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The legendary Margin of Safety

I have an opportunity to read Margin of Safety, the 1991 investment book by Seth Klarman that’s long out of print and regularly sells secondhand for hundreds, if not upwards of a thousand dollars.

Suffice it to say, I feel a certain obligation to read it since it’s highly regarded enough for people to pay those prices.

Margin of Safety

Seth Klarman argues in his book Margin of Safety that free markets are inefficient and make mistakes. He gives examples of how he exploited those mistakes for big profits.

The premise of the book is that there is no simple mathematical formula to outperform the market. But since markets are inefficient, it’s possible to make investments that have a low risk of decreasing in value and outperform the market that way.

Let me put that another way. I found it jarring to hear a billionaire saying that markets make mistakes, and explaining how to exploit it. It’s a bit countercultural, at least in the United States.

The Klarman formula, simplified

For example, let’s say HP had gone through with its plans to spin off its PC division into a separate company in 2011. The share price on that new company would have been artificially low for a variety of reasons, but partly because all of us who have index-based mutual funds would have immediately sold our shares as soon as we received them, because that new company wouldn’t be an S&P 500 company. So the new company might well have had assets worth, say, $15 per share while the stock traded for, say, $10 per share.

Eventually, that imbalance would likely correct itself. So investors who bought the spinoff shares while everyone else was selling could net a 50% profit pretty easily. They just had to be willing to wait. And if the worst happened and the spinoff went under, it had assets worth $15 per share. So when the company was liquidated, those investors would still profit even if those assets were liquidated at a slight discount.

While that spinoff didn’t happen, at least not in 2011, Klarman discusses Emerson’s 1990 spinoff of Esco Electronics and the specifics that made that spinoff a good opportunity. Esco had enough assets that even if it lost, the early investors would still win. But it didn’t lose–the company still exists today, some 22 years later–so those early investors won big.

Avoiding fads

What’s interesting to me is that Klarman talks about junk bonds and the stock market crash of 1987 like it was yesterday–which it was, in 1991–but there are parallels to the housing crisis. Both crises were largely brought about by investment fads. Junk bonds were the rage in the 80s, and mortgage-backed securities were the rage circa 2005. In both cases, underwriters were taking loans that were unlikely to pan out, packaging them together, and convincing people to buy them. And for a while, a lot of people made money off them, but eventually, reality caught up.

The lesson there is that another fad is always around the corner, and to avoid them. Which may explain why investing in cryptocurrency always seemed risky to me.

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