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The most expensive investment book in the World Investors are all too often lured by the prospect of instant millions and fall prey to the many fads of Wall Street. The myriad approaches they adopt offer little or no real prospect for long-term success and invariably run the risk of considerable economic loss - they resemble speculation or outright gambling, not a coherent investment program.
But value investing - the strategy of investing in securities trading at an appreciable discount from underlying value - has a long history - has a long history of delivering excellent investment results with limited downside risk. Taking its title from Benjamin Graham's often-repeated admonition to invest always with a margin of safety, Klarman's 'Margin of Safety' explains the philosophy of value investing, and perhaps more importantly, the logic behind it, demonstrating why it succeeds while other approaches fail.
The blueprint that Klarman offers, if carefully followed, offers the investor the strong possibility of investment success with limited risk. Recent Posts from This Journal. Post a new comment Error Anonymous comments are disabled in this journal. Your reply will be screened Your IP address will be recorded.
Post a new comment. Create Alert Alert. Share This Paper. Background Citations. Citation Type. Has PDF. Publication Type. More Filters. Modern Portfolio Theory, standard asset pricing models and the concept of rational decision makers in efficient markets have major limitations as systems for modeling investor behavior and prices of … Expand. View 3 excerpts, cites background. In spite of their long history and … Expand. View 2 excerpts, cites background.
The Journal of Investing. We show that, by using this heuristic, an investor … Expand. Investment risk measurement using only quantitative methods does not always work properly measuring risk and avoiding losses. In order to effectively measure and reduce risk it is appropriate to use … Expand. View 1 excerpt, cites background.
We use simple ranking of stocks based on four screens that we … Expand. The Value of Share Buybacks. A formal theory is presented for the valuation of share buybacks. Formulas are given for calculating the equilibrium and effect on shareholder value in different share buyback scenarios. The … Expand. Investing in the capital market is high risk and return.
Enter the email address you signed up with and we'll email you a reset link. Need an account? Click here to sign up. Download Free PDF. Bruce Kovner. A short summary of this paper. Download Download PDF. Translate PDF. I look back on my experience at Mutual Shares very fondly. My learning in the two years working with Max and Mike probably eclipsed what I learned in the subsequent two years at Harvard Business School.
It is to Max's memory that I dedicate this book. The unconventional offer to join a startup investment-management firm in Cambridge, Massachusetts, presented the opportunity to begin building an investment track record early in my career. Each of my colleagues—Howard in particular—went out on a long, thin limb to bet on me and my abilities, not only to manage their own money but also that of their families and close friends, which was perhaps the greater act of faith.
It has been my great privilege to be associated with such knowledgeable, energetic, warm, and caring people. Together we have built something to be proud of. I am grateful to each of them for his many insights and observations, a number of which appear in one form or another in this work.
I am also fortunate to have some of the finest clients a professional investor could have. A number of them encouraged me in this endeavor. While I shall respect their privacy by not naming them, their patience, interest, and support have been key elements in our investment success. My nine years at Baupost have brought me into contact with many of the finest people in the investment business, on both the buy side and the sell side. I am grateful to each of them for teaching me so much about this business and for putting up with me when I was having a bad day.
Though they are too numerous to thank individually, I owe each of them a great deal. I do wish to thank the people who have been especially helpful with this project. A number of other friends made very helpful suggestions at earlier stages of this project.
Jess Ravich, in particular, offered many valuable insights into the junk-bond and bankruptcy sections. Finally, Jim Grant, perhaps without realizing it, inspired me to take on this challenge. I thank each of them for their help, and far more important, I will always cherish their friendship. My wife, Beth Klarman, offered the fresh perspective of a non-financial-professional as she devotedly read every chapter and made numerous helpful recommendations.
She also made every accommodation to help free up time for me to devote to this project and urged me to press on to completion the many times when progress was slow. I thank her for being a great wife and mother and my best friend. My father, Herb Klarman, was perhaps the most careful reader of multiple drafts of this manuscript.
He is a true craftsman of the art of writing, and his comments are literally incor- porated on every page of this book. I thank him for his tremendous assistance. Acknowledgments xi I also want to thank my mother, Muriel Klarman, for teaching me to ask questions and encouraging me to discover the answers. Finally I must acknowledge the extraordinary efforts of Mark Greenberg, my editor at HarperBusiness, and Mitch Tuchman, my developmental editor, in improving this manuscript in so many ways.
