- Klarman has two
goals in this book - to identify the pitfalls that face investors (so as
to help investors avoid losing strategies) and to recommend one particular
path of investing - the value-investment philosophy.
investing, the strategy of investing in securities trading at an
appreciable discount from underlying value, as a long history of
delivering excellent investment results with very limited downside
- Why would
Klarman write a book to encourage people to become value investors? Won't
increased competition reduce his own investment returns? He says two
- Many already
expressed this view (on value investing) before, including Benjamin
Graham and David Dodd in Security Analysis and The
Intelligent Investor, and Warren
Buffett in his numerous articles and letters.
- Even if his
returns are diminished, but people begin to invest in a more
sophisticated manner, it'll be worth it for the greater good. "The
truth is, I am pained by the disastrous investment results experienced by
great numbers of unsophisticated or undisciplined investors. If I can
persuade just a few of them to avoid dangerous investment strategies and
adopt sound ones that are designed to preserve and maintain their
hard-earned capital, I will be satisfied. If I should have a wider
influence on investor behavior, then I would gladly pay the price of a
modest diminution of my own investment returns" (xiv).
- Chapters 1-3
explore investors vs. speculators, the structure of Wall Street, and the
behavior of institutional investors. Chapter 4 is a case study of junk
bonds to illustrate the things discussed in the first three chapters. The
idea is that something like the junk-bond mania is not a
once-in-a-millennium type of thing, but it may repeat in the future.
- For value
investors, the primary goal is the preservation of capital. Hence, a
margin of safety is needed. "A margin of safety is necessary because
valuation is an imprecise art, the future is unpredictable, and investors
are human and do make mistakes. It is adherence to the concept of a margin
of safety that best distinguishes value investors from all others, who are
not as concerned about loss" (xix).
- Chapters 5-8
explore the philosophy and substance of value investing - investment
implications of the risk-averse attitude, the meaning and importance of a
margin of safety, the three important underpinnings of value investing,
and the principal methods of security valuation used by value investors.
- Chapters 9-14
describe the value-investment process and the implementation of the
value-investment philosophy - research and analytical process, various
value-investment opportunities from corporate liquidations to spinoffs and
risk arbitrage, the opportunities in thrift conversions and bankrupt
companies, the importance of good portfolio management, and professional
once you adopt a value-investment strategy, any other investment behavior
starts to seem like gambling" (xx).
- Part 1: Where Most Investors Stumble
1: Speculators and Unsuccessful Investors
idea: it is important to
distinguish between investment and speculation, and then between
successful and unsuccessful investing; as a successful investor, you want
to look for undervalued opportunities, concentrate on the underlying
business reality rather than perceptions, and ignore the fear and greed
caused by the latest trends and fads (which essentially can result in
- Investors vs.
investors, stock is fractional ownership of the underlying business
(and bonds are loans). "Investors believe that over the long run
security prices tend to reflect fundamental developments involving the
underlying businesses" (3). Investors in a stock thus expect to
profit in one of three possible ways:
- From free
cash flow generated by the underlying business - which will either be
reflected in a higher share price or distributed as dividends
- From an
increase in the multiple that investors are willing to pay for the
underlying business as reflected in a higher share price
- By a
narrowing gap between share price and underlying business value.
by contrast, buy and sell securities based on whether they believe the
prices will rise or fall in the future. "The buy securities
because they 'act' well and sell when they don't" (4). Speculators
are obsessed with guessing the direction of the stock prices.
- "As we
shall see, investors have a reasonable chance of achieving long-term
investment success; speculators, by contrast, are likely to lose money
over time" (5).
- The essence
- Analogy of
eating sardines vs. trading sardines - even though the underlying value
(fundamentals) is bad, the public perception and trading can drive up
the perceived value to great heights.
essentially buy (even if at an overvalued price) when they expect the
price to keep going up, so that they can sell to a "greater
fool" at an even higher price.
is also going along with the crowd - there's comfort in numbers.
- Just as
financial-market participants can be divided into investors and
speculators, the securities and assets being traded can also be
classified as either investments or speculations.
difference between the two: investments throw off cash flow for the
benefit of the owners, while speculations depend exclusively on
"the vagaries of the resale market" (8) - i.e. supply and
such as art, antiques, rare coins, etc. are not investments but
speculations. "Investments, even very long-term investments likely
newly planted timber properties, will eventually throw off cash flow.
[…] By contrast, collectibles throw off no cash flow; the only cash
flow they can generate is from their eventual sale" (8).
- Some major
firms, interestingly, deal in such speculations. Chase Manhattan Bank
has a fund for "investing" in art. Salomon Brothers publishes
the rate of return on paintings and Chinese ceramics - in June 1989,
the returns from these categories actually far outdistanced those of
investors need to distinguish between investments and speculations.
investors tend to be unemotional, allowing the greed and fear of others
to play into their hands" (9).
- Once you
choose to invest rather than to speculate, you must evaluate two views
of the markets:
- View 1:
financial markets are efficient and that trying to outperform the
averages is futile. The best thing you can do is match the market
return (i.e. what John Bogle advises through index investing) -
attempts to outperform the market will incur high transaction costs
and taxes, causing actually underperformance of the averages.
- View 2:
some securities are inefficiently priced, which creates opportunities
for investors to profit with low risk. This view was expressed by
Graham in his analogy of Mr. Market, who buys and sells securities
daily at various prices. Sometimes "he is pessimistic, offering
to sell securities for considerably less than underlying value. Value
investors - who buy at a discount from underlying value - are in a
position to take advantage of Mr. Market's irrationality" (10).
Market's daily fluctuations may seem to provide feedback for investors'
recent decisions. For a recent purchase decision rising prices provide
positive reinforcement; falling prices, negative reinforcement"
(10). This is the view expressed by Jesse Livermore in Lefevre's Reminiscences of a Stock
Operator - i.e. buy/sell
incrementally, watching whether the market reflects the correctness of
your decision. This is, however, essentially speculation - you are
going along with the masses. Klarman warns against this.
- It is
important to distinguish stock price fluctuations from underlying
business reality. Movements in stock price do not necessarily reflect
the real success of an investment. "Security prices move up and
down for two basic reasons: to reflect business reality (or investor
perceptions of that reality) or to reflect short-term variations in
supply and demand" (12).
- Reality can
change via numerous ways, some company-specific, some macroeconomic in
nature. A business expanding may reflect an increase in business
value. A rise if the expected rate of economic growth can reflect
increased business value across the board.
- On the
other hand, "security prices sometimes fluctuate, not based on
any apparent changes in reality, but on changes in investor
perception" (12) - i.e. hot trends, new fads, etc.
"Supply-and-demand imbalances can result from year-end tax
selling, an institutional stampede out of a stock that just reported
disappointing earnings, or an unpleasant rumor" (12).
security prices can change for any number of reasons and because it is
impossible to know what expectations are reflected in any given price
level, investors must look beyond security prices to underlying
business value, always comparing the two as part of the investment
investors are dominated by emotion. Rather than responding coolly and
rationally to market fluctuations, they respond emotionally with greed and fear" (13).
same people who would read several consumer publications and visit
numerous stores before purchasing a stereo or camera yet spend little
or no time investigating the stock they just heard about from a
friend" (13). This is the same point made by Peter Lynch in One Up on Wall Street.
unsuccessful investors regard the stock market as a way to make money
without working rather than as a way to invest capital in order to earn
a decent return" (13). Interestingly, Jesse Livermore in Reminiscences of a Stock
Operator, while a speculator,
also makes this point - do not use the stock market to make quick money
for free (for example, to earn enough to buy a new gadget - or, in
Jesse's case, a new fur coat).
- Greed and
fear are the two powerful emotions that can cause large losses.
gives numerous examples of where "yield pigs" (investors
susceptible to any investment product that promised a high rate of
return) allowed faulty perceptions to hide the truth when chasing
high-yield investments - junk-bonds, Ginnie Maes, and option-income
mutual funds that wrote call options against their portfolio holdings.
point - when bond yields are low, investors rush into the stock market.
However, at this point, stock prices will already be inflated.
"Yield-seeking investors who rush into stocks when yield are low
not only fail to achieve a free lunch, they also tend to buy in at or
near a market top" (16).
investors try to search for an investment formula. They look at past
experiences and project them into the future - which, of course, does
not guarantee any success, since we can't predict the future.
Essentially, Klarman claims that financial markets are too complex to
incorporated into a formula. Instead, spend time doing the fundamental
analysis of specific investment opportunities.
2: The Nature of Wall Street Works Against Investors
idea: the standard behavior on
Wall Street is to pursue maximization of self-interest with a short-term
outlook and a strong bullish focus; this must be understood and
acknowledged by the successful investor.
