17 January 2022

For this weeks’ episode, we decided to play episode 149 that originally aired back in July 2017. Preston and I are reviewing billionaire Seth Klarman’s book, Margin of Safety.  

As you’ll learn in the episode, both Preston and Stig consider it one of the best value investment books of all time. Perhaps that is why Warren Buffett keeps a copy in his office. The book is much better written than The Intelligent Investor, and a must read for any serious investor.

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  • The different methods for stock investing valuations.
  • The difference between investors and speculators.
  • When you should hold short term and long term bonds.
  • How to counteract risk in your portfolio.


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Stig Brodersen 00:00

The past two Mondays, today, and the next following Monday, we’ll republished four of our favorite episodes of We Study Billionaires. We’re calling the episodes “Classic,” and it’s in addition and not to replace any of our recurring episodes.  

Preston and I, and now more recently Trey, have been hosting our show since 2014. We’re grateful for getting new listeners every week, and we know that many of you haven’t listened to some of our classic content. 

For this weeks’ episode, we decided to play episode 149 that originally aired back in July 2017. Preston and I are reviewing Billionaire Seth Klarman’s book, Margin of Safety.  

As you’ll learn in the episode, both Preston and I consider this one of the best value investment books. Perhaps that is why Warren Buffett keeps a copy in his office. The book is much better written than The Intelligent Investor, and a must read for any serious investor.

So without further delay, here is today’s classic episode, Seth Klarman’s book, Margin of Safety. 

Preston Pysh  00:02  

Hey, how’s everyone doing out there? Today we’re going to be covering an interesting billionaire that’s been referred to as the most successful and influential investor you’ve probably never heard of. In fact, investing legend Warren Buffett evidently keeps a copy of this person’s book in his office at work. 

So, the name of the book is, “Margin of Safety,” and the investor is Seth Klarman. Klarman’s personal net worth is about $1.5 billion. And he’s a hardcore value investor that bases his investing approach around Benjamin Graham and the principles that have precipitated out of Graham’s approach.

Stig Brodersen  00:36  

“Margin of Safety” is really an iconic book within the value investing community. Not only because it’s a great book, but also because he only chose to put 5,000 copies into existence. In a research for this episode, we even found out that university libraries have named this as one of the most waitlisted titles, and even more impressively, or perhaps discouraging is actually that the book is most often claimed as lost. 

Preston Pysh  1:02  

So that’s right, Stig, and because Klarman’s book is so rare and highly sought after, the book retails from anywhere between $700 and $3,000 for a single copy. Luckily, we were able to get our hands on this very valuable book and pick apart some of the more interesting parts to highlight in this episode. So, without further delay, let’s hop to it.

Intro  01:25  

You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  01:45  

Alright, so like we said in the introduction, we’re going to be covering billionaire Seth Klarman’s book today. And the title of this book is, “Margin of Safety”. This was a great read. I was thoroughly impressed. You know for how expensive the book was, I was kind of expecting it to put some gold bars in my pocket while I was reading it, but that obviously didn’t happen. But I will say, this was a fantastic read if the book was $5 or $3 or something like you know, was given to you for free, I would still say this was a fantastic read. I’m kind of curious the way Stig sees it.

Stig Brodersen  02:20  

Yeah, I have the similar impression as you, Preston. It was a great book, and it’s definitely one of the better value investing books. The book is almost legendary among many investors. It’s kind of one of those must-read things if you’re super geeky like you and me, Preston, I guess.

Preston Pysh  02:36  

Yeah. You know why I liked it, and why I’m saying I think it’s so good is, it’s easy to read. For me, this was 1,000 times better than the “Intelligent Investor”. I think anybody who would read this would find this much easier to understand than the “Intelligent Investor”, and I think it actually goes into a lot more depth than the “Intelligent Investor”.

Stig Brodersen  02:54  

Yeah, and the books are very, very similar. Just one way to look at that is the amount of times that he mentions Benjamin Graham and Warren Buffett in the book, in many ways is sort of like an updated version of the “Intelligent Investor”/ “Security Analysis”, I guess. Really good content that’s really easy to read.

Preston Pysh  03:12  

Yeah, much easier to read than Benjamin Graham’s writing style. 

Okay, so what we’re going to do is we’re going to hit some of the great discussions that we had found. Stig took his notes when he read it. I have my notes of what I wanted to discuss going through this. So one of the first things that I want to talk about is very early in the book, Klarman models a lot of the book around the “Intelligent Investor.” 

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And so, just like Benjamin Graham’s “Intelligent Investor,” he starts off with a discussion about the difference between speculation and investing. And I can see Stig smiling because I think I stole his first point, was this what you’re going to talk about, Stig?

Stig Brodersen  3:47  

Oh yeah, exactly.

Preston Pysh  3:49  

So, I really like the way Klarman describes this. I actually like it a lot better than the way Benjamin Graham describes it. And I took two paragraphs out of the book to read here for you. So this is what Seth Klarman has to say about the difference between these two things. He says, “Investors believe that over the long run, security prices tend to reflect fundamental developments involving underlying businesses. Investors in a stock, thus, expect the profit in at least one of three possible ways – from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends back to the shareholders from an increase in the multiple that investors are willing to pay for the underlying businesses as reflected in the higher share price, or, by a narrowing of the gap between the share price and the underlying business value.” So, that’s what he defines as an investor. 