I thank them both for their help in seeing this project to fruition. I also owe thanks to Martha Jewett, who made helpful comments on an early draft, and special thanks to Virginia Smith, who proposed this project out of the blue. Jacqui Fiorenza, Mike Hammond, and Susie Spero were of enormous assistance with the typing and retyping of this manuscript. Kathryn Potts made numerous editorial suggestions and helped to prepare the glossary. Carolyn Beckedorff provided research assistance as needed.
As with any work such as this, full responsibility for errors must be borne by the author. I hope those that remain are minor and few in number. Introduction Investors adopt many different approaches that offer little or no real prospect of long-term success and considerable chance of substantial economic loss.
Many are not coherent investment programs at all but instead resemble speculation or outright gambling. Investors are frequently lured by the prospect of quick and easy gain and fall victim to the many fads of Wall Street. My goals in writing this book are twofold. In the first section I identify many of the pitfalls that face investors.
By highlighting where so many go wrong, I hope to help investors learn to avoid these losing strategies. For the remainder of the book I recommend one particular path for investors to follow—a value-investment philosophy. Value investing, the strategy of investing in securities trading at an appreciable discount from underlying value, has a long history of delivering excellent investment results with very limited downside risk.
This book explains the philosophy of value investing and, perhaps more importantly, the logic behind it in an attempt to demonstrate why it succeeds while other approaches fail. I have chosen to begin this book, not with a discussion of what value investors do right, but with an assessment of where other investors go wrong, for many more investors lose their way along the road to investment success than reach their destination.
It is easy to stray but a continuous effort to remain disciplined. In fact, it almost ensures it. You may be wondering, as several of my friends have, why I would write a book that could encourage more people to become value investors. Don't I run the risk of encouraging increased competition, thereby reducing my own investment returns?
Perhaps, but I do not believe this will happen. For one thing, value investing is not being discussed here for the first time. While I have tried to build the case for it somewhat differently from my predecessors and while my precise philosophy may vary from that of other value investors, a number of these views have been expressed before, notably by Benjamin Graham and David Dodd, who more than fifty years ago wrote Security Analysis, regarded by many as the bible of value investing.
That single work has illuminated the way for generations of value investors. More recently Graham wrote The Intelligent Investor, a less academic description of the value-investment process. Warren Buffett, the chairman of Berkshire Hathaway, Inc. He has written countless articles and shareholder and partnership letters that together articulate his value-investment philosophy coherently and brilliantly.
Investors who have failed to heed such wise counsel are unlikely to listen to me. The truth is, I am pained by the disastrous investment results experienced by great numbers of unsophisticated or undisciplined investors. If I can persuade just a few of them to avoid dangerous investment strategies and adopt sound ones that are designed to preserve and maintain their hard-earned capital, I will be satisfied.
If I should have a wider influence on investor behavior, then I would gladly pay the price of a modest diminution in my own investment returns. In any event this book alone will not turn anyone into a successful value investor. 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. Introduction 8 This book most certainly does not provide a surefire formula for investment success. There is, of course, no such formula. Rather this book is a blueprint that, if carefully followed, offers a good possibility of investment success with limited risk. I believe this is as much as investors can reasonably hope for.
Ideally this will be considered, not a book about investing, but a book about thinking about investing. Like most eighth-grade algebra students, some investors memorize a few formu- las or rules and superficially appear competent but do not really understand what they are doing.
To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don't when they don't.
I could simply assert that value investing works, but I hope to show you why it works and why most other approaches do not. If interplanetary visitors landed on Earth and examined the workings of our financial markets and the behavior of financial-market participants, they would no doubt question the intelligence of the planet's inhabitants.
Wall Street, the financial marketplace where capital is allocated worldwide, is in many ways just a gigantic casino. The recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of activity than its economic utility. Pension and endowment funds responsible for the security and enhancement of long-term retirement, educational, and philanthropic resources employ investment managers who frenetically trade long-term securities on a very short-term basis, each trying to outguess and consequently outperform others doing the same thing.
In addition, hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies designed to avoid significant underperformance at the cost of assured mediocrity.