- Wall Street
has 3 principal activities: trading, investment banking, and merchant
- Trading -
Wall Street firms act as agents, earning a commission or trading spread
for bringing buyers and sellers together.
banking - Wall Street firms arrange for the purchase and sale of entire
companies by others, underwrite new securities, and provide financial
banking - Wall Street firms commit their own capital while acting as
principal in investment banking transaction (very popular in the late
1980s but ceases in 1990 and early 1991).
- What is good
for Wall Street is not necessarily good for investors, and vice versa.
There are frequently conflicts of interest and a short-term orientation
on Wall Street. Investors need to understand this and "act with
cautious skepticism in any interactions they may have" (20).
- Wall Street's
traditional compensation package is in the form of up-front fees and
commissions. Brokerage commissions and investment banking/underwriting
fees are collected up front regardless of the outcome for the investor
(i.e. success or failure).
compensation package leads to primary conflicts of interest:
- Brokers urge
clients to buy/sell stock instead of holding it (churning the
banks underwrite either overpriced or highly risky securities
banks have become direct competitors of their underwriting and
brokerage clients - they buy and sell entire companies or large
subsidiaries for their own accounts
- Wall Street
favors underwriting over secondary-market transactions. Brokers can earn
on average several times more money from selling shares in new
underwritings than they can earn from a secondary-market transaction of
similar size. Interesting point: "Gone are the days (if they ever
existed) when a new issue was a collaborative effort in which a business
that was long on prospects but short on capital could meet investors
with capital in hand but with few good outlets for it. Today the initial
public offering market is where hopes and dreams are capitalized at high
multiples. Indeed, the underwriting of a new security may well be an
overpriced or ill-conceived transaction, frequently involving the
shuffling of assets through 'financial engineering' rather than the
raising of capital to finance a business's internal growth" (22).
- Wall Street
has a short-term focus - concentrate on the current transaction and
worry about the next later. "The utter hipocrisy of Wall Street is
exemplified by the 'equitization' wave of 1991, whereby overleveraged
companies issued equity and used the proceeds to repay debt. Wall Street
collected investment banking and underwriting fees when those companies
were acquired in highly leveraged junk-bond-financed takeovers and
collected large fees again when the debt was replaced with newly
underwritten equity" (24).
- Many Wall
Street firms view their clients' financial success as a secondary
consideration - the short-term maximization of their own income being
the primary one.
- Wall Street
has a strong bullish bias, which coincides with its self-interest.
- Many more
security underwritings can be completed in good markets, and brokers do
more business in a rising market.
- Wall Street
research is strongly oriented toward buy rather than sell
recommendations. Two reasons:
brokerage business to be done when issuing an optimistic research
- Wall Street
analysts don't like to issue sell recommendations due to a reluctance
to say negative things (however truthful they may be) about companies
they follow, since these companies may be current or future
corporate-finance clients of the firm.
prefer rising security prices, as do the companies (more flexibility in
raising capital, higher stock price for management team's stock
regulators of the securities markets impose rules that are biased
toward bullish markets:
institutions (including all mutual funds) are prohibited from selling
stocks and bonds short.
"circuit breakers" (temporarily seize/freeze trading on
various occasions) only apply for downward swings but not upward.
combination of restrictive short-sale rules and the limited number of
investors who are both willing and able to accept the unlimited
downside risk of short-selling increases the likelihood that security
prices may become overvalued" (27).
- "Many of
the same factors that contribute to a bullish bias can cause the
financial markets, especially the stock market, to become and remain
overvalued. Correcting a market overvaluation is more difficult than
remedying an undervalued condition" (28).
innovations are good for Wall Street but bad for clients. They attract
new investors by touting short-term success, which is not a reliable
indicators of the innovations' ultimate merit. "What appears to be
new and improved today may prove to be flawed or even fallacious
tomorrow" (29). "In virtually all financial innovations and
investment fads, Wall Street creates additional supply until it equals
and then exceeds market demand" (30).
- Klarman gives
many examples of new innovations (junk-bonds, Dutch auction bonds, IOs
and POs in the mortgage securities market) and then investment fads
(energy, technology, gambling, warehouse shopping).
market fads come to an end. Security prices eventually become too high,
supply catches up with and then exceeds demand, the top is reached, and
the downward slide ensues. There will always be cycles of investment
fashion and just as surely investors who are susceptible to them"
point I am making is that investors should be aware of the motivations
of the people they transact business with; up-front fees clearly create
a bias toward frequent, and not necessarily profitable,
3: The Institutional Performance Derby: The Client Is the Loser
idea: institutions have a very
short-sighted performance mentality and myriads of obstacles that impede
their performance; investors must understand the institutional investment
mentality because institutions dominate financial-market trading and
because ample investment opportunities may exist in the securities that
are excluded from consideration by most institutional investors.
investment accounts for a very large amount of trading. "Total
funds under management rose from $107 billion in 1950 to more than $500
billion in 1968, to approximately $2 trillion in 1980, and $6 trillion
in 1990. Over the same forty years, the share of institutional ownership
in all publicly traded U.S. equity securities increased from 8 to 45
- Why should
you care? Because all investors today are affected by what institutions
do. Understanding their behavior is helpful in understanding why certain
securities are overvalued while others are bargain priced - enabling
investors to identify areas of potential opportunity.
- The prevalent
mentality among institutions is consensus or groupthink. Acting along
with the crowd ensures an acceptable mediocrity, whereas acting
independently runs the risk of unacceptable underperformance. "Most
money managers consider mediocre performance acceptable" (38).
- A great
majority of institutional investors are plagued with a short-term,
relative-performance orientation and lack a long-term perspective. They
are also impaired by many rules and restrictions (Peter Lynch makes a
strong point about this in One Up on Wall Street).
- Why the
mediocre performance? Most money managers are compensated not according
to the results they achieve but as a percentage of the total assets
under management. The incentive is then to expand managed assets in
order to generate more fees. "Yet while a money management business
becomes more profitable under
management increase, good investment performance becomes increasingly
- The many
obstacles to good institutional investment performance:
short-term, relative-performance derby:
are frequently ranked. This comparative ranking reinforces the
short-term perspective, as the firm is likely to lose customers if it
underperforms in the short run compared to competitors.
also have to often impress pension fund consultants (who select funds
for pension funds to invest into) - which only adds to the short-term
managers motivated to outperform an index or a peer group of managers
may lose sight of whether their investments are attractive or even
sensible in an absolute sense" (39).
- In other
words, money managers often become speculators and forgo objective
money managers don't manage their own money (or very rarely do). This
frees them to pursue their firms' best interests, rather than those of
- Shortage of
time - too much information to look through, too many investors to meet
with - not enough time to do careful analysis of securities being
bureaucratic decision-making process - essentially, conforming is key.
Any institutional investor with an innovative or contrarian investment
idea assumes personal risk within the firm, which compounds the
owned securities is difficult:
investments are illiquid, and disposing of the institutional-sized
positions isn't easy.
creates additional work as sale proceeds must be reinvested into
- The SEC
regards portfolio turnover unfavorably.
analysis process - managers get data on individual companies from
lower-ranked analysts and combine it with their own outlook on various
sectors and markets. So the people making the buy decisions have not
actually analyzed what they will be buying or selling.
money managers, "despite being professionals, frequently fall
victim to the same forces that operate on individual investors: the
greedy search for quick and easy profits, the comfort of consensus, the
fear of falling prices, and all the others" (42).
portfolio size for many firms hurts their returns. Portfolio size
- The return
per dollar invested declines as total assets increase. "The
principal reason is that good investment ideas are in short
- Most of the
major money management firms only consider large-cap securities for
investment. They cannot justify analyzing small and medium-sized
companies in which only modest amounts could ever be invested.
Unfortunately this often automatically excludes thousands of companies
from investment consideration - regardless of individual merit.
investors often impose additional constraints on themselves:
fully invested at all times. This again stems from the necessity of
good short-term performance - idle money must be invested in order not
to underperform the market. This is not good - "In investing,
there are times when the best thing to do is nothing at all"
narrow categorization - strong emphasis on rigidly defined categories
(i.e. bonds, stocks, etc.), whereas many investment vehicles can fit
into multiple categories. This simplifies the job of the managers, but
sometimes makes them miss out on good opportunities. "The
attractive historical returns that draw investors to a particular type
of investment may have been achieved before the category was
identified as such" (45).
dressing - the practice of making a portfolio look good for quarterly
buying shares of the current quarter's best market performers and
selling shares of significant underperformers.
positions with significant unrealized losses so that clients will not
be reminded of the major mistakes month after month.
- Over the past
several years, institutional investors have been trying to abandon
fundamental investment analysis in the favor of certain
"sure-thing" formulas, such as the following…
insurance - selling stock index futures if the market dropped 3% - this
would essentially limit the losses to 3%. Of course this doesn't work
in a volatile market. This contributed strongly to the Black Monday on
October 19, 1987 - so many futures were sold that arbitrageurs were
able to buy the futures and sell the actual stocks, making profit. This
resulted in more futures being sold, reinforcing the cycle.
asset allocation - swapping bonds and stock depending on what looks
more lucrative. The main problem is that neither market is infinitely
deep - vast sums cannot be switched instantaneously. On October 24,
1989, Renaissance Investment Management, Inc. swung $1 billion from
U.S. Treasury bills into the stock market, which drove up prices
- Index funds
- accepting average performance with minimal work. See more on this
- Index funds -
the trend toward mindless investing. Klarman doesn't approve indexing.
