Introduction

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.
"Value 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 risk" (xiii).
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 things:

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 money management.
"Indeed, once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling" (xx).

Part 1: Where Most Investors Stumble

Chapter 1: Speculators and Unsuccessful Investors

Main 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 public manias).
Additional notes:

Investors vs. speculators:

To 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.

Speculators, 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 of speculation:

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.
Speculators 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.
Speculation 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.

Main 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 demand.
Collectibles 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 true investments.
Successful investors need to distinguish between investments and speculations.

Successful investors:

"Successful 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).

"Mr. 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).

"Because 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 process" (13).

Unsuccessful investors:

"Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear" (13).
"The 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.
"Many 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.

Klarman 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.
Interesting 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).

Many 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.

Chapter 2: The Nature of Wall Street Works Against Investors

Main 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.
Additional notes:

Wall Street has 3 principal activities: trading, investment banking, and merchant banking.

Trading - Wall Street firms act as agents, earning a commission or trading spread for bringing buyers and sellers together.
Investment banking - Wall Street firms arrange for the purchase and sale of entire companies by others, underwrite new securities, and provide financial advice.
Merchant 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).
The compensation package leads to primary conflicts of interest:

Brokers urge clients to buy/sell stock instead of holding it (churning the portfolio)
Investment banks underwrite either overpriced or highly risky securities
Merchant 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:

More brokerage business to be done when issuing an optimistic research report
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.

Investors prefer rising security prices, as do the companies (more flexibility in raising capital, higher stock price for management team's stock options, etc.).
Government regulators of the securities markets impose rules that are biased toward bullish markets:

Many institutions (including all mutual funds) are prohibited from selling stocks and bonds short.
Various "circuit breakers" (temporarily seize/freeze trading on various occasions) only apply for downward swings but not upward.

"The 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).
Financial-market 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).
"All 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" (33).
"The 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, transactions" (21).

Chapter 3: The Institutional Performance Derby: The Client Is the Loser

Main 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.
Additional notes:

Institutional 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 percent" (36).
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 difficult" (37).
The many obstacles to good institutional investment performance:

The short-term, relative-performance derby:

Managers 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.
Managers also have to often impress pension fund consultants (who select funds for pension funds to invest into) - which only adds to the short-term performance pressures.
"Money 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 analysis!

Institutional 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 their clients.
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 purchased.
The 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 investment risk.
Selling owned securities is difficult:

Many investments are illiquid, and disposing of the institutional-sized positions isn't easy.
Selling creates additional work as sale proceeds must be reinvested into something new.
The SEC regards portfolio turnover unfavorably.

Top-down 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.
Institutional 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).
Large portfolio size for many firms hurts their returns. Portfolio size matters:

The return per dollar invested declines as total assets increase. "The principal reason is that good investment ideas are in short supply" (43).
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.

Institutional investors often impose additional constraints on themselves:

Remaining 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" (44).
Overly 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).
Window dressing - the practice of making a portfolio look good for quarterly reporting purposes:

Deliberately buying shares of the current quarter's best market performers and selling shares of significant underperformers.
Selling 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…

Portfolio 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.
Tactical 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 significantly.
Index funds - accepting average performance with minimal work. See more on this below.

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.
"By 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:

Self-defeating 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.
Problems 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).
"A 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).

Chapter 4: Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s

Main 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.
Additional notes:

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 of default.
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 securities.
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 junk-bond market.
Essentially, 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 artificially low:

It takes time to run short of cash - so even the most overleveraged junk-bond issuers did not default immediately.
Some 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.
Widespread 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).

Investors kept buying junk bonds due to these reported low default rates and to other various reasons:

Financial 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).
High-yield bond mutual funds catered to "yield-pigs," gladly buying low-quality junk bonds to boost their short-term reported performance yields.
Thrifts and insurance companies also found good use of junk bonds.

Most 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).
Investment standards were relaxed:

Zero-coupon 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).
Interest 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).
The 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.
Klarman 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 depreciation allowance.
Service 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.
"EBITDA 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:

"Junk 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

Chapter 5: Defining Your Investment Goals

Main 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.
Additional notes:

Warren 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).
Risk 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.
"Stating 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.
Targeting 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 run.
Furthermore, targeting returns leads investors to focus on upside potential rather than on downside risk.

Chapter 6: Value Investing: The Importance of a Margin of Safety

Main 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).
Additional notes:

"Value 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.
"The 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 pitches.

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.

Value 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 insurance companies.
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 opportunity).
Valuating a business can be very complex - how can you ever be sure that you are buying at a discount?

