Discover more from Kiko's Musings
My notes on Seth Klarman's Margin of Safety - Part 1
A few years ago, after leaving BTG Pactual and before starting Qulture.Rocks (right around the time I was at Nubank), I read Seth Klarman's famous book Margin of Safety and took copious notes on it, which I hoped to publish someday (more on that eventually). I've decided to publish them here in a series of posts. I hope you enjoy them!
Btw, if you don't know Margin of Safety, it's a book that has been out of print for decades and that sells for more than $1.000 apiece on Amazon, even though you can find the whole text on the web. And Seth Klarman is the founder and manager of Baupost, a huge value-oriented hedge fund based in the U.S.
Here we go.
Part One: Where Most Investors Stumble
The first part of the book, entitled "Where Most Investors Stumble," is divided into four chapters, in which Klarman describes a number of traps in which regular investors may fall in the financial markets, that will invariably drive them to investment defeat if not acknowledged and understood.
First, he distinguishes investment and speculation (a classic theme amongst investment authors) by identifying and comparing their different mindsets.
Second, comes a chapter dedicated to discussing how Wall Street - the environment investors operate in - is stacked against investors because of the multiple conflicts of interest inherent to the various business lines involved. Klarman argues that these conflicts are not necessarily a product of Wall Street's ill intentions, but plainly the nature of the business.
The third chapter is devoted to discussing how the rise of institutional money management has changed the markets, and what limitations do professional money managers operate within because of the workings of their industry. Markets became so dominated by institutional flows that it is important to understand how they think and operate in order to avoid traps and exploit opportunities.
The fourth and last chapter of the first part of the book is a practical discussion about the junk bond trend of the 1980s, where Klarman discusses a bit of the history of the asset class, the mistakes made by various market players, the motivations behind these mistakes, their analytical limitations and what outcomes came out of it.
Chapter 1: Speculators and Unsuccessful Investors
In the first chapter, Seth Klarman differentiates investors from speculators (and investments from speculations) and then proceeds to state that investing is the only sustainable way to make money in the long run.
He goes on to define investors as those who "...tend to believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flows generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value."
Kiko's notes on notes: It seems a bit confusing that the author would even consider other options other than the first (free cash flow generation that either is reflected as cash distributions or share price increase) as valid objectives for an investor. Speculating on trading multiples seems hardly different from speculating on share prices, and the third option seems like a reread of the first.
Speculators, on the other hand, "...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."
In order to illustrate how speculators think, Klarman uses the anecdote of a little known sardine bubble that happened in California in the early 19th century, when sardine prices soared through the roof. One day a market participant decided to treat himself to a meal of sardines, after which he concluded that the sardines were rotten. Complaining to his supplier, he was met with a curious response, that those were „not eating sardines, but trading sardines." The point being, obviously, how market speculators frequently depart from rationality, by losing sight of the fundamental value of whatever it is they are investing on: what use is there in a trading sardine?
This is Seth Klarman, in case you wanted to know what he looked like.
Other examples of speculators parting ways with rationality are supplied: the winchester hard-drive industry in the 80s, that went from a combined market cap of more than $ 5 billion to only $ 1.5 billion, when investors realized there was little financial backing for all the fuzz. Another was the country-specific fund craze, that drove share prices of a certain Spain Fund Inc, a closed-end fund (meaning it is IPOed as a company and has a limited number of shares on the market - whereas a mutual fund freely issues and cancels new shares as investors subscribe or withdraw - causing, therefore, its share price to fluctuate with supply and demand) way above its fair price, even though the assets held by it where freely traded on the markets. The third and last example is U.S. Government-issued bonds, that have roles both as a store of short-term savings and as an instrument for interest rate speculation. The effect of this dual-use can be measured by the very little period on which investors, on average, hold long-term treasuries (twenty days,) or rarely to maturity, losing sight of the fundamentals behind them (interest rates, government creditworthiness, etc).
