The original article was written by Jack Lyons.

What Is Seth Klarman’s Margin of Safety?

One of the biggest names in investing is that of Seth Klarman’s. The chief executive of the Baupost Group is a famous value investor, but Klarman is probably best known for the book that he wrote – Margin Of Safety.

Seth Klarman’s margin of safety is the theory that he built his financial empire upon, using the wisdom of Benjamin Graham and Warren Buffett. The idea, while incredibly simple, is applicable to each and every value investing strategy – including yours.

By learning how to effectively apply Seth Klarman’s margin of safety to your portfolio, you can both strengthen your portfolio and enhance your investment returns. But, what really is a margin of safety? How does it fit into an investment portfolio? Finally, how do you apply it to your own basket of shares?

According to Klarman, it all starts with patience and discipline.

“Warren Buffett uses a baseball analogy to articulate the discipline of value investors. A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handlean undervalued investment opportunity. Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky. Hence, few value investors will own the shares of technology companies. Many also shun commercial banks, which they consider to have unanalyzable assets, as well as property and casualty insurance companies, which have both unanalyzable assets and liabilities.”

Value Investing Really Is Just Like Baseball – And Most People Are Bad At Baseball

The analogy to which Klarman refers is extremely apt for value investors. However, just like in baseball, it is extremely difficult and if our natural instinct is to allow a ball to pass us, then this would be easy to do. However, by passing on pitches that many others would have struck out on, we save our strength (or in investing, our capital) for those that are within our strike zone and are just right. These pitches are the ones that give us the best chance of a home run.

In investing terms, this means waiting for the right investment opportunity to appear. The right opportunity is the one that is within our “circle of competence.” If it is the stock of a company, we must be able to understand what industry it’s in, how it makes money, what its balance sheet is made up of, and so on.

Again, most people cannot adhere to such rules. They feel the urge to swing at stocks that are not undervalued or that they do not understand. They simply do not have the discipline to carry out a value investing style of any sort, let alone adhere to Seth Klarman’s margin of safety.

“Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is a margin of peril.”

Do I Need To Be A Harvard Graduate To Be A Successful Investor?

It is often too easy to doubt yourself. If everyone on Wall Street invests in apples (get it?) and unicorns, how am I supposed to believe that I have a better way? If all of those Harvard and Princeton grads invest and trade a certain way, surely there is no better way?

There are many reasons why investors don’t adhere to value investing. They range from ignorance (they simply don’t know about it) to stubborness(they refuse to accept it). For someone who has received an Ivy League education and learned all about the ways of modern portfolio theory and investment theory, it is very difficult to accept that there might be another (or even a better) way out there. This is why such a high level of education in a subject can often reduce your ability to learn about it further, as your pride prevents you from considering alternate theories.

If you still need convincing, just take a look at Klarman, Buffett, and all of the superinvestors of Graham and Doddsville. They are all advocates of various forms of value investing, and they have all been massively successful in doing so! And, as if you didn’t just receive as much good news as you could possibly take, I have more for you – if you can understand the following sentence, you too can understand Seth Klarman’s margin of safety.

“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.”

What Exactly Is Seth Klarman’s Margin Of Safety?

Seth Klarman’s margin of safety is simply the idea that one should always ensure that the stock that they buy is priced at significantly less than its fair value. By always adhering to this rule, an investor ensures that he minimizes his potential losses and maximizes his potential gains.

“Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today’s value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety. Because investing is as much an art as a science, investors need a margin of safety. 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. According to Graham, ‘The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.’ ”

Great, But How Can I Apply The Margin Of Safety To My Own Investment Portfolio?

Due to the incredible simplicity of the idea, Seth Klarman’s margin of safety is readily understandable and easily applicable. Added to that, the theory is timeless. By placing Seth Klarman’s margin of safety at the top of your investing checklist, you can quickly learn the discipline required to be a successful value or special situations investor. If it’s not cheaper than cheap with a major catalyst, then don’t buy it. It is as easy as that.

It’s just as easy to apply it as it is to understand it. Using a net net strategy, one could set a limit on the share price of a stock, above which they must not buy. In this case, the margin of safety could be defined by a percentage, say: [(NCAV/Share Price) – 1] x 100. Then, when you find a number of them, you select the ones with a major catalyst unfolding.

Alternatively, using an Acquirer’s Multiple to value spinoffs, you could simply refuse to purchase any stocks that had a multiple that is greater than ten. Then focus in on the ones where management is buying stock or otherwise setting some great compensation packages based on stock price targets.

By adhering to one of these rigid strategies, you would already be applying your own margin of safety and well on your way to the path of special situation investing success.

Here’s a real-life example, courtesy of Klarman:

“Perhaps the best recent example of investing with a margin of safety occurred in the debt securities of Texaco, Inc. In 1987 Texaco filed for bankruptcy as a result of uncertainty surrounding a $10 billion legal verdict against it in favor of Pennzoil. Although the value of Texaco’s assets appeared to more than fully cover all of its liabilities even under a worst-case scenario, in the immediate aftermath of Texaco’s Chapter 11 filing its stock and bonds plunged in price. As with any bankruptcy, many investors were suddenly constrained from owning Texaco securities. Even the company’s public statement that bondholders would receive all principal and postpetition as well as prepetition interest failed to boost prices much.”

In this situation, Texaco’s share price plunged following its filing for bankruptcy. However, even with a $10bn liability, Texaco was still a viable company. The majority of investors could not see that this massive price drop actually provided an investment opportunity. Within 12 months, Texaco’s share price had doubled – a 100% return on investment! The bonds did very well, in addition.

What we’ve learned in this passage is that by applying one fundamental idea, you can begin investing like the value investing greats. Now, go forth and prosper with your newfound knowledge and, with your returns, you just might be able to afford the legendary book that is the Margin of Safety!*

* Note that there are many false copies (photocopies) of the book being sold – even on Amazon. However, the book is so sought-after that people are willing to pay massive amounts to get their hands on even a fake!

Read next: Is Merger Arbitrage an Event Driven Strategy?

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