Margin of safety by seth klarman pdf free download

Doub le-digit interest rates on U. When interest rates declined to sing le digits, many investors remained infa tuated with the attainment of higher yields and sacrificed credit quality to achieve them either in the bond market or in equities. Wall Street responded with gusto, as Wall Street tends do when there are fees to earn, creating a variety of instrumen ts that promised high current yields.

Ic achieve current cash yields appreciably above those availIe from U. Low-grade securities, such as junk bonds, offer higher yields than govema.

Junk-bond mutual unds were marketed to investors in the s primarily ugh the promise of high current yield. Junk bonds were not the only slop served up to the yield pigs the s. Every month owners of GNMAs receive distri. The principal portion includes contractual payililents as well as voluntary prepayments. Many holders tend to of the yield on GNMAs in terms of the total monthly disution received. The true economic yield is, in fact, only the! The principal component of the monthly distributions is a yield on capital, but a return of capital.

Thus investors who A call option is the right to buy a security at a specified price during a stated period of time. This total cash distribution is touted as the current yield to investors. When covered call options written against the portfolio are exercised, however, the writer forgoes appreciation on the securities that are called away. The upside potential on the underlying investments is truncated by the sale of the call options, while the downside risk remains intact.

This strategy places investors in the position of uninsured homeowners, who benefit currently from the small premium not paid to the insurance company while remaining exposed to large future losses. As long as security prices continue to fluctuate both up and down, writers of covered calls are certain to experience capital losses ove r time, with no possible offsetting capital gains. In effect, these funds are eating into principal while misleadingly reporting the principal erosion as yield.

Some investors, fixated on current return, reach for yield not with a new Wall Street product, but a very old one: common stocks. Finding bond yields unacceptably low, they pour money in to stocks a t the worst imaginable times. These investors fail to consider that bond market yields are public information, well known to stock investors who incorporate the current level of interest rates into share prices.

When bond yields are low, share prices are likely to be high. Yield-seeking investors who rush into stocks when yields are low not only fail to achieve a free lunch, they also tend to buy in at or near a market top. It is human nature to seek simple. Given the complexithe investment process, it is perhaps natural for people to that only a formula could lead to investment success.

The idea is - ::l: paying a low multiple of earnings, an investor is buying ut-of-favor bargain. In reality investors who follow such a Investors who buy such stocks may soon find - :. The - recovery after the October stock market shakeout and unk-bond market collapse provide reinforcement of this. The quest for u. Inves tors would be much better off to redirect the time and effort committed to devising form ulas into fundamental analysis of specific investment opportunities.

Conclusion The financial markets offer many temp tations to vu lnerable investors. It is easy to do the wrong thing, to speculate rather than invest. Emotion lies dangerously close to the surface for mos t investors and can be particularly intense when market prices move drama tically in either direction.

It is crucial that investors understand the difference between speculating and investing and learn to take advantage of the opportunities presented by Mr. Noles 1. Sequoia Fund, Inc. William A. Sahlman and Howard H. Other precious metals and gems have a less-established value than gold but might be considered by some to be a similar type of holding. Benjamin Graham, The Intelligent Investor, 4th ed.

The sad truth is, however, that many investors Me no t well served in their dealings with Wall Stree t; they uld benefit from developing a greater understanding of the oay Wall Street works.

The prob lem is that what is good for. IIStreet is not necessarily good for investors, and vice versa. Wall Street has three principal activities: trading, investment enking, and merchant banking.

As investment bankers they iIrrallge for the purchase and sale of entire companies by others, derw rite ne w securities, prov ide financia l ad vice, and opine the fairness of specific transactions. As merchant bankers. As Wall Stree t pursu es its various activities, however, it frequently is plagued by conflicts of interest and a short-term orientat ion. Investors need not condemn Wall Street for this as long as they remain aware of it and act with cautious skepticism in any intera ctions they may have.

Brokerage commissions are collected on each trade, regardless of the outcome for the investor. Investment banking and underw riting fees are also collected up front, long before the ultimate success or failure of the transaction is known. All investors are awa re of the conflict of interest facing stockbrokers.

