We Study Billionaires - The Investor’s Podcast Network - TIP149: Billionaire Seth Klarman's book - Margin of Safety (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. 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 Clarman. Claremont's personal net worth is about $1.5 billion and he's at a hardcore value in

Starting point is 00:00:30 that bases his investing approach around Benjamin Graham and the principles that have precipitated out of Graham's approach. 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 that university libraries have named this as one of the most waitlisted titles, and even more impressive, or perhaps discouraging, is actually the book most often claimed as lost. So that's right, Stig.

Starting point is 00:01:03 And because Clarmann's book is so rare and highly sought after, the book retails from anywhere between $703,000 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. You are listening to The Investors Podcast, where we study the financial markets and read the book that influence self-made billionaires the most.

Starting point is 00:01:34 We keep you informed and prepared for the unexpected. All right, so like we said in the introduction, we're going to be covering billionaire Seth Clarman's book today. And the title of this book is Margin of Safety. And 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,

Starting point is 00:02:04 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. Yeah, you know, I have a similar impression as you, Preston.

Starting point is 00:02:23 It was a great book and it's definitely one of the better value investing books. The book is almost legend, right, among million investors. So it's kind of one of those must-reak kind of thing if you were super geek like you and me, Preston, I guess. Yeah. No, 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 a thousand times better than the intelligent investor. I think anybody who would read this would find this much easier to understand than the intelligent investor.

Starting point is 00:02:50 And I think it actually goes into a lot more depth than the intelligent investor. Yeah, and the books are very, very similar. And 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 it's sort of like an updated version of the intelligent investor slash security analysis I guess really good content that's really easy to read 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

Starting point is 00:03:18 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 Claremond models a lot of the book around the intelligent investor. And so just like Benjamin Graham's intelligent investor, he starts off with the discussion about the difference between speculation and investing. And I can see Stig smiling because I think I stole his first point.

Starting point is 00:03:45 Was this what you were going to talk about Stig? Oh yeah, exactly. So I really like the way Clarmine 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 Clarmine 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.

Starting point is 00:04:11 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.

Starting point is 00:04:54 Their judgment regarding future price movements is based not on fund, 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

Starting point is 00:05:31 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 an 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

Starting point is 00:06:12 comfortable because when you see a crowd, you want to go with the crowd. That's what's normal. The crowd's 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 Claremond did it here. One of the things that he's saying is that a speculator really doesn't like to look stupid,

Starting point is 00:06:57 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.

Starting point is 00:07:17 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 Klaman actually talks about this more in detail is, if you're an investor, you will go for investments that spins 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 typically comes from a drop in the stock price.

Starting point is 00:07:52 And he talks about, like 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's going into the retained earnings on the balance sheet. So, you know, 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. Whenever he's talking about spinging off cash,

Starting point is 00:08:14 is basically, is the company profitable and is profitable on a free cash flow basis. That's really what you're looking for. And if you look at a company like Singa, for instance, that's been really hot lately. You know, if you bought Singa, it's the video game developing company, if you bought that at the beginning of 2017,

Starting point is 00:08:31 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, and it's not making a profit today. but the price has gone up. So if you're a speculator, you might not look at fundamentals at all, but you just see something that just increased 50%. And you're thinking, hmm, perhaps this is interesting.

Starting point is 00:08:54 It's an easy narrative to tell your friends. And that's exactly what Seth Klaman are telling you what not to do. And in continuation of this discussion, he also talks about treacheries. 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 was a 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

Starting point is 00:09:31 explanations why they're doing it. One reason might be that they're required to do that by law, and 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 of something like KAPM. And KAPM is one of those academic terms that Seth Klaman and Warren Buffett for that matter really, really doesn't like. If you're a fund manager and you're not a hardcore value investors like these guys, you are looking at different types of data. You're looking at how do I limit my volatility, for instance. And like 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

