A Great Piece of Advice From Seth Klarman’s Margin Of Safety

In Seth Klarman’s book Margin of Safety, which has become a cult classic due to its excellent wisdom and the fact that Klarman ran a limited edition 5,000 copy print of the book (which regularly sells on Ebay, Amazon, and other sites for north of $1,000), the legendary value investor says:

“The single most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising. One half of trading involves learning how to buy. In my view, investors should usually refrain from purchasing a ‘full position’ (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to ‘average down,’ lowering their average cost per share, if prices decline.

Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices. If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place. Potential investments in companies that are poorly managed, highly leveraged, in unattractive businesses, or beyond understanding may be identified and rejected.”

Just like you give your car an oil change every 3,000-4,000 miles, it can be useful to perform portfolio maintenance once per year and ask yourself the following question for every single stock you own: If the price of this stock fell 50%, would you be more inclined to buy more of it? At the very least, would you truly be willing to hold on to it? If not, why: Is it because the business in question is highly leverage, unattractive, or engaging in business practices that you do not understand?

If Coca-Cola fell to $20 per share, there is no doubt that the purchase would be the deal of the generation. Same thing if Johnson & Johnson fell to $45 per share, or if Disney fell to $35 per share. If Exxon fell to $50 per share and Chevron fell to $60 per share, it would be time to put on the cowboy hat and become an oil tycoon. If Colgate-Palmolive fell to $30, it might be one of the most simplistically poetic facts that massive long-term wealth would get built due to something as seemingly mundane as soap and toothpaste.

The “50% Test” is like a B.S. detector for your portfolio. It makes you refocus on quality and owning assets that you understand. Let’s say you really understand Coca-Cola. You know it generates over $10 billion across over 200 countries, with over 500 brands (sixteen of which now conduct $1 billion in annual sales). You understand that making well-branded syrup concentrates is one of the most lucrative gigs in American history, and fully appreciate the vast distribution networks that allow Coca-Cola to spend a few nickels selling a product that will eventually retail for 10-15x that amount.

When you have something like that in your portfolio, and you can fully appreciate the business side rather than just the stock price side of the equation, then you will not only be able to tolerate 2008-2009 situations, but you will come to embrace them with the understanding that this is the moment to create substantial wealth.

When the financial crisis of 2008 and 2009 came along, Coca-Cola stock price fell from $32 per share to $18 per share. Here is what people that have long-term orientations and think like business owners would have known: the 43% decline in stock price did not correspond to a 43% decline in profitability. In 2008, Coca-Cola made $1.51 in profits for each share someone bought. In 2009, Coca-Cola made $1.47 per share in profits. During the worst calamity in the past century, the business profits didn’t even dip 3%. This is why long-term investors obsess over quality.

And, in 2009, Coca-Cola’s dividend did the same thing it has been doing every year since 1963: it went up. Coca-Cola shareholders collected $0.76 in actual cash for each share they held in 2008, and then they collected $0.82 per share in 2009. Worst crisis in a century, and your personal cash flow increased 7.89% from your Coca-Cola holding. Where is in life can you get a payday increase like that during an economic crisis? While companies were laying off employees, freezing salaries, and slowing down promotions and curbing career advancements, Coca-Cola shareholders kept seeing their cash payouts hum along, isolated from the economic storm that was engulfing many around it.

I consider investing to be the act of acquiring 20-30 businesses just like Coca-Cola gradually over the course of your lifetime. McCormick, Colgate-Palmolive, Hershey, Brown-Forman, Johnson & Johnson, Nestle, Pepsi, Procter & Gamble, General Mills, and Disney share these same traits, too.  When you combine McCormick, Procter & Gamble, and General Mills, you will see three companies that have combined to pay uninterrupted dividends for three centuries in total. With companies like that, you should be excited to see share price declines because you are acquiring a larger ownership stake than would otherwise be the case.

You focus on the profits that the companies generate. You focus on the dividends that get shared with the owners. You focus on the products that got sold during WWI, WWII, the Cold War, and withstood the technological obsolescence of the 1980s, 1990s, and 2000s. Those are the companies that readily pass the “50% Fall” test. I couldn’t own something like Best Buy; if it fell 65%, I would break out the Emily Dickinson poetry on death, thinking that bankruptcy is right around the corner. It wouldn’t suit my style to buy-and-hold a retailer that is being gradually made obsolete by Wal-Mart and Amazon, and has flighty profits and needs constant capital expenditures that don’t result in permanent increases in the profit base. If you wouldn’t buy more of a stock simply because it fell 20%, 30%, or 40%, you should spend some time thinking about whether you want to own a share of that company in the first place. Stock market crashes have come before and will come again, so you might as well build a portfolio of the companies that you’d want to own when we see it next.


Originally posted 2014-02-04 08:15:28.

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One thought on “A Great Piece of Advice From Seth Klarman’s Margin Of Safety

  1. scchan_2009 says:

    While I agree with Klarman assessment in not overreacting to price fluctuations (i.e. “ignore Mr Market” in Graham words), the issue is a bit different for “dividing up full position” in buys. Here i am not referring to buying dollar cost averaging investment over the years. Say you intend to buy 3000 dollars worth of Coke shares per year, you might as well do at one go – put in that 3000 dollar all in one trade and once per year. The reason is broker fees. If short term fluctuations should be ignored, why would you divide up the 3000 dollars into 2-3 parts? You just increase your costs.

    Also about Best Buy – retail is generally cut throat and lack moats, unless the retail business is really niche, but then the more niche it gets growth will be harder. I prefer business that actually makes the stuff. Lynch once joked the biggest profiteer of the gold rush are the ones who make mining tools and not the diggers (laugh)

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