The author then compares investments and speculations, citing that "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 return to the owners of speculations depends exclusively on the vagaries of the resale market." He cites the example of collectibles, like antiques and paintings, as assets that are frequently mistaken for investments, but that are not because their value "fluctuates solely with supply and demand," meaning that, in the example of biotechnology stocks in the 90s, "the only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing."
Kiko's notes on notes: One could argue that all price movements in the world are the product of supply and demand fluctuations. What Klarman means here is that investor perception is in itself the only price driver for speculations, whereas investments have intrinsic fundamentals that drive their prices on the long-run, and are the only variable that can be sustainably analyzed by "intelligent” investors.
In the second half of the first chapter, Klarman tries to identify the traits that separate successful investors from unsuccessful speculators. His definition is very good: "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."
He uses the anecdote first introduced by Ben Graham, father of value investing (and who taught Warren Buffet at Columbia,) who used to refer to the sum of market participants as "Mr. Market," saying that it’s always willing to give market participants a price for their securities. But Mr. Market, he goes on, is very moody, irrational, and can act unreasonably with utmost frequency, offering investors with sound judgment and cool temper an opportunity to purchase good investments at a bargain when Mr. Market’s depressed, and to sell them dearly when euphoric. Klarman notes, as Graham did, that it is very important not to follow Mr. Market, but to learn to exploit its inefficiencies. "The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in the underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments of value deterioration."
Klarman continues to cite excessive emotion as a great handicap for investors, who must keep their cool when Mr. Market acts against their sound reasoning (and the price of a stock falls, for example, right after an investor purchases it,) but – countercyclically - holding or increasing positions accordingly, and refraining from panicky selling as if Mr. Market was the bearer of truth (presuming, of course, that the analysis was sound in the first place, and fundamentals have not changed). Greed is another great ghost for investors, making them "shift their focus away from the achievement of long-term investment goals in favor of short-term speculation." Greed is what drove investors to flock to junk bonds in the 80s, an example of poor investment reasoning, as well as to seek for a one-size-fits-all miraculous formula for success in the markets, that does not exist.
Key Ideas from chapter 1
1. Investors base their decisions on fundamentals and speculators on the hope of finding someone to purchase securities from them at a higher price (the greater fool theory)
2. Investments generate cash flows for their holders. Speculations don't - their returns are solely based on their resale price
3. The market is a source of opportunity, but not investment guidance. It will frequently depart from reason when investors should exploit it for their advantage by buying cheaply and selling dearly
4. Emotions should not guide investment decisions. Nor should Market
5. Greed drives mistakes. It turns focus away from long-term fundamentals, to short-term speculative gains
Chapter 2: The Nature of Wall Street Works Against Investors
The second chapter of the book discusses Wall Street, and how investors should beware of its workings to avoid being led into traps.
Wall Street firms make money in three main ways: sales and trading (brokering on behalf of clients,) investment banking (underwriting equity and debt offerings, and advising clients on mergers and acquisitions,) and merchant banking (investing in transactions as a principal investor.) On all three of them, firms' interests are not aligned with clients'. On the first two, they earn an up-front commission on the services rendered – just like doctors, lawyers and other professionals do - with no vested interest whatsoever in the outcome of the investments or advice being sold. On the third, firms make money by competing with clients for deals and trades, which is an even more explicit conflict. Klarman refrains from judging if its right, wrong, moral or immoral, but states plainly that these conflicts are inherent to the business and must, therefore, be known and discounted for by investors.
Kiko's notes on notes: As the investigations after the Lehman debacle showed, Wall Street firms frequently act as counterparties to customers’ trades, as market makers. When liquidity is shallow, customer-facing teams may themselves quote prices with the firms’ principal investors, who in practice take contrary bets against customers.
