MARGIN OF SAFETY

AUTHOR: SETH A.

KLARMAN

THE RETIREMENT GROUP LLC

“PARTNERS IN RETIREMENT”

Presented by Steven Hume

Introduction

Section I: Where Most Investors Stumble Chapter 1: Speculators and Unsuccessful Investors Chapter 2: The Nature of Wall Street Works Against

Investors Chapter 3: The Institutional Performance Derby Chapter 4: Delusions of Value: The Myths and

Misconceptions of Junk Bonds in the 1980’s

TABLE OF CONTENTS

Investors are frequently lured by the prospect of quick and easy gain and fall victim to the many fads of Wall Street.

Value investing is the strategy of investing in securities trading at a discount from underlying value. This strategy has a long history of delivering excellent investment results with very limited downside risk.

Value investing regards stocks as fractional ownership of the underlying businesses that they represent.

Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Only a fraction of investors have the proper mind-set to succeed.

INTRODUCTION

Value investors seek a margin of safety. They know valuation is an imprecise art, the future is unpredictable, and people do make mistakes.

Value investors benefit most when the market is falling. This is when planning for safety protects the value investor from large losses.

Value investing is a concept that must be absorbed and adopted at once, or it is never truly learned.

INTRODUCTION

Investors believe that over the long run, security prices tend to refl ect fundamental developments involving the underlying businesses.

Investing Vs. Speculation Investors buy and sell securities that appear to offer attractive

returns for the risk incurred and sell when the return no longer justifies the risk.

Investors buy and sell on the basis of the current prices of securities compared with the perceived values of those securities.

Speculators buy and sell securities based on whether they believe those securities will rise or fall in price. Speculators are obsessed with predicting the direction of stock prices.

Investments Vs. Speculations Both investments and speculations typically fluctuate in price and

so appear to generate investment returns. However, investments bring cash flow for the owner’s benefit while speculations depend wholly on the resale market. Speculations depend on the people’s taste, whims that will change indiscriminately.

SPECULATORS AND UNSUCCESSFUL INVESTORS

Successful Vs. Unsuccessful Investors Successful investors

Tend to be unemotional, allowing the greed and fear of others to play into their hands Have confi dence in their own analysis and judgment Respond to Mr. Market’s irrationality with calculated reason, not blind emotion Demonstrate caution in frothy markets and steadfast conviction in panicky markets Believe that some securities are ineffi ciently priced (undervalued), creating opportunities

to profi t with low risk Look beyond security prices to underlying business value, always comparing the two as

part of the investment process

Unsuccessful investors Look to Mr. Market for investment guidance Place the judgment of Mr. Market above their own, ignoring their own assessment of

underlying value Easily panic and sell at the wrong time

Unsuccessful Investors and Their Costly Emotions Characteristics of unsuccessful investors

Respond to market fl uctuations emotionally with greed and fear Seek shortcuts to investment success, attempt to turn quick profi ts by acting on hot tips Greed surfaces as undue optimism or complacency in the face of bad news Choose short-term speculation over long-term focus Justify buying or holding overvalued securities by reasoning that we live in a new age in

history

SPECULATORS AND UNSUCCESSFUL INVESTORS

Brokerage commissions are collected on each trade, regardless of the outcome for the investor. Investment banking and underwriting fees are also collected up front.

Up-front fees create a short-term focus on the current transaction and a bias toward frequent, and not necessarily profi table, trading. Only brokers benefi t from a high level of activity.

Higher commissions on new underwritings provides a strong incentive to stockbrokers to promote them to clients over secondary-market products. New fi nancial-market innovations are created to provide Wall Street with fees and commissions at no risk.

Wall Street maintains a strong bullish bias which allows fi rms to complete more security underwritings and keep customers happy.

THE NATURE OF WALL STREET WORKS AGAINST INVESTORS

Institutional investors dominate the fi nancial markets, accounting for roughly ¾ of stock exchange trading volume.

Because most money managers are compensated by a percentage of total assets under management, making the same decision everyone else is making ensures average results. Money managers with average returns are considerably less l ikely to lose cl ients than those who are worse performers.

I t is diffi cult to maintain a long-term view when the penalt ies for poor short-term performance could cost the institutional investor their job.

Short-term performance is most often measured relative to broad stock market indices or other investors’ results. The motivation to outperform an index or peers often causes managers to speculate, guessing what others are going to do and then doing it fi rst.