He then says that a speculator by contrast buy and sell securities. They buy and sell stocks and bonds, based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based not on fundamentals, but on a prediction of the behavior of other people. 

They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of indifferences to investor fundamentals. They buy securities because they act well and sell when they don’t. Indeed, even if the speculator was certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today. 

So, something else that he gets into in the first chapter, so you can see how he’s delineating this. He’s saying speculators are just looking at the price, the price alone and they’re going with the flow, where investors are looking at it as a business. They’re looking at the fundamentals, and then they’re using discount cash flow to determine what they think the value is discounted back at appropriate rate. 

So what I like about his discussion, as it goes further into this chapter about speculation versus investing, is he talks about how it’s a lot easier for a person to be a speculator, and the reason why he says that, is because speculators are running with the crowd. If the price is going up, you’re going with everybody else and saying, “Yeah, I think the price is going to go higher and your human nature that feels right, that feels comfortable, because when you see a crowd, you want to go with the crowd. That’s what’s normal. The crowds are running away from something. Your natural inclination is to run with them.” 

So, he’s saying that deep down inside, you have to really, really work at not being a speculator because everything psychologically that’s going on in your brain is telling you that’s how you should be investing. And I found that discussion to be really well thought out, and the way that he presents it in the book is really well written. And compared to the “Intelligent Investor,” I never really captured that discussion in the “Intelligent Investor” as well as the way Klarman did here.

Stig Brodersen  6:51  

One of the things that he’s saying is that a speculator really doesn’t like to look stupid, whereas if you’re an investor, you should be prepared to look stupid. But it’s a way of talking about whenever you are speaking with your peers, what is it really that you’re saying to them? Are you saying, look at this price, it’s been going up, I think a trend will follow. Is that what you’re saying? Or are you saying, this looks really, really cheap. 

Now, I’m discussing the business model. Do you think that something might change? Is that how you approach a problem? And the way that Klarman actually talks about this more in detail is, if you’re an investor, you will go for investments that spin off cash. That’s kind of like more or less how he looks at it. And cash in this situation is not the same as dividend. That’s not what he’s saying at all. 

He actually talks about later in the book that if you’re looking at dividend yield, you’re probably doing something wrong; if that is your measure, simply because the dividend yield comes from a drop in the stock price. 

Preston Pysh  7:52  

And he talks about what Stig said later in the book. He’s talking about the dividend yield and how that’s only part of the cash flow that’s being generated. The rest of it is going to the retained earnings on the balance sheet. So, I got the impression that if you’re doing a discount cash flow just on the dividend, you’re totally missing a very large chunk of what the potential value is with the business.

Stig Brodersen  8:12  

Whenever he’s talking about spinning off cash is basically, is the company profitable? And is it profitable on the free cash flow basis? That’s really what you’re looking for. And if you look at a company like Zynga, for instance, that’s been really hot lately. If you bought Zynga, it’s the video game development company. You bought that at the beginning of 2017, you would today have made almost 50% return. 

Now, the company didn’t make any profit last year, or the year before, or the year before that, and it’s not making any profit today. But the price has gone up. So, if you’re a speculator, you might not look at the fundamentals at all, but you just see something that just increased 50% and you’re thinking, hmm, perhaps this is interesting. It’s an easy narrative to tell your friends and that’s exactly what Seth Klarman is telling you what not to do. 

And in continuation of this discussion, he also talks about treasuries. And the reason why he’s talking about treasuries is that, do you really understand what is it that you’re holding? And he’s really puzzled by this. 

He’s saying that he really doesn’t understand why most people would buy treasuries. When I say treasury it’s basically like government bonds. He’s saying, very, very few people actually buy a bond with the intention of holding it to maturity, which is kind of like the key concept of holding a bond. There are tons of other explanations why they’re doing it. One reason might be that they’re required to do that by law. One example would be something like finance institutions. 

But more importantly, when people buy something like treasuries, they’re actually doing it because of reasons like CAPM [capital asset pricing model]. CAPM is one of those academic terms that Seth Klarman and Warren Buffett for that matter, really, really don’t like. If you’re a fund manager, and you’re not a hardcore value investor like these guys, you are looking at different types of data. You’re looking at how do I limit my volatility, for instance. And the academic way of looking at this is that you should have as little volatility as possible, because that will give you what they call the efficient frontier, which is basically how to get the highest possible return for the least amount of volatility points, if you like. 

The interesting thing is that and what he’s touching on here is, if you have overvalued stocks and if you have overvalued bonds, you can still come up with a really good measure for the efficient frontier and for CAPM. It looks like a really, really interesting investment for you. 

But the reason why it’s a really good investment is because you have no opportunity cost. You’re only looking at a universe with only stocks and bonds. And that’s really what he doesn’t like, and that is really speculating, not investing. 

I’m sorry, some of that came off a bit too academic, but I think my point here is really, why are you holding that type of security? What is the reason why you’re doing it? If you don’t know how to answer that in one sentence, for instance, like here with the treasuries, you’re probably speculating, you’re not investing.

Preston Pysh  11:14  

So great comments there, Stig. I just wanted to throw this out to the audience so that they understand this term CAPM as what Stig was saying. And CAPM stands for capital asset pricing model. This is a very academic model that I personally think is a bunch of bunk, but it’s something that is taught in every single business school. It’s taught through all finance literature, in academia. 