While their customers might be best off owning minimal commission U. Treasury bills or commission-free no-load mutual funds, brokers are financially motivated to sell high-commission securities. Brokers also have an incentive to do excessive short-term trading known as churning on behalf of discretionary customer accounts in which the broker has discretion to transact and to encourage such activity in nond iscretionary accounts.

A significant conflict of interest also arises in securities underwriting. This function involves raising money for corporate clients by selling new ly issued securities to customers. Need less to say, large fees may motivate a firm to underw rite either overpriced or highly risky securities and to favor the limited number of underwriting clients over the many small buyers of those securities. In merchant banking the conflict is more blatant still.

Doctors, lawyers, accountants, and other fessionals are paid this way; their compensation does not oend on the ultimate outcome of their services. The point I making is that investors should be aware of the motivations e people they transact business with; up-front fees clearly a re a bias toward frequent, and not necessarily profitable, actions.

These sha red with stockbrokers who sell the underwritten securiro clients. By contrast, the commissions earned by brokers on secry-market transactions, which involve the resale of securifrom one investor to another, are much smaller.

Large Small individual investors are G ly charged considerably more. The higher commission on new underwritings provides a strong incentive to stockbrokers to sell them to clients. The strong financial incentive of brokers touting new security underwritings is not the only cause for investor concern. The motivation of the issuer of securities is also suspect and m ust be thoroughly investigated by the buyer.

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 bu t 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. Investors even remotely tempted to buy new issues must ask themselves how they cou ld possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting.

Indeed, how attractive could any secu rity underwriting ever be when the issuer and underwriter have superior information as well as control over the timing, pricing, and stock or bond allocation? The deck is almost always stacked against the buyers. Sometimes the lust for underwriting fees drives Wall Street to actually create underwriting clients for the sale purpose of having securities to sell.

Most closed-end mutual funds, for example, are formed almost exclusively to generate commissions for stockbrokers and fees for investment managers. There was a story a few years ago that an announcement to the sales force of a prestigious Wall Street underwriting firm regarding the formation of a closed-end bond fund was met with a standing ovation. The clients could have purchased the same securities much less expensively on a direct basis, but in the form of a closed-end fund the brokers stood to make many times more in commissions.

Within months of uance, closed-end funds typically decline in price below the. This means that purchasers of closedfunds on the initial public offering frequently incur a quick -- of 10 to 15 percent of their investment. The boom in the creation of new closed-end country exemplifies the tension between Wall Street and its cusers. As noted in chapter I, speculative interest in closed-end try funds resulted in the shares of many funds being bid above underlying NAVs.

Buying into new offerings red to be a quick, easy, and almost certain way to make. In June , for example, the Spain Fund, Inc. Funds were formed to invest in such exotic locales as rria, Brazil, Ireland, Thailand, and Turkey.

Ironically, only after the boom in issuance of closed-end country funds Iraq invaded Kuwait. The prospect of finding new buyers who would pay. As a resul t. The periodic boom in closed-end mutual-fund issuance is a useful barometer of market sentiment; new issues abound wh en investors are optimistic and markets are rising.

Wall Street firms after all do not force investors to buy these funds. They simply stand ready to issue a virtually limitless supply since the only real constraint is the gullibility of the buyers. Brokers, traders, and investment bankers all find it hard to look beyond the next transaction when the cu rrent one is so lucrative regardless of merit.

This was even more applicable than usual in the late s and early s, a timewhen fees were enormous and when most Wall Streeters felt less than secure abou t the permanence of their jobs, and even their careers, in the securities industry. Wall Street collected inves-tment banking and underwriting fees when those companieswere acquired in highly leveraged junk-band-financed takeovers and collected large fees again when the debt was replaced with newly underwritten equity.