However, outperforming the market in the short run is futi le since so many people are attempting the very same thing and near-term stock and bond prices fl uctuate at random.

I f money managers invested their own assets in parallel with the cl ient’s, they would stop trying to outguess each other and start to maximize their returns with only reasonable r isk.

THE INSTITUTIONAL PERFORMANCE DERBY: THE CLIENT IS THE LOSER

Newly issued junk bonds off er no margin of safety to investors trading around par value. They have very l imited appreciation potential but carry substantial downside risk.

Because of the growth of the economy, early successes of junk-bond investors led to unrealist ic expectations that cash fl ow would always grow and that upcoming maturit ies could be refi nanced. The optimism of investors led to a relaxation of investment standards.

Assets tended to fl ow to the fund that reported the highest yield therefore managers had a strong incentive to buy increasingly low-quality junk bonds in order to enhance reported yields.

The Relaxation of Investment Standards Zero-Coupon and PIK debt accrue interest rather than paying it in cash, acting as

a life support system by allowing bidders to defer the paying of the interest. Calling junk zero-coupon and PIK securities bonds didn’t give them the same risk

and return characteristics as other bonds, but it did make them easier to sell to investors.

Investors using the flawed definition of cash flow, EBITDA, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out. If adequate capital expenditures are not made, a corporation is very unlikely to enjoy a steadily increasing cash flow and will almost certainly face declining results.

DELUSIONS OF VALUE: THE MYTHS AND MISCONCEPTIONS OF JUNK BONDS IN

THE 1980S

Chapter 5: Defining Your Investment Goals Chapter 6: Value Investing: The Importance of a Margin of

Safety Chapter 7: At the Root of a Value-Investment Philosophy Chapter 8: The Art of Business Valuation

SECTION II: A VALUE-INVESTMENT PHILOSOPHY

“Don’t lose money” means that over several years an investment port fo l io should not be exposed to apprec iable loss of pr inc ipal .

The actual r isk of a part icular investment cannot be determined from histor ica l data but depends on the pr ice paid.

Risk avoidance is the s ingle most important e lement of an investment program.

Greedy, short - term-or iented investors may lose s ight of a sound mathematical reason for avoiding loss : compounding returns .

Perseverance at even re lat ively modest rates of return is of the utmost importance in compounding your net worth. An investor is more l ikely to do wel l by achieving cons istent ly good returns wi th l imited downside r isk than by achieving spectacular gains with cons iderable r isk of pr inc ipal .

Investors intent on avoiding loss must pos i t ion themselves to surv ive and even prosper under any c i rcumstances.

DEFINING YOUR INVESTMENT GOALS

The prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.

In the long run, stock prices are tethered to the performance of the underlying businesses. If the stock price does not reflect the current underlying value of the business, it will eventually fall and those who bought in will incur losses.

Instead of targeting a desired rate of return, investors should target risk.

DEFINING YOUR INVESTMENT GOALS

How can investors be certain to achieve an adequate margin of safety? Securities must be purchased at prices suffi ciently below underlying value Give preference to tangible assets over intangibles By replacing current holdings as better bargains come along By selling when the market price of any investment comes to reflect its

underlying value By holding cash until other attractive investments become available

Investors need to pay attention not only to whether or not current holdings are undervalued but also to why. Investors need to sel l when the reason for owning it no longer applies.

Look for investments with catalysts that may assist directly in the real ization of underlying value.

Give preference to companies having good managements with a personal fi nancial stake in the business.

Diversify holdings and hedge when it is fi nancial ly attractive to do so.

Value investing is predicated on the proposition that the effi cient-market hypothesis (EMH) is frequently wrong.

VALUE INVESTING: THE IMPORTANCE OF A MARGIN OF

SAFETY

There are three central elements to a value-investment philosophy:1. Value investing is a bottom-up strategy entailing the identification of specific

undervalued investment opportunities2. Value investing is absolute-performance, not relative-performance oriented3. Value investing is a risk-averse approach; attention is paid as much to what

can go wrong (risk) as to what can go right (return) Individual investment opportunities are identifi ed one at a t ime

through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits.

Investors must learn to assess value in order to know a bargain when they see one.