What it is, is it describes the relationship between systematic risk, or when a stock market crashes, and it’s a credit contracting event, that’s called systematic risk, just so you understand that. 

And so, this is a model that describes the relationship between that systematic risk and the expected return of the asset, whether you’re talking about a stock or a bond or whatever, and most of the time CAPM is applied to the stock market. This is highly dependent on the variance that exists for a particular stock. 

So, let’s say General Electric has a lot of volatility compared to, you name another company, call it Coca-Cola, CAPM is going to say that there needs to be a larger discount rate associated with the more volatility. Is that right that last part, Stig?

Stig Brodersen  12:25  

Yeah, because basically about optimizing something that’s at least, in my opinion is completely useless, because if you look at how this *inaudible* is derived, you come up with this solution that you should always buy government bonds. I mean, that is the conclusion that you end up with. If that’s the only solution you could come up with, always buy government bonds, period. 

If you’re not thinking about the valuation at all, you’re not thinking about the valuation of stocks, more or less. It gets even worse if you go into the details of how they actually derive the return of the stock market which is another discussion. But to me, it seems hopeless.

Preston Pysh  13:00  

Yeah, oh, sorry, we’re getting so technical here. But the other thing that I find very frustrating with CAPM is it all depends on the timeframe that you attribute to what you’re using as your entire market value. 

So, if you’re using the last 5 years of data, 10 years of data, 15 years of data, all of it completely changes based on the historical data that you’re using. This whole thing falls apart for me, personally. There’s a lot of people, a lot of very smart people out there arguing that this is how this works. But very few people with a very high net worth arguing in favor of this. 

In fact, I don’t know that I can even name any person with a very high net worth that has ever come out and promoted the use of CAPM. You know of any, Stig?

Stig Brodersen  13:43  

No, no one. And I think you should be aware if you hear anyone say that’s probably because he owns a fund or something. I’m kind of laughing while I’m saying that but it’s actually true. Like, whenever people are endorsing something like this, it’s typically because they have some sort of fund or they have a risk profile with the assets, that they mentioned, like, they promised investors that we have so much volatility. 

One way to mitigate your volatility, at least, mathematically would be to buy government bonds. And that’s regardless of the prices. So, if you’re like questioning yourself, “I hear about this negative interest rates. I hear about people lending the money [for] 30 years in some countries for less than 1%, why is that?” This is exactly why, because I mean, these are the models that these so-called investors or speculators, I would call them, are using mixed results. I guess.

Preston Pysh  14:37  

Yeah. So needless to say, in this book, he lightly addresses some of those areas pertaining to CAPM, and basically how he thinks the entire thing’s bunk. When you start talking CAPM, you have to rely back on the efficient market hypothesis which he blows total holes through in this book of why that’s the antithesis of value investing. 

Value Investing is fully based on the idea that markets are not efficient. So, some interesting discussion, sorry to get too academic there with you guys, but if you’re in business school, you might have enjoyed some of that, and you might disagree with us. We strongly encourage that. And if you do disagree with us, and you think that there’s a bunch of people making lots of money with CAPM, shoot us up on Twitter and tell us who they are and why you feel that way. 

Anyway, so the next section that I want to talk about in the book was this idea where he talks about this Wall Street bias. I’m really happy that somebody with such a high net worth has come out and talked about this so openly in his book. Unfortunately, the book is not as accessible as others because of the price of it, but, he says, “Investors must never forget that Wall Street has a strong bullish bias, which coincides with its own self interest.” 

And what he’s saying is if you talk to somebody on Wall Street, what they think the market’s going to do, they’re going to tell you it’s going to go up. And you shouldn’t be surprised by that. 

From my own personal experience, having talked to various people that work on Wall Street and many money managers and all that, boy, it’s hard to find anybody who thinks that the market will ever go down. I totally agree with them. 

And it’s interesting to see him talk about this in such a contrarian point of view from other money managers. Then you know, who else is like this? Bill Gross, billionaire Bill Gross. He’s exactly like Seth Klarman where he’s not always a bull. He can be a real bear sometimes. I mean, right now, he’s a perfect example of that.

Stig Brodersen  16:35  

So basically, Preston, I think it boils down to incentives. I mean, if you are a huge believer in Wall Street, let’s call it the CAPM people, you actually don’t make money from outperforming the market. Well, you do. But if you actually look at how they make money, they make the vast majority of the money from fees. And if you can convince people that the market is going up, well, then, they will give you money, and you’ll just make a small percentage of that, which is a lot of money because they’re a large amount at the end. 

So, they really have no incentive not to tell you that the market is going up. And if you’re looking to invest your money, who would like to speak to someone like, I guess, Preston and me, who will tell you not to invest. It’s not interesting. That’s not what people want to hear, so that’s not what you’re telling them. 

And basically what Seth Klarman is getting at here is that Wall Street is not finance people. It’s marketing people. And that’s really what he doesn’t like. And Seth Klarman himself, multiple times since he *inaudible* his fund, he’s been holding more than 50% in cash.

Preston Pysh  17:35  

So on that note, he goes into another discussion, which I think is very difficult to find in almost any finance book. And it’s this discussion about being fully invested at all times. I’m going to read this because this is so golden to the way Stig and I think and what we believe, so it’s awesome when we find other people writing this. 