Some people work on Wall Street solely to earn high incomes, expecting to depart after a few years. Others, do ubting their -n ultimate success, perhaps justifiably, are unwilling to rego short-term compensation for long-term income that may -er arrive. Notwithstanding, a minority of peo ple on Wall Street have caaintained a long-term perspective. A few Wall Street partnernips have done a particularly good job of motivating the ir employees to think past the current transaction.

Many Wall Stree ters, especially stockbrokers, ha ve come to Iieve that their clien ts will normally leave the m after a coup le. There are no sure things on Wall Seeet, and even the best-intentioned and most insightful advice y not work out. It is true tha t clien ts who incur losses may itch brokers. This does not excuse those who assume that t tu rnover is the norm and thus seek to max imize commis5JOfLS and fees over the short term, making client tu rnover a self-ful fillin g p rophecy.

Wall Street firms can Brokers, likewise, do more business and have happier cusers in a rising market. Even securities held in inventory to. Iben a Wall Street analyst or broker expresses op timism, resters must take it with a grain of salt.

The bullish bias of Wall Street man ifests itself in many ways. Wall Stree t research is strongly oriented toward buy rather than sell recommenda tions, for example. Perhaps this is the case because anyone with money is a candida te to buy a stock or bond, whi le only those who own are cand ida tes to sell. In other words, there is more brokerage business to be done by issuing an op timistic research report than by writing a pessimistic one. In addition, Wall Street analysts are un likely to issue sell recommendations due to an understandable reluctance to say negative things, however tru thful they may be, about the companies they follow.

This is especially true when these companies are corporate-finance clien ts of the firm. It is easy for Wall Streeters to be bullish. A few optimistic assumptions will enable a reasonable investment case to be ma de for practically any stock or bond. The prob lem is ilia: with so much attention being paid to the upside, it is easy to lose sight of the risk. Investors naturalf prefer rising secur ity pr ices to falling ones, profits to losses. It is more pleasant to contemplate upside po tential than downside risk.

Rising markets are accompanied by investor confidence, which the regulators desire to maintain. Any downturn, according to the regulatory mentality should be orderly and free of pa nic. Disorderly rising mar kets. Accordingly, market regulators have devised certain stock market rules that have the effect of exacerbating the upward bias of Wall Streeters. First, many institutions, including all mutual funds, are prohibited from selling stocks or bonds short. A short sale involves selling borrowed stocks or bonds; it is the opposite of the traditional investment strategy of buying a security, otherwise known as going long.

The combination of rest rictive short-sale rules and the limited um ber of investors who are both willing and able to accept the unlimited downside risk of short-selling increases the likelid that security prices may become overvalued.

Short-sellers, who might otherwise step in to correct an overvaluation, are sew in number and significantly constrained. These included restrictions on the price movement of ks and index futures and on program trading. If stocks fall another points after trading resumes, will be an additional two-hour halt. Although high stock prices cannot be legislated some-e tha t many on Wall Street may secretly wish , regulation cause overvalua tion to persist by making it easier to occur more difficult to correct.

The upward bias of market regula-. 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 d ifficult than remedying an undervalued condition, With an undervalued stock, for example, a value investor can purchase more and more shares un til control is achieved or, better still, until the entire company is owned at a ba rgain pr ice.

It the value assessment was accura te, this is an attractive outcome for the investor. By contrast, overvalued markets are not easily corrected; shor t-selling, as mentioned earl ier, is no t an effective antido te. In addition, overvaluation is not always apparent to investors, ana lysts, or managements. Occasiona lly sud: offerings bo th solve the financ ial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, tha t is, the generation of fees anc commissions.

Wall Street earns fees and commissions with no risk; institutional inves tors may be able at tract more money to manage by creating new vehicles invest in the innovative securities. The buy side and sell side in effect become co-conspirators, each having a vested interest in the contin ued success of the innovation. Any long-term benefit to the issuers or actual owners of the new securities is considerably less certain.

In the s the financial markets were flooded with new varie ties of debt and derivative securities. Some of these securi ties, such as auction-rate preferred-stock and zero-coup on bonds, have been discredited by events. Investors must recognize that the early success of an innovabL1n is not a reliable indicator of its ultimate merit. Both buyers ii:id sellers must believe that they will benefit in the short run, the innovation will not get off the drawing board; the longerterm consequences of su ch innovations, however, ma y not have considered carefully.