They must exhibit patience and discipl ine to wait unti l a bargain emerges from their searches and buy it, regardless of the prevail ing direction of the market or their own views about the economy at large.

Bottom-up investors wil l hold cash when they are unable to fi nd attractive investment opportunities and put the cash to work when the opportunities appear. They wil l not attempt to time the market.

The entire strategy can be concisely described as “buy a bargain and wait.”

AT THE ROOT OF A VALUE-INVESTMENT PHILOSOPHY

The point of business valuation is to establish that the value is adequate to protect a bond or justify a stock purchase.

Investors should not fool themselves into believing they are capable of greater precision than expert analysts based on l imited available information. Analyzing each potential value investment opportunity begins with an assessment of business value.

Three useful methods of business valuation: Net present value (NPV) – The discounted value of all future cash flows

that a business is expected to generate. Analyzing the cash flows of a company is the best way to value a stock. Private market value – Related to present value, this flawed shortcut method

values businesses based on the valuation multiples that prudent businesspeople have recently paid to purchase similar businesses.

Liquidation value – The expected proceeds if a company were to be dismantled and the assets sold off. This method considers each of the components of a business at its highest valuation.

Stock market value – An estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. This method is less reliable than the other two and is only occasionally useful.

THE ART OF BUSINESS VALUATION

Chapter 9: Investment Research: The Challenge of Finding Attractive Investments

Chapter 10: Areas of Opportunity for Value Investors: Catalysts, Market Ineffi ciencies, and Institutional Constraints

Chapter 11: Investing in Thrift Conversions Chapter 12: Investing in Financially Distressed and

Bankrupt Securities Chapter 13: Portfolio Management and Trading Chapter 14: Investment Alternatives for the Individual

Investor Why I Can Contribute to the Firm

SECTION III: THE VALUE-INVESTMENT PROCESS

Good investment ideas are rare and valuable which must be persistently searched out.

Computer screening techniques can be used to fi nd stocks sel l ing at a discount to breakup or l iquidation value.

Rate of return situations are reported in the Wall Street Journal and the New York Times as well as special ized periodicals and newsletters.

Asset-conversion opportunities are identifi ed in the fi nancial press, special ized publications, and research services.

Fundamental information on troubled companies is found in published fi nancial statements and court documents (bankruptcy).

The Wall Street Journal’s leading percentage-decl ine and new-low l ists occasional ly turns up an out-of-favor investment idea.

Institutional constraints create opportunities for investors.

Year-end tax sel l ing also creates market ineffi ciencies.

Insider buying and sel l ing can be tracked with Vickers Stock Research.

INVESTMENT RESEARCH: THE CHALLENGE OF FINDING ATTRACTIVE

INVESTMENTS

The fi rst 80% of the research is gathered in the fi rst 20% of t ime spent.

Investors benefi t from making decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.

Law abiding investors must err on the side of ignorance, investing with less information than those who are not so ethical.

When investors are not sure whether they have crossed the l ine, they would be well advised to ask their sources and perhaps their attorneys as well before making any trades.

Investment research is the process of reducing large piles of information to manageable ones, however an investment program wil l not succeed for long if high-quality research is not performed on a continuing basis.

A bargain should be inspected and re-inspected for fl aws.

When a bargain is found, investors need to ask “Why” the bargain has become available. What are the motivations of the management?

INVESTMENT RESEARCH: THE CHALLENGE OF FINDING ATTRACTIVE

INVESTMENTS

Hard work! Usually investors have to work harder and dig deeper to fi nd undervalued opportunities either by discovering hidden value or by comprehending a complex situation.

Because other investors disparage and avoid them, corporate l iquidations may be particularly attractive opportunities.

Complex securities are frequently ferti le ground for bargain hunting by value investors.

Spinoff s frequently go unnoticed by most investors and Wall Street analysts and often present attractive opportunities for value investors. There is typically a two or three month lag before information on them reaches computer databases. Spinoff s typically do not fi t within institutional constraints and consequently are quickly sold by institutional investors.

Opportunity exists, in part, because the complexity of the required analysis l imits the amount of investors that can capably participate.

AREAS OF OPPORTUNITY FOR VALUE INVESTORS: CATALYSTS, MARKET

INEFFICIENCIES, AND INSTITUTIONAL CONSTRAINTS

When an area of investment becomes popular, more money flows to specialists in the area.