He says, “Remaining fully invested at all times is consistent with a relative performance orientation.” Meaning, I’ve just got to keep up with the Joneses kind of thing. “If one’s goal is to beat the market, particularly on a short term basis without failing significantly behind, it makes sense to remain 100% invested. Funds that would otherwise be idle must be invested in the market in order to not underperform the market.” 

And notice how he said in the short term. Then, he goes in the next paragraph. He says, “Absolute performance oriented investors by contrast will buy only when the investment meets absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, referring to remain less than fully invested when both conditions are not met. 

In investing, there are times when the best thing to do is nothing at all, yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.” 

So, that was his way of saying Wall Street is all about keeping up with the Joneses. And if you want to have long term performance that outperforms the market, you need to not be fully invested at certain points in time. 

Stig, in my opinion, that right now, in the summer of 2017, one of those times that you should not be fully invested. We think that the market is very expensive. And you can only expect about a 3% return if you’re invested today. It has been like that since we’ve been doing this show. The market has not gone up too terribly high since we started doing this show. We continue to hold that opinion. 

The market has been fairly flat in level for the last, I don’t know how many months, and we expect that to continue maybe a little bit more upside, but not something that I think the risk is worth chasing that couple percent. 

I think there’s enormous risk associated with chasing a couple percent. I think your downside risk could be as high as 50% chasing a couple percent. So, that’s what he’s getting at here. That’s exactly what he’s getting at this paragraph in the book.

Stig Brodersen  20:01  

It’s really interesting to speak to fund managers because what fund managers typically tell you is that my investors don’t pay me to hold the money in cash because I’ve done that myself, so I need to invest it. And then, you hear people like Warren Buffett or Seth Klarman saying, “People actually pay me to get the best possible return.” 

Oh my god, the difference and the trust you can put into a person saying something like that compared to you just needing to be fully invested for the sake of being fully invested. It’s just tremendous. 

And I think, whatever you are reading the “Margin of Safety”, you can just feel how Seth Klarman really, really just comes off like a really good and genuine person. It’s definitely a good read. I just do want to say like we’ve been bashing on the price a few times. As far as I know, whenever this book was written, back in 1991, it was actually sold for $25. 

The reason why it’s so expensive today is there are only 5,000 copies of the book, and he’s not like updating and sending it out again, so that’s why it’s so expensive. And people are just beating it up. It’s really a question about supply and demand. 

Just like a really fun story to this. I’ve read that university libraries have a really special relationship to this book. Not only is this one of the most waitlisted titles you can find out there, it is also the one of the most popular books claimed as lost. And it just tells you something about the popularity of the book, I guess.

Preston Pysh  21:31  

So on Stig’s note about not being fully invested and the way that Seth Klarman might be sitting on 50% cash. I want to highlight that throughout Stig and I’s opinion of where the market’s priced today in the summer of 2017, but I also want to tell you what Warren Buffett’s doing here in the summer of 2017. 

When I’m looking at Berkshire Hathaway, his cash and cash equivalent sitting on his balance sheet today is at $96 billion. Just to give people a hint of what’s going on. So the last time we talked about this, it was in the low 80s. Just in the last two quarters alone, he’s added $12 billion to his cash position. 

I mean, he’s almost at $100 billion in cash on his balance sheet in the summer of 2017. So, if you think he’s having trouble finding cheap picks, that would be a good assumption, I think, for a lot of people. And you might want to take note of his positioning because I know I sure am.

Stig Brodersen  22:33  

If you look at his portfolio, it’s around $130 billion at the moment. He’s holding almost as much cash as he’s holding common stock. I’m almost hundred percent sure that if he didn’t have to think about the tax consequences of the stocks that he bought really cheap and our price is really, really high, he would be a lot more than 50%.

Preston Pysh  22:54  

So Stig’s talking about his marketable securities that he’s holding on his balance sheet. So today, he has $133 billion dollars of marketable securities or stocks. So whenever he says he owns Coca-Cola, Coca-Cola makes up a part of that $133 billion here, this figure that we’re talking about. The reason he doesn’t sell Coca-Cola is because it’s gone up. What would you guess, Stig? 10 times what he paid for? 

Stig Brodersen  23:17  


Preston Pysh  23:18  

Yeah, probably around there. So, if he sells that position, even though he thinks that a lot of this stuff is overpriced, this is our assumption here. He’s not going to sell it because his capital gains on a 10 times or a 10x position is astronomical. He’s never going to sell that because of the tax implications. 

So, what Stig’s saying is, he’s almost at a 50% cash position between his cash and his marketable securities. But if he didn’t have such a huge tax burden, and because of his massive gains on the ones that he is holding, he’d probably be at 75% or something even larger in cash. That’s our opinion. Other people might see it differently, but you know, that’s how we see it. 

Alright, so my next point, and I apologize right up front, we’re going to be talking about accounting here. So, if that makes your ears bleed, you might want to skip forward here, but we’re going to be talking about EBITDA [earnings before interest, taxes, depreciation, and amortization], and I love Seth Klarman’s talk about EBITDA in this book. It is so crystal clear. 

He puts this little chart in here, this little income statement chart where he has Company X and he has Company Y, and he shows a company that has depreciation and amortization expense, and the other one has no depreciation, amortization expense. And he shows the difference between using EBIT [earnings before interest and taxes] and EBITDA. 