Starting point is 00:10:16 frontier, which is basically how to get the highest possible return for the least amount of volatility points, if you like. And 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 KABM. 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 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 if someone came off like a bit too academic. But I think my point here is really, why are you holding that type

Starting point is 00:11:04 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. So great comments there, Stig. I just wanted to throw this out to the audience so that they understand this term cap M is what Stig was saying. And cap M stands for capital asset pricing model. And 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. And 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

Starting point is 00:11:50 systematic risk, just so you understand that. And so this is a model that describes a relationship between that systematic risk and the expected return of the asset, you know, 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 if, let's say, General Electric has a lot of volatility compared to, you name another company call it Coca-Cola, Cap M 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?

Starting point is 00:12:25 Yeah, because it's basically about, like, optimizing something that's, at least in my opinion, is completely useless. Because if you look at how this formula 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. And, I mean, if that's the only solution you could come up with, always buy government bonds, period. You're not thinking about the valuation at all. You're not thinking about the valuation of stocks, more or less.

Starting point is 00:12:52 It gets even worse if you go into the detail of how they actually derive the return of the stock market, which is another discussion. But it's just, to me, it seems hopeless. Yeah. I'm sorry, we're getting so technical there here. But the other thing that I find very frustrating with CAPM is it all depends on the time frame that you attribute to what you're using as your entire market value. So if you're using the last five years of data, 10 years of data, 15 years of data, all of it completely changes based on the historical data that you're used. This whole thing falls apart for me personally. But 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. Do you know of any Stig?

Starting point is 00:13:44 No, no, not anyone. And I think you should be aware if you hear anyone say that. It's probably because he owns a fund or something. Yeah, I know what I'm like, I'm kind of laughing when 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're managing. Like they promise the investors that have so and so much volatility. And 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 these negative interest rates.

Starting point is 00:14:22 I hear about people lending their money 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 that they're using missed result, I guess. Yeah. So needless to say, in this book, he lightly addresses some of those areas pertaining to CAP-M and basically how he thinks the entire thing's bunk. He gets into, when you start talking CAP-M, 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 because value investing is wholly based on the idea that markets are not efficient. So some interesting discussion. Sorry to get so academic

Starting point is 00:15:07 there with you guys, but if you're in business school, you might have enjoyed some of that. And you might disagree with us. And 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 wanted to talk about in the book was this idea where he talks about this Wall Street bias. And 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.

Starting point is 00:15:56 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. And from my own personal experience, having talked to, you know, various people that work on Wall Street, 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 and such a contrarian point of view from other money managers. And you know who else is like this? Bill Gross, billionaire Bill Gross. He's exactly like Seth Claremont, 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. So basically, Preston, I think it boils down to incentives.

Starting point is 00:16:39 I mean, if you are a huge believer in Wall Street, let's call it the KAPM people, you know, you actually don't make money from outperform 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, you actually, you if you can convince people that the market is going up, well, then they will give you your 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. And 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,

Starting point is 00:17:18 so that's not what you're telling them. And basically what Seth Klaman is getting at here is that Wall Street, it's not finance people, it's marketing people. And that's really what he doesn't like. And Seth Klaman himself multiple times since he accepted his fund. He's been holding more than 50% in cash. 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. 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 was to beat the market, particularly on a short term basis, without failing

Starting point is 00:18:09 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 this 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 and number and compelling and attractiveness, preferring 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.

Starting point is 00:18:56 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, is that right now in the summer of 2017 is 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. And we continue to hold that opinion. And the market has been fairly flat and level for the last, you know, I don't know how many months.

Starting point is 00:19:40 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 percent. Chasing a couple percent. So that's what he's getting at here. That's exactly what he's getting at in this paragraph in the book. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord. In every conversation you have is, with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures.

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Starting point is 00:24:10 All right, back to the show. It's really interesting to speak to fund managers because what fund managers would typically tell you is that my investors doesn't pay me to hold the money in cash. They could have done that themselves, so I need to invest it. And then you hear people like Warren Buffett or people like Seth the Clarenner saying, you know, 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 need to be fully invested for the sake of being fully invested.

