Monday, September 17, 2012

Klarman & Graham: The Margin of Safety Principle

From the introduction section of Seth Klarman's book Margin of Safety:

"If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. 

Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites."

In rising markets, it's the favored stocks that have captured the imagination of active participants that tend to do better than what, at least in the near term, might be out of favor (cheap or otherwise). In the book Seth Klarman points out that those with a value focus tend to sell "too soon" as equities, in general, go from becoming fully valued to just being plain overvalued.

I'd add that, for similar reasons, a value approach also often leads to buying and selling "too soon".*

More from Margin of Safety:

"The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.

Those who can predict the future should participate fully...when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments."

Some might be tempted to adjust investing styles and strategies to the environment.

In other words, in addition to a value focus, why not try to learn how to predict the direction of price action of a particular security or for the market as a whole?

Why suffer the consequences of selling or buying too early, right?

Well, best of luck with that.

Maybe more than a few can actually predict the future direction of the market effectively. Yet consider me skeptical that a methodology, whatever it might be, can be applied by a large number of market participants in a way that reliably produces above average results.

It just doesn't seem very likely this can be done reliably well. My guess is the result would be costly mistakes leading to sub-par returns over the long haul for most who try.

At a minimum, identifying examples of those that can reliably foresee the future direction of the market, and have a proven track record, isn't easy.
(I suspect this won't deter those who seem to try!)

By comparison, finding examples of capable value investors with proven long-term track records is rather easy.

There's plenty of evidence that any number of variations of disciplined value investing can produce attractive long-term results. The primary driver of returns is intrinsic business value and how it changes over time and no real need to know what direction the market might be headed near term. The market is simply there to serve the investor.

Value investing only works over the long haul if securities are purchased with an appropriate margin of safety (even if in the short run price action implies otherwise) and value is consistently well-judged. The benefits of a well-executed value approach is particularly significant when viewed through a risk-adjusted prism.

One serious mistake that gets made is as follows: projecting forward the earnings a business has produced under recent favorable economic conditions. In other words, not enough consideration of what they'll look like under much less than optimal conditions. The end result ends up being an insufficient margin of safety. For all but the highest quality businesses earnings needs to be normalized over at least a full business cycle.

For some lower quality businesses -- particularly those that are capital intensive, highly cyclical, and in fiercely competitive industries -- a full business cycle may not even enough.

Benjamin Graham had the following to say in Chapter 20 of The Intelligent Investor.** 

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to 'earning power' and assume that prosperity is synonymous with safety."

Earning power under favorable business conditions is usually insufficient. It is especially the case for the lower quality variety of enterprise. Understanding how earning power might vary over a full business cycle (again, and sometimes even longer) matters a bunch.

As does balance sheet strength. Weaker franchises require the most balance sheet flexibility.

The higher quality enterprises (and I'm generally NOT talking about fast-growers or highly dynamic industries), those that sometimes even seem just a little expensive, will often suffer rather modest drops in earnings during periods of severely unfavorable business conditions.

Judging their normalized earning power, and how it may increase over the long haul, is more straightforward than most.

The benefits of their relative earnings persistence shouldn't be underestimated but frequently is.

The lower quality enterprises, those that may even appear cheap but in reality are anything but, will sometimes see near catastrophic drops in earnings capacity during severely unfavorable business conditions.

Judging their normalized earning power is far from straightforward.

For these, it is more likely that a substantial misjudgment by the investor will end up being made. So, inevitably, they demand a much larger margin of safety and, more often than not, they should just be avoided due to the wide range of possible outcomes.

The most vulnerable businesses, especially those that don't prepare operationally and financially for the next severe drop in economic activity, will leave common equity shareholders wondering what happened to what once appeared to be a nice margin of safety.

Adam

* It seems not exactly surprising those with a value focus (and less interested in playing near-term price action) would be early sellers and buyers. There are many reasons why what's cheap just gets cheaper and vice versa in the near-term and, yes, sometimes for a bit longer. It seems inevitable that those who invest primarily with value in mind will, at times, act too early in either situation. If something is plainly cheap accumulation has to begin at some point and it's likely not at the eventual lowest price. Yet selling and buying early is anything but a big problem long-term if you're mostly getting business value right and clearly paying a nice discount. Only if the investing time horizon is short is it a real issue. So it's learning to not be annoyed by, or pay much attention to, near term price action. Not always easy. It's a necessary trained response considering how much loss aversion can impact investing behavior. I mean, a value focus should lead logically to the hope that what is cheap does get even cheaper in the near or even intermediate term. This is especially true during the share accumulation process but not limited to it. A stock that gets cheaper -- and I've covered this many times -- also allows the benefits per dollar spent on a buyback to be even more potent for long-term owners. The important thing is, of course, that shares are actually selling below intrinsic value. So if value has been judged generally well, then a temporarily lower stock price is a very good thing. Learning to manage the innate influence of loss aversion is probably the toughest part for most. Attempts to buy at the lowest price creates its own problems. One being possibly owning few shares (or no shares) when an investor wants to own a meaningful amount (a partial or complete error of omission). What if the stock happens to unexpectedly reverse course? Some may not consider this but it is a real risk. Maybe the window of opportunity closes, maybe it doesn't. What's worse, staring at temporary paper losses for some time, or permanently missing the chance to own a meaningful amount of something for the long-haul? When highly confident that an attractive long-term investment is selling plainly below what it's worth, it's important to buy it in some quantity when the chance is there. It's difficult enough to find something one understands and wants to own for the long haul. Why worry about some near term price fluctuations in those cases?
** Margin of safety is the principle focus of Chapter 20.

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