The author then goes on to discuss specific examples of how Wall Street firms can mislead and/or confound investors: they have an incentive to sell the highest-commission products; to make clients trade as frequently as possible; to trade more than reasonable in case they manage discretionary accounts (churning); it has an incentive to sell primary offerings, which are higher commission paying and last, but not least, Wall Street has a structural bullish bias. Closed-end funds are again cited as an important example since they are created with the sole purpose of enabling firms to reap underwriting fees while offering customers a bad investment proposition since its holdings were available without offering or management fees over them in the markets.
The bullish bias is a topic in which Klarman delves deeper. It is important to understand why it’s there, and how it affects investors. To begin with, he explains that all market participants - companies, Wall Street firms, and investors – profit disproportionately from bullish markets. They are good for the underwriting business, nudging companies into issuing securities, and customers into buying them; they boost investor confidence, and these trading volumes, which cause higher trading commissions. Therefore, sell-side research analysts, who are paid by these underwriting and trading commission revenues, are, despite efforts to the contrary (named Chinese Walls,) biased towards bullish analysis and ratings. Their jobs and personal revenues are tied to the success of the investment banking and trading businesses. To make matters worse, financial projections and valuation models are very easy to torture, making bullish predictions quantitatively justifiable when questioned.
What results is an extremely biased ecosystem.
After discussing how research analysts are biased, Klarman gets into the structural and regulatory limitations of short selling, which make the strategy hard to put in practice. Investors must first lend securities to sell them short – a difficult task per se -, and second, lending costs money; therefore short-sellers face negative carry, in practice starting underwater. Second, because regulators restrict short-selling on behalf of a number of market participants, like mutual funds. And third, because stock exchanges greatly restrict short movements with circuit breakers and the sorts, while not impeding upwards movements symmetrically. These short-selling difficulties generate a structural lag for stocks and other assets to correct down when fundamentals deteriorate and contribute to the market's general bullish bias.
Lastly, Klarman discusses trends and fads, that can drive investor irrationality through the roof, and are overlooked by Wall Street because they tend to be profitable to its players through trading commissions and expensive financial innovations. He discusses "innovations" like Interest-only (IO) and Principal-only (PO) mortgage strips, which are synthetic divisions of mortgages into its principal and interest components, carrying very specific risks in themselves, and that have been exhausted by Wall Street as "hot investments." He also cites stock market sectors that have become overly in favor (and then overly out-of-favor) throughout the years with no sound fundamentals, like franchisers, defense contractors, gambling properties, and TV shopping channels. He cites that "investors are often overly optimistic about the sustainability of a trend, the ultimate degree of market penetration, and the size of profit margins. As a result, the stock market frequently attributes a Coca-Cola multiple to a Cabbage Patch concept," and ends that "there will always be cycles of investment fashion and just as surely investors who are susceptible to them."
Kiko's notes on notes: Klarman stops labeling ill-prepared investors as speculators in this chapter, calling everybody "investors," indistinctively.
Key Ideas from chapter 2
1. Investors must acknowledge that Wall Street operates under relevant conflicts of interest, and discount their actions for them
2. Main conflicts of interest are: WS wants to sell high-commission products; WS prefers offerings to secondary trading because they earn more fees; WS wants customers to trade frequently; WS has an incentive to churn customer discretionary accounts; WS has a short-term focus, and finally, WS has a bullish bias
3. Sell-side research analysts reinforce this bullish bias because they are sustained by trading and investment banking business, which in turn profit from happy corporate executives and bullish investor sentiment
4. Financial innovations are usually bad for investors and tend to be heavily exploited by WS
5. Stock-market trends and fads drive investors irrational and always fade
Chapter 3: The Institutional Performance Derby - The Client Is the Loser
In the third chapter of the book, Seth Klarman discusses the rise of institutional money managers as a predominant force in stock markets (responsible for 75% of U.S. trading volumes at the time of the book's writing.) This trend was pushed by the growing available savings pool after WWII, which culminated with the ERISA act, regulating the management of retirement funds. Money managers, according to Klarman, are very peculiar players in the markets, and thus knowing their behavioral patterns "... is helpful in understanding why certain securities are overvalued while others are bargain-priced and may enable investors to identify areas of potential opportunity." In other words, understanding money managers is, in some important ways, understanding the Market.