Starting point is 00:24:42 It's just tremendous. And I think whenever you are reading the margin of safety, you can just feel how South Claman really just come 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, you know, bidding it up. It's really Christian about supply and demand. Just like a really fun story to this. I've read that university libraries have a really special relationship to

Starting point is 00:25:27 this book. Not only is it one of the most waitlisted titles you can find out there. It's 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. So on Stig's note about, you know, not being fully invested and the way that Seth Claremont might be sitting on 50% cash, I want to highlight, you know, I threw out Stig and I's opinion of where the market's price 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 equivalence sitting on his balance sheet today is at $96 billion, just to give people a hint of what's going on.

Starting point is 00:26:15 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. So, 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 on his positioning, because I know I sure am.

Starting point is 00:26:43 If you look at his portfolio, it's around $130 billion at the moment. So, I mean, he's holding almost as much cash as he's holding common stock. I'm almost 100% sure that if he didn't have to think about the tax consequences of the stocks that he bought really cheap and our price really, really high, he would be a lot more than 50%. So Stig's talking about his marketable securities that he's holding on his balance sheet.

Starting point is 00:27:07 So today he has $133 billion 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? Ten times what he paid for? Yeah. Yeah, probably around there. So if he sells that position, even though he thinks that a lot of this stuff is overpriced, is our assumption here.

Starting point is 00:27:36 He's not going to sell it because his capital gains on a 10 times or a 10x position is astronomical. So 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. Now, other people might see it differently, but that's how we see it. All right. 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 EBITA.

Starting point is 00:28:22 And I love Seth Klarman's talk about EBITA in this book. It is so crystal clear and so So, you know, 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 and EBIT. So when we say EBIT, 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, you know, when we are 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 EBITA? And they said, well, because the appreciation 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.

Starting point is 00:29:23 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 EBITA. 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 EBITA, you're getting a higher number and you know, 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 this number is so stupid.

Starting point is 00:30:00 I'm also puzzled why people keep talking about EBITDA. It really doesn't add that much value to anything, I guess. It's perhaps as one of those. That is what we 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. And sometimes I like to come up with this example

Starting point is 00:30:18 that the keyboards that we're using for our computers, they're not the most efficient ones, the way that the letters are outlined. But it's just too hard to switch to another standard because now we'll actually learn how to, type on this type of keyboard, even though you actually can even do it a lot faster on another type of keyboard. I kind of feel 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

Starting point is 00:30:42 of a hassle. Let's just keep giving people bad information. At least that's my take. You know, 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, you know, man, I cannot understand why you're using EBIT 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. So the next highlight I have is this discussion about defining your investment goals. I hear a lot of investors talking about that they decided they will make 10% a

Starting point is 00:31:28 year or 12% a year, whatever it is. And what Seth Klaman is explaining is that it's really dangerous to set a target for herself. Why it might seem like it's a very ambitious goal and really keeps your focus 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 great picks. I might find something that, you know, it's fairly priced and say I could get like a 6% return with almost no existing downside. I think today that would 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

Starting point is 00:32:15 pick. And you'll be looking at, for instance, growth 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 hitting at here is that if you are focusing on getting that kind of annual return, what typically happens is that you get this idea you should be doing something all the time. He's saying, you know, short term, it might take some time before the stock really experienced that increase in price, really 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 in transaction cost.