There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and the frenzied atmosphere of the financial markets. As a result, investors, particularly institutional investors, become enmeshed in a short-term relative- performance derby, whereby temporary price fluctuations become the dominant focus. Relative- performance-oriented investors, already focused on short-term returns, frequently are attracted to the latest market fads as a source of superior relative performance.
The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd. Investors are sometimes their own worst enemies. When prices are generally rising, for example, greed leads investors to speculate, to make substantial, high-risk bets based upon opti- mistic predictions, and to focus on return while ignoring risk. At the other end of the emotional spectrum, when prices are generally falling, fear of loss causes investors to focus solely on the possibility of continued price declines to the exclusion of investment fundamentals.
Regardless of the market environment, many investors seek a formula for success. The unfortunate reality is that investment success cannot be captured in a mathematical equation or a computer program. The first section of this book, chapters 1 through 4, examines some of the places where investors stumble.
Chapter 1 explores the differences between investing and speculation and between successful and unsuccessful investors, examining in particular the role of market price in investor behavior. Chapter 2 looks at the way Wall Street, with its short-term orientation, conflicts of interest, and upward bias, maximizes its own best interests, which are not necessarily also those of investors. Chapter 3 examines the behavior of institutional investors, who have come to dominate today's financial markets.
Chapter 4 uses the case study of junk bonds to illustrate many of the pitfalls highlighted in the first three chapters. Introduction 10 The rapid growth of the market for newly issued junk bonds was only made possible by the complicity of investors who suspended disbelief. Junk-bond buyers greedily accepted promises of a free lunch and willingly adopted new and unproven methods of analysis. Neither Wall Street nor the institutional investment community objected vocally to the widespread proliferation of these flawed instruments.
Investors must recognize that the junk-bond mania was not a once-in-a-millennium madness but instead part of the historical ebb and flow of investor sentiment between greed and fear. The important point is not merely that junk bonds were flawed although they certainly were but that investors must learn from this very avoidable debacle to escape the next enticing market fad that will inevitably come along.
A second important reason to examine the behavior of other investors and speculators is that their actions often inadvertently result in the creation of opportunities for value investors. Institutional investors, for example, frequently act as lumbering behemoths, trampling some securities to large discounts from underlying value even as they ignore or constrain themselves from buying others. Those they decide to purchase they buy with gusto; many of these favorites become significantly overvalued, creating selling and perhaps short-selling opportunities.
Herds of individual investors acting in tandem can similarly bid up the prices of some securities to crazy levels, even as others are ignored or unceremoniously dumped. Abetted by Wall Street brokers and investment bankers, many individual as well as institutional investors either ignore or deliberately disregard underlying business value, instead regarding stocks solely as pieces of paper to be traded back and forth.
The disregard for investment fundamentals sometimes affects the entire stock market. Consider, for example, the enormous surge in share prices between January and August of and the ensuing market crash in October of that year. One side—the wrong choice—is a seemingly effortless path that offers the comfort of consensus. This course involves succumbing to the forces that guide most market participants, emotional responses dictated by greed and fear and a short- term orientation emanating from the relative-performance derby.
Investors following this road increasingly think of stocks like sowbellies, as commodities to be bought and sold. This ultimately requires investors to spend their time guessing what other market participants may do and then trying to do it first. The problem is that the exciting possibility of high near-term returns from playing the stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness.
The correct choice for investors is obvious but requires a level of commitment most are unwilling to make. This choice is known as fundamental analysis, whereby stocks are regarded as fractional ownership of the underlying businesses that they represent.
One form of fundamental analysis—and the strategy that I recommend—is an investment approach known as value investing. There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.
The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. Introduction 12 Institutional investors, in particular, are usually evaluated—and therefore measure themselves— on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers.
Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.
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. 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.
When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon. 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, indeed on margin using borrowed money, 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. The second section of this book, chapters 5 through 8, explores the philosophy and substance of value investing.
Chapter 5 examines why most investors are risk averse and discusses the investment implications of this attitude. Chapter 7 considers three important underpinnings to value investing: a bottom-up approach to investment selection, an absolute-performance orientation, and analytical emphasis on risk as well as return.