So, when we say EBITDA, we’re talking about the earnings before interest, tax, depreciation and amortization. When we say EBIT, we’re talking about the earnings before interest and tax. And when we were out at the shareholders meeting, Stig, I don’t know if you heard this from the audio from the last shareholders meeting, somebody brought this up and asked Buffett and Munger, “Why don’t you guys like EBITDA?” 

They said, “Well, because depreciation and amortization is a real expense to the business, so why in the world would we use something that’s basically subtracting out real expenses?” And man, I love this discussion. 

I’m so glad he put this in the book, and I’m so glad Buffett and Munger talk about this. Because why Wall Street is using EBITDA is beyond my comprehension. I can’t figure it out. I can’t find one person on the planet that can actually argue this for any cause, other than basically making people pay higher multiples for a business. 

By using EBITDA, you’re getting a higher number, and you get better multiples and you get higher premiums that Wall Street can charge for a business out of this. So, this was awesome that he outlined this in the book. The little chart was priceless that showed why these numbers are so stupid.

Stig Brodersen  25:49  

I’m also puzzled why people keep talking about EBITDA. It really doesn’t add that much value to anything, I guess. Perhaps it’s one of those that is what we’ve always done, so we just keep on doing it, even though it doesn’t make sense, or it’s just too hard to switch. I mean, that might be another thing. 

Sometimes I like to come up with this example that the keyboards that we’re using for our computers, they’re not the most efficient ones the way that the layers are outlined. But it’s just too hard to switch to another standard because we have actually learned how to type on this type of keyboard, even though you actually can even do it a lot faster on another type of keyboard. 

Probably like the same thing with something like EBITDA. It’s just people have always been using it, we need to come up with different terms. It’s just too much of a hassle. Let’s just keep giving people bad information. At least that’s my take.

Preston Pysh  26:37  

It’s funny, in business school, they teach people to come up with a value by taking the EBITDA times the enterprise value, in order to determine the value of the entire business to include the debt. And I just, man, I cannot understand why you’re using EBITDA instead of EBIT. 

I’m sure listeners are not enjoying this conversation. So, let’s move on to the next thing. For me, it’s very entertaining, but I’m sure others aren’t finding it as entertaining. So we’ll go on to the next thing here.

Stig Brodersen  27:05  

So the next highlight I have is his discussion about defining your investment goals. I hear a lot of investors talk about how they decided they will make 10% a year or 12% a year, whatever it is. And what Seth Klarman is explaining is that it’s really dangerous to set a target for yourself. 

Why it might seem like it’s a very ambitious goal and really keeps you focused, if you want to reach, call it, 10% every year. The bad thing about this is that you focus too much on the potential upside instead of the potential downside. 

So for instance, if I look at the market today, as a value investor, I really don’t find that many rate picks. I might find something that’s fairly priced and say I could get like 6% return with almost no existing downside. 

I think today will be somewhat reasonable, but if you have the idea that you have to make 10% or 12% every year, you will completely disregard that value pick. And you’ll be looking at, for instance, gross stocks that have previously shown that they can grow by 12%, even though that the fundamentals are not showing that at all.

Another thing that he’s really hinting at here is that if you are focusing on getting that kind of annual return, what typically happens is that you get this idea that you should be doing something all the time. He’s saying, short term, it might take some time before the stock really experiences that increase in price to reflect the intrinsic value. So if you have this idea that, okay, I simply need to make this and that every year, you just end up paying a fortune instead of transaction cost. 

Now, so what are the big companies in the States doing? For this example, I’m just talking about Warren Buffett’s letters to his shareholders back in 2007 because this is related to this, and it’s about pension accounting. I know that people are thinking, wow, this is like watching paint dry or something, whenever I say something like pension accounting. But again, it’s actually a very neat example. 

So, what Warren Buffett talks about is that 363 companies in the S&P 500 have pension plans. And the assumption is, and he’s looking back in 2006, but it just might as well be today. They expect to make an 8% return. Okay, now he’s saying, you really can’t make that much from your cash and bonds that you’re supposed to hold, so you’ll actually need to make more on equities. 

And this example, it’s like 9.2%, and it’s somewhat similar today. So actually, what you can see whenever you look at the balance sheet, is what they’ve been accounting for. They will in the long run make, say, 9% every year on stocks, and you’ll see the exact same thing today. 

So, I’m just asking what will happen to people’s pensions if the markets crash, if we expect to make that kind of return? And that’s exactly what you saw after the crash in 2008 to 2009. The money was just gone. Because it was just projected, it will always compound with that amount.

Preston Pysh  30:10  

So, if we have any listeners from Japan, I’m really interested in hearing your opinion on what Stig just presented there, because when you go back to Japan in the 1990s, and you look at what’s happened ever since then, I think we’re about to see and experience something very similar here in the United States as to what Japan has experienced over the last two to three decades. 

And when you think about my parents’ generation, and individuals that are retired at this point, and they have nowhere to go with their money to get any kind of yield, without assuming enormous amounts of risk. I can only imagine where this is going to be after the next credit cycle contracts and the Fed is doing everything it can to lower rates and to do more QE [quantitative easing] and things to stimulate the economy which is going to drive rates even lower, what is that they’re going to do. 

