Today’s Chapter is based on the book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” by Seth Klarman.
Seth Klarman is an American billionaire investor and CEO of The Baupost Group, a Boston-based value-oriented investment firm he has managed since its founding in 1982. He is best known for his disciplined, risk-averse value investing philosophy.
Here’s what I learned:
Avoid Capital Loss
“My goal was to keep losses down, and if I could catch a few stocks going up, compound returns would work their magic.”
— Walter Schloss
Seth Klarman believes that good returns don’t come from by pursuing high returns but by avoid permanent capital loss at all cost. While this may sounds counterintuitive, mathematically speaking, it does make sense considering it would take a 100% return to recover from a stock that lost 50% of his value.
As a matter of fact, Klarman explains that “In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.”
As such, it is not surprising that Warren Buffett once said that the first rule of investing is ‘Don’t lose money’ and that the second rule of investing is to ‘Never forget the first rule.’ Similarly, Klarman writes 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.”
“A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success.“
— Seth Klarman
Furthermore, Klarman challenges the notion that the risk from investing comes from volatility. In his opinion, if you are confident in your assessment of value, short-term price drops should be considered as opportunities, not risks. He writes, “Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals. But are temporary price fluctuations really a risk? Not in the way that permanent value impairments are and then only for certain investors in specific situations.” Therefore, the true risk the permanent loss of capital, which is why the primary goal of an investor must always be the avoidance of loss. By avoiding high-risk and speculative bets, the investor protects his ability to compound wealth over time.
As mentioned, this insight challenges the conventional wisdom that dominates Wall Street, where higher risk is often equated with higher potential reward. Klarman elaborates that “greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.”
This reminds me of what Mohnish Pabrai calls Dhandho investing which is based on the concept that high returns do not necessitate high risks. Instead, Pabrai advocates for a mindset that seeks asymmetric bets, those with significant upside potential but minimal downside risk. This principle, encapsulated in the phrase “Heads, I win; tails, I don’t lose much”, is a cornerstone of the Dhandho framework and reflects his belief that disciplined investors can achieve extraordinary results by carefully selecting opportunities with favorable odds.
As a matter of fact, Pabrai explains that “We have all been taught that earning high rates of return requires taking on greater risks. Dhandho flips this concept around. Dhandho is all about the minimization of risk while maximizing the reward. The stereotypical Patel naturally approaches all business endeavors with this deeply ingrained riskless Dhandho framework—for him it’s like breathing. Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.”
To demonstrate the power of Dhandho, he mentions the story of how Richard Branson built Virgin Atlantic with zero capital. In fact, although the airlines businesses is known to be capital-intensive and highly regulated, Branson was able to identify a service gap and exploited it with minimal initial capital outlay, leveraging creativity over cash. The potential upside was building a global brand; the downside was limited because so little equity was risked upfront.
“My take on Virgin Atlantic is simply this: if you can start a business that requires a $200 million 747 jumbo jet and a boatload of employees in a tightly regulated industry for virtually no capital, then virtually any business that you want to start can be gotten off the ground with minimal capital. All you need to do is replace capital with creative thinking and solutions. Branson found a service gap and went after it. By the time that gap narrowed and British Airways and his other competitors woke up, he had already built a strong brand. Even today, Virgin Atlantic offers a very unique product in a very tough industry. The Virgin Atlantic business model is pure Dhandho. Heads, I win; tails, I don’t lose much!”
— Mohnish Pabrai
Margin of Safety
“The idea of a margin of safety, a Graham precept, will never be obsolete.”
— Charlie Munger
Seth Klarman defines value investing as acquiring companies that are trading below their intrinsic value. However, he is also aware with the fact that calculating the intrinsic value of a company is difficult and imprecise. Therefore, a smart investor must only invest in a company when he has a sufficient margin of safety which provides a buffer against errors in valuation, unforeseen events and human fallibility. Klarman writes, “A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”
An example of having a sufficient margin of safety is, for example, to purchase a dollar for fifty cents. Klarman mentions that the concept of margin of safety comes from the father of value investing, Benjamin Graham, famously known as the mentor of Warren Buffett. Klarman mentions that “Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today’s value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.”
Similarly, Buffett had this saying that “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.“
“The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.”
