In this post, I’ll give a summary of the elusive book by Seth Klarman: Margin Of Safety. I’ll highlight the most important lessons and high-level takeaways for me. The book itself goes into a lot more specific details on various strategies, like capital structure arbitrage or spinoffs and things of the nature. This post will focus on the high-level principles as a summary, but if you want all the details grab Seth Klarman’s Margin of Safety here.

Summary Of “Margin Of Safety” By Seth Klarman – It is Value Investing

The strategy this book focuses on is value investing.

This means you invest from a first-principles basis. This requires looking at the stock from a lesn of business fundamentals and your stock purchase as a fractional ownership of the company.

The “value” in value investing is what the underlying business creates for society, and what that represents on a monetary level.

The share price is what you pay for that value.

Value investing is just making sure you pay a cheap price relative to a business’s value.

Price Action Doesn’t Matter

Share price going up isn’t representative of the underlying business doing better. Nor is the reverse true.

Things like technical analysis and looking at how price changes is a waste of time. The reason’s because it’s unclear which future events are “baked into” the price already, and which aren’t. And these sets of future events being baked into the price will change constantly.

In other words: why the market prices a security a certain way is inherently unknowable and is a random combination of market emotion.

Seth Klarman “Margin Of Safety” In Short-Term Investing Summary

Here’s Seth Klarman’s take on things like technical analysis and short-term investing: it’s a waste of time.

This is because short-term results are somewhat random. Thus, maintaining good results over the long-term is a mathematical impossibility. Second, you’ll always have the pressure to trade and meet some arbitrary return objective. This’ll make your trades more prone to mistakes. In investing, there are times when the best thing to do is nothing at all. That is, if all the deals are bad on the market, you should opt for inaction as opposed to taking a bad deal.

Lastly, there are already hedge funds full of very highly paid, extremely talented people who are collectively trying to trade in the short-term. They deploy thousands of AI models simultaneously. They also have Ais that generate AI to trade algorithms. Trading in the short-term is a zero sum game and you’ll always lose. And even if you win consistently: you’ll lose soon enough since their algorithms will just pick up on your strategy and beat you at your own game. That is: even if you somehow have the impossible edge against hedge funds by your lonesome, it’s unlikely to be maintained for long.

What About Indexing?

Warren Buffett has observed that “in any sort of a contest-financial, mental or physical-it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”6 I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.

In this blog, I preach so much about the S&P500 that you’d be surprised to hear that this book does not recommend indexing.

Margin Of Safety, Seth Klarman talks about how indexing is dangerously flawed – let me give a summary of his reasons. First:

…it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.

The book also says indexing is a fad and diverges from value investing. For example, when companies get included in the S&P 500, its share price goes up. Why is this? There’s no fundamental change in the business. The only thing driving the price up is that it’s included in an index, which means more money goes into the company. This artificially boosts the returns of S&P 500 listed companies and reinforces further investment that isn’t based on business fundamentals. The skewed view that being in an index automatically makes a business “good” is maintained, the cycle continues, and you end up with only price-inflated companies on the index.

In other words: stocks listed on an S&P 500 is likely overpriced, or the opposite of what you want in a value investing strategy.

Lastly:

My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea.

Chasing High Yield Bonds Or Dividends

One should be very careful about high yield bonds and dividends. Don’t be a yield chaser and let the “high yield” alone lure you into buying.

The underlying business must be making money as well in order for it to be a good investment. A company that’s losing money offering bonds or a very high dividend is essentially a ponzi scheme: they’re just giving you a return OF your capital, as opposed to a return ON your capital.

Think about it: how can a company that’s not making money afford to pay you a dividend? Only by returning your money back to you.

The book highlights the junk bond craze and goes into a lot more specifics, but I’ll skip that here for the sake of brevity.

Summary Of Accounting Magic, As Observed By Seth Klarman In Margin Of Safety

Don’t take financial statements at face value. Things like goodwill are put there because there are accounting requirements to do so. They don’t mean anything for the underlying value of the business.

Another thing to beware of: capex deducations as income. Businesses that need to generate capex this quarter will probably need to generate capex in the future, despite the cost being “non-gaap”. Future capex expenses should offset the deduction for this quarter (more, if the business scales). Thus, one should not take deductions as income when evaluating the business from a lifetime value POV.

Another huge takeaway for me: the accounting department knows investors look for YoY growth. Thus, they might do tricks where they sandbag profits for a few years and show at-par profits for a year, then show inflated profits for the year after. This sort of accounting magic can give the illusion that a struggling business is profitable.