- Has become
very popular for institutional investors in the past several years.
Attractive to clients due to low transaction costs and management fees.
- Touted by
those who believe in the efficient-market hypothesis - the theory which
holds that all information about securities is disseminated and becomes
fully reflected in security prices instantaneously - and that therefore
it is futile to try to outperform the market.
contrast, value investing is predicated on the belief that the
financial markets are not efficient. Value investors believe that stock
prices depart from underlying value and that investors can achieve
above-market returns by buying under-valued securities" (51).
- Klarman is
against indexing. He believes that it just another Wall Street fad that
will pass. He also believes that value investors will outperform the
market - choosing to match it is lazy & shortsighted!
- Indexing is
a flawed strategy for several reasons:
as more and more investors adopt it. The idea is predicated on
efficient markets, but the higher the percentage of people who index,
the more inefficient the markets become as fewer and fewer investors
would be performing actual research and fundamental analysis.
arise when stocks in the index must be replaced. The implicit
assumption in indexing is that securities markets are liquid, and that
the actions of indexers do not influence the prices of securities in
which they transact. But this is not true. When a stock is added to an
index, its price often jumps up as indexers rush to buy.
- The above
problem is even more serious in small-cap indexes. "When
small-capitalization-stock indexers receive more funds, their buying
will push prices higher; when they experience redemptions, their
selling will force prices lower. By unavoidably buying high and
selling low, small-stock indexers are almost certain to underperform
their indexes" (52).
self-reinforcing feedback loop has been created, where the success of
indexing has bolstered the performance of the index itself, which, in
turn, promotes more indexing" (53).
4: Delusions of Value: The Myths and Misconceptions of Junk Bonds in the
idea: Klarman uses the
junk-bonds of 1980s as a case study of how poor public perception and the
general ignorance of institutional investors allowed a huge market to
develop from nothing and furthermore continue growing for some time in
the face of the huge losses experienced by the investors.
- This is a
good case study to demonstrate ignorance and delusion. "What is
unique about junk bonds is the speed and magnitude of their rise; their
strong and pernicious influence on other securities, on financial
markets, and on the behavior of businesses; and their continued
popularity in the face of large investor losses" (56).
- Junk bonds
are essentially low-grade bonds - they feature high yields and high risk
- Junk bonds
were touted by Michael Milken, who studied the work of Braddock Hickman
while at Wharton - which essentially showed that a well-diversified
low-grade bond portfolio could earn a greater rate of return than a
high-quality bond portfolio, since the higher yield rates on low-rated
securities would more than compensate for capital losses from defaults
of some of the bonds. Milken took this too far in extrapolating from a
few distressed securities overlooked by others to an entire new type of
- The central
claim was that the risk was low: losses from defaults would be more than
offset by incremental yield. Milken also promised liquidity for the
the claim was false. Newly issues junk bonds had higher default rates
than touted by underwriters, academics, and investors - which means they
had higher risk. However, for a long time, the default rate was kept
- It takes
time to run short of cash - so even the most overleveraged junk-bond
issuers did not default immediately.
underwriters, to postpone "the financial day of reckoning,"
used a trick where they raised as much as 25-50% more cash that was
immediately needed by issuers in order to fund upcoming cash-flow
shortfalls. This helped maintain a low default rate for some time.
issuance of zero-coupon securities (also known as non-cash-pay or
pay-in-kind) - where interest is not paid throughout the life of the
bond, but returned together with the principal at the end. Needless to
say, that reduced the reported junk-bond default rate temporarily.
Needless to say, they defer "the financial day of reckoning"
far into the future. These types of bonds are actually more likely than
cash-pay securities to ultimately default - "they accrue a growing
debt burden that is not being serviced (and is often unserviceable)
from current cash flows" (59).
kept buying junk bonds due to these reported low default rates and to
other various reasons:
alchemy, as described by Louis Lowenstein: "Owners of the junk
bonds issued by the many companies whose interest expenses were greater
than their pretax profits were able to claim to have earned interest
income in excess of the profits earned by the underlying businesses. As
long as investors were willing to purchase bonds on such terms, there
were new underwritings to be done. And as long as the yield illusion
was perpetuated, investors kept buying the bonds" (60).
- Wall Street
created an entire infrastructure around junk bonds. "At the same
time the sermon shifted from the low historical rate of default to a
new theme: junk bonds as the economic salvation of America. Our
country's nagging problems of slow growth, declining productivity, and
diminished international competitiveness would quickly be solved
through increased junk-bond issuance" (61). The argument was that
small unknown companies that are otherwise unable to attract capital
would now be able to get capital and grow, innovate, and create jobs.
- Junk bonds
were used very heavily in the highly-leveraged financial takeovers,
where firms could buy almost any company in the country (RJR Nabisco
LBO for $25 billion in 1988 by KKR).
bond mutual funds catered to "yield-pigs," gladly buying
low-quality junk bonds to boost their short-term reported performance
- Thrifts and
insurance companies also found good use of junk bonds.
junk-bond buyers were assuming that the economy and the junk-bond market
would continue expanding. "Many junk-bond issuers, for example, had
razor-thin or nonexistent interest coverage (ratio of pretax earnings to
interest expense) and insufficient cash flow to meet upcoming
debt-principal repayments" (63) - but they believed that business
would continue growing and things would be ok.
- Junk bonds
also led to companies being grossly overvalued in buyouts.
"Regardless of any possible merits of earlier issues, the junk
bonds of the late 1980s were bound to fail simply because the issuers
were routinely overpaying for corporate assets" (64).
standards were relaxed:
securities (as described above) were heavily used, allowed takeover
artists to engage in financial recklessness: "had the buyer of a
highly leveraged business expected to pay cash interest from day one on
the debt incurred in the purchase, his or her bid would have been
modulated to chronologically match expected cash inflow with cash
debt-service requirements" (67).
rate resets - which promised the coupon rate to be adjusted at a
specified future date to cause the bond to trade at par. KKR used these
in their RJR Nabisco buyout - and the guarantee of interest rate resets
essentially convinced the sellers to go with KKR's bid rather than that
of the management group (in part, at least… the other reasons included,
for example, the public dislike of Ross Johnson, as described in Barbarians at the Gate).
misconception that junior debt provided a degree of protection.
"Emphasis on the junior claims against a company is a greater-fool
argument, wherein one takes comfort from the potentially foolish
actions of others rather than from the wisdom of one's own" (71).
- A flawed
definition of cash flow - via the EBITDA - led to overvaluation.
- In their
haste to analyze free cash flow, investors in the 1980s frequently
used the EBITDA.
describes in detail why the EBITDA is a flawed measure of cash flow.
For example, you can't just assume that depreciation expense (unlike
amortization) represents a portion of free cash flow, because often
that money needs to be reinvested into the business equipment to
remain competitive - capital expenditures are a direct offset to
company X and manufacturing company Y may have the same EBITDA but
different EBIT - because company Y must reinvest its depreciation
allowance (or possibly more due to inflation) back into the business
to replace its worn-out machinery. It may have no free cash flow over
time, whereas company X has no capital-spending requirements and has
free cash flow (that can be used to pay off debt in a corporate
takeover). Even though both have the same EBITDA, the EBIT are
different, and buying company Y on a leveraged basis is a bad idea.
may have been used as a valuation tool because no other valuation
method could have justified the high takeover prices prevalent a the
time. This would be a clear case of circular reasoning. Without
high-priced takeovers there were no up-front investment banking fees,
no underwriting fees on new junk-bond issues, and no management fees
on junk-bond portfolios. This would not be the first time on Wall
Street that the means were adapted to justify an end. If a
historically accepted investment yardstick proves to be overly
restrictive, the path of least resistance is to invent a new
standard" (74). Hah!
- Note: it seems that the cash flow statement only became a
mandatory financial statement in 1987/1990 (which one is correct?),
which is why before 1990 cash flow had to be calculated manually via
various methods - such as EBITDA, etc. The EBITDA is not true cash
flow also because it doesn't take into account changes in accounts
receivable, inventory, prepaid expenses, accounts payable, income tax
payable, and accrued expenses payable (John Tracy, How to Read A Financial Report - p.82-83).
- So, junk
bonds were a poor investment, contrary to the promises of underwriters.
They offered too little return for their substantial risk. As the
junk-bond market collapsed in 1990, investors couldn’t get out. So, why
do we care about this today? Because:
bonds had a pernicious effect on other sectors of the financial markets
and on the behavior of most financial-market participants. The
overpricing of junk bonds allowed many takeovers to take place at
inflated valuations" (77).