Chapter 8 demonstrates the principal methods of securities valuation used by value investors. The third section of this book, chapters 9 through 14, describes the value-investment process, the implementation of a value-investment philosophy. Chapter 9 explores the research and analytical process, where value investors get their ideas and how they evaluate them. Chapter 10 illustrates a number of different value-investment opportunities ranging from corpo- rate liquidations to spinoffs and risk arbitrage.
Chapters 11 and 12 examine two specialized value-investment niches: thrift conversions and financially distressed and bankrupt securities, respectively. Chapter 13 highlights the importance of good portfolio management and trading strategies. Finally, Chapter 14 provides some insight into the possible selection of an investment professional to manage your money. The value discipline seems simple enough but is apparently a difficult one for most investors to grasp or adhere to.
As Buffett has often observed, value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned. I was fortunate to learn value investing at the inception of my investment career from two of its most successful practitioners: Michael Price and the late Max L.
Heine of Mutual Shares Corporation. While I had been fascinated by the stock market since childhood and frequently dabbled in the market as a teenager with modest success , working with Max and Mike was like being let in on an incredibly valuable secret. How naive all of my previous investing suddenly seemed compared with the simple but incontrovertible logic of value investing.
Indeed, once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling. Introduction 14 Throughout this book I criticize certain aspects of the investment business as currently practiced. Many of these criticisms of the industry appear as generalizations and refer more to the pressures brought about by the structure of the investment business than the failings of the individuals within it. I also give numerous examples of specific investments throughout this book.
Many of them were made over the past nine years by my firm for the benefit of our clients and indeed proved quite profitable. The fact that we made money on them is not the point, however. My goal in including them is to demonstrate the variety of value-investment opportunities that have arisen and become known to me during the past decade; an equally long and rich list of examples failed to make it into the final manuscript.
I find value investing to be a stimulating, intellectually challenging, ever changing, and financially rewarding discipline. I hope you invest the time to understand why I find it so in the pages that follow. Notes 1. Sequoia Fund, Inc.
Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success. To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. They transact when they think they know something that others don't know, don't care about, or prefer to ignore.
They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk. Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others.
They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. They buy securities because they "act" well and sell when they don't. Indeed, even if it were certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today. Speculators are obsessed with predicting—guessing—the direction of stock prices.
Every morning on cable television, every afternoon on the stock market report, every weekend in Barron's, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading. Many speculators attempt to predict the market direction by using technical analysis— past stock price fluctuations—as a guide.
Technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.
Market participants do not wear badges that identify them as investors or speculators. It is sometimes difficult to tell the two apart without studying their behavior at length. Examining what they own is not a giveaway, for any security can be owned by investors, speculators, or both.
As we shall see, investors have a reasonable chance of achieving long-term investment success; speculators, by contrast, are likely to lose money over time. Trading Sardines and Eating Sardines: The Essence of Speculation There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared.
One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines.
Speculation offers the prospect of instant gratification; why get rich slowly if you can get rich quickly? Moreover, speculation involves going along with the crowd, not against it. There is comfort in consensus; those in the majority gain confidence from their very number.
Today many financial-market participants, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a "greater-fool game," buying over- valued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price. There is great allure to treating stocks as pieces of paper that trade.
Viewing stocks this way requires neither rigorous analysis nor knowledge of the underlying businesses. Moreover, trading in and of itself can be exciting and, as long as the market is rising, lucrative. But essentially it is speculating, not investing. You may find a buyer at a higher price — a greater fool—or you may not, in which case you yourself are the greater fool.
Speculators have no such tether. Since many of today's market participants are speculators and not investors, business fundamentals are not necessarily a limiting factor in securities pricing. The resulting propensity of the stock market to periodically become and remain overvalued is all the more reason for fundamental investors to be careful, avoiding any overpriced investments that will require selling to another, even greater fool.
Speculative activity can erupt on Wall Street at any time and is not usually recognized as such until considerable time has passed and much money has been lost. Between and forty-three different manufacturers of Winchester disk drives received venture- capital financing.
A Harvard Business School study entitled "Capital Market Myopia"2 calculated that industry fundamentals as of mid could not then nor in the foreseeable future have justified the total market capitalization of these companies. The study determined that a few firms might ultimately succeed and dominate the industry, while many of the others would struggle or fail. The high potential returns from the winners, if any emerged, would not offset the losses from the others.