"The truth is, you cannot" (90).
Sometimes, 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:

Perform 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.
Understand 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).

The importance of margin of safety.

Benjamin 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 world" (92).
Buffett's 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. intangible assets:

Some investors like Warren Buffett recognize the value of intangible assets (broadcast licenses, soft-drink formulas, etc.).
Klarman believes that intangible assets don't provide enough margin of safety - tangible assets in certain business may be, for example, sold at a liquidation.

So, how do you make certain of achieving a margin of safety?

Always buy at a significant discount to underlying business value.
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 become available.

"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.
Give preference to companies having good managements with a personal financial stake in the business/company.
Diversify your holdings and hedge when it is financially attractive to do so.

Value investing shines in a declining market.

Securities 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.

Value 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).
Semistrong: no published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.
Strong: there is no information, public or private, that would benefit investors.

The 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.
Klarman 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 returns" (98).
Large-cap 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 value.
And investor unable to meet a margin call can't hold to full value - forced to sell.
"Institutional selling of a low-priced small-cap spin-off, for example, can cause temporary supply-demand imbalance, resulting in a security being undervalued" (100).
Year-end tax selling and quarterly window dressing can also cause market inefficiencies.

"A 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!

Chapter 7: At the Root of a Value-Investment Philosophy

Main 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.
Additional notes:

Bottom-up investing:

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 thing.
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.
Significant 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 the market.
"Bottom-up 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 valid.

Absolute-performance orientation:

Relative 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.
Relative 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.
Absolute-performance-oriented 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.

Risk-averse approach:

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.
However, 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:

Essentially, 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.
Academics and market professionals use the concept of beta to quantify risk.

Beta 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 1).
Klarman 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 $100/share).
"The 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).

Short-term price fluctuations - what does this entail for value investors?

Temporary 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).
However, short-term price fluctuations are important for value investors, because:

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" (115).

Chapter 8: The Art of Business Valuation

Main 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.
Additional notes:

Business 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.
Since 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.
"Every 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.
However, this is rare and difficult:

Future cash flows are hard to predict - "a recurring theme in this book is that the future is not predictable, except within fairly wide boundaries" (123).
When growth is already anticipated and therefore discounted in securities prices, shortfalls will cause share price declines - and loss for investors.
Growth, a single number, actually depends on a huge number of factors.
"An unresolvable contradiction exists: to perform present-value analysis, you must predict the future, yet the future is not reliably predictable" (124).

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 therefrom" (125).
Discount 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.
Klarman 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).
Discount rate is influenced by fluctuations in interest rates.
When 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.
Private-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.
Multiples paid to acquire businesses vary over time - even across nearby transactions.
Buyers of businesses do not necessarily pay reasonable intelligent prices (late 1980s)!

Liquidation value - the expected proceeds if a company were to be dismantled and the assets sold off.

Conservative assessment in which only tangible assets are concerned (intangibles dismissed).
Liquidation 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.
It's important to consider off-balance sheet liabilities - underfunded pension plans, as well as liabilities incurred in the course of the actual liquidation.

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.
"Knowing 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.
Liquidation - valuing an unprofitable business whose stock trades well below book value.
Stock market value - valuing a closed-end fund or other company that owns marketable securities.
Sometimes 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.
Other conventional valuation methods also exist. These can be considered as one component of a more thorough and complete analysis, but nothing more.

Earnings and earnings growth

Easily 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

The historical accounting of shareholder's equity (assets minus liabilities).
"What 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).

Dividend yield

Dividend 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

Chapter 9: Investment Research: The Challenge of Finding Attractive Investments

Main 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.
Additional notes:

"Good investment ideas are rare and valuable things, which must be ferreted out assiduously" (151).
Value investing encompasses several niches that can be divided into three categories:

Securities selling at a discount to breakup or liquidation value

Computer-screening technologies can help identify these.
But it seems like in today's super-connected world, these would be difficult to find.

Rate-of-return situations

Risk arbitrage and complex securities.
Mergers, tender offers, and other risk-arbitrage transactions - can be found in the Wall Street Journal and the business section of the New York Times - and other publications.

Asset-conversion opportunities

Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers - in this category, investors' existing holdings are exchanged for new securities.
"Price 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.

Many 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 paying dividends.
Some opportunities can also be created by institutional sellers (as described earlier, as well):

Some 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" (154).
Small 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, though.
Also, 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).
"Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The 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 safety!

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.
Value 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.