- This is not
the first or the last investment fad on Wall Street.
- Part 2: A Value-Investment Philosophy
5: Defining Your Investment Goals
idea: the main concern of a
risk-averse investor (which is almost everyone) should be to avoid loss
of capital; rather than targeting a desired rate of return, investors
should target risk.
Buffett's first rule of investing: "Don't lose money." Looks
very similar to what Phil Town describes in Rule #1 - I wonder if he borrowed Buffett's idea.
Klarman also believes that "avoiding loss should be the primary
goal of every investor" (81). Essentially this means that over
several years, and investment portfolio should not be exposed to an
appreciable loss of capital.
- Today many
people believe that risk in not from owning stocks, but from not owning
them - because you miss out on market returns. This is manifested by the
indexing strategy and by institutional investor's tendency to be fully
invested at all times. This is because people believe that stocks offer
higher returns for higher risk.
- There is
certainly an element of truth to the idea. Stocks over time offer higher
returns than other investment vehicles (money market, bonds, etc.) and
stocks do have certain risks. They are junior in company's capital
structure - meaning that, in a corporate liquidation, liabilities
(including bonds) must be satisfied first, and then equity receives
whatever is left over.
- So you need
to be very careful when analyzing risks involved. For an investor, loss
avoidance should be the cornerstone of investment philosophy.
- Why is loss
so bad? Because of the effects of compounding. It is very difficult to
recover from a large loss. "An investor is more likely to do well
by achieving consistently good returns with limited downside risk than
by achieving volatile and sometimes even spectacular gains but with
considerable risk of principal" (83).
avoidance is not the primary concern of most institutional investors,
because they need to display great short-term performance, so as to keep
and attract clients.
- It is silly
to target a certain desired rate of return, because no one can predict
the future. You need to be prepared for unexpected and unpredictable
adversity, even if it forces you to forgo some near-term return.
that you want to earn, say, 15 percent a year, does not tell you a thing
about how to achieve it. Investment returns are not a direct function of
how long or hard you work or how much you wish to earn" (85). An
investor can't just decide to think and work harder to achieve higher
returns from stocks is also futile because "while the value of a
stock is ultimately tied to the performance of the underlying business,
the potential profit from owning a stock is much more ambiguous.
Specifically, the owner of a stock does not receive the cash flows from
a business; he or she profits from appreciation in the share price,
presumably as the market incorporates fundamental business developments
into that price" (85). And this will usually only occur in the long
targeting returns leads investors to focus on upside potential rather
than on downside risk.
6: Value Investing: The Importance of a Margin of Safety
idea: this chapter concentrates
on the ideas behind value investing and how it works, and why a margin of
safety is crucial; essentially, value investing is buying securities at a
discount from current underlying values, creating a margin of safety to
safeguard against losses - this requires discipline (to avoid
unattractive opportunities), patience (to wait for the right one), and
judgment (to know when the time and value are right).
investing is the disciple of buying securities at a significant discount
from their current underlying values and holding them until more of
their value is realized. The element of a bargain is the key to the
process" (87) - this is the basic idea.
disciplined pursuit of bargains makes value investing very much a
risk-averse approach. The greatest challenge to value investors is
maintaining the required discipline. Being a value investor usually
means standing apart from the crowd, challenging conventional wisdom,
and opposing the prevailing investment winds. It can be a very lonely
undertaking. A value investor may experience poor, even horrendous,
performance during prolonged periods of market overvaluation. Yet over
the long run the value approach works so successfully that few, if any,
advocates of the philosophy ever abandon it" (88).
- A value
investor must be very patient. Buffett uses a baseball analogy with many
- You have
infinite patience and are willing to wait for the right pitch.
- You can't be
influenced by the way others are swinging/performing - you should only
be motivated by your own results.
investors don't own businesses they don't understand or consider risky -
technology companies (too risky), commercial banks (unanalyzable
assets), property and casualty insurance companies (unanalyzable assets
and liabilities). Note - Buffett actually owns a lot of property and
- An investment
must be purchased at a discount from underlying worth, making it a good
absolute value. However, you must choose the best absolute value among
those currently available. You should also never be afraid to reexamine
current holdings as new opportunities appear, even if you realize losses
on selling current holding (this seems like a contradiction to Klarman's
rule of not losing money - but I guess he means that these losses would
be short-term, and would be more than made up by the new investment
- Valuating a
business can be very complex - how can you ever be sure that you are
buying at a discount?
truth is, you cannot" (90).
due to various conditions, business value can decrease - which is a
"dagger at the heart of value investing" (91). For this
reason, you must buy at a discount (providing a margin of safety).
- The 3 things
you can do to ensure that you're buying at a discount:
valuation conservatively, giving considerable weight to worst-case
liquidation value as well as to other methods.
- Demand a
greater than usual discount between price and underlying value
(especially if you fear deflation) in order to make new investments or
to hold current positions.
the time frame of investments and if there is a catalyst for the
realization of underlying value. "In a deflationary environment,
if you cannot tell whether or when you will realize underlying value,
you may not want to get involved at all. If underlying value is
realized in the near-term directly for the benefit of shareholders,
however, the longer-term forces that could cause value to diminish
become moot" (92).
importance of margin of safety.
Graham was only interested in buying at a discount. "By investing
at a discount, he knew that he was unlikely to experience losses. The
discount provided a margin of safety" (92).
- A margin of
safety is achieved when "securities are purchased at prices
sufficiently below underlying value to allow for human error, bad luck,
or extreme volatility in a complex, unpredictable, and rapidly changing
description: "When you build a bridge, you insist it can carry
30,000 pounds, but you only drive 10,000-pound trucks across it. And
that same principle works in investing" (93).
- Tangible vs.
investors like Warren Buffett recognize the value of intangible assets
(broadcast licenses, soft-drink formulas, etc.).
believes that intangible assets don't provide enough margin of safety
- tangible assets in certain business may be, for example, sold at a
- So, how do you make certain of achieving a margin of safety?
- Always buy at a significant discount to underlying business
- Give preference to tangible assets over intangibles.
- Replace current holdings as better bargains come along.
- Sell when the market price of any investment comes to reflect
its underlying value.
- Hold cash, if necessary, until other attractive investments
- "It is
critical to know why you have made an investment and to sell
when the reason for owning it no longer applies" (94) - same idea
as Peter Lynch describes - you should be able to give a 2-min summary
describing why you are buying/selling. General advice on investments:
- Look for
investments with catalysts that may assist directly in the realization
of underlying value.
preference to companies having good managements with a personal
financial stake in the business/company.
your holdings and hedge when it is financially attractive to do so.
investing shines in a declining market.
owned by value investors are not bid up due to high expectations (and
possibly torpedo down). They are stocks that are usually ignored - some
sell below net working capital per share, some below net cash per
share, some at a very low multiple of current earnings and cash flow.
- In a
declining market, "whenever the financial markets fail to fully
incorporate fundamental values into securities prices, an investor's
margin of safety is high" (97). While stocks fall, the securities
priced to reflect their depressed fundamentals have little or no room
to fall further. If either public perception changes or when
fundamentals improve, investors will benefit.
investing is predicated on the efficient-market hypothesis being wrong,
since it is based on the idea that markets are inefficient - i.e. some
securities are mispriced.
- There are 3
forms of the efficient-market hypothesis:
- Weak: past
prices provide no useful information on future prices (i.e. technical
analysis is worthless).
no published information will help investors to select undervalued
securities since the market has already discounted all publicly
available information into securities prices.
there is no information, public or private, that would benefit
implication of the semistrong and strong forms is that fundamental
analysis is useless - which means that investors might as well just
buy/sell stocks at random.
strongly believes that only the first form is valid - technical
analysis is a waste of time.
- The other
two forms are not really valid. "There is simply no question that
investors applying disciplined analysis can identify inefficiently
priced securities, buy and sell accordingly, and achieve superior
stock pricing tends to be more efficient than small-cap stock and
distressed bond pricing. This is because lots of analysts follow IBM
but few cover small-cap stocks and obscure junk bonds. Therefore,
investors are more likely to find inefficiently priced securities
outside large-cap indexes.
- So, why are the markets inefficient? Many reasons, the
most obvious being that securities prices are determined in the short
run by supply and demand. Examples:
- A company
that reported disappointing results might be dumped by investors who
focus exclusively on earnings, depressing the price below underlying
investor unable to meet a margin call can't hold to full value -
forced to sell.
selling of a low-priced small-cap spin-off, for example, can cause
temporary supply-demand imbalance, resulting in a security being
tax selling and quarterly window dressing can also cause market
central tenet of value investing is that over time the general tendency
is for underlying value either to be reflected in securities prices or
otherwise realized by shareholders" (101). This won't happen right
away, but is rather the long-term expectation. Many forces help make
this happen - share issuance or repurchase, subsidiary spin-offs,
recapitalizations, liquidation or sale of business, hostile takeovers
and proxy fights.