While investors at the time may not have realized it, the shares of these disk-drive companies were essentially "trading sardines. Another example of such speculative activity took place in September The shares of the Spain Fund, Inc. Much of the buying emanated from Japan, where underlying value was evidently less important to investors than other considerations. Speculators and Unsuccessful Investors 20 Although an identical portfolio to that owned by the Spain Fund could have been freely purchased on the Spanish stock market for half the price of Spain Fund shares, these Japanese speculators were not deterred.
The Spain Fund priced at twice net asset value was another example of trading sardines; the only possible reason for buying the Spain Fund rather than the underlying securities was the belief that its shares would appreciate to an even more overpriced level. Within months of the speculative advance the share price plunged back to pre-rally levels, once again approximating the NAV, which itself had never significantly fluctuated.
For still another example of speculation on Wall Street, consider the U. Treasury bonds every day. Even long-term investors seldom hold thirty-year government bonds to maturity. According to Albert Wojnilower, the average holding period of U. Treasury bonds with maturities of ten years or more is only twenty days. Yet someone who buys long-term securities intending to quickly resell rather than hold is a speculator, and thirty-year Treasury bonds have also effectively become trading sardines.
We can all wonder what would happen if the thirty-year Treasury bond fell from favor as a speculative vehicle, causing these short-term holders to rush to sell at once and turning thirty-year Treasury bonds back into eating sardines. Investments and Speculations Just as financial-market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations.
Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.
The greedy tendency to want to own anything that has recently been rising in price lures many people into purchasing speculations. Stocks and bonds go up and down in price, as do Monets and Mickey Mantle rookie cards, but there should be no confusion as to which are the true investments. Collectibles, such as art, antiques, rare coins, and baseball cards, are not investments, but rank speculations. This may not be of consequence to the Chase Manhattan Bank, which in the late s formed a fund for its clients to invest in art, or to David L.
Even Wall Street, which knows better, chooses at times to blur the distinction. Salomon Brothers, for example, now publishes the rate of return on various asset classes, including in the same list U. Treasury bills, stocks, impressionist and old master paintings, and Chinese ceramics. In Salomon's June rankings the latter categories were ranked at the top of the list, far outdistancing the returns from true investments.
Investments, even very long-term investments like newly planted timber properties, will eventually throw off cash flow. A machine makes widgets that are marketed, a building is occu- pied by tenants who pay rent, and trees on a timber property are eventually harvested and sold. By contrast, collectibles throw off no cash flow; the only cash they can generate is from their eventual sale.
The future buyer is likewise dependent on his or her own prospects for resale. The value of collectibles, therefore, fluctuates solely with supply and demand. Collectibles have not historically been recognized as stores of value, thus their prices depend on the vagaries of taste, which are certainly subject to change. Speculators and Unsuccessful Investors 22 The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought.
This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns. Such logic can fail at any time. Investment success requires an appropriate mind-set. Investing is serious business, not entertainment. If you participate in the financial markets at all, it is crucial to do so as an investor, not as a speculator, and to be certain that you understand the difference. Needless to say, investors are able to distinguish Pepsico from Picasso and understand the difference between an investment and a collectible.
When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high. The 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 judgment, they respond to market forces not with blind emotion but with calculated reason.
Successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones. Indeed, the very way an investor views the market and its price fluctuations is a key factor in his or her ultimate investment success or Failure. Taking Advantage of Mr. Market I wrote earlier that financial-market participants must choose between investment and speculation. Those who wisely choose investment are faced with another choice, this time between two opposing views of the financial markets.
Matching the market return is the best you can hope for. Those who attempt to outperform the market will incur high transaction costs and taxes, causing them to underperform instead. The other view is that some securities are inefficiently priced, creating opportunities for investors to profit with low risk.
This view was perhaps best expressed by Benjamin Graham, who posited the existence of a Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets.
He provides this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell. Frequently, however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other times he is pessimistic, offering to sell securities for considerably less than underlying value.
Value investors—who buy at a discount from underlying value—are in a position to take advantage of Mr. Market's irrationality. Some investors—really speculators—mistakenly look to Mr. Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value.
Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market's periodic irrationality, by contrast, have a good chance of enjoying long-term success.
