We Study Billionaires - The Investor’s Podcast Network - TIP737: Margin Of Safety by Seth Klarman w/ Kyle Grieve

Episode Date: July 13, 2025

On today’s episode, Kyle Grieve discusses the principles of value investing, including how to distinguish between speculation and true investing, the dangers of Wall Street's incentive structures, and the importance of prioritizing downside protection over upside potential. We’ll also delve into discipline for value investing, how to develop a margin of safety mindset, and how to build a risk-averse strategy and portfolio. IN THIS EPISODE YOU’LL LEARN: 00:00 - Intro 05:04 - Why most investors speculate rather than invest—and how to tell the difference 11:01 - Why fund managers have structural weaknesses that require them to prioritize the wrong things 13:26 - Why EBITDA can mislead—and how it hides a business’s actual condition 16:46 - Why value investors focus more on downside protection than upside potential 18:47 - How to think about margin of safety when constructing a portfolio 31:51 - The three temperamental traits most critical to successful value investing 36:38 - Why value investors hold cash and how they use it as a strategic weapon 44:00 - A detailed breakdown of how Klarman values businesses 20:06 - The major types of value opportunities—and where to find them 1:02:49 - Klarman’s perspective on diversification and intelligent position sizing Disclaimer: Slight discrepancies in the timestamps may occur due to podcast platform differences. BOOKS AND RESOURCES Join Clay and a select group of passionate value investors for a retreat in Big Sky, Montana. Learn more ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Join the exclusive ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TIP Mastermind Community⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ to engage in meaningful stock investing discussions with Stig, Clay, Kyle, and the other community members. Buy a copy of Margin of Safety here. Follow Kyle on Twitter and LinkedIn. Check out all the books mentioned and discussed in our podcast episodes ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Enjoy ad-free episodes when you subscribe to our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Premium Feed⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. NEW TO THE SHOW? Get smarter about valuing businesses in just a few minutes each week through our newsletter, ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠The Intrinsic Value Newsletter⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Check out our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠We Study Billionaires Starter Packs⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Follow our official social media accounts: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠X (Twitter)⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠LinkedIn⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Instagram⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Facebook⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TikTok⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Browse through all our episodes (complete with transcripts) ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Try our tool for picking stock winners and managing our portfolios: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TIP Finance Tool⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Enjoy exclusive perks from our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠favorite Apps and Services⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Learn how to better start, manage, and grow your business with the ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠best business podcasts⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. SPONSORS Support our free podcast by supporting our sponsors: SimpleMining Hardblock AnchorWatch Human Rights Foundation Cape Unchained Vanta Shopify Onramp Abundant Mines HELP US OUT! Help us reach new listeners by leaving us a ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠rating and review⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ on ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Spotify⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠! It takes less than 30 seconds, and really helps our show grow, which allows us to bring on even better guests for you all! Thank you – we really appreciate it!⁠ Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Learn more about your ad choices. Visit megaphone.fm/adchoices Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm

You're listening to TIP. Since 1982, Seth Clarmine has soundly defeated the S&P 500 by a wide margin. His fund, the Boutos Group, has achieved annualized returns of 15% during that period compared to just 11% for the S&P 500. Now, what is Claremontz? A risk-averse, value-driven philosophy which follows the timeless principles of Benjamin Graham's central tenant, The Margin of Safety. In 1991, Claremn published a book, Margin of Safety, which quickly became a cult-class

in the investing world. The book reveals not only how to succeed, but also how to fail. We'll cover why most investors speculate instead of invest and how that's a dangerous game to play. We'll examine why chasing returns rather than avoiding losses can lead to lower compound rates of return and the risk of never even reaching the finish line. And we'll discuss why investors who focus on relative performance tend to achieve such poor absolute performance results. Now, this book is over 30 years old now, but many of its lessons remain just as well. important now as they were then. And I believe many aspects of the book will remain just as relevant in another 30-plus years. This includes having a strategy that emphasizes capital preservation,

why investors shouldn't be afraid to build up cash positions, how to avoid the pitfalls of EBITDA, and how to construct a resilient portfolio that can survive and thrive in both bull and bear markets. We'll also explore some of Carmen's insightful perspectives on Wall Street, his views on index funds, and its approach to valuing specific businesses. If you've ever been burned by buying an overpriced stock, want to understand more about the discipline required to succeed it as an investor, and want more safety in your investments, this episode is right up your alley.

Now, let's get into this week's episode on the book, Margin of Safety. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Greve. Welcome to the Investors' podcast.

I'm your host, Kyle Greve, and I'm thrilled to discuss a very, very interesting book today with you. So one of the bedrocks of investing is to buy assets that offer both downside protection and an acceptable return. Benjamin Graham was the first person to develop this framework for this concept, which he referred to as the margin of safety. It's been a primary principle of Warren Buffett and just scores of other legendary Valley investors over the last century. And since this idea is so powerful, there's been many other very intelligent people who have entered the arena to continue discussing the benefits of this concept. One such person is Seth Clarmint. He wrote a book titled The Margin of Safety, which is the book that we're going to be discussing in a lot more detail today. Now, it's important to remember this book was published in 1991, so it's not new by any means.

However, I think the concepts from the book remain entirely valid today. So Stig and Press and covered this book in detail way back in 2017 on TIP 149. But I think a lot has changed and a lot has happened since then. So I think this book is worth discussing again. So one thing I want to preface this by, this book is very hard to come by. I had to get it from a library. You can buy copies on Amazon for I think it's thousands of dollars, but your best bet is probably the library.