The increased buying bids up prices, increasing the short-

term returns of investors creating a self-fulfilling

prophecy.

This attracts even more investors, bidding prices up

even more. The influx of funds generates strong investment

results for the earliest investors, but higher prices

serve to reduce future returns.

The good investment performance, generated by

those who participated in the area before it became popular, ends and a period of mediocre

or poor results follows.

As poor performance continues, those who rushed

into the area become disillusioned.

Clients withdraw funds as quickly as they added them a

few years earlier.

Redemptions force investment managers to raise cash by

reducing investment positions. This selling pressure causes

prices to drop, making the poor investment performance worse.

Eventually “hot money” leaves the area, allowing remaining

investors to exploit opportunities and newly

created bargains resulting from the forced selling. The stage is

set up for another cycle.

The Cycle of Investment

Fashion

The conversion of hundreds of mutual thri ft inst itut ions to stock ownership has created numerous opportunit ies for value investors. Negative publ ic ity coupled with the economics of thri ft conversion served to unduly depress the share prices of many thri fts.

Thri ft conversions are the only investment in which both the volume and price of insider buying is ful ly disclosed ahead of t ime and in which the publ ic has the opportunity to join the insiders on equal terms.

Thri fts incurring high r isks or speculating in new investment instruments should be avoided. I f you don’t quickly comprehend what a company is doing, then management probably doesn’t either. This init ial test l imits investors to low-risk thri fts.

In evaluating thri fts investors should: Adjust book value upward to refl ect understated assets Adjust book value downward to refl ect balance sheet intangibles Adjust earnings for nonrecurring items

Thri fts with low overhead costs are preferable to high-cost inst itut ions because they are more profi table and because they enjoy greater fl exibi l i ty in t imes of narrow interest rate spreads.

Thri ft conversions i l lustrate the way the herd mental ity of investors can cause al l companies in an out-of-favor industry to be seen negatively.

INVESTING IN THRIFT CONVERSIONS

Investors have traditionally attached a stigma to the securit ies of fi nancially distressed companies, perceiving them as highly risky and imprudent.

Financially distressed and bankrupt securit ies are analytically complex and often i l l iquid and identifying attractive opportunit ies requires very detailed analysis to fi nd a worthwhile opportunity.

Most investors are unable to analyze these securit ies and unwill ing to invest in them, leaving frequent opportunities to purchase undervalued investments.

Investors in bankrupt securit ies must develop a thorough understanding of the reorganization process in general as well as the specifi cs of each situation being analyzed.

Bankrupt securit ies are not very sensit ive to fl uctuations in the stock or bond market and so are not pursued by relative-performance investors.

The bankruptcy process can allow troubled fi rms the opportunity to improve their business operations putting the companies in a posit ion to become a low-cost competitor in its industry upon reorganization.

INVESTING IN FINANCIALLY DISTRESSED AND BANKRUPT

SECURITIES

Stage 2

•Immediately after the Chapter 11 filing is the time of greatest uncertainty but the best bargains in this process for investors appear amidst the uncertainty and high risk of this stage.

•The market for the debtor’s securities is in disarray, with many holders forced to sell their holdings regardless of price.

Stage 3

•This stage involves the negotiation of a plan of reorganization and begins anywhere from a few months to several years after filing.

•Analysts will have poured over the debtor’s business and financial situation and security prices will incorporate the available information. Considerable uncertainty remains about the plan of reorganization.

Stage 1

•The period between the finalization of a reorganization plan and the debtor’s emergence from bankruptcy usually lasts three months to one year.

•The lowest but most predictable returns are available in the third stage, after the reorganization plan becomes publicly available.

THE THREE STAGES OF BANKRUPTCY INVESTING

An investor’s portfol io management responsibi l i t ies include maintaining appropriate diversifi cation, making hedging decisions, and managing portfol io cash fl ow and l iquidity.

Portfol ios should maintain a balance, opting for greater i l l iquidity when the market compensates investors well for bearing it . When investors do not demand compensation for bearing i l l iquidity, they almost always come to regret i t .

In truth, l iquidity is c losely correlated with investment fashion. There must be a buyer for every sel ler of a security.

Disastrous eff ects of improbable events can best be mitigated through prudent diversifi cation. As few as ten to fi fteen diff erent holdings are enough to reduce the portfol io r isk. Diversifi cation is about how diff erent the vehic les you do own are in the r isks that are attached.