Thus, the total sums of accounting statements should not be taken at face value. And you should consider each line item in the financial statements carefully to get a good picture of what’s going on.

Lastly, the book advises that the numbers aren’t everything. They are just a tool to gauge the landscape the business is in. Intangible factors such as competition, product-market fit, vision of the board of directors, and much more should be considered.

What To Buy

You should buy stocks where the price is much lower than the value of the business.

This minimizes risks while maximizing returns. Other words: buy things with the highest Sharpe Ratio possible.

In your research, you’ll finally find a stock that has a great bargain. When you see a great bargain, you must not say “What a great bargain!” but instead ask “What’s wrong with it?”

Skepticism can help you save tons of money. Usually, great bargains come in the shadow of some looming trouble. There’s fundamental reason for a depressed price, but the bargain generally comes when investors panic and underprice the asset far below the worst outcome for the underlying issue.

You should buy things when they look ‘uncertain’. This is because by the time the uncertainty has been resolved, the share price will be restored to reflect par value and no more gains can be found there.

You get good safety margins buying good bargains. But you get even better safety margins if you buy with good margins, with a catalyst in sight (i.e. a known future event that’ll resolve the uncertainty).

When To Sell

You should sell when your underlying analysis of the business no longer holds true. For example, suppose you assumed a company’s expenses will go down due to manufacturing advances. Now suppose the manufacturing advancement completes but the costs remain roughly the same. Time to sell and cut your losses as some of your major assumptions no longer hold true.

The other time you should be selling is when the value is captured. For example, if share price was at $1/share and your analysis found that it should be fairly priced at $5/share. A catalyst happens and it jumps to $5.10/share. You should sell. After all, nobody ever went broke taking profits.

Summary Of Your Margin Of Safety vs. Institutional Investors

Hedge funds are smarter than you and have more resources than you. So what’s your edge as a retail, value investor?

First, you should have infinite patience and you should wait for the ‘right pitch’ to throw. As alluded above, doing nothing is oftentimes the best move. Doing this gives you a huge edge. Institutions must show results QoQ. They’re thusly at a disadvantage because they have political pressure to show returns in the short-term. They’re forced to swing at pitches that aren’t perfect, and as a result have a lower Sharpe Ratio than someone just patiently waiting for the best possible thing to invest in.

Next, a lot of large institutions have artificial constraints where they’re not allowed to buy stocks with share prices that are “too low”. The book argues that this is nonsensical, because a $10 with a 10-to-1 stock split would mean the shares are at $1. At $10/share, some institutions would buy it. But at $1/share post-split, no institution would touch it. But there’s no fundamental change to the company. So why is it all of a sudden a bad investment, just because the share price has changed? It isn’t, and places like this is where you can exploit inefficiencies in how institutions invest.

Example Opportunities

When people aren’t sure about the timing of when something uncertain will resolve itself, things become panicky and underpriced. Take certain bankruptcy filings for example where the stock prices plunges far below book value. Or COVID in general where the stock tanked for a couple months, only to realize that COVID isn’t permanent and came to rebound stronger than ever.

Another opportunity is stocks with lower market caps. Companies with higher market caps will be more efficient (and have more competition). Conversely, be aware of companies with such low enough market cap and volume to the point of illiquidity or very high bid-ask spreads.

Lastly, You Should Have Cash

Having cash minimizes opportunity costs. If you find a great bargain but have no money in your bank account, you obviously can’t take advantage of said opportunity.

Below are some tips to always have cash in your account so that you can always have some gunpowder to take advantage of investment opportunities.

First, don’t go “all-in” on one stock with all your money, all at once. If the share price tanks for a few years, you’re looking at a large opportunity cost. Instead, dollar cost average with the thought of “If the price tanks 80%, then that’s a great bargain and I’ll be glad to buy more.” Never buy a part of a business with the thought of “if it tanks, I need to jump ship and sell.” If you go into a stock with the latter thought, then your thesis is not strong enough and you should not purchase the stock in the first place. In sum, dollar-cost averaging makes it so that you’ll always have some cash available.

Next, you may consider some dividend-paying stocks in your portfolio for cash flow so you can use that to invest should you run low on cash. Be cautious of underperforming businesses with high yields though.

Third, you may also consider hedging your bigger positions such that if the share price tanks and you can’t sell them, your hedged position should net you a sizable profit to reinvest. Thus, if you “win” and you capture value, you can just sell it for a win and use that extra capital to buy something else. If you “lose,” you just HODL to your shares while liquidating your hedged position and you’ll still have cash to invest.