- Beware of
value pretenders - in the last half of 1980s, value pretenders gained
widespread acceptance and earned high returns. However, they are
"charlatans who violate the conservative dictates of value
investing, using inflated business valuations, overpaying for
securities, and failing to achieve a margin of safety for their
clients" (103). This only works in rising markets!
7: At the Root of a Value-Investment Philosophy
idea: there are 3 central
elements to a value-investment philosophy - value investment is a
bottom-up strategy, absolute-performance (not relative-performance)
oriented, and a risk-averse approach; throughout all three elements, the
concept of holding cash is important so as not to forgo opportunities.
- As discussed
earlier, many professional investors use a top-down approach, which
involves making a prediction about the future, ascertaining its
investment implications, and then acting upon them. There are several
problems with this approach:
- It is
essentially trying to predict the unpredictable more accurately and
faster than thousands of other people who are trying to do the same
- There is no
margin of safety in top-down investing. Decisions are not based on
value of underlying business, but rather on concept, theme, and trend.
- Hard to
gauge the level of expectations already reflected in the company's
current share price.
- By contrast,
the bottom-up strategy used in value investing identifies opportunities
one at a time through fundamental analysis. A top-down view is only
considered in how it affects the valuation of securities.
difference between the two approaches: bottom-up investors hold cash
when they are unable to find attractive investment opportunities,
whereas top-down investors are usually fully invested, trying to time
investors investors can easily determine when the original reason for
making an investment ceases to be valid. When the underlying value
changes, when management reveals itself to be incompetent or corrupt,
or when the price appreciates to more fully reflect underlying business
value, a disciplined investor can reevaluate the situation and, if
appropriate, sell the investment" (108). Top-down investors, on
the contrary, may find it difficult to know when their bet is no longer
performance is concerned with matching or beating a certain index - it
is often a short-term view. Value investors are absolute-performance
oriented, taking on a long-term perspective.
performance chases near-term results and often avoids attractive
absolute returns over the long run if that risks near-term
underperformance. Absolute performance, on the other hand, prefers
out-of-favor holdings that may take longer to come to fruition - but
also carry less risk.
investors are willing to hold cash reserves
(relative-performance-oriented investors must invest it at least into a
market index in order to not fall behind the benchmarks in the
near-term), because it is liquid and hence can be channeled into other
investment outlets - cash does not involve any risk of incurring
opportunity cost (loses from the inability to take advantage of future
bargains) since it is highly liquid (and hence always available for you
to use) and does not drop in value during market declines (as, for
example, an investment in a market index would.
- Some insist
that risk and return are always positively correlated - the greater the
risk, the greater the return. This is a basic tenet of the
capital-asset-pricing model taught in business schools.
this only holds true in an efficient market. "In inefficient
markets it is possible to find investments offering high returns with
low risk" (110).
Likewise, it is possible to find high-risk investments that offer low
returns (remember, financial markets are biased toward overvaluation).
- Because of
this, investors can't simply select a level of risk and expect a
certain return. "Risk and return must instead be assessed
independently for every investment" (111).
- The nature
of risk is tricky:
the risk of an investment is described by both the probability and the
potential amount of loss. Risk depends on both the nature of the
investments (biotech research vs. utility equipment purchase) and on
their market price - which is different from the faulty (in Klarman's
opinion) definition of beta.
and market professionals use the concept of beta to quantify risk.
compares a security's or portfolio's historical price fluctuations
with those of the market as a whole (the market's beta is taken to be
dislikes this, because beta views risk solely from the perspective of
market prices - it fails to consider specific business fundamentals
or economic developments. Also, the price level is ignored (i.e.
buying IBM at $50/share has the same risk as buying IBM at
reality is that past security price volatility does not reliably
predict future performance (or even future volatility) and therefore
is a poor measure of risk" (113).
- You can't
really ever know the risk - either before or after an investment is
concluded, unlike the return - which you know for certain afterwards
(i.e. after selling).
- You must
always remember this. "There are a few things investors can do to
counteract risk: diversify adequately, hedge when appropriate, and
invest with a margin of safety. It is precisely because we do not and
cannot know all the risks of an investment that we strive to invest at
a discount. The bargain element helps to provide a cushion for when
things go wrong" (112).
price fluctuations - what does this entail for value investors?
price fluctuations are not really a risk in the same sense that a
permanent value drop is. In the long run, value will ultimately be
reflected in the price of a security - no need to worry near-term if
you did your research and bought the security at a discount (i.e. with
a margin of safety).
short-term price fluctuations are important for value investors,
- If you need
to sell in a hurry, you are at the mercy of market prices. "The
trick of successful investors is to sell when they want to, not when
they have to" (114).
- If you
invested in a troubled company that needs to raise additional capital,
this company may have trouble raising the capital it needs, as what it
gets is determined by the current stock and bond prices.
- Mr. Market
can create very attractive opportunities to buy and sell. If you are
holding cash, you can take advantage of these opportunities - this is
why it's important to hold cash. "Maintaining moderate cash
balances or owning securities that periodically throw off appreciable
cash is likely to reduce the number of foregone opportunities"
8: The Art of Business Valuation
idea: it's difficult to get a
precise valuation of a business - thorough analysis should be performed
(Klarman recommends 3 methods) depending on the specific case, and the
investor should always be conservative (to maximize the margin of
safety); if a business can't be valued, better to skip it and stick with
what you know.
value cannot be precisely determined. Even though the NPV and IRR
calculations provide accurate summary numbers, these tools are of no use
in determining the likelihood that the investors will actually achieve
the projected returns. In other words, they can be misleading if all the
cash flows are not contractually determined and not all payments are
received when they are due.
businesses don't have contractual cash flows (unlike bonds), there is
usually a range of values that investors can come up with. Benjamin
Graham agreed with this in Security Analysis and urged to find not the exact value of the security, but
rather whether it is considerably higher or lower than the market price.
asset being bought and sold this has a possible range of values bounded
by the value to the buyer and the value to the seller; the actual
transaction price will be somewhere in between" (121).
- Out of many
business valuation methods that exist, Klarman suggests only 3 that he
finds useful. When the results diverge, he suggests that investors err
on the side of conservatism. The methods are:
- Net present
value (NPV) - the discounted value of all future cash flows that a
business is expected to generate.
- Works best
when future cash flows are predictable and an appropriate discount
rate can be chosen - this is when NPV analysis is one of the most
accurate and precise valuation methods.
this is rare and difficult:
cash flows are hard to predict - "a recurring theme in this book
is that the future is not predictable, except within fairly wide
growth is already anticipated and therefore discounted in securities
prices, shortfalls will cause share price declines - and loss for
- Growth, a
single number, actually depends on a huge number of factors.
unresolvable contradiction exists: to perform present-value analysis,
you must predict the future, yet the future is not reliably
- How do
investors deal with this? The answer is: conservatism. "Investors
are well advised to make only conservative projections and then invest
only at substantial discount from the valuations derived
rate is the rate of interest that would make an investor indifferent
between present and future dollars. "Investors with a strong
preference for present over future consumption or with a preference
for the certainty of the present to the uncertainty of the future
would use a high rate of discounting their investor. Other investors
may be more willing to take a chance on forecasts holding true; they
would apply a low discount rate, one that makes future cash flows
nearly as valuable as today's" (126).
- In other
words: low risk = low rate, high risk = high rate.
considers a short-term risk-free rate that of short-term U.S.
Treasuries. "My view is to match the timing of the cash flows to
the maturity of the U.S. Treasury security" (146).
rate is influenced by fluctuations in interest rates.
interest rates are unusually low, share prices will be trading at high
multiples - so value investors should be reluctant to commit their
capital in such a market.
value - you can try to compare the business you are valuating to a
similar one that was recently bought by someone else. Can be useful
for comparison, but has problems:
- Not all
companies are the same, even within a given business or industry.
paid to acquire businesses vary over time - even across nearby
- Buyers of
businesses do not necessarily pay reasonable intelligent prices (late
value - the expected proceeds if a company were to be dismantled and
the assets sold off.
assessment in which only tangible assets are concerned (intangibles
is usually a worst-case assessment. Some are break-ups, some are quick
liquidations (fire sales), some are orderly over a long time - where
the liquidation of current assets will yield value close to the stated
book value. But many factors are considered - for example, inventories
may contain outdated product.
- Graham uses
the "net-net working capital" to approximate the liquidation
value of a company. Net working capital consists of current assets
less current liabilities (accounts, notes, and taxes payable within
one year). Net-net-working capital is net working capital minus all
the long-term liabilities.
important to consider off-balance sheet liabilities - underfunded
pension plans, as well as liabilities incurred in the course of the
- Stock market
value - an estimate of the price at which company (or its subsidiaries
considered separately) would trade in the stock market.
