These are notes taken from a Columbia Business School conference presented on October 2, 2008. Seth Klarman wrote the excellent book called “Margin of Safety.” You can find our detailed notes of the book at this link https://www.rbcpa.com/Notes%20To%20Margin%20of%20Safety.pdf . I mostly included Klarman’s comments, yet James Grant is such a valuable resource. James has a newsletter called Grant’s Interest Rate Observer http://www.grantspub.com , which we find invaluable.
We have studied Klarman for years and find his work to be incredibly valuable. He reminds us that times like these when markets are down 25% or so, that value investing should have its day in the sun again. He pounds the table that competent value investors need to avoid the noise of the day, avoid the investors that are short-term oriented and to stand apart from the crowd.
We hope you enjoy these notes.
Seth Klarman at Columbia Business School Conference on 10/2/08
1. His Biggest fear was buying too soon and on way down, from up in over-valued levels. He knew market collapse was possible and sometimes imagined he was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.
2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.
3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.
4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.
5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.
A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.
B. Avoid highly leveraged stocks, junk bonds and shaky financials.
C. Look for bargains in various industries and nations.
D. Look at value, not great companies and great management.
E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.
6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.
7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.
8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.
9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.
10. Controlling your process is essential.
A. Be focused on process, not outcome.
B. Do not judge a decision based on its outcome.
C. During periods of under-performance it is easy to change your process.
D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.
11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.
12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.
Q&A
1. How do you see current investment climate?
A. James Grant – Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.
B. Seth Klarman – Unusual amount of forced sellers, via margin calls. This could breed opportunity. Sees a lot of money managers staying on the sideline. He finds this as an opportunity to buy. Buy when others react to news or false news. His experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.
C. Bruce Greenwald – Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.
2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.
3. James Grant – Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.
4. What factors do you look at in sizing a position?
A. Seth Klarman – He thinks this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25 positions. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don’t own gold as a commodity. We won’t disclose our inflation hedge, yet with enough work, you can find true inflation hedges.