The central point of the chapter revolves around the fact that money managers are not incentivized to optimize for investor returns, but for the perpetuation of their business. He highlights the fact that the bulk of revenues in the business comes from management fees, or the fees that are charged from investors regardless of returns, and therefore minimizing client churn - withdrawals - becomes a manager’s key objective: "the business of money management can be highly lucrative. It requires very little capital investment while offering high compensation and the rapid development of what is effectively an annuity. Once an investment management business becomes highly profitable, it is likely to remain that way as long as clients do not depart in large numbers."
Kiko's notes on notes: Hedge funds, which are riskier cousins to mutual funds and pension funds described by Klarman, have developed a system for charging a "performance fee" - usually 20% of the profits earned on the clients' assets -. But the fact that hedge funds charge performance fees rarely isolates them from the same constraints of short-term orientation and asset flight undergone by their more conservative peers, since the bulk of the assets managed by hedge funds comes from institutions very much like the ones described by the author. When hedge fund managers do take bold risks in their strategies and are wrong, losing client money, criticism also comes. Pundits may say hedge funds take outsized risks only because they are managing other-peoples'-money (OPM). Money managers rarely escape criticism.
Customer withdrawals tend to come when funds negatively stand apart from the averages. Allocators perform periodical portfolio reviews and replace worst-performing managers by new ones. Therefore, "those with only average results are considerably less likely to lose accounts than are the worst performers. The result is that most money managers consider mediocre performance acceptable. Although unconventional decisions that prove successful could generate superior investment performance and result in client additions, the risk of mistakes, which would diminish performance and possibly lead to client departures, is usually considered too high." In this rat race of short-term focus, who is to blame? "There is ample blame for both to share," explains Klarman.
Other limitations become handicaps to the money management business. The first of them is the fact that managers – on average - carry very little of their own funds inside the vehicles they run. Therefore, investing with "other people's money" generates a bias towards more risk-taking and less risk management.
Another problem is the fact that since money management is an asset-gathering business, managers tend to be distracted by one too many client meetings, both with the purpose of prospecting and relationship management, even though all customers are worst off having managers waste time with marketing. "It is ironic that all clients, present and potential, would probably be financially better off if none of them spent time with the money managers, but a free-rider problem exists in that each client feels justified in requesting periodic meetings. No single meeting places an intolerable burden on a money manager's time; cumulatively, however, the hours diverted to marketing can take a toll on investment results."
The same dynamic that caps investment performance on an industry level also hinders individual portfolio managers' performances within their firms. Internal politics nudge them into not standing apart from the - internal - crowd. "Any institutional investor with an innovative, or contrarian, investment idea goes out on a limb. He or she assumes a personal risk within the firm, which compounds the investment risk. The cost of being wrong goes beyond the financial loss to include adverse marketing implications as well as personal career considerations. This helps explain why institutional investors rarely make unconventional investments."
Another important limitation faced by money managers according to Klarman is the one imposed by size. Markets have finite liquidities, meaning that there is only so much trading a firm can do in a day to get in and out of a position in a stock. Some stocks have a daily trading volume of a few million dollars and some of a few hundred million dollars. Fund managers restrict the amount of a specific stock they can hold by the amount of the average trading volume their funds would dominate if they had to dispose of the position in a given number of days. Some managers also restrict the percentage of the company's market cap or even free-float, it can hold. In any case, these policies may restrict the array of companies a given fund can invest in, or drive them to irrational decisions. "To illustrate this point, consider a manager at a very large institution who oversees a $ 1 billion portfolio. To achieve reasonable but not excessive diversification, the manager may have a policy of investing $ 50 million in each of twenty different sticks, To avoid owning illiquid positions, investments might be limited to no more than 5 percent of the outstanding shares of any one company. In combination, these rules imply owning shares of companies with a minim market capitalization of $ 1 billion each. At the beginning of 1991, there were only 559 companies with market capitalizations this large, a fairly small universe."