So, let's get started. The first theme that I'd like to discuss here is where Seth thinks most investors go wrong. So Seth does a great job of discussing the fundamental differences between both speculation and investing. So let's start there. As investors, we should strive to minimize speculation as much as possible. Now, to achieve this, we have to have a framework to understand exactly what speculation is. Speculation is generally short-term oriented.

investors are trying to figure out, you know, which stocks are going to increase or decrease in price, and they just ignore the risk of losing money on that idea. They also like to base their judgment of whether a stock's price will increase or decrease based on the behaviors of others and not on the fundamentals of a business. And then they just, you know, tend to ride momentum, buying stocks that are rising in price. And lastly here, they're just obsessed with predicting the direction of stock prices. You know, you hear people talking about this thing's going to go to the moon when in reality you have no idea when the next macroeconomic shift is going to happen, a war is going to break out

and cause all sorts of chaos onto what can actually happen with the stock price. Now, Seth mentions a really, really cool story here about speculation and he uses sardines as a metaphor for stocks. So he mentions that there was this time in Monterey, California, when sardines were basically disappearing from the waters due to excessive trading of these. sardines. So there were commodity traders here that were bidding up the prices of the sardines, and the prices just soared, which caused the sardines to be overfished. One day, a buyer treated themselves to a very, very expensive meal of sardines. And he quickly became ill after eating them.

So we went back and told the sellers that these sardines weren't any good. The person who sold it to them said, you don't understand. These are not eating sardines. These are trading sardines. Now, this is a particularly effective metaphor because I think it really illustrates how two separate parties can perceive an asset differently. Seth makes the point that most investors are trading sardines, not because they're necessarily superior to other cans, but because they can simply sell them at a higher price. A great example Seth gives is in disc drive companies back in the 1980s. So during this time, there were about 12 publicly traded businesses that were selling these Winchester disc drives. And there are also significant financings going on in the private market. So the

the total competition was a lot more than that number of 12. Now, the total market cap of the industry once reached $5 billion due to excessive euphoria. But, you know, the product essentially was just a commodity. And so once sentiment waned and interest began to leave and go elsewhere, the industry actually broke down to just about $1.5 billion in only 18 months. So, you know, it's really easy to see speculation, just pretty much anywhere in the market at any time. When a public business's stock price skyrockets, speculators are attracted to similar companies like Moth's Fuel Flame. For instance, in 2024, there were three quantum computing companies.

So there's quantum computing, Righetti computing, and IonQ. And they all achieved very impressive returns. So quantum earned about 1,900 percent. Raghetti earned about 1,800 percent, and Ion Q returned just to Paltry 240%. But let's single out quantum computing here. So the business is growing revenue very, very well. I looked at it. And in Q1 of 2025, it reached $39,000 in revenue from $28,000 a year ago, which, you know, that's good growth. So let's annualize this. If we do that, we get about $156,000 in revenue. Now let's look at the market cap.

As of June 16, 2025, the market cap is $2.93 billion. So you get this fine tech business at a multiple of 18,782 times forward revenue. That's peak speculation. So, Clarman makes an obvious distinction between what he believes is a speculative versus a non-speculative investment. He says that speculative investments just don't generate any cash flow to the benefit of their holders. That means he thinks things like gold and Bitcoin are speculative assets.

It's worth noting here that he's not talking about businesses with a dividend yield that are paying out cash. any business with an earnings yield or a cashful yield will suffice. Let's take a look at some of the structural flaws of Wall Street that Seth aims at here. So I really enjoyed this part because he definitely did not hold back any punches with what he's saying back here in 1991. And everything back then is still completely valid today. So he says that Wall Street has three primary activities. The first one is trading.

And that's because they earn a commission on all trading activities. Every time you buy, you sell, they're making money. The second one is investment banking. So brokers obviously take part in the purchase and sale of entire companies. They underwrite new securities like initial public offerings. They provide financial advice. And through this, they earn fees. They earn equity.

They can get options, warrants, among other benefits. And the third here is merchant banking. So in merchant banking, they basically commit their capital while acting as a principle in investment bank transactions. So you can just think of this today as private equity. Now, the problem with this system here and these three benefits are its lack of alignment. You'll notice here that none of these three options mention anything about making your clients a good return.

So trading commissions are earned based on trading volume. This means Wall Street profits more, actually, when there is excessive trading. A broker may also be incentivized to sell shares and businesses that specifically have high commission fees. And then looking at investment bankers, they're charging underwriting fees. So the spread on these fees can reach 4 to 5%. It's quite lucrative. So let's look at the Airbnb IPO.

This IPO raised about $3.5 billion in capital. The investment bankers would have netted approximately $150 million. And just regardless of what happens to Airbnb stock price, that fee is still paid. So the problem here, once again, is that the underwriters aren't participating in the downside. Additionally, they can even raise money for subpar businesses when the stock market's heating up, and they can take advantage of that temporary euphoria when, in fact, if markets are very heated, there's a very good chance that the price is going to come down. But again, because they're not aligned, they don't take part in that downside.