Starting point is 00:32:56 Now, so what are the big companies in the States doing? For this example, I just talk about Warren Buffett's letters to shareholders back in 2007 because this is related to this and it's about pension accounting. And I know that people are like 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 Warren Buffett talks about is that 363 companies in the S&P 500, they have pension plans. And the assumption is, and this is like he's looking back in 2006, but he just might as well

Starting point is 00:33:31 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 that what they've been

Starting point is 00:33:54 accounting for, they will, in that. the long run make, say, 9% every year on stocks. And you see the exact same thing today. So I'm just asking, what will happen to people's pensions if the market should crash, if we expect to make that kind of return? And that's exactly what you saw after the crash in 0809. The money was just gone because it was just projected. We will always compound with that amount. 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 an experience something very

Starting point is 00:34:38 similar here in the United States as to what Japan has experienced over the last two to three decades. And, you know, 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 have a lot 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 and things to stimulate the economy, which is going to drive rates even lower. What it is that they're going to do. Japan's already experienced this. They've already been through all of this.

Starting point is 00:35:15 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's 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. If you're looking at the states right now, you know, it's really consumption driven. You know, 70% of GDP in the states, that's consumption. What we have seen in Japan is that because

Starting point is 00:35:54 the yield is so low. And the intention of having the yield is so low is actually for people to spend more. But because you have a lot of people who are looking to retire, people actually don't spend at all. They just say 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? All right. So one section in the book that I wanted to talk about that I found an interesting discussion was this paragraph where he talks about how investors can counteract risk. This is what Claremont 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.

Starting point is 00:36:35 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. You know, Stig, 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 seven. Seven picks and the variance that's associated with those seven 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

Starting point is 00:37:17 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

Starting point is 00:38:01 to invest with the margin of safety. What he's getting at 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 nine, you don't have a very large margin of safety there. But if it's trading for five 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've got to feel like you're getting enough return for the price that you're buying it at. I think there are two different biases in many

Starting point is 00:38:38 retail investors in mind. One is that they want to feel that they're 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, what's called loss aversion. So 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 can use financial or intemence and whatever. But what South Klaman is really getting at here, instead of being fully invested and still pay for a hedge, which is kind of like paying for an insurance, Instead, he would be saying, perhaps you should just hold more of your funds in cash. That's a hitch in itself.

Starting point is 00:39:15 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 hatch for you. Because by definition, you'll lose money from insurance if you do this over and over. So that's not good. So what can you do instead? And one of the reasons why it's so sold by Wall Street is they want to give you the idea

Starting point is 00:39:45 that you can invest 100% of your funds with them. So why wouldn't you like insurance with them? But if you were afraid of being too much exposed to energy or too exposed to mining or that kind of industry, don't put all your money in mining. Don't put all your money in oil. Just put whatever you think is adequate and then put your money in something else afterwards, perhaps in cash, perhaps in other equities. So I really like 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

Starting point is 00:40:16 hedge you can make. It's basically just to hold cash if you think that you can't find anything that's interesting. 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 the interest rates are so low, like the 10-year treasury is just barely over two. percent. We're basically saying, you know, 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 2%'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, you know, even higher than it is now with respect to

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Starting point is 00:44:15 fundrise.com slash income. This is a paid advertisement. All right. Back to the show. But 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 five-year, something probably shorter duration. simply because my expectation is whenever the credit event and the business cycle ends, that 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,

Starting point is 00:45:04 especially if you're listening to this and you're overseas. So 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 5 or 6 percent, I think the advice to you might be you need to own a short duration government bond if the rates are around that level, 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. really good that you separate talking about the states, which is typically what we talk about

Starting point is 00:45:40 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 to spark the economy, which is typically what we will do. As President 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. comment, I guess. And so just so people understand why I was saying that I would own shorter duration, so we can get into this discussion a little bit as well. Let me just provide a hypothetical here so that we kind of can walk through this. Let's say the year's 1999 in the United States,

Starting point is 00:46:22 okay, and the stock markets going sky high, and 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 it goes down, the 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, you know, the stock market rising and basically putting a larger and larger position into short-term bonds.

Starting point is 00:47:13 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. So 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. And Preston, I think that discussion really relates back to what Seth Klaman said in his section about investing and speculation. Why are you holding a bond? There might be tons of different reasons. Having a short-term bond, you know, you have a lot of flexibility.