At the time of issuance a new type of security will appear to add valu e in the sam e way that a new isumer product does. What ap pears to be new and roved today may pro ve to be flawed or even fallaciou s. If one d successfully completed, Wall Street sees this as a sure sign still another deal can be done, In virtually all financial inn tions and investment fad s, Wall Street creates additional su until it equals an d then exceeds market demand.

The p motivation of Wall Street firms and the intense compe. The eventual market saturation of Wall Street fads coin. When a particular is in vogue, success is a self-fulfilling prophecy. As buyers up p rices, they help to justify their original enthusiasm. A conventional mortgage-backed security fluctuates in. First, the va lue mortgage declines as interest rates rise because, as w it in teres t-bearing security, it is worth less when its periodic flows are discounted at the new, higher ra te.

The responses of separate las and pas to interest changes are ve ry differen t from those of an intact mort -. The reais, if interest rates rise, interest payments on an 10 will be ived for a longer period. Experience shows that the present e of a larger number of payments is more than that of a lier number of payments, even at a somewhat higher dist rate. Because of this counterfluctuation, such mortgage - tors as thrifts and insurance companies are attracted to lOs a potential hedge against changes in interest rates.

The price s, conversely, moves in the same direction as conventional r gages in response to interest rate changes but with greater ility, Thus they are potentially useful instruments for anyw ish ing to speculate on interest rates.

The question, as with any - cial-m arket innovation, is whether anyone else was better especially after allowing for the commissions, fees, and er markups. The buyers, frequently thrifts and insurance anies, were betting on their own ability to understand a new security. They needed to understand it better than market participants, and at least as well as Wall Street, to being exploited.

They depended on the emergence of a ined, liquid market for the securities they bought. What if accurate and timely What if interest rate fluctuations rendered each of securities more volatile than expected? It was, in other words, possible. Securities are not the only th! During the s such diverse industries energy, technology, biotechnology, gambling, warehouse S:! Investors soon found excuses to c. Businesses tha t existed in the early s, such as Silk Greenhouse, Inc. Each has since fallen from investor favor franchise value is no longer mentioned, except dispara Ironically, many businesses that formerly had real cons franchises lost them in the s.

Cra zy went bankrupt. Hutton was no longer talking; i tomers, no longer listening. Altman went out of business. The initial enthusiasm turned out to ifican tly overblown.

Investors are often. Indeed, many. The fad becomes gerous, however, when share prices reach levels that are supported by the conservatively appraised values of the unoeelying businesses. Conclusion Wall Street can be a dangerous place for investors. You have choice but to do business there, but you must always be on y guard.

The standard behavior of Wall Streeters is to pUL maximization of self-interest; the orientation is usually term. This must be acknowledged, accepted, and dealt wit you transact business with Wall Street with these cavea mind, you can prosper. If you depend on Wall Street to you, investment success may remain elusive. Notes 1. The only advantage of closed-end over open-end mutual : is that closed-end funds can be managed without consider of liquidity needs since they are not subject to sharehol redemptions.

This minor advantage does not offset the. If the last price fluctuation was upward, the next trade a: same price is called a zero-plus tick; short-selling ma y place on a zero-plus tick.

Many Wall Streeters have a different view of short-selling. T: believe that short-sellers are dangerous manipulators of sec ties prices, driving prices down for their personal finar gain.

Program trading is an arbitrage activity in which the stoci an index are purchased and futures contracts on that index sold, or vice versa, in either event locking in a riskless profit. Several de cades ago the financial markets were dominated by - -idual investors who mad e their own investment decisions. That world was a cautious one, as memories of the stock market crash and the Great Depression tha t followed were slow to fade.

In the years after World War II, however, increasing pools of retirement savings in corporate pension funds created an opportunity for professional money managers to go in to bus iness. Over the same forty years, the share of institutional ownership in all publicly traded U. Over time, however, the modus operandi of institutional investors began to diverge from what the statute inte nded.