Other important aspects highlighted by Klarman are some funds’ policies of remaining fully invested in stocks at all times, believing that their task is stock picking and not market timing. "They believe that their clients have made the market timing decision and pay them to fully invest all funds under their management." Some managers adopt the practice of window dressing, that is, changing the portfolios of their funds at specific dates, like reporting quarters or year-ends, in order to show promising positions and/or hide losing ones.
Kiko's notes on notes: Some investors, especially large, institutional ones like endowments and pension funds, really do expect managers to remain fully invested at all times. The reasoning goes that these funds decide on a broad asset-allocation strategy, and then pick specialized managers who can provide alpha over the asset class. Therefore, when they invest in a long-only equity manager, they want returns that exceed those of equities, but not decoupling from equities’ aggregate returns.
The chapter ends with a discussion on rising trends like the use of portfolio theory and the CAPM model, index funds, and the corresponding belief in efficient markets, that have driven managers away from the sound, fundamental company analysis, towards mediocracy and group-thinking. He illustrates his disbelief of indexing and efficient markets with a quote from the world's most prominent value investor: "Warren Buffet has observed that 'in any sort of contest - financial, mental or physical - it's an enormous advantage to have opponents who have been taught that it's useless to even try." Another very important impact of indexing is that indexed or index-seeking funds are obligated to trade in an out of certain stocks that get placed or displaced on certain indexes. These outsized - and not fundamentally backed - movements create great market inefficiencies that can be exploited by shrewd investors.
Key Ideas from Chapter 3
1. Institutional money managers are structurally handicapped and on average perform below-potential
2. The major constrain is the fear of losing assets under management. This can happen when managers stand out negatively from the pack, driving them to avoid bold ideas in favor of the beaten path
3. Other important constraints are; size, which limits the array of opportunities available; managers’ time spent on marketing efforts; and finally, internal firm dynamics (politics). These constraints all hinder performance
4. Trends like index funds and Efficient Market Theory only contribute to the impact these players have on stock markets
Chapter 4: Delusions of Value - The Myths and Misconceptions of Junk Bonds in the 1980s
The fourth chapter of Margin of Safety is a market folly case study based on the junk bond craze of the 1980s. It draws conclusions that can help those looking for investment success.
The main point of the chapter is that all market participants were in some ways (mainly outsized greed) responsible for the huge losses that followed: banks made huge commissions on junk bond offerings; fixed-income investors were lured by the high yields being offered and, consciously or not, overlooked the flawed analysis that supported the asset class; companies and corporate raiders exploited the abundance of debt and made some reckless takeovers; finally, everybody loved the byproduct of the craze: soaring stocks. "The junk bond boom would not have occurred without the enthusiastic acceptance of financial-market participants. The greed and possibly ignorance of individual investors, the short-term orientation of institutional investors, and the tendency of Wall Street to maximize its self-interest above all came together in the 1980s to allow a $ 200 billion market to develop virtually from scratch."
If there is one person responsible for the development of the junk bond market, it's Michael Milken, who went on to become a Los Angles-based partner of Drexel Burnham Lambert. He saw an opportunity to underwrite middle-market, high yield bond offerings in the early days of his career as a trader of "fallen angels": bonds that had become very illiquid because of worsening credit prospects – and thus ratings – of their issuers. Milken saw that the low liquidity of fallen angels made them very profitable: liquidity premiums usually overly compensated for the credit risk incurred in holding these bonds.
To foster the underwriting business, Milken argued that investing in new junk-bond offerings would be as profitable as investing in fallen angels. He managed to foster a – previously nonexistent - market for these offerings. The only problem was that these hot new bonds, issued by worse off companies, carried no liquidity premiums, and compensated for that in higher credit risk premiums. These made the fallen angel analogy a – very – flawed one.