— Benjamin Graham
By consequence, in his book, Seth Klarman provides a practical framework on how investors can invest with a sufficient margin of safety. He writes, “How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.”
A great example of a value investor who understood the importance of investing with a large margin of safety is Peter Cundill who was also deeply rooted in the principles of value investing. His method wasn’t just about picking cheap stocks; it was about ensuring a margin of safety that protected against downside risks while positioning for substantial upside potential.
Cundill’s early experiences shaped this view, as he veered toward solid companies in unfashionable industries that had seen sharp price declines without corresponding negative fundamentals. His first major investment in Bethlehem Copper exemplified this: the shares were trading at the price of the company’s cash on the balance sheet, with no debt and a profitable mine backed by long-term contracts. This kind of exhaustive analysis revealed opportunities hidden from the casual observer, turning apparent bargains into profound value plays.
“The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favourable investment opportunities.”
— Peter Cundill
Cundill quickly formalized his own investment philosophy which can be summarized with the following:
The share price must be less than book value. Preferably, it will be less than net working capital less long term debt.
The price must be less than one half of the former high and preferably at or near its all time low.
The price must be less than one half of the former high and preferably at or near its all time low.
The price earning multiple must be less than ten or the inverse of the long term corporate bond rate, whichever is the less.
The company must be profitable. Preferably it will have increased its earnings for the past five years and there will have been no deficits over that period.
The company must be paying dividends. Preferably the dividend will have been increasing and have been paid for some time.
Long term debt and bank debt (including off-balance sheet financing) must be judiciously employed. There must be room to expand the debt position if required.
Furthermore, Cundill’s willingness to concentrate holdings in a few undervalued securities, even in a single market, reflected not only his confidence in this value investing approach, but is a perfect example of how focus can reduce risks. As Cundill explains, “The portfolio has been concentrated. The number of holdings has been decreased by approximately one-third and the average size of position increased by 20%. Our focus, but especially my own, has consequently been considerably sharpened. My father was a very good birdshot and he always said “never shoot into the brown.” In other words, never shoot into a flock of birds without first choosing a single bird—at least in your mind.”
Patience
“The big money is not in the buying and the selling, but in the waiting.”
— Charlie Munger
Based on Seth Klarman’s teaching, if loss avoidance is the destination for value investors, patience is the vehicle that can get you there. Klarman mentions that value investing demands extraordinary discipline that few possess. The market presents countless pitches, but the successful investor recognizes that most are not worth hitting. He writes, “Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.”
To illustrate the importance of patience, he refers to the baseball analogy that is frequently used by Warren Buffett. Klarman explains that “A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.”
“For a value investor a pitch must not only be in the strike zone, it must be in his ‘sweet spot.’ Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift the bat from his shoulder; the cheapest security in an overvalued market may still be overvalued.”
— Seth Klarman
The baseball analogy from Warren Buffett is actually based on Ted Williams who, as a hitter, was known for his exceptional ability to wait for the right pitch, the one in his “happy zone” where he could maximize his chances of success. He believed that even the greatest hitters couldn’t be successful if they swung at bad pitches.
As a matter of fact, Williams notes that “a good hitter can hit a pitch that is over the plate three times better than a great hitter with a questionable ball in a tough spot. Pitchers still make enough mistakes to give you some in your happy zone. But the greatest hitter living can’t hit bad balls good.“
“The first rule in the book... is to get a good ball to hit.”
— Ted Williams
As such, to be a value investor, not only do you need to wait for the right opportunity, you must also be disciplined enough to hold cash when nothing attractive is available, a decision that can be especially excruciating during rising markets. As Klarman says, “Above all, investors must always avoid swinging at bad pitches.”
This is extremely difficult, as it often leads value investors needing to be contrarians and to go against the herd. As a matter of fact, Klarman argues that value investors must avoid the temptation to outperform the market in the short run. Owning securities should be because they are undervalued, not because they are popular among other investors. He mentions that one should chase absolute performance rather than chasing relative results. He writes, “Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring.”
Beyond the Book
Read "Seth Klarman: The Forgotten Lessons of 2008" by Farnam Street
Read "PRESERVE CAPITAL" by Investment Masters Class
Read "MARGIN OF SAFETY" by Investment Masters Class
Watch " Seth Klarman on Finding Value and Maintaining Discipline" on YouTube
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