Market's daily fluctuations may seem to provide feedback for investors' recent decisions. For a recent purchase decision rising prices provide positive reinforcement; falling prices, negative reinforcement. If you buy a stock that subsequently rises in price, it is easy to allow the positive feedback provided by Mr.
Market to influence your judgment. Speculators and Unsuccessful Investors 24 You may start to believe that the security is worth more than you previously thought and refrain from selling, effectively placing the judgment of Mr. Market above your own. You may even decide to buy more shares of this stock, anticipating Mr. Market's future movements. As long as the price appears to be rising, you may choose to hold, perhaps even ignoring deteriorating business fundamentals or a diminution in underlying value.
Similarly, when the price of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned. They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell at just the wrong time. Yet if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more.
Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration. It is vitally important for investors to distinguish stock price fluctuations from underlying business reality.
If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market—ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions.
If you look to Mr. Market as a creator of investment opportunities where price departs from underlying value , you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money. Reality can change in a number of ways, some company-specific, others macroeconomic in nature. If Coca-Cola's business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value.
If Aetna's share price plunges when a hurricane causes billions of dollars in catastrophic losses, a decline in total market value approximately equal to the estimated losses may be appropriate. When the shares of Fund American Companies, Inc. On a macroeconomic level a broad-based decline in interest rates, a drop in corporate tax rates, or a rise in the expected rate of economic growth could each precipitate a general increase in security prices.
Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception. The shares of many biotechnology companies doubled and tripled in the first months of , for example despite a lack of change in company or industry fundamentals that could possibly have explained that magnitude of increase.
The only expla- nation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing. In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason.
Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. Most day-to-day market price fluctuations result from supply-and-demand variations rather than from fundamental developments.
Investors will frequently not know why security prices fluctuate. They may change because of, in the absence of, or in complete indifference to changes in underlying value. It is never clear which future events are anticipated by investors and thus already reflected in today's security prices. Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.
Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money but only a few minutes to invest it. The same people would read several consumer publications and visit numerous stores before purchasing a stereo or camera yet spend little or no time investigating the stock they just heard about from a friend.
Rationality that is applied to the purchase of electronic or photo-graphic equipment is absent when it comes to investing. Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors.
Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them. Finally greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.
High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before.
As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify ever higher prices, and a mania can ensue. In the short run resisting the mania is not only psychologically but also financially difficult as the participants make a lot of money, at least on paper.
Then, predictably, the mania reaches a peak, is recognized for what it is, reverses course, and turns into a selling panic. Greed gives way to fear, and investor losses can be enormous. As I discuss later in detail, junk bonds were definitely such a mania. Prior to the s the entire junk-bond market consisted of only a few billion dollars of "fallen angels.
Buyers greedily departed from historical standards of business valuation and creditworthiness. Even after the bubble burst, many proponents stubbornly clung to the validity of the concept. Greed and the Yield Pigs of the s There are countless examples of investor greed in recent financial history. Few, however, were as relentless as the decade-long "reach for yield" of the s. Double-digit interest rates on U. When interest rates declined to single digits, many investors remained infatuated with the attainment of higher yields and sacrificed credit quality to achieve them either in the bond market or in equities.
Wall Street responded with gusto, as Wall Street tends to do when there are fees to earn, creating a variety of instruments that promised high current yields. To achieve current cash yields appreciably above those avail-able from U.
Low-grade Securities, such as junk bonds, offer higher yields than government bonds but at the risk of principal loss. Junk-bond mutual funds were marketed to investors in the s primarily through the promise of high current yield. As with a magician performing sleight of hand, investors' eyes were focused almost exclusively on the attractive current yield, while the high principal I risk from defaults was hidden from view.
Junk bonds were not the only slop served up to the yield pigs of the s. Wall Street found many ways to offer investors an enhanced current yield by incorporating a return of the investors' principal into the reported yield. GNMA pools collect mortgage interest and principal payments from homeowners and distribute them to bondholders. Every month owners of GNMAs receive distributions that include both interest income and small principal repayments. The principal portion includes contractual payments as well as voluntary prepayments.
Many holders tend to think of the yield on GNMAs in terms of the total monthly distribution received. The true economic yield is, in fact, only the interest payments received divided by the outstanding principal balance. The principal component of the monthly distributions is not a yield on capital, but a return of capital. Thus investors who spend the entire cash flow are eating into their seed corn. A call option is the right to buy a security at a specified price during a stated period of time.