Now, in investment banking, Seth points out that, quote, Wall Street firms have become direct competitors of both their underwriting and brokerage clients, buying and selling entire companies or large corporate subsidiaries for their own accounts. Instead of acting as middlemen between issuers and buyers of securities, firms have become, issuers and investors themselves. Nowadays, when the phone rings and your broker's on the line, you don't even know in what capacity or on whose behalf he or she is acting. So another problem here with Wall Street is that it's just nearly always bullish. As you can see from these three flaws above, they all profit when the markets are especially bullish and euphoric. Now, these are

the times when trading volumes go up, IPOs are at record numbers and money is just flying all over the place chasing the next hot deal. Additionally, Wall Street's customers are also happier during these times because they're obviously making money as well. So it's crucial here to think about the incentives of people who are trying to sell you things. I think about this pretty often. You don't want someone selling you something because they profit from you buying it, no matter what the outcome is for you. I'm much more willing to have an intelligent conversation about a business when a person I'm talking to has skin in the game and participates in both the upside and the downside in that business. So in this case, at least I know that they aren't trying to

earn some sort of fee based on whatever my decision is. The next area that I'd like to discuss here is Clarmine's perspective in the fund management business. He's definitely not the biggest fan of the industry, even though that's where he's made much of his net worth. He mentions a lot of the usual problems here, you know, that funds are generally set up to grow assets under management and not to optimize their partner's return. And, you know, even when a fund can produce good returns, what usually happens is they increase their AUM and this increase in AUM forces them to change your strategy. And then what can happen from that is if your universe of stocks that have produced great results

in the past becomes smaller and smaller because of this increase in your AUM, your opportunity set decreases and your ability to differentiate yourself from competitors just diminishes. Another problem with the fund industry is that redemptions happen when a fund underperforms the market. As a result, funds just tend to focus very little on actually outperforming the market and instead prioritize on just matching it. If they do this, they can then reduce the chance of redemptions happening. But they also reduce the chances of their partners making superior returns. And since they take the strategy, the long-term fundamentals of a business become less critical. What becomes more important is how the market will perceive the stock in the next quarter.

So John Maynard-Cain said, Worldly Wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. This quote aptly describes the exact scenario that fund managers often face. Interestingly, Clarmine didn't think very highly of index funds either. So he points out here that the more investors who end up indexing, the more investors are actively doing less fundamental analysis as they're just trying to mirror the index. And this in turn makes the market actually less efficient.

Then, when you look at index inclusions or removals, this requires a large amount of a company's stock to be purchased in the open market, and this can rapidly change a stock's price. And then looking at index investors, they just kind of become ambivalent towards the performance of the index because they're just trying to match it, not necessarily outperform it. And therefore, if you have a proxy contest in a specific business, they're unlikely to cast a vote and affect a business in any positive way. So Seth also believed that indexing was a fad and that it would have been a fad. fade away like many other fads. So, you know, this was one of his takes, I think that hasn't aged

very well, but I appreciate the fact that he had a view on it and expressed it in a very rational manner. Now, the next concept I'd like to discuss is Seth's insightful use of earnings before interest, taxes, depreciation and amortization, which I'm just going to refer to here on out as EBITDA. So EBITDA was formulated by John Malone of TCI, who I spoke about at length on TIP 619. So his business was unprofitable, according to generally accept. accounting principles. However, in reality, many of the non-cash charges of depreciation and amortization were masking the cash flow generation that TCI was actually achieving. So he basically ended up trying to train analysts to view the business through the lights of this metric rather

than using gap earnings. So Claremont also mentions that in the 1980s, companies were being bought out because of this. You know, many potential buyers wanted just a single metric with which to evaluate businesses. And EBITDA was what they eventually settled on. Now, there are multiple problems with EBITDA. So let's go over them. So the first one here is that depreciation is a real expense. So adding it back in simply is not the reality that we live in. Yes, it's a non-cash expense, but CAPEX needs to be spent in the future to maintain a company's operations.

So Seth makes a point that if depreciation exceeds capital expenditures, the company is actually undergoing a gradual liquidation. Now, when we look at amortization, he points out that amortization is more of an accounting fiction. So if a company purchased another company for more than its tangible assets, the difference is recorded as a line item on the balance sheet called Goodwill. So when Clarmine wrote this book, Goodwill was advertised over about a 40 year period. Now Goodwill is tested annually for impairment. And if it's impaired, it's recognized as a loss on the income statement. Amortization is applied to things like patents and software licenses today. But the main point that Carmen was making was

that a company will need to expense CAPEX at or above its depreciation costs just to maintain its business. This is why some investors use depreciation as a proxy for something like maintenance capital expenditures, which I actually think is a pretty intelligent idea. And it just makes a lot of sense. If you're adding back depreciation, even though you will eventually need to spend it on CAPEX, it kind of seems odd to add it back in, doesn't it? Now, Seth's other main problem with EBIT does that it can obscure both a bad and a good business when comparing EBITDA of two similar companies. So let's say we have two identical companies in terms of revenues and cash expenses. The only difference between the two of them is that one has $0 in depreciation and

amortization and the other has $20 million in depreciation and amortization. So if we evaluate both of these, they're actually going to have identical EBITDA. However, the business with zero in depreciation and amortization is a more attractive proposition than the one with 20 million in depreciation and advertising, simply because it just has no requirements to reinvest into the company to maintain its operations. It's what you'd call a capital-like business. So the next theme of this book I'd like to discuss, which is very, very important, is risk. So value investors are more concerned with avoiding losses than with generating profits.

However, most investors don't really think that way. You know, most of them are very, very focused on the aspect of making money and less on the chances of them losing it. So, Clarman makes the point that loss avoidance must be a cornerstone of a risk-averse investment philosophy. Now, this is an area that I've been trying to focus on a lot more. I've had a few investments where I've lost money and I think I was probably underway in the likelihood of the downside while trying to model what these businesses were worth.