A U. Department of Labor ruling that the prudent-man standard applied to an entire portfolio rather than to the individual securities within it opened the door to portfoliooriented investment strategies that ignore risk on an investment-by-investment basis. In addition, a great many institutional inves tors have been swept into the short-term relative-performance derby, an orientation inconsistent with the prudent-man test.

Today ins titu tional investors dominate the financial markets, accounting for roughly three-fourths of stock exchange trading volume. The prevalent mentality is consensus, groupthink.

Unfortunately for stmen t clients these objectives frequently are at odds. The incentive is to expand managed assets in order to rate more fees.

Once an investment management business becomes. In the money management busianagement fees paid by new clients constitute almost refit. The pressure to retain clients exerts a stifling influence on institutional investors. Since clients frequen tly replace the worst-performing managers and since money managers live in fear of this , most managers try to avoid standing apart from the crowd.

Those with only average results are considerably less likely to lose accounts than are the worst performers. The result is that most money managers consider mediocre performance acceptab le. Although unconventional decisions that prove successful could generate superior investment performance and result in client additions, the risk of mistakes, which wo uld d iminish performance and possibly lead to client departures, is usually considered too high.

The Short-Term, Relative-Perfonnance Derby Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative -performance derby. Fund managers at one institution have suffered the distraction of hourly performance calculations: numerous managers are provided daily comparisons of their results with those of managers at other firms. Frequent comparative ranking can only reinfo rce a short-term investment perspective.

It is understandably difficul t to maintain a long -term view when, faced with the penalties for poor short-term performance, the longterm view may well be from the une mployment line. The short-term orientation of money managers may be exacerbated by the increasing popularity of pension fund consultants.

These consultants evaluate numerous money managers, compare their performances, contrast their investment styles. Because their recommend ations can have a significant influence on the health of a money management business, the need to impress pension fun d consultants may add to the short-term performance pressures on money managers.

Vhat is a relative-performance orientation? Money managers motivated to outperform an index or - reer group of managers may lose sight of whether their investts are attractive or even sensible in an absolute sense. Rather than making sensible judgments about a tractiveness of specific stocks and bonds, they try to guess iat others are going to do and then do it first.

The task becomes singly intricate: guess what the other guessers may guess. Is it fault of managers who believe clients want good short-term , rman ce regardless of the level of risk or the impossibility - e task? There is ample blame th to share. Attempting to outperform the market in the short run is e since near-term stock and bond price fluctuations are ranand because an extraordinary amount of energy and talent - ready being applied to that objective.

The effort only disa m oney manager from finding and acting on sound longo portunities as he or she channels resources into what is dally an unwinnable game.

Only brokers benefit from the. You should be no more satisfied with a money manager w ho does not eat his or her own cooking. If the arch came crashing down, he was the first to know.

Thus his concern for the quality of the arch was intensely personal, and it is not surp rising that so many Roma n arches have survived. Money managers who invested their own assets in parallel with clients would quickly abandon their relative-performance orientation. Intellectual honesty would be restored to the institutional investment process as the focus of professional investors wo uld shift from trying to outguess others to maximizing returns under reasonable risk constraints.

If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overva lua tion and market fads wo uld less likely be carried to excess.

Investments would only be made w hen they presented a compelling opportuni ty and not simply to keep up with the herd. Impediments to Good Institutional Investme nt Perfonnance One major obstacle to good instituti onal inv estment performance is a sho rtage of time.

There is more information avai lable. Thinking about and digesting all this material, urse, would take considerably longer. He or she assumes a per. This helps explain why institutional rarely make unconventional investments. It also 5. The multidimensional risk ing too long is usually less than the risk in selling too o. First, many investments are illiquid, and disposing of ins titutional-sized positions depends on more than simply the desire to do so.

