Sunday, June 1, 2014

Book review: "Margin of Safety" by Seth Klarman

I recently had a chance to read Seth Klarman's Margin of Safety. This book is famous for selling for more than $1000 a copy on Amazon and eBay-- it went out of print soon after it was published, and Klarman has declined to put it back in print, giving copies of the book scarcity value. Is it worth more than $1000? Maybe not, but it's still a good read.

Klarman divides Margin of Safety into three sections.

The first section describes the self-defeating things investors do, the ways that Wall Street scams its clients, and the pitfalls of junk bonds. Klarman argues that the best-performing junk bonds are the ones that were originally investment-grade but fell to junk status after their issuers encountered financial problems. By contrast, bonds that were junk when they were issued perform much worse.

He also mentions that the surge in junk-bond issuance during the 1980s made default rates appear lower than they really were: “For most of the 1980s the default-rate numerator (the volume of junk-bond defaults occurring in a given year) lagged behind the rapidly growing denominator (the total amount of junk bonds outstanding during that year). It was only when issuance virtually ceased in 1990 that the deterioration in credit quality was reflected in default-rate statistics.

Klarman warns of the risks inherent to collateralized bond obligations (CBOs) that invest in junk bonds. The senior tranches of a junk CBO are considered investment grade, but they're riskier than they appear: since most junk issuers depend on the refinancing market to meet their obligations, these investment grade tranches may experience losses during an extended recession or credit crunch. This dynamic was evident when subprime CDOs blew up in 2007-08.

The second section emphasize the importance of minimizing risk by having a margin of safety. Contra Buffett, Klarman doesn't ascribe much value to intangible assets because he thinks they offer no margin of safety. He uses 7-Up as an example, writing that the intangible value of its soft-drink formula could disappear if tastes change. Similarly, he doesn't think top-down investing offers any margin of safety.

Klarman warns against overly precise valuations (“Any attempt to value businesses with precision will yield values that are precisely inaccurate”) and takes a shot at “value pretenders,” people who claim to practice value investing while ignoring its basic precepts and using aggressive valuation methodologies.

The third section describes investment opportunities that are off the beaten path: thrift conversions, companies in bankruptcy or financial distress, stocks with no analyst coverage, corporate liquidations, spin-offs, contingent value rights, et cetera.

Some of the ideas in this section are similar to the ideas in Joel Greenblatt's You Can Be a Stock Market Genius. Klarman undoubtedly influenced Greenblatt, but they're very different temperamentally: Greenblatt writes a lot about how leverage can increase returns, while Klarman emphasizes its risks. Klarman also discusses investing theory far more than Greenblatt does.

Klarman makes a lot of interesting points, including the following:

• Fundamental research is a necessary part of investing, but it has several drawbacks. 1) Past a certain point, it has diminishing marginal returns. 2) Doing extensive bottom-up fundamental research can make one miss the forest for the trees. 3) “[B]usiness information is highly perishable” -- industries and the broad economy change over time, sometimes rapidly, so investors constantly have to refresh their knowledge of the companies in which they've invested.

• Sometimes it makes sense for investors to buy when they have incomplete information: “Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

• Merger arbitrage was very profitable in the early 1980s, and this encouraged more people to start doing arbitrage. Normally this would lower returns, but the mid-80s M&A boom meant that the number of arbitrage opportunities grew alongside the number of arbitrageurs, so returns stayed high for much longer than one might have expected them to.

• For a company that's in financial distress, exchange offers can be a way of avoiding bankruptcy, but they're difficult to pull off because of the free-rider problem. If a majority of stockholders vote for a certain proposal, the minority can be compelled to go along with it. Not so with bondholders: if 75% of bondholders agree to participate in an exchange offer, trading in their bonds for securities with a lower net present value, the remaining 25% can free-ride on their sacrifices. Klarman mentions pre-packaged bankruptcies as one way of resolving this problem.

• Bankruptcy is a lot more destructive to some companies than others. Financial companies that depends on investors' and depositors' trust suffer the most from bankruptcy. Counterintuitively, capital-intensive companies tend to get through bankruptcy okay: once they emerge from Chapter 11 and their access to capital is restored, their business can return to normal.

The book also includes a great quote from Louis Lowenstein: "In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community."

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