However, the more experience I get, the longer I invest. and the more I just realize how crucial it is to not lose significant capital on any single investment. So Seth Claremonton does a great job of explaining why this is the case through the lens of compounding. So he wrote, An investor who earns 16% annual returns over a decade, for example, will perhaps surprisingly end up with more money than an investor who earns 20% for nine years and then loses 15% in the 10th year. Perhaps this is part of the reason that Charlie Munger insisted that compounding should never be interrupted unnecess.

necessarily. Now, there's another interesting point that Clara makes about setting return targets. He mentions that creating targets can cause investors to take too much risk in pursuit of those targets. And the problem with investing as an activity is that you can't really work harder to achieve your goals. This is likely one of the reasons that investors such as Buffett and Howard Marks, who place such an emphasis on the downside, tend to just lose less in bear markets and kind of match benchmarks in bull markets. The difference, I think, is that Buffett has benchmarks that he demands from his investments. While they will be based more on capital efficiency than return, I assume that he assumes

that his returns will approximate these capital efficiency numbers, such as return on equity. So while I agree with Clarmine that if an investor has a goal, it's unlikely that they'll achieve that goal on a yearly basis, I still think if you have a goal and you focus on the fundamentals of business, your results will smooth out over longer periods of time. But, you know, if you do set goals, I think you should really not only focus on the upside, but also focus on what you can lose, which transitions very well to the subject of what the book is named after, margin of safety. So value investors utilize the margin of safety because it provides downside protection. If you had the chance to buy $1 for, let's say, either $1 or for 50 cents,

you're obviously going to buy it for 50 cents. Another key point, in portfolio management is to deploy capital into the best possible opportunities. For instance, if you have two options to buy stock and one is trading at half its value while the other is trading at a quarter of its value, you're going to pick the cheaper option between the two. While this makes sense, there are also other factors to consider. For instance, if you find a truly exceptional business, you may want to allocate a significant portion of your portfolio to it. If you used Clarmine's framework, chances are you may never add to these exceptional businesses because you're going to find cheaper opportunities in lower quality companies.

I know that in my portfolio, if I'd follow this advice and only bought the cheapest, I'd never have added to positions like Eritzia, Terabest, Topicus, or Zedcore, which are all positions that have contributed the most to increasing my net worth. The margin of safety concept remains valid, however. There is an art component to investing that is required in portfolio construction. So there's going to obviously be positions that may never feel right to add to just because of their high stock price. But I bet there will be a handful in your portfolio that should be the largest position that you own, despite them not being the cheapest stocks that you own.

So where else the margin of safety shine? In inflationary environments like the ones we're living in today in 2025. So you got investors like Bob Rabadi and Harris Kupperman who have been acquiring tangible assets because they anticipate that inflation is going to persist as a long-term issue. If you buy discounted tangible assets, their value can easily be a lot higher than they are on the books. For instance, let's say an offshore rig that is already built is going to have a replacement cost with heavily inflated expenses. Therefore, something that's maybe on the books for $200 million might have replacement costs of $400, $600 million. So the margin of safety, as Carmen points out, works best in businesses with a tangible asset heavy focus. For businesses that derive value from

things like intangible assets, such as, you know, a brand or intellectual property, it can be harder in Carmen's mind to achieve a margin of safety. For instance, much of Coca-Cola's value is in the strength of its brand. But, you know, let's just say hypothetically taste change. In that case, Coca-Cola's margin of safety goes down significantly because in a liquidation event, the IP of Coca-Cola would have no value and only tangible assets are going to be left over to have value to liquidate. This is why Seth prefers asset-heavy businesses that can be liquidated and still offer a return

to their investors. Now, I will say that I listened to a recent interview with Seth Klamarmer, I think from 2023. And he did say if he updated the book, he would probably do a lot more work on the intangible asset side of things, just given how much industry has changed over time. So I wanted to make sure that I added that caveat here. 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, and 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

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All right. Back to the show. So I mentioned earlier that value investors tend to shine the most in declining markets. Now, why is this? To answer that, let's first look at the perception of stocks in a bull market. So in bull markets, the stocks that have increased the most in price tend to also have the highest expectations. However, in bare markets, businesses with the highest expectations, which also generally have the lowest or no margin of safety, tend to decline the fastest. So contrast that with a value investment, which tends to be boring, trades at a discount to intrinsic value, or trades for something like less than its net cash position or even below its networking capital per share.

These businesses often have very, very low expectations. So when the market declines, investors aren't in as large of a hurry to sell these kind of ugly ducklings. And once sentiment changes back to being bullish, these businesses with low expectations can often close the gap between price and value directly from a re-rating in their multiple because they exceed these very, very low expectations. Now, another area of importance for the margin of safety is a potential just for bad luck or misjudgment. You know, look, none of us is perfect. And I can pretty much guarantee that every investment you own will go through some period of bad luck or have some sort of event that you couldn't have imagined happening to it, often punishing you. for being a holder of its equity. When a company is priced for perfection, any minor hiccup can cause a downward re-rating

of the business, which wouldn't be a good scenario, as you probably know, if you own a stock for a decent period of time. If, on the other hand, you own a business where things do not necessarily need to happen ideally, you reduce risk by avoiding the painful chance of a rerating downwards, but also take part in the potential re-rating upwards if the business outperforms its low expectations. Now, it's easy for me to say how good value investing is, but in reality, it's really hard. Clarmine summarizes it nicely in the conclusion to chapter six. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it's time to swing.

