Hi all,
I have been reading and collecting relevant points from the book “Margin of Safety”. This is for the benefit for all of us. I have summarized Lesson 1-3 and would be posting further summary on remaining lessons as I read through the book.
Margin of Safety (Seth Klarman) – Lessons Learned
Chapter 1: Speculators and Unsuccessful Investors
Mark Twain - There are two times in a man’s life when he should not speculate:
• When he can’t afford it
• When he can
Stocks represent fractional ownership to the businesses, bonds represent loans to those businesses.
Technical Analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to the future stock prices.
According to Albert Wojnilower, > the average holding period of U.S. Treasury bonds with maturities of ten years or more is only 20 days. Professional Traders and investors alike keep 30 year treasury bonds for liquidity and use them to speculate short term interest rate movements, while never contemplating the prospect of actually holding them for 30 years to maturity.
On differences between Successful and Unsuccessful Investors
Successful Investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgement, they respond to market forces not with blind emotion but with calculated reason. Successful investors demonstrate caution in frothy markets and steadfast conviction in panicky ones. The success of an investor depends on how he/she views the market and its price fluctuations.
Value investors who buy at a discount from underlying value are in a position to take advantage of Mr. Market’s irrationality. If you look to Mr. Marker as a creator of investment opportunities (where price departs from underlying business value), you have the makings of a value investor.
Security Prices move up and down for two basic reasons:
• To reflect business reality (or investors perception of that reality) or
• To reflect short-term variations in supply and demand.
Supply and demand imbalances can result from year-end tax selling, an institutional investor coming out of stock as a result of disappointed reported earnings, or an unpleasant rumour.
Unsuccessful Investors and their costly emotions
Greed can cause investors to shift their focus away from the achievement of a long term investment goals in favour of short term speculations.
The Search for an investment Formula
The financial markets are far too complex to be incorporated into a formula. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.
Chapter 2: The Nature of Wall Street Works against Investors
What is good for Wall Street is not necessarily good for investors and vice-versa.
Wall Street has 3 principle activities:
• Trading
• Investment Banking
• Merchant Banking
Wall Streeters get paid for what they do, not how effectively they do it.
On IPO Markets
IPO market is where hopes and dreams are capitalized at high multiples. IPOs involve some sort of shuffling of assets through financial engineering rather than the raising of capital to finance a business’s internal growth. The deck is almost always stacked against the buyers.
Investors must never forget that Wall Street has a strong bullish bias which coincides with its self-interest. When a Wall Street analyst or broker expresses optimism, investors must take it with a grain of salt. Wall Street bias is strongly oriented towards Buy side rather than Sell recommendations. Anyone with the money is a candidate to buy a stock or bond, while only those who own are candidates to sell. There is more brokerage business to be done by issuing an optimistic research report than by writing a pessimistic one. It is more pleasant for investors to contemplate upside potential to the upside than downside risk.
Security prices reflect investor’s perceptions of reality and not necessarily reality itself, overvaluations may persist for a long time.
Investment Fads
The value of a company selling a trendy product depends on the profitability of the product, the product life cycle, competitive barriers, and the ability of the company to replicate its current success. Investors are often overly optimistic about the sustainability of a trend, the ultimate degree of market penetration, and the size of profit margins. All market fads come to an end. Security prices eventually becomes too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues.
The standard behaviour of Wall Streeters is to pursue maximization of self-interest; the orientation is usually short term.
Why open-ended MFs are better than Closed-ended MFs
The only advantage of a closed-end over open-end mutual funds is that closed-end funds can be managed without consideration of liquidity needs since they are not subject to shareholder redemptions. This minor advantage does not offset the high up-front commissions charged to initial purchasers of closed-end fund shares.
Chapter 3: The Institutional Performance Derby: The Client is the Loser
The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long term perspective that retirement and endowment funds deserve.
Most Money Managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management.
Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices.
Impediments to Good Institutional Investment Performance
• Shortage of time – Hours are diverted to marketing than on finding long shots.
• Bureaucratic Decision making process – Group decision making influences the decision.
• Institutional baggage and Emotions
• Analyst and Portfolio managers work in silos.
On 100% invested
Remain fully invested at all times is consistent with a relative-performance orientation. If one’s goal is to beat the market (particularly on a short term basis) without falling significantly behind, it makes sense to remain 100% invested.
Absolute-performance oriented investors, will buy only when investments meet absolute standard of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all.
On Indexing
To value investors the concept of indexing is at best silly and at worst hazardous. It becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient market, 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. Indexing creates a self-enforcing feedback loop where the success of indexing has bolstered the performance of the index itself, which in turn, promotes more indexing. When the market reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.
Investors must understand the institutional investment mentality for 2 reasons.
• Institutions dominate financial market trading; investors who are ignorant of institutional behaviour are likely to be periodically trampled.
• Ample invest opportunities exist in the securities that are excluded from consideration by most institutional investors.
Note: The book reflects the era of 1990s and some of the variable may have changed in current times. However, the fundamentals and the behavioral aspect does not change rapidly during this time.
Cheers,
Amit
