Graham Summary & Book Review-

The Intelligent Investor by Benjamin Graham, also referred as the bible of the stock market, was originally written in 1949 by Benjamin Graham, a legendary investor and also known as the father of value investing.

Ben Graham was also the mentor and professor of well-known billionaire investor, Warren Buffett.

The 2006 revised edition of the book ‘The Intelligent Investor’ has added commentary by Jason Zweig, a famous wall-street investor, and editor. These added commentaries are used to relate Graham’s idea to the present world. It highlights that the book has time-tested techniques. The book has over 600 pages (although originally around 450-500 page but the added commentaries in revised edition increased the width of the book). Overall, it’s a classic book with added quick notes.

Why You Should Read This Book:

Warren Buffett (worth over 73.1 billion dollars) says- ‘This book is by far the best book on investing ever written’. Needless to mention that this book is Warren Buffett’s all-time favorite. He also admitted that the book helped him in developing a conceptual framework for his future investments and capital allocations. Further, he made the following remarks about the book in its preface:

  • Investing doesn’t require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. This book precisely and clearly prescribes the proper framework.
  • Pay special attention to chapters 8 & 20.
  • Outstanding results are based on three things – Effort, Research, amplitudes of the market (This book will allow you to profit from them, not participate)

NOTE: If you want to buy this book, I highly recommend you to buy through Amazon at this link. It’s currently on sale here- THE INTELLIGENT INVESTOR by Benjamin Graham

The Intelligent Investor by Benjamin Graham book has many valuable concepts and a must read for all the stock market investors. The first few chapters of the book are dedicated to the general concepts of the market. As the book was originally written in 1949, the book also consists of lots of details about the bonds, preferred stocks & inflation.

The next few chapters describe the methods to analyze stocks using ratios, balance sheet, cash flow etc. The second half of the book is of more importance for the stock investors as it explains the different strategies of the defensive & enterprising investors, along with chapters on management, dividend policy, and case studies.

Please also read: 10 Must Read books for the Stock Market Investors

The three main points covered in the books:

Although there are lots of proven concepts covered in the book, however, the key three points in the book- the intelligent investor by Benjamin Graham is summarized here:

1. Investing vs. Speculating:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” – Benjamin Graham

Let’s understand this concept with the help of an example. Imagine you are planning to buy a printing press. Now, to buy this company you can use two approaches.

First, you visited the company, calculated the asset value of the printing shops, checked the total income and cash flow of the company, verified the effectiveness of the managers, calculated the total assets & liabilities and then lastly come up with a final price for the printing company.

The second approach is that you met with the owner and decided to pay the price whatever he is asking for.

From the example, we can establish the difference between an investor and a speculator. The Investor follows the first approach while the speculator follows the other. Here is the key difference between these two:

Investor Speculator
1.       Goes through proper analysis Does not meet these standards.
2.       Considers the safety of principle
3.       Gets adequate returns


Here is the quote about Speculators by Benjamin Graham:

the intelligent investor summary 5

2. The margin of Safety:

This is another one of the pronounced concept introduced by Benjamin Franklin. He says that one should always invest with a margin of safety. Let us understand this by an example.

Imagine you are in a construction business. You took an order to make a bridge, which can hold up to 8 tons. Now, as a constructor, you might consider making the bridge with an additional 2 tons of holding capacity so that it will not collapse in some extraordinary situation. Overall, you will make the bridge with a total of 10 tons of holding capacity.

Here, your additional 2 tons is the margin of safety.

In the same way, while investing we should consider this margin of safety. It is the central concept of value investing.  If you think a stock is valued at Rs 100 per share (fairly), there is no harm in giving yourself some benefit of the doubt that you may be wrong with this calculation. And hence, you should buy at Rs 70, Rs 80 or Rs 90 instead of Rs 100. Here, the difference in the calculated amount and your final price is your margin of safety.

Here is the quote about the importance of margin of safety by Benjamin Graham:

The Intelligent Investor by Benjamin Graham

3. Mr. Market

In the book ‘The Intelligent Investor’, Graham tells a story about a man he calls Mr. Market. In the story, Mr. Market is a business partner of yours (Investors). Every day Mr. Market comes to your door and offers to either buy your stake of the partnership or sell you his stake to you.

But here’s the catch: Mr. Market is an emotional man who lets his enthusiasm and despair affect the price he is willing to buy/sell shares on any given day. Because of this, on some days he’ll come to the door feeling jubilant and will offer you a high price for your share of the business and demand a similarly high price if you want to buy his. On other days, Mr. Market will be inconsolably depressed and will be willing to sell you his stake for a very low price, but will also only give you the same lowball offer if you want to sell your stake.

On any given day, you can obviously buy or sell to Mr. Market. But, you also have the option of completely ignoring him i.e. you don’t need to trade at all with Mr. Market. If you do ignore him, he never holds it against you and always comes back the following day.

The intelligent investor will attempt to take advantage of Mr. Market by buying low and selling high.  There is no need to feel guilty for ripping off Mr. Market; after all, he is setting the price. As an intelligent investor, you are doing business with him only when it’s to your advantage. That’s all.

The key point to note here is that though Mr. Market offers some great deals from time to time. Investors just have to remain alert and ready when the offers come up.

Mr. Market and Stock Market:

Now, like Mr. Market, the stock market also behaves in the same manner. The market swings give an intelligent investor the opportunities to buy low and sell high. Every day we can pull up quotes for various stocks or for the entire market as a whole. If you think the prices are low in relation to value, you can buy. If you think prices are high in relation to value, you can sell. Lastly, if prices fall somewhere in the grey area in between, you’re never forced to do either.

So, this is a value-oriented disciplined investing. Don’t fall victim to irrational exuberance if the underlying fundamentals of the company is strong. In short, do not react to the hyperboles of the market’s daily fluctuations. Don’t panic, don’t sell.

The Intelligent Investor by Benjamin Graham

Other key points from the book The Intelligent Investor by Benjamin Graham on the Investor and market fluctuations:

  • A common stock portfolio is certain to fluctuate over any period of time. The investor should be prepared financially and psychologically for this fluctuation. Investors might want to make a profit from market level changes. But this can lead to speculative attitudes and activities which can be dangerous. Anyways, if you want to speculate do so with eyes open, and knowledge that you will probably lose money in the end.
  • Graham’s Opinion on aggressive investing: The low probability of aggressive picks will out-weigh the gains collected over a long period of time. ‘The aggressive investor will expect to fare better than his passive equivalent, but his results may well be worse.’

That’s all. I hope this post about the ‘The Intelligent Investor Summary & Book Review’ is helpful to you. I will highly recommend you to get a copy of this book and start reading. There are many valuable concepts by Benjamin Graham that new and old stock investors should learn.

If you need any further help with the book or have any doubts- feel free to comment below. I will be happy to help you. Happy Investing!

The Intelligent Investor by Benjamin Graham

The Intelligent Investor by Benjamin Graham

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Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting