Book Review: Margin of Safety

Margin of Safety (1991) by Seth A. Klarman

This book is widely regarded as a classic text on value investing. The basic approach involves buying a stock or a bond at a discount to its intrinsic value, then holding onto it until that value is realized in the market. A key factor is the discount, which reflects how much the security is undervalued and determines the margin of safety for the investment. The greater the discount, the greater the margin of safety because the upside potential will substantially outweigh the downside risk. The author discusses the value investing approach and the concept of margin of safety not only in relation to common stocks and bonds, but also in the context of special cases, such as financially distressed and bankrupt securities.

What I found most influential was the general commentary about investing and "where most investors stumble," which is the title of the first part of the book. He notes that the first step toward investing success is distinguishing between speculation and investment. Speculation involves trying to predict future price movements from technical analysis, which the author considers a waste of time. Investment involves recognizing that stocks reflect fractional ownership of underlying businesses and making decisions based on fundamental analysis of the perceived values of those businesses. Investors can be successful by taking advantage of market inefficiencies, such as cases of undervaluation. The author notes that "value investing is predicated on the efficient-market hypothesis being wrong" and backs it up with compelling arguments.

The author also discusses how investors can be derailed by their emotions (greed and fear) and get caught up in the "short-term, relative-performance derby" of trying to beat the market -- the latter being a major reason why many institutional investors routinely deliver mediocre returns to clients. His discussion of how institutional investors handicap themselves is quite interesting. With respect to valuing businesses, he makes the important point that investors should not focus on the precision of fundamental-based model analyses, but seek a range of value with a conservative emphasis.

In summary, the book provides some good insights into the value investing philosophy and investing more generally. It is not really a how-to guide, but the basic principles outlined in the text -- margin of safety being the main one -- should steer investors toward suitable opportunities for achieving satisfactory returns while minimizing risk. It is worth noting that the author has demonstrated the success of his approach in practice: As manager of the Baupost Group, he has achieved an average annual return of nearly 20% since 1982.

Note: I read this book in July 2012.