Yes and Not Yes

I’ve had the good fortune of a friend loaning to me Seth Klarman’s Margin of Safety. Having recently read The Intelligent Investor by Graham, I must say that the price for which people are selling Margin of Safety is a bit exorbitant. It is a great book, no doubt about that, but I see it as merely a condensed and updated version of The Intelligent Investor. The book is more accessible because of this, but the concepts are very similar.

Anyways, not knowing if I’ll ever get to see Margin of Safety again, I’ve already read it once and I’m now rereading it and taking some notes. The following are my notes on Chapter 7 of the book.

At the Root of a Value-Investment Philosophy

Klarman writes there are three central elements to a value-investment philosophy:

1. Value investing is “a bottom up strategy entailing the identification of specific undervalued investment opportunities.”
2. Value investing is “absolute-performance-, not relative-performance oriented.”
3. Value investing is “a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).”

The Merits of Bottom-Up Investing

A top-down approach to investing is difficult and risky as it involves making a prediction about the future and ascertaining its investment implications. This approach has no margin of safety. Purchases are based upon concepts and trends, not upon valuation. Also, the uncertainties facing value-investors are limited whereas top-down investors face seemingly unlimited uncertainties and possibilities; in fact, as many uncertainties as the future they are attempting to predict holds.

Also, it is more difficult for a top-down investor to determine or realize when their investment choice is no longer valid. A value investor can simply reevaluate the business to see if the price has caught up to intrinsic value.

Adopt an Absolute-Performance Orientation

The difference between relative- and absolute-performance seems to be the same difference between those who follow and imitate others and those who are comfortable being in the minority. Investors focusing on absolute performance take a longer-term perspective while relative-performance investors take a short-term approach and are usually fully invested at all times. Absolute-performance investors are willing to hold sizable cash reserves.

Risk and Return

As Klarman is dismissive of the efficient markets theory, it is only natural that he does not believe risk and return are always positively correlated.Klarman writes, “By itself risk does not create incremental return; only price can accomplish that.”

“The risk of an investment is described by both the probability and the potential amount of loss.” Klarman writes that risk is difficult to quantify: it “simply cannot be described by a single number.”

To counteract risk, an investor can: “diversify adequately, hedge when appropriate, and invest with a margin of safety.”

Conclusion

In conclusion, a bottom-up approach, an absolute-performance orientation, and paying careful attention to risk will help investors avoid losing money.