The cash distributions paid by these funds to shareholders are comprised of both interest income earned on the bond portfolio and premiums generated from the sale of options. This total cash distribution is touted as the current yield to investors. When covered call options written against the portfolio are exercised, however, the writer forgoes appreciation on the securities that are called away.
The upside potential on the underlying investments is truncated by the sale of the call options, while the downside risk remains intact. This strategy places investors in the position of uninsured homeowners, who benefit currently from the small premium not paid to the insurance company while remaining exposed to large future losses.
As long as security prices continue to fluctuate both up and down, writers of covered calls are certain to experience capital losses over time, with no possible offsetting capital gains. In effect, these funds are eating into principal while mis-leadingly reporting the principal erosion as yield.
Some investors, fixated on current return, reach for yield not with a new Wall Street product, but a very old one: common stocks. Finding bond yields unacceptably low, they pour money into stocks at the worst imaginable times. These investors fail to consider that bond market yields are public information, well known to stock investors who incorporate the current level of interest rates into share prices.
When bond yields are low, share prices are likely to be high. Yield-seeking investors who rush into stocks when yields are low not only fail to achieve a free lunch, they also tend to buy in at or near a market top. The Search for an Investment Formula Many investors greedily persist in the investment world's version of a search for the holy grail: the attempt to find a successful investment formula.
Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success. Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future. Some investment formulas involve technical analysis, in which past: -rock-price movements are considered predictive of future prices.
Despite the enormous effort that has been put into devising such formulas, none has been proven to work. The idea is that by paying a low multiple of earnings, an investor is buying an out-of-favor bargain. In reality investors who follow such a fomula are essentially driving by looking only in the rear-view mirror. Another type of formula used by many investors involves projecting their most recent personal experiences into the future, As a result, many investors have entered the s having "learned" a number of wrong and potentially dangerous lessons from the ebullient s market performance; some have come to regard the stock market crash as nothing more than an aberration and nothing less than a great buying opportunity.
The quick recovery after the October stock market shakeout and junk-bond market collapse provide reinforcement of this shortsighted lesson. Many investors, like Pavlov's dog, will foolishlylook to the next market selloff, regardless of its proximate as another buying "opportunity. Moreover, if any successful investment formula i be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.
Conclusion The financial markets offer many temptations to vulnerable investors. It is easy to do the wrong thing, to speculate rather than invest. Emotion lies dangerously close to the surface for most investors and can be particularly intense when market prices move dramatically in either direction. It is crucial that investors understand the difference between speculating and investing and learn to take advantage of the opportunities presented by Mr.
William A. Sahlman and Howard H. The only possible exceptions to this cash flow test are precious metals, such as gold, which is a widely recognized store of value; throughout history, for instance, the value of an ounce of gold has been roughly equivalent to the cost of a fine men's suit. Other precious metals and gems have a less-established value than gold but might be considered by some to be a similar type of holding.
Benjamin Graham, The Intelligent Investor, 4th ed. Lowenstein, What's Wrong with Wall Street, p. The sad truth is, however, that many investors are not well served in their dealings with Wall Street; they would benefit from developing a greater understanding of the way Wall Street works. The problem is that what is good for Wall Street is not necessarily good for investors, and vice versa. Taking its title from Benjamin Graham's often-repeated admonition to invest always with a margin of safety, Klarman's 'Margin of Safety' explains the philosophy of value investing, and perhaps more importantly, the logic behind it, demonstrating why it succeeds while other approaches fail.
The blueprint that Klarman offers, if carefully followed, offers the investor the strong possibility of investment success with limited risk. Finance Business Loading interface About the author. Klarman 2 books 73 followers. Seth Klarman is an American hedge-fund manager and a billionaire who founded the Baupost Group, a Boston-based private investment partnership, and the author of a book on value investing titled Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.
Klarman grew up in a Jewish family in Baltimore, where his father was a public health economist at Johns Hopkins University and his mother taught high school English. Create a free account to see what your friends think of this book! Community Reviews.
The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor Hardcover – October 1, ; Print length. pages ; Language. English. 4. Always buy with margin of safety, remember that value investing is about avoid losing money: Value investing is a risk-averse approach; attention is paid as.