Margin Of Safety – Seth Klarman’s 10 Rules For Investing Success

June 13, 2017

Margin Of Safety – Seth Klarman’s 10 Rules For Investing Success

  • After summarizing Seth Klarman’s book, I thought added value could be created by listing his most important investing rules.
  • Some rules are easy to understand and apply, while some go against what the majority thinks. Think averaging down.
  • Klarman achieved returns of over 20% for more than 35 years. Therefore, it’s extremely important to learn and listen when he says something as he doesn’t speak much.

Introduction

We have completed the chapter by chapter summary of Seth Klarman’s book, Margin of Safety. Click here to view all of these articles on the Investiv Daily website.

As I find Klarman’s investment style so powerful and yet so simple, I thought it would be a good idea to conclude the summary of his book with 10 of his investment rules. You may want to bookmark today’s article to compare future investment ideas and opportunities against Klarman’s view on investing.

Rule #1: Invest, Don’t Speculate

Investors buy a part of a business, thus some value at a certain price. Speculators only care about the stock price and hope to correctly guess its future movement.

Not just Klarman, but history has shown that investors fare much better than speculators. It’s simple: your returns will be perfectly correlated to the underlying earnings or value of the business you own.

Rule #2: Don’t Pay Fees To Wall Street 

In his book, Klarman refers to an older investing book written in the 1930s titled Where Are The Customers’ Yachts? The problem put forth in this book is that if you allow Wall Street to invest your money, Wall Street will make their money in the form of fees and commissions, not make money for you. Therefore, do-it-yourself investing is essential and even better if you do it following rule number three.

Rule #3: A Value Investing Strategy Is The Best Because You’re Buying Something Of Value

A stock isn’t an electronic blip on a screen, it’s a part of a business that should have some value.

Even if something goes wrong, your investment is always protected by the underlying value of the business. Therefore, the chance of losing money is minimized.

For example, Klarman doesn’t own Apple (NASDAQ: AAPL) because the book value of it is $25.5 while the stock price is $155. He prefers to own companies like NovaGold Resources (NYSE: NG) where the market capitalization is $1.3 billion while the gold, copper, and silver in the ground have a value of $47 billion at current metal prices just for NG’s share of the projects. Of course, it will take a lot of money to dig those metals out and it isn’t that profitable at current prices, but the huge amount of reserves provides a margin of safety and when gold prices increase, NG’s stock price will easily jump 20-fold.

Rule #4: Don’t Just Invest In Value, Try Finding It At A Bargain Price

For example, the current stock price of Berkshire Hathaway (NYSE: BRK.A, BRK.B) is around $250,000 and above its book value. However, just 8 years ago, the stock price was around $75,000 and well below its book value and intrinsic value.

Rule #5: Be Patient – Opportunities Will Come To Those Who Look For Them

You might regret not buying BRK at $75,000, but Klarman’s advice is to be patient as sooner or later, extremely attractive investing opportunities will arise.

Rule #6: The Market Is Inefficient

Be convinced that the market is inefficient and that the majority of market participants are manic-depressive, and are thus willing to pay any price when greedy and euphoric and sell at extremely low prices when in panic.

Rule #7: Always Have Sufficient Liquidity To Weather Everything

When you manage a $30 billion-dollar hedge fund, having a few billion in cash is always enough to not enter into any forced sales due to client withdrawals. Despite that, Klarman has 25% of his portfolio in cash at the moment.

When we scale it down to a normal portfolio, it’s always important to have liquidity as we never know what’s going to happen. Imagine the worst possible scenario for your portfolio and how it would affect your life depending on your necessary liquidity. Klarman states that as long as you aren’t betting your lifestyle on the stock market, you’ll be fine.

Rule #8: Don’t Be Afraid To Average Down

Speaking of liquidity, Klarman also advises us not to be afraid to average down.

Markets are always extreme, sometimes to the positive, sometimes to the negative. When the market turns negative on a stock but the fundamentals, earnings, and future prospects remain the same, we should thank Mr. Market for the buying opportunities.

The following two charts perfectly explain how Klarman approaches averaging down. In the first case, Allergan (NYSE: AGN), Klarman started buying at prices way above $200. However, when the stock price dropped below $200, he simply bought more as his research gave him confidence in the stock. Soon after, the stock price increased.


Figure 1: Klarman’s approach to averaging down. Source: Nasdaq.

On his largest U.S. position, Cheniere Energy (NYSE: LNG), we can also learn something about portfolio management. As LNG’s stock price dropped, Klarman bought more, but when the stock price recovered, he sold part of his position in order to keep his portfolio in balance.


Figure 2: Buying more on the way down but rebalancing after the increase. Source: Nasdaq.

Rule #9: Don’t Be Afraid To Trade & Rebalance Your Portfolio, Even If You Have To Pay Taxes

Klarman suggests that we should always own the best bargains out there and trade the stocks that aren’t such a bargain anymore for better ones. So when a stock appreciates and there’s another stock that’s much cheaper, a proper value investor sells the first stock in order to buy the better bargain. This also implies selling a position where we were wrong at a loss. We’ll always have some investments where we were simply wrong. The best thing to do is to accept it and move on. Thankfully in investing, you can make money even if you get one out of 5 right.

What’s also important is to always calculate the impact of potential taxes before making the investment. In this way, it’ll be much easier to pay taxes when the stock becomes fairly valued or overvalued as the risks then are much higher while the rewards are much lower.

Rule #10: Know What You’re Doing, Investing Is A Long-Term Game

This rule sums it all up. The more you know, the lower your risk and the higher the return.

Thankfully, today we know what works in the long term as the Klarmans, Buffetts, Dalios, Grahams, and Templetons of the world have provided enough confirmation. There is so much knowledge out there and I find it really unbelievable that the majority of investors still don’t take advantage of such an abundance of knowledge. Perhaps it’s better for things to stay this way as it allows those of us who are always learning about markets and what works in the long term to take advantage of market irrationalities.

Value investing has allowed me to achieve excellent returns in the last 15 years, I’m very positive it will do the same in the next 15 years, despite the fact that I haven’t beat the market in the last 6 months. Thankfully, investing is a very long-term game, one where if you don’t lose money, you’ll go far.

Conclusion

Klarman is definitely not the most famous, nor the most outspoken investor out there. However, his returns are much stronger than his voice.


Figure 3: Top 10 hedge fund managers in the last 50 years. Source: Bloomberg.

What’s far more important than the money made by the hedge fund managers above, is that what Klarman and Dalio (Bridgewater) have done in the last few decades is the strategy easiest to replicate by the part-time, do-it-yourself investor.

Keep reading Investiv Daily as tomorrow I’ll write about Dalio’s All-Weather portfolio strategy and how to apply it to current market conditions and the macro environment.