Seth Klarman in “Security Analysis”

I am currently reading what is considered as the “bible of value investing”, Security Analysis by Ben Graham and David Dodd. Seth Klarman has written the preface to the Sixth Edition of the book. Though the whole piece is worth reading, I have taken out some key things which I believe should be kept in mind by every investor.

Investing in bargain-priced securities provides a “margin of safety” – room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.

As Graham has instructed, those who view the market as a weighing machine – a precise and efficient assessor of value – are part of the emotionally driven herd. Those who regard the market as a voting machine – a sentiment-driven popularity contest – will be well positioned to take proper advantage of the extremes of market sentiment.

Essential characteristics of a value investor are patience, discipline and risk aversion.

As Warren Buffett said in his famous article, “The Superinvestors of Graham and Doddsville”, “It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. Its like an inoculation. If it doesn’t grab a person right away, I find you can talk to him for years and show him records, and it doesn’t make any difference.”

While formulas such as the classic “net working capital” test are necessary to support an investment analysis, value investing is not a paint-by numbers exercise. Skepticism and judgement are always required. For one thing, not all elements affecting value are captured in a company’s financial statements – inventories can grow obsolete and receivables uncollectible; liabilities are sometimes unrecorded and property values over or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analysed investments fail to achieve profitable outcomes. Sometimes a stock becomes cheap for a good reason: a broken business model, hidden liabilities, protracted litigation or incompetent or corrupt management. Investors must always act with caution and humility, relentlessly searching for additional information while realizing that they will never know everything about a company. In the end, the most successful value investors combine detailed business research and valuation work with endless discipline and patience, a well-considered sensitivity analysis, intellectual honesty, and years of analytical and investment experience.

Another important change in focus over time is that while Graham looked at corporate earnings and dividend payments as barometers of a company’s health, most value investors today analyze free cash flow.

Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow.

There is a significant downside to paying up for growth or worse, to obsessing over it. Graham and Dodd astutuely observed that “analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.” Strongly preferring the actual to the possible, they regarded the “future as a hazard which his (analyst’s) conclusions must encounter rather than as the source of his vindication”. Investors should be especially vigilant against focusing on growth to the exclusion of all else, including the risk of overpaying. Again, Graham and Dodd were spot on, warning that “carried to its logical extreme, ….(there is no price) too high for a good stock, and that such an issue was equally ‘safe’ after it had advanced to 200 as it had been at 25.

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