Seth A. Klarman

gone to the dogs has a post featuring a speech by Seth A. Klarman (the author of Margin of Safety) at MIT. Here are a few quotes from the speech:

Seth Klarman makes the point that most investors lack a strategy that equips them to deal with a rise in volatility and declining markets.

Buying at a discount creates a margin of safety for the investor—room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies.

The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.

Recourse leverage changes this equation, as you can seemingly own all the investments you want simply by borrowing to buy them. There is no healthy portfolio discipline enforced by the desire to make new purchases or the anticipation that you may want to. There is also a bit of a slippery slope in that if a little leverage is good, why isn’t more leverage better? When do you stop?

Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor—room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies. Following a value approach won’t be easy for everyone, especially in today’s media-dominated, short-term oriented markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk averse strategy in a world where nearly all of us are, or should be, risk averse.

We’ve delivered great returns to our clients for a quarter century—a dollar invested at inception in our largest fund is now worth over 94 dollars, a 20% net compound return. We have achieved this not by incurring high risk as financial theory would suggest, but by deliberately avoiding or hedging the risks that we identified. In other words, there is a large gap between standard financial theory and real world practice.

Value investing involves the purchases of bargains, the proverbial dollars for fifty cents. Unlike speculators, who think of securities as pieces of paper that you trade, value investors evaluate securities as fractional ownership of, or debt claims on, real businesses.

Value investing lies at the intersection of economics and psychology. Economics is important because you need to understand what assets or businesses are worth. Psychology is equally important because price is the critically important component in the investment equation that determines the amount of risk and return available from any investment.

My firm’s approach is to seek situations where there is urgent, panicked or mindless selling. As Warren Buffett has said, “If you are at a poker table and can’t figure out who the patsy is, it’s you.” In investing, we never want to be the patsy. So rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers. This concept applies to just about any asset class: debt, real estate, private equity, as well as public equities.

The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.

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