- Useful in
certain cases when valuating
companies like closed-end mutual funds, whose assets consist of
securities that could be sold on the stock market.
the stock market's appraisal for the newspaper industry would be of
some use, however, in estimating the near-term trading price of the
newspaper subsidiary about the be spun off to the shareholders of a
media conglomerate" (135).
- So, which
method should you chose? It depends.
- Net present
value - valuing a high-return business with stable cash flows (such as
a consumer-products company); its liquidation value would be too low.
- Net present
value - valuing a business with regulated rates of return on assets
such as a utility.
- valuing an unprofitable business whose stock trades well below book
- Stock market
value - valuing a closed-end fund or other company that owns marketable
different portions of a complex business should be valued by different
methods. Ideally, use all possible methods to get multiple viewpoints
of the business you are valuating.
- Theory of
reflexivity by George Soros - a company's stock price can at times
significantly influence the value of a business. This occurs when a
company needs to expand, for example - and may have difficult time
selling more shares in a secondary offering if its stock is trading too
low. Reflexivity is a minor factor in valuation.
conventional valuation methods also exist. These can be considered as
one component of a more thorough and complete analysis, but nothing
- Earnings and
subject to manipulation and accounting vagaries - due to GAAP.
- Cash flow
is really a better way to measure the true economics of a business.
- Book value
historical accounting of shareholder's equity (assets minus
something cost in the past is not necessarily a good measure of its
value today" (144).
- Plants and
equipment could be outdated. However, fully depreciated plant and
equipment may have carrying value below real economic value. Real
estate could also be either undervalued or overvalued in the books -
depending on how times, regulations, and laws have changed.
- "As a
result of accounting rules and discretionary management actions, two
companies with identical tangible assets and liabilities could have
very different reported book values" (145).
yield is a "relic" - stocks should not be bought on the
basis of their dividend yield.
- A high
dividend yield paid by some companies may be not a return on invested
capital but rather a return of invested capital that represents
liquidation of the underlying business.
- Part 3: The Value-Investment Process
9: Investment Research: The Challenge of Finding Attractive Investments
idea: there are some good places
to find hidden opportunities - many created by restrictions and
constraints posed onto institutional investors; you will never know
everything about a business, so don't waste time doing more research
(diminishing returns) if that will cause you to lose the opportunity to
buy in while still adhering to a margin of safety; watch for insider
buying; keep in mind that value investing is contrarian by nature.
investment ideas are rare and valuable things, which must be ferreted
out assiduously" (151).
investing encompasses several niches that can be divided into three
selling at a discount to breakup or liquidation value
technologies can help identify these.
- But it
seems like in today's super-connected world, these would be difficult
arbitrage and complex securities.
tender offers, and other risk-arbitrage transactions - can be found in
Street Journal and the
business section of the New York Times - and other publications.
distressed and bankrupt securities, corporate recapitalizations, and
exchange offers - in this category, investors' existing holdings are
exchanged for new securities.
quotations may only be available from dealers since many of these
securities are not listed on any exchange" (153) - I wonder how
true that is today.
undervalued securities don't fall into any of the above categories.
Looking at stocks on the Wall Street Journal's leading percentage-decline and new-low lists can help find
out-of-favor investment ideas. Same occurs with companies that stop
opportunities can also be created by institutional sellers (as described
earlier, as well):
institutional investors cannot legally purchase spin-offs.
- They also
won't engage in risk-arbitrage transactions since their mission is to
"invest in ongoing businesses, not speculate on takeovers"
companies whose shares are closely held and infrequently traded are not
followed closely - because institutional investors don't typically
invest in them, as mentioned before.
- Year-end tax
selling - also as mentioned before.
- "Obscurity and a very thin market can cause stocks to
sell at depressed levels" (155).
- After you
find a bargain, it is crucial to find out why it is a bargain - you need to inspect it for flaws.
"Perhaps there are contingent liabilities or pending litigations
that you are unaware of. Maybe a competitor is preparing to introduce a
superior product" (154).
- How much
research and analysis is sufficient?
- You will
never know everything. That doesn't mean you should never invest,
spending too much time on research is subject to diminishing returns -
"the first 80 percent of the available information is gathered in
the first 20 percent of the time spent" (157).
frequently benefit from making investment decisions with less than
perfect knowledge and are well rewarded for bearing the risk of
time other investors spend delving into the last unanswered detail may
cost them the chance to buy in at prices so low that they offer a
margin of safety despite the incomplete information" (158). Don't forget the margin of
- Watch insider
buying and management stock options. While there are many reasons for
insiders to sell, there is only one reason to buy - if they believe the
business will succeed (Peter Lynch says the same thing in One Up on Wall Street).
- Laws and
guidelines on inside information are ambiguous, so tread carefully in
this area - what you hear from a corporate executive or investment
banker may not be public information.
investing is by nature contrarian, which means that you don't follow the
crowd but do the contrary thing form it. Out-of-favor securities may be
undervalued and popular securities are usually overvalued. Hence you are
going against the herd. Since you're acting against the crowd, you are
almost always initially wrong and likely to suffer some paper losses for
a time - it takes time to see gains.
10: Areas of Opportunity for Value Investors: Catalysts, Market
Inefficiencies, and Institutional Constraints
idea: invest into securities
with catalysts, if possible; liquidations, complex securities, rights
offerings, risk arbitrage, and spinoffs can present excellent
opportunities for value investors.
investors prefer investments with catalysts, which are essentially
events that cause value to be realized by the shareholders. Catalysts
can be internal (decision to liquidate) or external (fight for control
of the board driving up share price).
- The presence
of a catalyst reduces risk: "If the gap between price and
underlying value is likely to be closed quickly, the probability of
losing money due to market fluctuations or adverse business
developments is reduced. […] Owning securities with catalysts for value
realization is therefore and important way to for investors to reduce
the risk within their portfolios, augmenting the margin of safety
achieved by investing at a discount from underlying value" (164).
that bring about total value realization (orderly sale or liquidation)
for partial value realization (corporate spinoffs, share buybacks,
recapitalizations, major asset sales) still server two important
- They do
help realize the underlying value.
- A company
that takes action resulting in partial realization of value shows that
the management is shareholder oriented and will pursue additional such
strategies in the future.
companies voluntarily liquidate in order to preempt a total wipeout of
shareholder value, especially when they lack other viable alternatives.
- Others are
motivated by tax consideration, persistent stock market undervaluation,
or the desire to escape a corporate raider.
investors shy away from liquidations. Most equity investors prefer (or
are sometimes required) to hold shares in an ongoing developing
business, not one that's being liquidated. Some believe the process to
be too complicated, uncertain, and protracted. Because of this,
corporate liquidations can present particularly attractive
opportunities for value investors.
gives an example of the City Investing Liquidating Trust, which was
selling at $3 per unit in 1985 with an underlying value of at least
$5.02 per unit. The Trust was delisted from the NYSE, so trading became
hard - over-the-counter, with no real-time quotes. This facilitated
further selling. Value investors that bought make over 3x their
investment by 1991 (with most of the value early).
define complex securities as those with unusual contractual cash flow
characteristics" (168). These securities typically distribute cash
according to some contingent event - for example, a certain level of
earnings, the price of a particular commodity, or the value of
- As a result
of obscurity and uniqueness, complex securities are great opportunities
to value investors.
gives examples with Bank of America and Seafirst Corporation, and
Marion Laboratories and the Dow Chemical Company. Essentially, these
cases were too complex and unusual for most investors to valuate (both
institutional and individual) - so which meant very limited demand,
securities are great because most investors find them too… complex.
This area presents a "fertile ground for bargain hunting"
(170). But keep in mind that not all complex securities are great
investments - some may be too overpriced or actually too difficult to
- In a rights
offering, unlike in a typical underwritten share offering (where buying
by new investors dilutes the percentage interest of current
shareholders), shareholders are given the opportunity to preserve their
proportional interest in the issuer by subscribing to additional
- For example,
XYZ is a closed-end mutual fund with 1 million shares outstanding,
which trade at a price equal to the fund's NAV of $25. XYZ wants to
raise $15 million for market opportunities, and issues every holder a
nontransferable right to buy another XYZ share for $15. If everyone
subscribes, then afterwards XYZ will have 2 million shares outstanding
at $20 per share. Every shareholder's interest in the company is
preserved. For example, if 50,000 holders didn't exercise their right,
the 1,950,000 shares outstanding afterwards would trade at $20.13. The
investors who subscribed have an average cost of $20 per share, while
those who didn't - average cost of $25. "Since nonsubscribers will
suffer an immediate loss of almost 20 percent of their underlying
value, all holders have a powerful incentive to subscribe" (171).
