The art of investing can be boiled down to knowing how to acquire assets below their actual worth. Famously, Ben Graham, the father of value investing, coined the phrase “margin of safety”, referring to the difference between the intrinsic value of a share and its market price. This is an approximate value based on the cash flow generated by the business, factoring in the appropriate capital cost. Investing without speculating. Margin of safety is also the title of a book written by well-known investor and Buffet disciple, Seth Klarman, about whom Warren Buffet once said, “If I had to delegate the management of my assets for one day, I’d name Klarman.” The text is an in-depth exploration of what we typically refer to as value investing.
The main takeaway from Klarman’s book is the importance of acting rationally on the market, understanding that behind each share there is a business whose value can be determined in a methodical way. Once assets are valued, good investors aim—with consistency and patience—to acquire them below market price, in order to obtain an adequate return over time as the business grows and the market reflects that fundamental growth in its prices. Klarman warns of Wall Street’s many short-term temptations, as well as their risks. To avoid succumbing to these temptations and to herd mentality, investors must control their emotions and train their temperament, by focusing their investment strategy on the long term.
Klarman ably describes what the art of valuation consists of, which—he notes—is always imperfect insofar as it relies on assumed sales growth and estimated profits in an uncertain environment. The concept of the margin of safety (or the difference between price and value, hence the term ‘value’ investing) emerges from this absolute possibility of error. It is a powerful risk management tool, the other being adequate diversification: not excessive, but reasonable. Thus, the manager of the Baupost Group distances himself from the neoclassical approach that relates volatility to risk (efficient-market hypothesis) and aims to avoid permanent capital losses, with regard to two main elements: the quality of the companies’ shareholder equity and the price paid for it. The higher the valuation, the higher the risk of a given asset. Having a basket of duly diversified companies and adopting a long-term approach amounts to what we would call rational risk management.
Apart from the many technical considerations, concerning asset valuation, the seasoned investor dedicates much of the book to aspects of investor conduct. According to Klarman, value investing is relatively easy to understand, but very difficult to execute because it requires the right temperament. Like other investors, such as Lynch or Munger, he shares the powerful conclusion that the difficult part of successful investment stems from patience and an ability to endure the anxiety of market volatility. It is, in short, an illuminating text that provides a sound approach to financial markets.