Starting point is 00:47:54 You might want to pour that into the equity market as soon as possible. It's better than the opportunity cost of getting almost nothing. The other strategy with long-term bonds, there'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. Yeah, exactly.

Starting point is 00:48:18 So perhaps my favorite part of the book, that was his discussion about valuation. Again, sorry to bast the price of the book. If you're thinking, now I'm paying a thousand bucks for a book, now I 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. And he talked about three main approaches to valuing equities. And what he also actually started saying is that while you can't value your home to the nearest thousand dollars, why should you be able to do this for a billion dollar complex business? I really like the way he started up with this. So he's really looking at things more, not 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 somewhat exact amount, it might be different tomorrow. And the industry just simply changes all the

Starting point is 00:49:21 times. You have new competitors, you have new technology, everything is just a different 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 describes 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 when appropriate rate, that's basically the valuation of a stock. Clearly, it's not always easy. So that's also why

Starting point is 00:50:03 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 typically use that approach for companies that are not making a profit. Because as you said before, whenever you need to discount cash flow, well, what if that business doesn't have any cashelers to discount? So the first one, the DCF 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 he talks about is the stock market value approach. It's more

Starting point is 00:50:49 targeted at a mutual fund and closed-end fund that is not so popular today. So the takeaway from valuation, if you're an investor today, is basically find a profitable company that are 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 interest in special situations and more complex businesses, you can use the liquidation approach. You know, Stig, Chapter 10 reminded me of. of, it almost seemed like Jewel Greenblatt had literally taken all of Chapter 10 and turned that

Starting point is 00:51:23 into You Can Be a Stock Market Genius. Did you get the same implications when you heard? Yes. And he even talked about the Marriott in this book. And I saw the exact, almost the exact same example in Greenblatt's book afterwards. Yeah. So, yeah, I definitely thought about that too. What Plarman 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

Starting point is 00:52:03 look at the past performance of the last 10 years and maybe the growth rate of free cash flow was 15%. And they just, you know, draw a line showing 15% into the future. And I think what Clarman would tell you after reading his book, he would probably tell you 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 is my discount rate. And they're using 2%. And they get a valuation that's saying that the

Starting point is 00:52:45 business is worth $10 trillion. And that's not going to be good. So I'm much more of an IRR person, which means what you do is you estimate the free cash flows of the business. And just so people know, Bill Miller, who we interviewed, you know, Leg Mason, CIO, and, you know, net worth of $500 million and all that good stuff. Whenever I had this discussion with Bill, he said, yeah, IR. And what you're doing with that is you're coming up with what you think the estimate of

Starting point is 00:53:13 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's 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%.

Starting point is 00:53:34 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.

Starting point is 00:54:17 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 then my question then becomes, is five times more yield worth it?

Starting point is 00:54:42 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. All right. 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 and 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. not Seth Claremont basically saying I want $700 for the book. Why do you think Seth Clarman is not printing more of these books or allowing some publisher to print more of these

Starting point is 00:55:22 books? Honestly, I think it's 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 sign copy or whatever. I think that's why. And I think that he really knows signaling. I think he really understands that the signaling or him something like that. It's really, really powerful. One of the reasons why it's so famous actually 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 read. The other similar great value investing books, but they're just like 20 bucks or something like that. What's your opinion, Preston?

Starting point is 00:56:06 Stig's 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 a 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 slash 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

Starting point is 00:56:49 of these books. Who knows? I mean, thinking about how much money he's making from just people who wants to invest with him, perhaps indirectly because of this and like the exposure he's been getting. Yeah. So you might be right, Preston. Yeah, who knows. Interesting. Let's 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 than the intelligent investor, and I think he's a fantastic writer. All right, guys, that was all the Preston I had for this week's episode of The Investors Podcast. We see each other again next week.

Starting point is 00:57:29 Thanks for listening to TIP. To access the show notes, courses, or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to AskTheInvesters.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP network. Written permission must be granted before syndication or rebroadcasting.

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