- Some right
offerings allow holders to oversubscribe beyond their own proportional
interest for shares that other didn't buy. In the above example,
someone could have bought the 50,000 shares at the original offering at
$15 per share and then sold immediately afterwards at $20 per share -
making a quick $250,000.
companies employ rights offerings to effectuate initial public
offerings in subsidiaries. Klarman gives an example in which
Consolidated Oil & Gas Inc. took its Princeville Development
Corporation public, offering the right to purchase one share of
Princeville for each share of Consolidated owned. There was some
obscurity and little public information available, so some were able to
make enormous profits - rights bought for as little as 1.5 cents rose
in price to $2. The market price of Princeville shares rose to $5 per
arbitrage involves in investing in takeover transactions - sometimes
also spinoffs, liquidations, and corporate restructurings.
arbitrage differs from the purchase of typical securities in that
gain/loss depends on the successful completion of a business
transaction rather than any fundamental developments. The return is
determined by the spread between the price paid by the investor and the
amount to be received if the transaction is successfully completed.
describes the takeover of Becor Western Inc. by B-E Holdings, Inc, in
which B-E's offer for Becor included multiple things, which perhaps
made the underlying value difficult to evaluate.
arbitrage comes in cycles - for example, in the late 1980s when
takeovers were huge, but then immediately stopped in early 1990s as
junk bonds fell out of favor. Klarman makes a point that risk-arbitrage
is not a sudden market fad.
arbitrage investments, which offer returns that generally are unrelated
to the performance of the overall market, are incompatible with the
goals of relative-performance-oriented investors. Since the great
majority of investors avoid risk-arbitrage investing, there is a
significant likelihood that attractive returns will be attainable for
the handful who are able and willing to persevere" (177).
- Spinoffs - a
great area of opportunity!
spinoff is a distribution of the shares of a subsidiary company to the
shareholders of the parent company. A partial spinoff involves the
distribution (or, according to the definition of some analysts, the
initial public offering) of less than 100 percent of the subsidiary's
- The basic
goal of a spinoff is to create parts with a combined market value
greater than the whole.
investors sell their shares in spinoffs right away:
investors can't keep them since they might be too small, trade at too
low of prices, or the company may not belong to any index - for index
investors don't know anything about the company.
- Wall Street
analysts don't usually follow spinoffs - too small cap, the spinoff is
likely to be in a different line of business than the parent, and too
much work already for analysts.
spinoffs try to artificially keep the stock low initially to realize
stock options. While this may attract corporate raiders, there are
usually anti-takeover provisions inserted into the corporate bylaws of
many spinoffs to protect management from corporate predators. This is a
great time to buy in.
gives an example of InterTAN being spun off from Tandy Corporation in
1986. InterTAN was trading at $11 per share, with a working capital of
$15 per share, and even the net-net working capital after all debt of
roughly $11 per share. The company itself was also profitable in
Australia and Canada, and value investors found a great opportunity
here. Institutional investors dumped it since owning a $40 million
chunk (a typical block of money to be invested into one company, for
example) would constitute 45% of InterTAN! Perfect example of a company
too small for institutions and not followed by anyone (so their
profitable operations were hidden by their losses in Europe).
11: Investing in Thrift Conversions
idea: mutual thrift conversions
offer excellent opportunities to value investors, as the process doesn't
dilute value (as in regular IPOs) but rather adds pre-existing net worth
of the institution to the investor's money.
1983 the conversion of hundreds of mutual thrift institutions to stock
ownership has created numerous opportunities for value investors.
Negative publicity coupled with the economics of thrift conversions
served to unduly depress the share prices of many thrifts" (182). I
wonder how applicable that is today. A Google search on thrift
institutions didn't come up with many results. Can credit unions go
- In a typical
IPO, all pre-offering shares are owned by insiders, who typically bought
in early at a very small price. When the company goes public, the
public's investment is diluted by these pre-offering shares. For example
- company XYZ has 1 million shares, which insiders bought at $1 per
share. When XYZ goes public, it offers 1 million new shares at $11 each.
Afterwards, there are 2 million shares with the company's proceeds of
$12 million. The book value of the company stock is then $6 per share (of
course, this doesn't reflect the public's expectations of growth in the
company - just the book value).
- In a thrift
conversion, the original net worth of the institution is added to the
funds injected by investors. In other words, as an investor, you're not
just getting your money's worth, but also some extra equity. For
example, institution ABC worth $10 million might issue 1 million shares
of stock at $10 per share. The proceeds are $10 million, resulting in
shareholder's equity of $20 million. The net worth is $20 per share -
greater than the investors' contribution.
- As long as
the thrift has positive business value before the conversion, this is
great for investors. "The conversion proceeds are added to the
preexisting capital of the institution, which is indirectly handed to
the new shareholders without cost to them. In a real sense, investors in
a thrift conversion are buying their own money and getting the
preexisting capital in the thrift for free" (184).
- In thrift
conversions, insiders must buy shares alongside the public at the same
price - and this is fully disclosed ahead of time (including both the
volume and price of insider buying).
- Of course,
you have to carefully analyze the thrift. You don't want to invest in a
thrift that has negative pre-conversion shareholder value!
"Investors, as always, must analyze each potential thrift
conversion investment not as an instance of an often attractive market
niche but individually on its merits' (186).
- When you are
doing the analysis, make sure you understand the thrift's business and
assets. "A simple rule applies: if you don't quickly comprehend
what a company is doing, then management probably doesn't either. This
initial test limits investors to low-risk thrifts" (185).
12: Investing in Financially Distressed and Bankrupt Securities
idea: investing in bankrupt
companies is a very complex task requiring careful analysis and
consideration of extra factors; it can yield great results, especially
due to the low number of investors willing to undertake such an
investment and due to the stigma attached to bankruptcy, but it can also
be very dangerous (do not buy common stock of bankrupt securities - too
don't like investing in financially distressed companies - they see them
as risky and imprudent. "Financially distressed and bankrupt
securities are analytically complex and often illiquid. The
reorganization process is both tedious and highly uncertain. Identifying
attractive opportunities requires painstaking analysis; investors may
evaluate dozens of situations to uncover a single worthwhile
financially distressed and bankrupt companies, there are even more
issues to consider: the effect of the distress on business results, the
availability of cash to meet upcoming debt-service requirements,
restructuring alternatives, the full reorganization process.
- Companies get
into financial trouble for at least of one three reasons: operating,
legal, or financial problems.
distress is characterized by a shortfall of cash to meet operating needs
and scheduled debt-service obligations. When this happens, suppliers
cease shipments, customers stop buying, employers leave for more secure
and less stressful jobs - this exacerbates the situation. A successful
exchange offer, an injection of fresh capital, or a bankruptcy
reorganization can fix a business, returning it to high levels of
- A holding
company can file for bankruptcy protection while their subsidiaries
continue to operate unimpaired.
- An issuer of
debt securities has 3 options during financial distress:
- Continue to
pay principal and interest when due - this can be done with cost
cutting, asset sales, or an infusion of outside capital. Usually this
can help in the short run, but in the long run it may hurt
relationships with customers, suppliers, and employees and result in a
diminution of business value.
- Offer to
exchange new securities for securities currently outstanding - usually
for outstanding debt securities and preferred stock.
- These are
difficult to complete due to the "free-rider" problem (or
the "prisoner dilemma" which means that not knowing what
others will do may guide you to the safer worst case chase) - the
value of "holding out" can be greater than the value of
going along with the restructuring, as long as the restructuring takes
place (i.e. enough have to accept the restructuring). Some will make
the sacrifice, but some will not. Even if you made the sacrifice, the
restructuring may fail and you will be worse off since you would now
have a smaller claim in bankruptcy. If you don't sacrifice, and the
restructuring still goes through, you're much better off.
- A way
around the free-rider problem to through a prepackaged bankruptcy, in
which creditors agree to a reorganization plan prior to bankruptcy
- File for
court protection under Chapter 11 of the federal bankruptcy code and
attempt to reorganize the debtor with a more viable capital structure.
- In a
bankruptcy, once new lenders can be assured of their senior creditor
position, they can inject capital. And since, under court protection,
payments to employees, lenders, etc. are temporarily ceased, cash builds
up - and the interest on that cash also builds up!
- Filing for
bankruptcy halts creditors from collecting payment from the company -
payment of principal and interest other than due on fully secured debt
reorganization plan is devised. The plan must be approved by the
bankruptcy judge, as well as "by a majority in number and
two-thirds in dollar amount of each class of creditors" (195).
Sometimes this takes a while, as the company and its creditors
obviously have different ultimate goals in mind.
- Cash in the
company begins to build up:
costs through contract rejections or through ordinary cost-cutting
interest payments on unsecured debt, suspended dividends payments on
common and preferred stock.
net-operating-loss (NOL) carry-forwards offset taxes currently due.
capital spending - specifically on unrelated diversification and on
will grow from compound interest earned on existing cash balances and
from interest on interest" (197).
- After the
reorganization plan is put in motion, the company emerges from
bankruptcy, and the firm's creditors exchange their claims for come
combination of cash, new debt securities, and equity in the reorganized
reorganization process essentially serves as a catalyst for realizing
underlying value in a company.