An investor is better off knowing a lot about a few investments than knowing only a l i tt le about each of a great many holdings. Your best ideas are l ikely to generate higher returns for a given level of r isk.

The r isk that the overal l stock market could decl ine can be l imited by hedging. Overpaying for a hedge is as bad a decision as overpaying for an investment. Hedges can be attractive investments on their own.

PORTFOLIO MANAGEMENT AND TRADING

The individual investor has few, attractive investment alternatives.

Investing is a full-time job. Given the enormous amounts of information available for analysis and the complexity of the investment task, a part-time or sporadic eff ort by an individual investor has l ittle chance of achieving long-term success.

It is not necessary to be a professional investor but a signifi cant ongoing commitment of time is a requirement.

Investors should certainly prefer no-load over lead funds. Load funds charge a sizeable up-front fee. Open-end funds are generally more attractive for investors than closed-end funds and some open-end funds do have a long-term value-investment orientation Watch the Mutual Series Fund and the Sequoia Fund, Inc.

Closed-end funds should never be purchased on the initial public off ering.

I f the fund manager is capable and the fee structure is fair, a closed-end fund sell ing at least 10% below underlying net asset value may be attractive.

INVESTMENT ALTERNATIVES FOR THE INDIVIDUAL INVESTOR

Emotional stability, inner strength, and consistent character in good times and in bad are areas where I have been tested and challenged to grow. These qualities are now strengths that have been born through perseverance, learning from mistakes, and making prudent choices.

In value investing, the ability to make wise choices day after day, year after year, and the strength and confi dence to stand fi rm in convictions is the diff erence between amazing returns and horrifi c losses.

My personality shares the following qualities with the value investor. I am confi dent and comfortable while: Standing alone and apart from the crowd Challenging conventional wisdom Opposing the prevail ing investment whims Resisting fear and the tendency to panic when prices are fal l ing Resisting greed and the tendency to become overly enthusiastic

when prices are rising Being motivated only by personal results Experiencing horrible performance compared with other investors

when the market is overvalued for a long period of t ime

WHY I CAN CONTRIBUTE TO THE FIRM!

Single minded focus in combing through every poss ib le scenar io to improve value, fl exibi l i ty , and longevi ty has been a gi ft of mine f rom an ear ly age. Fi rst , i t was basebal l cards and sports memorabi l ia , then playing sports and sports v ideo games, which grew into p layer contracts , roster management, and salary cap analys is . The jump to business consul t ing and tax account ing leading me toward value invest ing is a natura l progress ion. I have had a pass ion for searching out key pieces at a bargain, tak ing the undervalued or over looked and putt ing that p iece in a pos i t ion to succeed. Discover ing something valuable in raw form and see ing i t improve wi th good management and di rect ion br ings a fee l ing of v ictory and sat is fact ion.

Value invest ing is st imulat ing, inte l lectual ly chal lenging, ever changing, and the opportuni ty to uncover h idden value and see i t grow to real ize i ts potent ia l i s very attract ive .

The value investor sk i l l s I have cul t ivated enable me to: Be a student of the game and learn f rom every pi tch, those I swing at and those

I pass on Display infi ni te pat ience, not invest in bus inesses I cannot readi ly understand

or bus inesses I fi nd excess ive ly r isky Dist inguish a good pi tch f rom a wi ld one Cont inual ly compare potent ia l new investments wi th current hold ings to ensure

The Ret i rement Group LLC owns only the most undervalued opportuni t ies avai lable , even i f that means real iz ing losses on the sale of current holdings. No investment should be considered sacred.

Exhibi t great se l f-d isc ip l ine in order to mainta in the integr i ty of the valuat ion process and l imit the pr ice paid

ALWAYS AVOID SWINGING AT BAD PITCHES!!! ! ! ! !

WHY I CAN CONTRIBUTE TO THE FIRM!

The opportunity to contribute to your firm and your philosophy of investing would be a blessing and an honor.

Please feel free to contact me at (951) 847-0826 or email me at Sthume44@hotmail.com. If you have a chance please take a quick look at more of

my work samples on my LinkedIn profile www.linkedin.com/pub/steven-hume/6b/75b/141/.

Thank you,Steven

WHY I CAN CONTRIBUTE TO THE FIRM!