Now, let's take a little bit of a tangent here and talk about an investor, I think, ticks all three of these boxes that Clarmine just mentioned. And that's two people that I think you're all going to be very familiar with, Nick Sleep and Kay Sakaria of Nomad Investment Partnerships. So these two investors managed to generate returns of 21% per annum for their partners over 12 years. They closed shop because they were just annoyed by the constant scrutiny of regulators over the concentration of having most of their money into just three positions, which were Costco. Amazon and Berkshire Hathaway. And since they felt that they'd found three outstanding businesses, which they ended up telling their investors just to buy them and hold them, they didn't really feel the need to continue accepting fees from their partners.

Now, when it comes to discipline, they were, and I think still are very disciplined. They eventually settle on a business model that they dubbed the scale economy shared. This is when a business scales up and shares its scale economies with its customers. I think Costco is probably the best example of these three and maybe the best example and business in the entire world. But there's also significant cases to be made for Amazon and Berkshire. So the reason they were so disciplined was because they knew very specifically what business model that they were looking for.

They knew what the businesses were worth that they analyzed and they didn't stray from that strategy. Let's just closely examine some other examples of discipline from Nick and Zach. So in 2004, during a period of underperformance, they chose to avoid chasing speculative of internet stocks and instead they stuck to the strategy of buying undervalue high quality businesses. Throughout the existence of the partnership, they avoided excess turnover. And, you know, in an industry where shares are trading faster and faster, they just refuse to take part in that action. They did this because they knew good investing was more about waiting than

being overly active. And then another part of their disciplined investing strategy was that they just stayed concentrated for the entirety of their. partnerships existence. They knew that to get different results from the market, they'd have to take a concentrated approach. Instead of diversifying to match to market, they concentrated to outperform it. So the strategy also obviously required considerable patience. For instance, one of their best investments was in Amazon. However, when they acquired it, the market did not possess the same level of understanding of the business that Nick and Zach had. They understood that Amazon was intentionally spending money to avoid paying taxes and to basically get free money to fuel further growth. However, Amazon could

have easily decided to be more profitable while still maintaining an exceptional business. In this case, the cash flows of Amazon would have been much more apparent to the market and maybe the cash flows that Nick and Zach attributed to it would have been aligned with the same cash flows that the market attributed to it. Now, like all investors, you must have patience to succeed. You're going to hold a business that the market doesn't like. For the price and value gap to close, some time will need to pass until other investors understand the value and bid up the price of an investment, allowing price and value to converge. Now, Nomad had numerous investments that required patients to generate returns. They even wrote in their letters that

investors should expect periods of low returns in the short term as they were specifically looking to get high returns in the long term. Now, the judgment aspect goes hand in hand, I think, with the part on discipline regarding the economies of scale shared. So they leapt to look for businesses that fit that model specifically and only that model. It's not easy to find these businesses. So ever since they closed their shop, Nick invested in a company called ASOS, which since the end of the Nomad Partnerships has compounded at a rate of negative 23% annually. Now, I don't know if he still owns it or not. The judgment to actively search for those business models while nobody else was, I think, speaks volumes to their ability to judge an opportunity. Now let's get back to the book here. So I want to

go over chapter 7 here, as I believe it's a very, very crucial chapter. So the chapter is titled at the root of a value investment philosophy. There are three primary aspects of a value investment philosophy. Number one, value investing is a bottom up strategy. Number two, value investing focuses on absolute performance and not on relative performance. And number three, value investing is a risk-averse approach, meaning the primary focus is on what can go wrong versus what can go right. So we've already discussed how some institutions make investing decisions not based on the fundamentals of the business, but instead on what they think the market thinks will do well over the short term. In this sense, they are avoiding all three of these value investing concepts.

But let's first start by discussing why value investors use a bottom up strategy and contrast that with a top-down approach. So the top-down investor must make low-probability assumptions. They must predict the unpredictable more accurately or more quickly than thousands of other brilliant people attempting the exact same thing. Now, Seth argues that it's unclear whether top-down investing is a greater fools game, where you only win when someone else is willing to pay you more for your shares. Or is it a genius game where only the investors with the best possible insights have an edge

over their competition. Now, in both of these scenarios, it's quite evident that both are not attractive as a game for any risk-averse investors. The point here is that top-down investors lack a margin of safety. Since they aren't buying based on value, they're buying based on a concept, a theme, or even a trend. Or as I see it, they're buying a story or a narrative. Morgan Howes wrote, every market valuation is a number from today multiplied by a story

about tomorrow, and the stories change much faster than the numbers. Now, what Seth, I think, is trying to get at with top-down investors, is he saying that they are forced to make many, many assumptions which increases risk. And in value investing where you traditionally derive your margin of safety from the balance sheet, you don't have to make assumptions in order for value and price gaps to close. And because of that, you get an additional margin of safety when your safety is coming specifically from assets. This is a pretty fascinating concept.

I mean, it really got me thinking a lot, mainly in regards to if I'm a top-down investor. because I generally do not consider a company's balance sheet when evaluating how much money I can potentially lose on an investment outside of obviously looking at the cash and debt position. And the reason is that a few of the businesses that I have invested in where I really did focus on buying below book value just didn't end up generating acceptable returns for me. Yes, true. I didn't lose very much on them, but they also took such a long period of time to realize

their value. And actually, to be honest, they never really realized. I still track some of them just on a very loose basis and the two that I'm thinking of both trade even further below book value today than they did when I own them. Now, this could just be a function of me being less carisseverse compared to someone like a Seth Klarman or other value investors. And I think that's perfectly okay. You know, we all have our own risk appetites and have different relationships and goals for our investing. However, there's been one thing that I've really focused on over the last 18 months, which is identifying which of my investments can potentially lose