Chapter 10: Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints

Main idea: invest into securities with catalysts, if possible; liquidations, complex securities, rights offerings, risk arbitrage, and spinoffs can present excellent opportunities for value investors.
Additional notes:

Value 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).
Catalysts that bring about total value realization (orderly sale or liquidation) are preferred.
Catalysts for partial value realization (corporate spinoffs, share buybacks, recapitalizations, major asset sales) still server two important purposes:

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.

Liquidations

Some 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.
Most 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.
Klarman 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).

Complex securities

"I 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 specified assets.
As a result of obscurity and uniqueness, complex securities are great opportunities to value investors.
Klarman 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, decreasing prices.
Complex 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 evaluate.

Rights offerings

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 shares.
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.
Sometimes 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 share.

Risk arbitrage

Risk arbitrage involves in investing in takeover transactions - sometimes also spinoffs, liquidations, and corporate restructurings.
Risk 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.
Klarman 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.
Risk 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.
"Risk 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!

"A 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 stock" (177).
The basic goal of a spinoff is to create parts with a combined market value greater than the whole.
Many investors sell their shares in spinoffs right away:

Institutional 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.
Individual 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.

Some 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.
Klarman 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).

Chapter 11: Investing in Thrift Conversions

Main 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.
Additional notes:

"Since 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 public?
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).

Chapter 12: Investing in Financially Distressed and Bankrupt Securities

Main 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 much risk!).
Additional notes:

Investors 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 opportunity" (189).
In 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.
Financial 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 profitability.
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 filing.

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!
Bankruptcy process:

Filing for bankruptcy halts creditors from collecting payment from the company - payment of principal and interest other than due on fully secured debt is suspended.
A 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:

Reduced costs through contract rejections or through ordinary cost-cutting efforts.
Suspended interest payments on unsecured debt, suspended dividends payments on common and preferred stock.
Potential net-operating-loss (NOL) carry-forwards offset taxes currently due.
Reduced capital spending - specifically on unrelated diversification and on risky activities.
"Cash 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 company.

The 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 Funds, Inc.:

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 out" (199).

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 resolve.

The financially distressed and bankrupt security investing process:

Concentrate 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 evaluated first.
"Risk-averse 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" (203).
Avoid common stock of financially distressed companies at virtually any price - the risks are too great and the returns too uncertain. Instead, concentrate on debt.
Examine 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 claim:" (204).

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).

Chapter 13: Portfolio Management and Trading

Main idea: it is important to manage your portfolio by overlooking your investments, diversifying, hedging (when appropriate), and always looking for new opportunities.
Additional notes:

"Portfolio 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.

Liquidity leads to a lesser return, however. Illiquidity should then only be justified by high returns.
"Because 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).
Liquidity cycle: start with liquidity (cash), invest and earn an incremental return, as investments come to fruition liquidity is restored.
This cycle serves two purposes:

Portfolio cash flow - the cash flowing into a portfolio can reduce an investor's opportunity cost.
Forces otherwise complacent investors to be constantly challenged to put the incoming cash to work, seeking out the best values available.

Portfolio risk can be reduced in two additional ways (aside from investing in individual investments with a sufficient margin of safety):

Appropriate diversification

"The 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).
"Diversification, 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).

Hedging

Market risk (risk that the overall stock market will decline) can't be reduced through diversification but can be limited by hedging.
Klarman gives numerous examples of hedging. One example for stocks:

"A 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).
Question, 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 advice.
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.
Don't 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 declines" (217).
Jesse Livermore (Reminiscences 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 prognosis).

Selling is the hardest decision of all.

Some 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 price" (218).
"Exactly 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 available" (218).
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.

Chapter 14: Investment Alternatives for the Individual Investor

Main idea: if you don't have time to devote to investing, you have some alternatives.
Additional notes:

"Investing, 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 managers.
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).
Unfortunately, many fund managers are participants in the short-term relative-performance derby.
Some rare open-end mutual funds do have a long-term value-investment orientation, but most unfortunately don't.

Discretionary stockbrokers or money managers

Both essentially have discretionary investment authority over some or all of your funds.
In evaluating either a stockbroker or a money manager, it is important to consider the following:

Understand precisely what they do - are their investment approaches valid?
"One 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?
Likelihood 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?
Any arbitrary constraints or rules imposed?
Evaluate 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 period?
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 successes?
Was/is the manager fully invested at all times? More than 100 percent invested (leverage)? "Leverage 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 leveraged companies?
Did the manager reduce risk through diversification, hedging, or investing in senior securities?

Make sure you are personally compatible with the manager: aggressive vs. conservative.

In 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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