Second, selling creates additional work as sale proceeds must be reinvested in a subsequent purchase. Retaining current holdings is much easier. With so many demands on their time, money managers have little incen tive to crea te additional work for themselves. Finally, the Securities and Exchange Commission SEC , the governmental agency wi th regu latory responsibility for mutual funds, regards portfolio turnover unfavorably.

Mutual fund managers thu s have yet another reason to avoid selling. Many large insti tutional inves tors separate analytical responsibilities from po rtfolio-management duties, with the portfolio managers senior to the ana lysts.

This approach is conducive to mistakes since the people making the decisions have not personally analyzed the securi ties they are buying and selling. Moreover, the analysts who do have direct knowledge of the underlying companies may be swayed in their recommenda tions by any apparent top-down bias manifested by the portfolio managers. There is one other impediment to good institutional investment performance: institutional portfolio managers are human beings.

In addition to the influences of the investment business, money managers, despi te being professionals, frequen tly fall victim to the same forces that opera te on ind ividu al investors: the greedy search for qu ick and easy profits, the comfort of consens us, the fear of falling prices, and all the others. The twin burdens of ins titutional baggage and human emotion can be difficu lt to overcome. Implications of Portfolio Size Insti tutional investors are caught in a vicious circle.

The more money they manage, the more they earn. However, there are. The p rincipal reason is th at goo d investmen t ideas are in short supply. Most of the m ajor mon ey m anagement firms cons ider only. These inst itutions cannot justify analyzing small and med ium-sized companies in which only modest amounts could ever be invested.

To avoid owning illiquid positions, investments ight be limited to no more than 5 percent of the outstanding hares of anyone company. In comb ination these ru les im ply -ning sha res of companies with a m inimum market capital::z.

This one is not, however, a comp letely arbitrary rule adopted by managers; the size of the rortfolio dictates such a rest riction. Unfor tunately for the client s : large money managers, like the one in this example, tho usands of companies are automatically excluded from investeeent consi de ration regardless of ind ivid ual merit. Self-Imposed Constraints on Institutional Investors Iost institutiona l investors are lim ited by a number of other self-imposed constraints.

In response to the prudent-man standa rd and sim ilar rules of accep tability, many inst itutions have unposed restr ictions on the ir portfolios. Some establish limits on the cash com ponent of a po rtfolio. Others may exclude mvestmen t in stocks selling be low five do llars a share, secu ri-. Remain Fully Invested at All Times The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times.

Many institutions interpret their task as stock picking, not market timing; they believe that their clients have made the markettiming decision and pay them to fully invest all funds under their management. Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments.

Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested.

Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost-foregoing the next good opportunity to invest-and the risk of.

Remaining fully invested at all times is consistent with a relative-performance orientation. Funds that would otherwise be idle must be invested in the market in order not to underperform the market.

Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met.

Save it to your desktop, read it on your tablet, or email to your colleagues. For them, low risk and low returns go together as do high risk and high returns.

Over a lifetime, we all encounter scores of low-risk, high return bets. They exist in all facets of life. As when you build a bridge that can hold ton trucks but only drive ten-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly, every assumption proving accurate, every break going your way. There are always breaks and the trick is to begin to anticipate, if you can, where the break points will be and shift.

Not the disciplines and not the framework but the tactics that are involved. The idea of value investing should be first and foremost about reducing risk. If you reduce risk the returns will take care of themselves. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life. An analogy is an investor standing on the 10th floor of a building, waiting for an elevator to carry him to the lobby.

The elevator door opens. The investor notices that the elevator is rated for pounds. There already are two relatively obese men in the elevator. The investor estimates their weights at about pounds each. The investor knows that he weighs pounds. The investor should not enter the elevator. There is an inadequate margin of safety.

Maybe he underestimated the weights of the two obese men. The investor waits for the next elevator. DMCA and Copyright : The book is not hosted on our servers, to remove the file please contact the source url. If you see a Google Drive link instead of source url, means that the file witch you will get after approval is just a summary of original book or the file has been already removed.

Loved each and every part of this book. I will definitely recommend this book to economics, finance lovers. Your Rating:. Your Comment:.