me the most money. Now, I've done this for a few reasons. First, I've lost on a few investments, and it really hurt my ability to compound. While I know I'll never bat 100%, I'd at least like to lose the least amount possible when I'm wrong. And second, I think it just helps build my filter. I want to think more quickly about what I can lose on an investment than I had done previously. I believe this mindset shift will help keep the margin of safety at the forefront of my mind. Now, let's go over what Klarman means here about making assumptions based on a company's future earnings. Let's say you're looking at a business that you expect to grow earnings by, you know, 10% per year based on a top-down analysis. Now, what happens if the market is pricing

in 15% growth? You are likely to lose money once investors' expectations decline and they remove capital to, let's say, pursue other higher growth opportunities. In this case, unfortunately, you're going to see a huge re-rating of the multiple downwards, which you could say is a risky investment. So what does the bottom-up value investor do instead? They simply buy a bargain and they wait. They aren't required to attempt to predict what the market will like in the future. In this sense, value investors must be disciplined and patient, which are two qualities we've already explored here. The reason is that if there are no bargains, then you just move into cash. This is something that we've seen from many great investors such as sleep in Zakaria, as well as Warren Buffett.

Once the market is not offering good ideas with downside production, they simply just don't invest. Top-down investors will remain invested and take on larger risks once the market has risen in price. Since they're trying to mirror competitors, if all of the competitors are trying to take part in this action, it's only logical not to stray from it. Another contrast that Claren makes is that bottom-up investors will focus on exiting investments when the thesis breaks or the price reaches full value. Clarman adds, in investing, it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it. Now, let's move on to the second. second aspect of the value investing philosophy. The value investor focuses on absolute performance

rather than relative performance. There's a short passage in the book that says that absolute performance is all that matters because you can't spend relative performance. I just love this. So why does this matter and why does this distinction matter so much? You know, investors chasing relative performance are unlikely to make bets into businesses that might take a long-term view. For instance, so I have two companies, Dino Polska and Eritzia, which have both spent quite a lot of capital expenditures for growth. Now, that CAPX obviously aid into their free cash flow, which the market did not like at all and it ended up punishing their share price. However, now that both businesses are reaping the rewards from improving their infrastructure, as a result of that CAPEX, their share prices are significantly higher. Now, the relative performance chaser might sell either of these stocks at a loss, even though they might actually agree with me that,

that over the next five years, the stock will be worth more. Now, they're doing this simply because they're trying to match an index. They may even reenter the position once it's doubled in price because the uncertainty has been removed from the investment. But you can probably see the problem here, you know, so using Eritzzi as an example, let's say a relative performance chaser owned it in November of 2022 when it was priced at about $54.

Let's say it dropped about 20%. They end up exiting that position at about a 20% loss. Now, from August to December of 2023, the shares traded down in the mid-20s. However, this investor avatar that we're talking about is still very uncertain about what the market's going to think about that business. So they just observe it, but they don't reenter the position. Now let's fast forward here to September of 2024.

And it's very clear, I think, that things are starting to look good again. And they reintered the position at about $45. This is where I believe retail investors or those seeking absolute performance just really have an advantage. absolute performance chasers would view Eritzia as just continually improving over this entire time. And when the stock price falls because short-term investors don't think the stock will rise in the short-term, they can pounce on shares at a lower price, which continues to lower their cost basis. Now, I personally put myself in the absolute performance chaser category.

If a business I own has a large drawdown and doesn't carry a significant weighting in my portfolio, I'm very likely to just add to that position rather than sell or do nothing. I recently took a walk with one of our TIP mastermind community members, and I mentioned that Eritzia has been a significant winner for me, but has also been an absolute roller coaster ride. Since I've owned it, it's had two 40% drawdowns, and I also significantly increased my positions in one of those drawdowns. When I added to my portfolio, I thought to myself, okay, yes, this could decline further, as they were likely to experience an additional few quarters of weak fundamental performance.

If I had been trying to compete with an index, it would have been a bad idea for me to hold the stock, as it was very unlikely to outperform the benchmark over the next few quarters. However, I don't care about what happens to the next few quarters. I'm more concerned about what's going to happen over the next few years. And to summarize, the absolute performance investor will have the discipline to hold the stock, even when the price craters. But that's provided that the long-term thesis is obviously intact. They'll also have to have the discipline to add to that position now that the margin of safety is higher and also carries along a better upside. And then, of course, you're going to have to require patience because you're going to need to understand

that it might take some time for the market to realize that your thesis is still on track. But I know a lot of investors find that very, very difficult to do. Now, there's one final contrast between absolute performance and relative performance investors that I wanted to cover. And that's concerning cash positions. So this is an area of investing that I think is quite contentious. So Seth makes some excellent points here. Since many of the investors that I learn from fund managers, they tend to be competing against

the benchmark. Whether they care about constantly beating it quarterly or not is a different question, but we need to consider incentives here. So a relative performance chaser typically chooses to be invested at all times. Now, there's a few reasons for this. So cash causes a drag on performance. That's completely true. There's some fund managers that believe that investors are paying them specifically to invest and not time the market. So they feel like they're doing their partners a disservice by not being fully invested. Then you have some funds that have very specific mandates that require that a percentage of their capital must be invested into, let's say, equities.

