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Subject:  Klarman's Margin of Safety Revisitied Date:  5/28/2020  9:24 AM
Author:  BenGrahamMan Number:  26249 of 26255

In May of 2006, I took these notes upon my reading of Seth Klarman's 'Margin of Safety."

I was recently asked a question on Reddit, where I had posted these notes, "Since re-reading your notes from 2006 how has this information held up in your experience after a decade?"

Here is my response to the question posed to me on Reddit.

How have these methods have held up for me over the last decade. I took these notes 14 years ago. We since have had two financial crises, one of which we are in now (Covid-19).

The question above was a catalyst for re-reading my notes, as well as contemplation. I was not surprised that over the years my observation is one mostly of reaffirming Klarman’s theories, and my continued acceptance of them. I truly believe that his views, which again are part of my internal structure, are the only way one can invest for the long-term. Perhaps I am being too stringent, or closed minded, yet at the end of the day, I use what works for me.

I remain unemotional in my investing. My all-in investment results over the last 15 years are acceptable in my view, but underperformed the S&P 500, for the 15-years ended December 31, 2019, my results were 6.3%, versus the S&P 500 returns of 8.5%. Part of that under-performance was clearly identified by Klarman, and one that I missed. I did not properly conceptualize the liquidity element of a materially over-weighted investment.

I have also been very vocal and insistent on not targeting investment returns. This is something Klarman discusses that one should target risk, and not returns. I have been able to maintain my discipline. I am a portfolio manager and am proud that maintaining my discipline is more important to me than anything, including client retention. At the end of the day, I do what I always think is best, and what more can someone ask for? As Klarman mentions, this can be a lonely undertaking. I have also found that I continue to learn about investing every day. I believe I have as Klarman puts it, “infinite patience.”

Klarman discusses that value investors work well in an inflationary environment. Of course, we had little or no inflation since my reading, as well as probably long before that, as well as deflation for long periods. I ponder if that is changing considering QE’s after the financial crisis, and massive Central Bank’s flooding capital into a world that has seen economies basically shut down because of Covid-19.

Until I re-read my notes, I had forgotten that Klarman discussed watching insiders was an important part of the investment process. I have watched and studied insider activity for my entire career. I was glad to re-read this and have affirmation. Yet, as I write this, I wonder, “Why do I need or want affirmation?”

Klarman discusses unexpected liquidity needs. He writes, “Liquidity can be illusory.” I was a victim of this, as I over-weighted a high-quality lender, selling well below book value during the financial crisis. I even discussed the investment with one of my heroes, Warren Buffett. What I failed to realize is that the lender was dependent on the financial markets for continued funding. Once liquidity to lenders ceased during this crisis, the company was doomed. It did not matter how healthy their loans were, they did not have the required funding and liquidity to continue as a thriving going concern. We had a very large position, and this was one of several reasons our long-term returns do not live up to my expectations.

You also asked if I have read anything that has helped me invest in technology, using value investing frameworks. Nothing really comes to mind. I do and have always invested in technology, and I try to use a value approach, and other than potential disruption and perhaps the illusion of a high priced security, I try to employ what I think a company could be producing in earnings or cash flow maybe 5, 10 and 15 years out, and then determine if I find value in a company that might have a high P/E, or P/CF, or P/FCF, or no earnings at all, and none expected for a few years out.

This question was a wonderful opportunity to revisit Klarman and some of my methods.

This is a link to the Reddit thread.

I appreciate the Fool community and this board as well as DMC here. I hope you are all safe and well. Stay safe, well and smart.


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