- Three stages
of bankruptcy investing, as identified by Michael Price of Mutual Series
- Stage 1 -
immediately after the Chapter 11 filing. This is the time of greatest
uncertainty but hence also of greatest opportunity.
- Stage 2 -
involving the negotiation of a plan of reorganization. Begins a few
months to several years after filing. Still some uncertainty.
- Stage 3 -
between the finalization of a reorganization plan and the debtor's
emergence from bankruptcy. Takes three months to one year. This stage
most closely resembles a risk-arbitrage investment.
- This type of
investing is not easy (hence so many shy away). "When badly done,
the results of investing in distressed and bankrupt securities can be
disastrous; junior securities, for example, can be completely wiped
- Most risky -
highly competitive or fashion-oriented businesses dependent on key
personnel and owning few tangible assets, companies that sell
customized or user-specific products, financial companies that are
especially dependent on investor and customer confidence.
- Least risky
- overleveraged capital-intensive debtors with a possible monopoly (or
near-monopoly) in their industries, business producing homogeneous or
undifferentiated products, companies with no legal public issues to
financially distressed and bankrupt security investing process:
on the balance sheet. Understand all the liabilities very well. Use the
valuation methodologies described in chapter 8.
- Watch for
off-balance-sheet assets (real estate carried below current value,
overfunded pension plan, patents owned, etc.) and liabilities
(underfunded pension plans, IRS issues, government claims, etc.).
- Evaluate the
liabilities in descending order of seniority - secured debt should be
investors will generally prefer to hold senior securities; the
potential return from senior securities is frequently less than that
available from junior claims, but the risk is also much lower"
- Avoid common stock of financially distressed companies at
virtually any price - the risks are too great and the returns too
concentrate on debt.
potential "blocking positions," in which one-third of the
outstanding debt is held closely. They can be used to dictate a
reorganization plan. "A blocking position is said to have
'hold-up' value in two senses: the owner hold up (delay) the bankruptcy
process as well as hold up (rob) other classes of creditors, extracting
nuisance value from what might otherwise be a nearly worthless
- Klarman gives
an interesting example with the Bank of New England Corporation. Its
bonds plunged while the common stock didn't. Shorting the stock (which
was going to be rendered worthless in an insolvency) allowed investors
to use short-sale proceeds to buy bonds. At worst, the bonds would fail
(as would the stock), and at best, the bonds would rally (by a greater
percentage than the stock - why? Klarman gives no reason).
13: Portfolio Management and Trading
idea: it is important to manage
your portfolio by overlooking your investments, diversifying, hedging
(when appropriate), and always looking for new opportunities.
management encompasses trading activity as well as the regular review of
one's holdings" (209). The main responsibilities include
appropriate diversification, making hedging decisions, and managing
portfolio cash flow and liquidity.
- Liquidity is
important - you want to be able change your mind about your investments.
leads to a lesser return, however. Illiquidity should then only be
justified by high returns.
the opportunity cost of illiquidity is high, no investment portfolio
should be complete illiquid either" (210).
- Note that
liquidity is a tricky thing. As Louis Lowenstein explains, it only
exists for an individual, but not for an entire market. Liquidity can
be correlated with investment fashion. "During a market panic the
liquidity that seemed miles wide in the course of an upswing may turn
out only to have been inches deep" (211).
cycle: start with liquidity (cash), invest and earn an incremental
return, as investments come to fruition liquidity is restored.
- This cycle
serves two purposes:
cash flow - the cash flowing into a portfolio can reduce an investor's
otherwise complacent investors to be constantly challenged to put the
incoming cash to work, seeking out the best values available.
risk can be reduced in two additional ways (aside from investing in
individual investments with a sufficient margin of safety):
number of securities that should be owned to reduce portfolio risk to
an acceptable level is not great; as few as ten to fifteen different
holdings usually suffice" (212).
- Avoid the
index fund mentality - extreme diversification. "My view is that
an investor is better off knowing a lot about a few investments than
knowing only a little about each of a great many holdings" (213).
after all, is not how many different things you own, but how different
the things you do own are in the risks they entail" (213).
- Market risk
(risk that the overall stock market will decline) can't be reduced
through diversification but can be limited by hedging.
gives numerous examples of hedging. One example for stocks:
diversified portfolio of large capitalization stocks, for example,
could be effectively hedged through the sale of an appropriate
quantity of S&P 500 index futures" (213).
though: what is this appropriate quantity?
- In this
situation, the investment success depends essentially on the
performance of your investments compared with the market as whole.
- Note that
it's not always smart to hedge - sometimes hedging is expensive and
time-consuming to maintain.
- Stay in touch
with the financial markets (so that it's not overly difficult to find
buying/selling opportunities regularly created by the markets) but do
not become obsessed with every uptick and downtick - which leads to
short-term-oriented trading. Staying in touch with a market can also be
dangerous in that you are exposed to brokers - they can provide useful
information, but never base a portfolio decision solely on broker
- Buying: leave
room to average down.
- Learn to
resist fear, the tendency to panic when prices are falling, and the
tendency to become overly enthusiastic when prices are rising.
purchase a "full position" in a given security all at once.
"Buying a partial position leaves reserves that permit investors
to 'average down,' lowering their average cost per share, if price
of a Stock Operator), being a
speculator, recommends a contrary viewpoint - "average up" -
purchase more stock if you see it rising (i.e. confirming your
- Selling is
the hardest decision of all.
investors create various rules (specific price-to-book value, sale
price targets, percentage gain thresholds, etc.) - Klarman believes
that none of these rules make sense. "Indeed, there is only one
valid rule for selling: all investments are for sale at the right
when to sell - or buy - depends on the alternative opportunities that
are available. Should you hold for partial or complete value
realization, for example? It would be foolish to hold out for an extra
fraction of a point of gain in stock selling just below underlying
value when the market offers many bargains. By contrast, you would not
want to sell a stock at a gain (and pay taxes on it) if it were still
significantly undervalued and if there were no better bargains
- Stop-loss orders to limit risk are crazy. "Although this strategy may seem an
effective way to limit downside risk, it is, in fact, crazy. Instead of
taking advantage of market dips to increase one's holdings, a user of
this technique acts as if the market knows the merits of a particular investment
better than he or she does" (219).
- Liquidity is
also a consideration - how deep is the market for the security you are
looking to sell?
- When looking
for a good broker, find one with sufficient standing within his or her
firm to provide you with good access to analysts and traders, one with
experience to handle your account properly and not waste your time (but
rather know when to call you). Good established brokers are hard to find
(for amateur investors) - one way is to find a fairly young but capable
broker who will gain important and standing within the firm over time.
14: Investment Alternatives for the Individual Investor
idea: if you don't have time to
devote to investing, you have some alternatives.
it should be clear by now, is a full-time job" (222).
- If you can't
devote substantial time to your investing activities, you have the
alternatives of mutual funds, discretionary stockbrokers, or money
- Mutual funds
- In theory,
attractive alternative for the individual investor - professional
management, immediate liquidity, easy diversification. In practice,
"they mostly do a mediocre job of managing money" (223).
many fund managers are participants in the short-term
- Some rare
open-end mutual funds do have a long-term value-investment orientation,
but most unfortunately don't.
stockbrokers or money managers
essentially have discretionary investment authority over some or all of
evaluating either a stockbroker or a money manager, it is important to
consider the following:
precisely what they do - are their investment approaches valid?
or more personal interviews are essential" (225).
- "Do they 'eat home cooking' - managing their own money
in parallel with their clients?" (225) - this is arguably the most important test of the
integrity of a manager.
- Are all
clients treated equally? If not, why not, and in what ways?
of achieving good investment results:
- Size of
the portfolio - assets under management exceedingly large?
- Are the
assets growing or shrinking? "In my experience, large increases
in assets under management adversely affect returns" (225).
- Does the
broker/manager have an intelligent investment strategy (i.e. the
value-investment strategy optimally)? Does he/she worry about relative
or absolute returns?
arbitrary constraints or rules imposed?
carefully the past performance of the individual or organization:
- How long a
track record is there?
- Was it
achieved over one more market and economic cycles?
- Was it
achieved by the same person who will manage your money?
- Does the
track record represent only results achieved during some favorable
- How did
this manager invest in down markets? Did clients lose money?
- Were the
results steady over time, or volatile?
- One or two
spectacular successes or numerous moderate winners?
- Is the
manager still following the same strategy employed to achieve past
- Was/is the
manager fully invested at all times? More than 100 percent invested
is neither necessary nor appropriate for most investors" (226).
- How risky
is the manager's approach? Were the investments in underlying
portfolio themselves particularly risky, such as shares of highly
- Did the
manager reduce risk through diversification, hedging, or investing in
- Make sure
you are personally compatible with the manager: aggressive vs.
conclusion, "I recommend that you adopt a value-investment
philosophy and either find an investment professional with a record of
value-investment success or commit the requisite time and attention to
investing on your own" (228).
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