Japan’s already experienced this. They’ve already been through all of this. In fact, their interest rates over there have been pegged at 0% for the last 10 years. So, I’m curious to see if anybody in our audience can shoot us an email, hit us up on Twitter, tell us what it’s been like for that generation for that older retired generation in Japan, and what they’ve done and what it has done to that segment of the population, because I think that that would be a very interesting case study, and maybe analogous to what we might be seeing in the United States coming in the next decade.

Stig Brodersen  31:33  

If you’re looking at the States right now, it’s really consumption driven. 70% of GDP in the States is consumption. What we have seen in Japan is that because the yield is so low, and the intention of having the yields so low is actually for people to spend more. But because you have a lot of people looking to retire, people actually don’t spend at all. 

They just save because now. They have no faith in the yield going up, so they’re not spending anything and it’s really, really bad for the economy. What happens if and when that’s the case in the States?

Preston Pysh  32:04  

All right, so one section in the book that I want to talk about that I found is an interesting discussion was this paragraph where he talks about how investors can counteract risk. This is what Klarman says. He says, “There are only a few things investors can do to counteract risk. The first thing they can do is diversify adequately. They can hedge when appropriate. 

And the third thing is that they can invest with a margin of safety.” So, let me just talk through these three points really fast. So, diversification. He doesn’t come out and say, or at least, I don’t remember reading anywhere where he says how many picks he would describe as having an adequate amount of diversification, but I do recall from Joel Greenblatt’s book, I think he said it was 7 picks, and the variance that’s associated with those 7 picks, if they’re in different sectors will give you an adequate amount of diversification. 

On the show, Stig and I have said 10 to 15 picks we think are something that’s reasonable and gives you enough diversification. So, that’s one way to counteract risk. 

The next thing he says is quite interesting. And this is the one I want to hear Stig’s opinion on. He says hedge when appropriate. I think that our previous discussion about not always being 100% invested is what he’s getting at with this comment. 

Now, he’s saying it differently by saying hedge when appropriate, but I think what he’s really saying is know where you’re at in the credit cycle. Know where you’re at with valuations and when they’re kind of extreme and you’re chasing a couple percent upside with enormous downside, that’s when you need to hedge with asset class you’re sitting in that won’t have a large amount of variance, at least, especially downside variance, if the economy starts to trend in a different direction. So that’s another way that he says that you should counteract risk. 

And then, the third one was to invest with a margin of safety. What he’s getting out here is if you’re going to buy a company, make sure you have a very large margin of safety of what you think it’s worth to what it’s currently trading at. So if you think the company is worth $10, and it’s trading for $9, you don’t have a very large margin of safety there. 

But if it’s trading for $5 and you think it’s worth $10, well, then you got a fairly significant margin of safety. In the book, he says there’s no way to calculate your margin of safety. It’s not some number that can be obtained. It’s just something that has to kind of feel right, and you got to feel like you’re getting enough return for the price that you’re buying it at.

Stig Brodersen  34:25  

I think there are two different biases in many retail investors’ minds. One is that they want to feel that they are always invested because they don’t want to lose out on anything. And then, on the other hand, they don’t want to lose money. [It’s] what’s called loss aversion. 

What’s actually happening is very often people would buy a hedge. And you can buy hedges in the market in many different ways like you use financial instruments and whatever. But what Seth Klarman is really getting at here, instead of being fully invested in still pay for hedge, which is kind of like paying for insurance, instead, he would be saying, “Perhaps you should just hold more of your funds in cash. That’s a hedge in itself. That’s a way to mitigate your downside.”

And I guess, the way that I look at hedging, or the way I look at insurance for that matter is you should never ever insure yourself if you don’t have to. At least you shouldn’t pay for some kind of financial instrument to hedge for you. Because by definition, you’ll lose money from insurance if you do this over and over. So that’s not good. What can you do instead? 

One of the reasons why it’s sold by Wall Street is they want to give you the idea that you can invest 100% of your funds with them. Why wouldn’t you like to have insurance with them? But if you are afraid of being too much exposed to energy or to mining or to any kind of industry, don’t put all your money in mining, or in oil, just put whatever you think is adequate, then put your money in something else afterwards, perhaps in cash; perhaps in other equities. 

I really liked his way and his take of doing that. And I think, perhaps the best example of what he’s doing now is the simplest and cheapest hedge you can make. It’s basically just to hold cash. If you think that you can’t find anything that’s interesting.

Preston Pysh  36:11  

So Stig, I want to just have a quick discussion about what you just said there as far as just hold cash. We’re doing the show here in 2017. And because interest rates are so low, like the 10 year treasuries which is just barely over 2%. We’re basically saying, it’s almost the same as holding cash, except you just don’t have to worry about liquidity or anything like that. It’s just simple to say cash because two percent’s like nothing. 

But if the time was different, if our timing was different; let’s say we went back to the year 2000,  and the market was screaming high, it was even higher than it is now with respect to price to earnings. 

However, the 10-year treasury back then was yielding 6.6%, and if it was back then, I would definitely be recommending holding some type of treasury position opposed to cash, whether it was a 10-year treasury or maybe even a 5-year; something probably [with a] shorter duration, simply because my expectation is whenever the credit event and the business cycle ends, the Federal Reserve has to lower interest rates in order to spark the economy. And when that happens, the value of that bond is going to go up if they drop interest rates. 

So as we’re saying that, I don’t want people to think that depending on whatever kind of business cycle you’re in, especially if you’re listening to this, and you’re overseas. If you’re in a different country, and your interest rate is higher, and let’s say that you’re in whatever country and the interest rates [are] 5% or 6%. 