So this means that when markets are expensive and stocks become riskier, they're basically forced to hold them or buy more rather than having to sell them and increase their cash positions in anticipation of buying things at a better price in the future. And then the last one here is just career risk. Holding cash implicitly means that a fund manager believes the price will fall in the future. If they don't fall, they're probably going to underperform the index or their peers, which may cause their investors to redeem. But if they're fully invested during a drawdown,

then they're going to match the index when it goes down and they decrease the likelihood of being fired when everyone else is going through that exact same struggle. But absolute performance investors think differently. If they can't find a bargain, they simply do two things. One, they sell positions that meet or exceed intrinsic value. And two, they don't stray from their desire to invest into new ideas that offer a large margin of safety. Obviously, Warren Buffett, the goat, is the best example of this.

So when he closed his partnership down, he knew he just couldn't continue finding deals that offered a large margin of safety and an attractive upside. Sure, he could have sold out on his investing philosophy, accepting more risk and lower returns. but he stuck to his principles and ultimately close his fund as a result. Then, when you look at his Berkshire days, you'll notice that his cash position has been building up higher and higher. If there were significant opportunities, my guess is his cash pile would be going down. But the fact that it's continuing to grow means he's having a harder time finding opportunities. And while Buffett waits, he still earns a return on his cash by investing

in things like short-term T-bills. This allows him to ensure that he's not losing the purchasing power of his cash to inflation. And since they're short-term, he has ample liquidity if a large opportunity were to present itself. While I believe that Claremont is entirely correct, that cash provides numerous options when the market fluctuates, I also think that different investment strategies are most effective with minimal cash positions. So let's just say you intend to hold businesses for a very long time. There's likely going to be periods where these stocks fall out of favor with the market. You can therefore kind of pick where and when to deploy your cash. The problem may arise in that situation where none of your stocks are even remotely attractively priced and offer a margin of safety.

In that case, holding positions and then just allowing cash to accumulate as a prudent choice, for my situation at least, I have a income. And every time I make money from my job, I'm putting part of that into my brokerage accounts. And therefore, I can choose whether to deploy that cash or if I can just let it stay there and wait until something becomes attractive. Now, it's important if you take a strategy like the one I just talked about that you should definitely understand the margin of safety and the potential downside and the potential upside of everything in your portfolio because obviously you want to be tracking them. It's nice to deploy capital, but you want to deploy it into the situations that make the

most sense for you and you need to understand value in order to do that. Now, I know for myself that I have to stay very, very disciplined. There's positions that are in my portfolio that, you know, maybe currently, are in that 5% range by cost basis, which I think are really high quality businesses, and I'd actually like to be in the 10% range. Unfortunately, some of these stocks are also excellent businesses. And unfortunately, the market has also taken note of that fact. So their evaluation multiples have expanded, making it more and more challenging for me to increase my position. So the current strategy for me is just simply wait until a business event

or a macro event occurs, which will cause its price to go down. And then I'll just add more. But, you know, like I said, this requires patience and it requires discipline, which are two aspects that I think I have to continually monitor and reflect on. Now, I discussed how Buffett considers both risk and return when evaluating investments. Clarmine strongly asserts that value investors prioritize risk. So why does Clarmine think it's so crucial for investors to prioritize risk over returns? To achieve a reasonable absolute performance, we must be able to continue compounding. And we cannot accomplish this if there's no capital to compound. Therefore, we ought to spend time trying to find investments where losing money becomes the primary goal rather than maximizing returns.

This is just a fascinating subject, and I think it's one that many investors largely overlook. When I'm perusing, you know, Twitter, I rarely see someone tweeting that, you know, cash tag XYZ can't lose money because it's trading below liquidation value. However, I can't tell you how many times I've seen someone tweet that, you know, XYZ is a 5x in the next five years. I think this plays very well into the fact that humans aren't the greatest at assessing risk and that we prefer to avoid it anyways because the feeling associated with making a gain is much, much more attractive than the feeling of making a loss. Now, I also appreciated how much Seth discusses bonds in this book.

So similar to Ben Graham's thinking, bonds are just inherently less risky than stocks. The reason is that the coupons are nearly guaranteed, as is the return of principle. In stocks, neither your principal nor your coupons, obviously the coupons don't exist the same way, but neither of them are guaranteed. And even if you thought a business was good and would be around, let's say, in 10 years' time, your ability to calculate what the coupons will be and what even the return of the principal will be in 10 years is pretty much impossible. Another great point that Carmen makes is that risk is largely unknown. And that is true both before and after an investment is made.

So, Carmen writes, unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning. Risk simply cannot be described by a single number. Intuitively, we understand that risk varies from investment to investment. A government bond is not as risky as the stock of a high technology company. But investments do not provide information about their risks the way that food packages provide nutritional data. Rather, risk is a perception in each investor's mind that results from,

analysis of probability and amount to potential loss from an investment. If an exploratory oil well proves to be a dry hole, it's called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, if the bond matures on schedule and the stock rallies strongly, can we say they weren't risky when the investment was made? Not at all. The point is, in most cases, no more is known about the risk of an investment after it is concluded than what was known when it was made. Now, the final part about risk I want to mention is the concept of volatility in time. Value investors do not equate volatility with risk. If you hold a stock that goes down 20% because the market is scared, that's perfectly acceptable

to a value investor. They actually welcome it because it allows them to strengthen their position. If a business goes from $10 to $50 but whipsaws up and down, it's still a good investment provided the intrinsic value of that company is increasing. Whether the price fluctuates more wildly than the index doesn't matter, as long as the chances of permanent capital destruction remain as close to zero as possible. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk,

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evaluating a business. Since he's made it clear that future returns are essentially unknowable, we need to use tools that can help us stay directionally correct. But what are they? He goes over three primary ones here. The first one is net present value analysis, which is just kind of the same thing as a discounted cash flow, which is basically just to calculate the value of future cash flows and then to discount it to a present value. Then it goes over liquidation value and then stock market values. So let's dig into each of these. So net present value or NPV is going to be very familiar, I think, with many of our listeners. I already told you it's essentially a cash flow analysis. Now, NPV is great when future cash flows are very, very predictable.