To further profit from junk bonds, Milken (and then all Wall Street firms afraid of being left out of the party) invented a series of innovations, like zero-coupon bonds and higher issuance sizes, that coupled with the great growth of the market, kept aggregate junk bond default rates at artificially low levels. Zero-coupon bonds and larger-than-needed issuances were a large part of it: the absence of immediate interest and principal payments delayed the occurrence of defaults. Excess proceeds only compounded the problem: "issuers who are able to defer the financial day of reckoning far into the future are not constrained by financial reality." Investors would only learn about defaults later on when the bulk of the investment banking business was already made. Secondly, this time "lag" enabled the numerator (volume of defaults) to grow much slower than the denominator (total volume of issuances,) keeping the result fraction (defaults/total = default rates) artificially depressed. "It was only when issuance virtually ceased in 1990 that the deterioration in credit quality was reflected in default rate statistics."
All market participants profited handsomely from the illusion that this new market was sound. "Early investors did well, emboldening others; subsequent (takeover) deals were performed at still higher multiples of earnings and cash flow. Dr. Pepper, Jack-in-the-Box, and Colt Industries, Inc., for example, were each bought and sold more than once at successively higher prices." And the illusion was also justified with the fact that junk bond markets were a big boost to the U.S. Economy, helping entrepreneurship, via funding smaller companies that had no previous access to debt capital markets, technological innovations, and the breakup of inefficient conglomerates via takeovers.
The junk bond market was only made possible by a relaxation of investment standards. "It is crucial that investors understand how the relaxation of standards came about, for the process was so subtle that many junk-bond buyers were probably not even aware that it occurred." Investors mistakenly understood the merits of zero-coupon and pay-in-kind bonds (discussed earlier to mask financial health of issuers,) interest rate resets (which gave investors a false sense of safety when bonds were reset to restore their face values,) and the relationship between senior and junior sources of capital within a company's liabilities: "although it may be superficially reassuring to know that there are investors in a company whose claims are subordinated to your own, this information is of little if any value in assessing the merits of your investment," and added that "emphasis on the junior claims against a company is a greater-fool argument, wherein one takes comfort from the potentially foolish actions of others rather than from the wisdom of one's own."
The final, and arguably most important, part of the fourth chapter is devoted to the limitations of EBITDA as an important measure of corporate cash flow generation for research purposes. "Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant. Even non-leveraged firms came to be analyzed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate. Unfortunately, EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses."
In Klarman's view, EBITDA is flawed because, for starters, it fails to account for capital expenditures, which are important and vital for the survival of businesses. Ignoring CAPEX is dangerous, because "if capital spending is less than the depreciation of a long period of time, a company is undergoing gradual liquidation" by not investing the necessary amounts to maintain its assets in cash-generation shape. Adding back 100 percent of depreciation and amortization to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out. Depreciation, as a proxy, can work as a conservative way to account for that need - called a maintenance CAPEX. It is important to note, though, that growing businesses (in the absolute majority of businesses) have to, conceptually, invest more than depreciation in capital goods. If not, a red flag should be raised.
EBIT, on the other hand, did not solve the problem, because it "is not necessarily all freely available cash. If interest expense is low, however, taxes consume an appreciable portion of EBIT." The solution, he posited, relied on what could be called EBIA: "After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream." That is, of course, ignoring debt and equity issuances and other changes in the company's capital structure, like reductions in working capital, which can't be said to come from "ongoing income.
Key Ideas from Chapter 4
1. Junk bonds were a poor investment. They were too risky for the returns offered
2. Market participants (Wall Street as underwriters on one side, thrifts, mutual funds, insurance companies, and others fixed-income investors on the other side) were motivated by greed and self-interest in faking and accepting the wrong default rates and cash-flow generation premises over which junk bonds were based
3. Junk bonds not only concerned those who dealt with them; effects spilled over to other aspects of financial markets and the economy in general. It fuelled takeovers that artificially boosted valuations.
I'll publish my notes on parts II and III of the book in the coming weeks.