I think [my] advice to you might be that you need to own a short duration government bond if the rates are around that level [as] opposed to holding cash, because whatever central bank is running the currency in that country, they’re going to have to lower interest rates whenever the business cycle ends. So, I’m curious to hear Stig’s opinion on what I just discussed there.

Stig Brodersen  38:02  

I think it’s really good that you are separately talking about the States, which is typically what we talked about and then other countries. I think for some international countries, it might even be beneficial not only to own short term bonds, but actually longer term bonds simply because if you expect for the central bank to lower the interest rate, just by the *inaudible* economy, which is typically what we will do, as what Preston said before, your bonds will become worth a lot more really, really fast. And the longer the duration of the bond, the more valuable they are. So yes, I agree with that additional comment. I guess.

Preston Pysh  38:34  

And just so people understand why I was saying that I would own a shorter duration, so we can get into this discussion a little bit as well. Let me just provide a hypothetical [situation] here, so that we can walk through this. 

Let’s say the year’s 1999 in the United States, and the stock market’s going sky high. I start buying 30 year bonds. From 1999 to 2000, as interest rates are creeping up and going higher, that’s going to be a very painful experience to go through if you’re owning long term bonds. But if you’re holding short term bonds, it’s not too much of a big deal for you because it’s not going to be as volatile. 

Now, the trade off for sitting in something that is short duration as interest rates are going up is that whenever the business cycle does end and then it goes down, trade off is that you’re not going to nearly make as much money by holding a short term bond as you would a long term bond. 

So, it’s a much more, when I say I’d be sitting in a short term bond through that experience of the stock market rising and basically putting a larger and larger position into short term bonds, it’s mostly because I’m much more of a conservative person, and I don’t want to experience that pain of watching a long term bond get crushed as interest rates would be going up. But as that starts to unravel, maybe you’d want to start sliding into longer duration bonds if you feel like you’re on the back end of a credit cycle. 

[I’m] not sure if all that made sense, but I think it’s an interesting discussion. And I think it’s really important for people that are not domestic into the United States to understand that.

Stig Brodersen  40:06  

And Preston, I think that discussion really relates back to what Seth Klarman said in his section about investing and speculation. Why are you holding a bond? There might be tons of different reasons. 

Having short term bonds, you have a lot of flexibility. You might want to pour that into the equity markets as soon as possible. It’s better than the opportunity cost of getting almost nothing. The other strategy with long term bonds, that’s more like, yes, I would like to make money on bonds and on stocks, but I’m also incurring more risk while I’m doing it, and I can afford to do that because even if the interest rate were to creep up. I don’t have to sell my bonds and take a loss. 

Preston Pysh  40:43  

Yeah, exactly. 

Stig Brodersen  40:46  

Perhaps my favorite part of the book was his discussion about valuation. Again, sorry, to bash the price of the book if you’re thinking, now I’m paying $1,000 for a book, I’d finally get that one equation that can just solve everything for me in terms of valuing stocks. I’m sorry to say it’s a bit more generic than that. But I still really, really liked this discussion. He talked about three main approaches to valuing equities. 

What he is also actually saying is that while you can’t value home to the nearest thousand dollars, why should you be able to do this $4 billion complex business. I really liked the way he started off with this. 

So, he’s really looking at things more not at an exact stock price, but more within the range. And he specifically talked about, since the interest rate always changes, the valuation of the business also changes. So, even if you come up with a somewhat exact amount, it might be different tomorrow. 

And the industry just simply changes all the time. You have new competitors, you have new technology, everything is just up in the air. So having a static valuation, and the mindset of a static valuation is really, really hard. And the way he describes this is that he’s saying, “Just remember, it’s garbage in. Garbage out.” 

What are the assumptions that you put into the model? The first approach that he’s talking about is what he calls the NPV approach, the net present value. Sometimes here on the show, we also describe that as the discounted cash flow approach. 

And basically, what he’s saying is that if you can estimate the cash flow, and just discount that back to today with an appropriate rate, that’s basically the valuation of a stock. Clearly, it’s not always easy. So that’s also why he’s specifically talking about, if you want to have a somewhat narrow range for your valuation, you need to find a really stable company.

And the second approach he’s talking about is liquidation value. What would it be worth if I just sold off everything today? And he would simply use that approach for companies that are not making profit because as you said before, whenever you need to discount cash flow, well what if that business doesn’t have any cash flows to discount? 

So, the first one, the DCF [discounted cash flow] approach is the most popular one. The second most popular one is the liquidation value, in his opinion, which is basically to look at what can I sell this for, if everything goes bad. And then, the third approach that he talks about is the stock market value approach. It’s more targeted at a mutual fund and closed-end fund that is not so popular today. 

The takeaway from valuation if you’re an investor today is basically find a profitable company that is somewhat stable and discount the cash flow back to today, that will give you the best valuation. If you’re a bit more advanced and more interested in special situations, more complex businesses, you can use the liquidation approach.

Preston Pysh  43:43  

You know, Stig, chapter 10 reminded me of, it almost seemed like Joel Greenblatt had literally taken all of chapter 10 and turned that into “You Can Be a Stock Market Genius.” Did you get the same implications?

Stig Brodersen  43:54  

Yes, and he even talked about the Marriott in this book and I saw the almost exact same example in Greenblatt’s book afterwards. I definitely thought about that, too.

