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Highlights from “Margin of Safety – by Seth Klarman”

Compiled by Priyank Kothari


Table of Contents

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Where Most Investors Stumble

Chapter 1.

Speculators & Unsuccessful Investors

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Where Most Investors Stumble Chapter 1 Speculators & Unsuccessful Investors

Investing vs Speculation "Mark Twain said that there are two times in mans life when he should not speculate: when he cant afford it and when he can"


To Investors stocks represent fractional ownership of underlying businesses and bonds represent loans to those businesses.

Investors believe that over long term Security prices reflect the fundamental developments involving the underlying businesses. Investors in stocks thus expect to profit in at atleast one of the three possibe ways: 1) 'from free cash flow generated by the underlying business, which eventually will be be reflected in a higher share price or distributed as dividends; 2) from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price or 3)by narrowing of the gap between share price and underlying business value.'


Speculators buy and sell securities based on whether they believe those securities will next rise or fall in price.

Their judgement regarding future price movements is based not on fundamentals but on prediction of the behavior of others.

They buy securities because they 'act' well and sell when they cant.

Speculators are obsessed with predicting guessing the direction of stock prices.

The culture is wide spread through more media, more interaction of market people, more cocktail party's etc.

Many of the so called " Investment Professionals" are actually speculators much of the time because of the way they define their mission, pursuing short term trading profits from predictions of market fluctuations rather than long term investment profits based on business fundamentals.

The Essence of Speculation "There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Moneterey, California. The Commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and tasted the sardines. He immediately became ill and told the seller the sardines were no good. The seller said, "You dont understand, these are not eating sardines, they are trading sardines".

Like sardines traders, many financial market participants are attracted to speculation, never bothering to taste the sardines they are trading. Speculation forces people to move along with the crowd that going against it. There is comfort in consensus those in majority gain confidence from their very number. Today knowingly or unknowingly many financial market participants have become speculators. They don't realize that they are playing the "Great Fool Game". Buyers are always hoping that there will be a greater fool who will buy it from him at higher than his cost price.

Investment & Speculation Klarman says that a point of clear difference between Investment and Speculation is that Investment throws out Cash flow for the benefit of the owners, speculation do not. The return to the owners of speculation s depends on the vagaries of the market and its movement.

The Difference between Successful and Unsuccessful Investors Successful Investors tend to be unemotional, allowing the greed and fear of others to play into their hands. Klarman says that there two perspective in which people look at Mr.Market. For Speculators:

They look at Mr. Market for Investment guidance. The daily movements of Mr. Market are used as data to make Buy or Sell decisions. Mr. Markets upmove is taken as positive factor for the stock and participants rush to buy more as if they knew more than they actually knew while in case if Mr.Market moves down, they rush to sell their holdings, ignoring their assessment of the underlying value of the business.

For Speculators, Mr.Market is person who directs them their trend or their direction of doing investment.

The reality is that Mr.Market knows nothing, as it is a product of collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.

For Investors:

The other view is they way Investors look at Mr. Market. For them it is a platform to fulfill their dreams of searching bargains which fetch them good returns over long term. Mr.Market sets prices of various business, where investors if finds value shall go ahead and Buy it and if he finds no value than shall keep quite and let Mr. Market do its activity on daily basis.

Value investors who buy at a discount from underlying value are in a position to take advantage of Mr. Markets irrationality.

Emotional Investors and speculators inevitably lose money, investors who take the advantage of Mr. Markets periodic irrationality, by contrast, have good chance of enjoying long term success. To avoid the day to day market vagaries one needs to focus as Investor and not let the daily price move have any control on their emotions which are directly linked to their portfolios. But one cannot also ignore the markets ignoring a source of Investment opportunities would obviously be a mistake but one must think of them self and not let Mr. Market to direct its decisions. Security prices reflect business reality or reflect short term variations in supply and demand. Klarman has made a very interesting differentiating point in realizing the value of a business. Mr. Market irrationality at

times gives great bargain and also gives great valuation to sell at extreme prices. Security prices sometimes fluctuate not based on any apparent changes in reality, but on changes in investor perception. The only explanation for the price rise or fall was that investors were suddenly willing to pay high ore willing to exit before someone else does it. Most day to day price fluctuations are due to supply demand variations rather than from fundamental changes.

Unsuccessful Investors and their costly Emotions Unsuccessful Investors are dominated by emotions. They respond with greed and fear to market fluctuations. People who act responsibly and deliberately most of the time but when it comes to Investing they go totally opposite. While buying a single camera or TV, they might take days and check lot of available options with their functions etc, while in investing similar amount, they spend very less time, they buying decisions are majority times based on tips from their friends or some other market participants. Rationality that is applied in buying an electronic product, is absent when it comes to investing. Greed can cause investors to shift their focus away from the achievement of long term investment goals in favor of short term speculation. High levels of greed sometimes cause new era thinking to be introduced by market participants to justify buying or holding overvalued securities. In short run resisting the mania is not only psychologically but also financially difficult as the participants make a lot of money, at least on paper.

The search for an Investment Formula Investors across the world always keep searching for the Holy grail, the attempt to find a successful investment formula. It is human nature to find simple solutions to problems. Most investment formulas project the recent past into the future. The experience in the recent bull and bear run and the successful strategy in that run is considered as a holy grail in judging the next investment run. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.

Conclusion The Financial markets offer many temptations to vulnerable investors. It is easy to do the wrong thing to speculate rather than invest. Emotions lies dangerously close to the surface of the investors and can be particularly intense when market prices move dramatically in either direction. It is crucial that investors understand the difference between speculating and investing and learn to take the advantage of the opportunities presented by Mr.Market.