Seth Klarman is an investing icon, though many on Main Street don’t know his name. In 1991, he published a book called Margin of Safety that earned a place in Wall Street’s lore. As popular as the book became – reportedly even Warren Buffett owns a copy – it has been out of print for decades, and last we looked sold for over $4,500 on Amazon. The book is a virtual step-by-step guide on how to invest well, so what lessons does it teach?
- Investors should focus on capital preservation more so than high returns. The stock market is a turbulent and volatile place, so it is crucial to focus on protecting your capital rather than trying to achieve high returns.
- It is important to understand the difference between price and value. Price is what you pay for a stock, while value is what it is worth.
- By calculating the intrinsic values of firms, investors can make better investment decisions.
Margin of Safety
It’s no surprise given it’s the title of the book that Klarman argues that a margin of safety is the key to successful investing. The definition of Margin of Safety is: the difference between the price paid for a stock and its intrinsic value. Seth claims that by buying stocks with a wide margin of safety, investors can protect themselves from greater losses and increase their chances of achieving long-term success.
The margin of safety ties into the Buffett’s first two rules “don’t lose money” and “don’t forget rule #1” – or in short, the importance of avoiding losses. Investors should focus on capital preservation more so than high returns. Like Buffett, Klarman highlights the importance of understanding the difference between price and value. Price is what you pay for a stock, value is you what it’s worth.
Necessarily, the stock market is turbulent and volatile, so to mitigate the risk of loss, it’s crucial to buy stocks at prices below their fair or intrinsic values.
How To Invest for Success
Klarman is prescriptive too; he details how to identify undervalued stocks, and how to calculate their intrinsic values while managing risk.
The value investing process begins with identifying undervalued stocks; these are firms trading below their intrinsic values, or what they are truly worth.
Once it’s clear that a company is undervalued, it’s necessary to then calculate its intrinsic value using a method such as a DCF analysis (discounted cash flow). And it’s just as important to sell stocks that are no longer undervalued, in order to mitigate risk.
Asset Class Diversification
Klarman also advocates for diversification across asset classes. It’s not sufficient to bet the farm on a single sector to achieve long-term investing success if you want to adhere to the most important rule of not losing money. Capital needs to be allocated across a spectrum of industries and sectors.
This provides a degree of inherent risk mitigation because some sectors may be negatively correlated. For example, healthcare and technology are often viewed as negatively correlated. So too are consumer staples and cyclicals, as are bonds and stocks.
Is Klarman Worth Listening To?
Klarman acknowledges that value investing is not easy, but he argues that it is the best way to achieve long-term success in the stock market.
He recognizes that finding undervalued stocks, assessing their intrinsic values, managing risk and staying disciplined are all challenging. So is his advice worth heeding?
Klarman has a long and successful track record of investing success. According to Morningstar, Klarman’s Baupost flagship fund has generated an average annual return of 19.7% since 1983, after fees. This is significantly higher than the S&P 500’s average annual return of 10.2% over the same period.
His track record would appear to prove his claim that value investing is the best way to achieve long-term success in the stock market.
As you view our research, commentary and alerts here at SummaMoney, you will see we focus heavily on the tenets of success employed by Klarman by identifying intrinsic values of companies and uncovering stocks that are trading at prices below those levels to ensure their margins of safety are wide.