Preston Pysh  44:05  

What Klarman says is you should be very conservative with the free cash flows that you estimate the company can actually get into the future. Not only should you be very conservative with the free cash flows that you estimate, but you should be very conservative with the discount rate that you use when discounting those free cash flows. And I think the combination of both of those is really, really important for people to understand because so many people look at the past performance of the last 10 years, and maybe the growth rate of free cash flow was 15%, and they just draw a line showing 15% into the future, and I think what Klarman would probably tell you after reading his book is that you should maybe use 0% growth moving into the future if a company had a big growth rate like that. 

Just use something ridiculously conservative, and then, once you get that, you should use a discount rate much higher than what other people might say. So a lot of people, what they’ll do is they’ll say, okay, so the growth rate is 10% a year with the free cash flow, and now let me use the 10-year treasury as my discount rate. 

They’re using 2%, and they get a valuation that’s saying that the business is worth $10 trillion. That’s not going to be good. So, I’m much more of an IRR [internal rate of return] person, which means what you do is you estimate the free cash flows of the business. Just so people know Bill Miller, who we interviewed, Legg Mason’s CIO whose net worth is $500 million, and all that good stuff. 

Whenever I had this discussion with Bill, he said, Yeah, IRR. And what you’re doing with that is you’re coming up with what you think the estimate of the free cash flow is going to be into the future. Once you have that, then you say, the stock price is fixed. It’s what it is on the stock market today. 

So, if the company is trading for $30, that’s the price that you use. And then what you do is you solve the equation for the discount rate. When you solve it, the discount rate might be 15%. It might be 10%, it might be 5%, whatever you solve it for.

And then, you ask yourself the question, is that large enough? Is that discount rate large enough for me to own it? And when we say discount rate, what we’re really meaning is, that’s the return that you would expect to get annually on the company. 

So, if you solve the math and the discount rate comes out to be 10%, then what you’re really saying is if I can buy the stock today for the price that I just used, which is the price on the stock market, say it’s $30, I can expect to get a 10% annual return. So then you’d say, “Is that good enough? Is the risk associated with those free cash flows that I projected good enough that I can accept the 10% return? Or do I think that I need a lot more because there’s a lot of risk.” 

He talks about all this stuff in the book, but he doesn’t talk about necessarily using the approach that I just described, which I find to be the most useful approach because what I’ll do is, let’s say I solve for the discount rate and I get 10%, and then, I look at the 10-year treasury, and it’s at 2%. 

I know that I’m getting about 5% more yield out of that pick. And so, my question then becomes: Is five times more yield worth it? 

And a lot of the times if it’s a large company that has very stable assets, and I think that those assets are going to continue to have a competitive advantage into the future, then I’d say, yes, but that’s how I’m thinking through intrinsic value calculations. 

Alright, so Stig, the last thing I want to talk about is the price of this book. So you go on the Amazon, it’s about $700. If you want to buy it on Amazon, somewhere around there, and it fluctuates. 

Stig talked about it in the episode that it’s because there’s such a small supply of these books and that the market demands and can fetch that price. It’s not Seth Klarman, basically saying I want $700 for the book. 

Why do you think Seth Klarman is not printing more of these books or allowing some publisher to print more of these books?

Stig Brodersen  47:50  

Honestly, I think it is kind of an ego thing. I think it’s really, really nice to have the most expensive investing book in the world or I guess it’s probably the most expensive one, just for like a regular copy. Not a signed copy or whatever. I think that’s why and I think that he really knows signaling. I think that he really understands that signaling or having something like that is really, really powerful. 

One of the reasons why it’s so famous actually is because of the price, not that it’s not a good value investing book, I mean, it’s not the best value investing book I’ve read. There are other similar great value investing books, but they’re just like $20. Something like that. What’s your opinion, Preston?

Preston Pysh  48:32  

Stig is smirking because he knows I have a really strong opinion, and I’ve thought a lot about this. So he’s smirking at me. I think it’s a marketing strategy. I think it’s very, very smart, and I think it shows you his intellect. It’s like, “Hey, if I got this book and it’s got a $700 valuation, a lot of people are going to talk about it. It’s going to get my name out there. It’s going to have this automatic psychological impact that there’s maybe more value in the book, because it’s so expensive.”

I think you get all of these things kind of bundled into this branding or marketing strategy that’s basically tied to his name and his investment firm. So, I think it’s pretty interesting what he’s done here. And I find it really interesting that he is not printing more of these books.

Stig Brodersen  49:17  

Who knows? I mean, thinking about how much money he’s making from just people who want to invest with him, perhaps indirectly because of this and the exposure he’s been getting.

Preston Pysh  49:26  


Stig Brodersen  49:27  

So, you might be right, Preston. 

Preston Pysh  49:28  

Yeah. Who knows? Interesting. Shoot us your comments if you guys agree, disagree, or whatever you think it is on Twitter, and we’ll respond back to you. 

So all right, that’s all we had for this episode. This was a really fun book. And I really liked this book a lot. I wish more people could read this starting out with the “Intelligent Investor”, and I think he’s a fantastic writer.

Stig Brodersen  49:49  

Alright, guys, that was all that Preston I had for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro  49:56  

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  • Seth Klarman’s book, Margin of Safety – Read reviews of this book.
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