But as I mentioned, most businesses do not offer predictable future cash flows. So MPV has some other drawbacks. For one, it's easy to increase the MPV number of a business if you just use overly aggressive growth assumptions. Then we have to also consider our own biases. For instance, we're going to have a lot of confidence in the numbers that we choose. And if we look at base rates of how confident we probably should be, we probably should be not as connearily as confident as we end up being. Now, the growth rate problem is one that I've spent a lot of time thinking about. I develop my meta model, which I call covert cyclicality. This occurs when a business is funded. fundamentals appear to be improving due to secular tailwinds, but are actually the product of less

obvious cyclicality. COVID-19 is a prime example in this regard, where the evaluation of many businesses was accelerated because investors assumed that the benefits from the lockdown would last indefinitely for certain businesses. Once that facade was cleared, and it became obvious that growth metrics during COVID-19 were unsustainable, many businesses were re-rated downwards. Now, I thought about this mental model simply because I've been a victim of it. Luckily, not anything really bad like, say, a Peloton, which had gone down about 96% in value from its COVID-induced highs. So, for instance, one trust manufacturer I own had experienced some pretty significant fluctuations

than its business, I think, specifically during the COVID-19 pandemic. So there were low interest rates, which led to a housing boom that proved to be unsustainable. While I still own the name and I like it, it has turned out to be a much more cyclical business than I had originally thought it would be. So if you get the growth rate wrong, your NPV will be entirely off. And, you know, it can be so distorted that it really becomes useless as a determining tool for value. The other consideration is a discount rate. This rate can fluctuate significantly during an entire economic cycle, which can drastically alter the intrinsic value of a business.

Figuring out what to use is yet another gray area that you're going to encounter when you're trying to make this calculation. Now, moving on a liquidation value. liquidation value is a conservative assessment of a business's worth when only considering tangible assets. So if a stock is trading at a discount to its liquidation value per share, it can make an attractive investment. There are two types of liquidation events, a resale or a complete liquidation. Klaman believes that a full liquidation can actually offer higher returns than a resale, specifically because in a resale, the buyer is going to severely discount the inventory of that business. So the last method that we'll discuss is using stock market value.

which is probably a pricing tool that many listeners are going to be familiar with. So this method utilizes the stock market to examine similar businesses and learn more about what the market values the equity at. While Seth doesn't believe in efficient markets, he does admit that using market values gives the appearance that the user acknowledges the market is efficient. And to that, Clarmond says no, because this method must be used in conjunction with other techniques to achieve a more comprehensive analysis of value. Now, I find stock market value is decent for comparing one business to another.

It doesn't obviously mean that if two firms are in the same industry, they should trade at the exact same multiple. But it can give insights into what the market thinks about a specific business. When you conduct additional analysis, you'll often find interesting areas where maybe a discounted business is lagging behind a premium price competitor. But let's say you're looking at two businesses in manufacturing. Perhaps a premium price one has higher margins. and better capital efficiency.

Suppose that you think the discounted business is actually undergoing a technological upgrade, period, and can maybe achieve higher margins and capital efficiency than the one trading at 20 times. In that case, you'll build some conviction that you can get a multiple re-rating and it could make a good investment. While evaluation is part art, part science, Clarman thinks the best strategy is to use a mixture of the three and weight specific ones more heavily on an individual basis. So if you're looking at a business that's heavily invested in assets, use a liquidation value as a basis for determining its value. If you're looking at a company that you think has very steady and predictable cash flows,

then overweight the use of net present value. And if a business, let's say, is spinning off a segment, then you can use stock values or use private market values to see what that spin-off might be worth. Now, the next area here I want to discuss is reflexivity. Reflexivity is a concept explored by George Soros in his book, The Alchemy of Finance. He wrote, Fundamental Analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. It's a strange concept, but there are many examples of its power in the markets.

I got about three here. So, first off, if a company requires capital, it's often going to be better off accessing it, issuing its own equity, specifically when it's priced at a premium compared to a discount. So obviously, raising capital via equity can add shareholder value if the stock is expensive, but it can actually destroy value when the stock is cheap. So the first one here is that a company requiring capital is better off accessing it by issuing equity when it's priced at a premium rather than a discount. A lot of companies end up destroying shareholder value because they issue stock at a to intrinsic value. The second one here is when a company can utilize its stock to go on acquisition sprees. So Teledyne is a notable example where its CEO, Henry Singleton,

utilize its very expensive shares of his business, Teledyne, as currency to acquire companies, which created significant shareholder value. And then when the narrative shifted and the market didn't like his company so much, he managed to continue adding value to shareholders by halting the M&A spree and by using the capital to buy back large amounts of shares at a huge discount. And the third one here, and probably the most powerful example, is just the narrative of a business. So let's say a stock is at a 52-week low for multiple years. Chances are you're probably not going to read about the CEO of this stock in the Wall Street Journal or CEM on TV. Whereas if they're at 52-week highs, then you're probably going to find the CEO featured in TV,

you know, journals, magazines, and other popular media outlets. When the public is exposed to the CEO, they might be persuaded by the narrative and subsequently purchase the product that they're talking about, which may further enhance a company's value. I think Elon Musk and Tesla are a great example of this. Value investors, when you think about it, are a pretty interesting bunch because much of what they do is driven by contrarian thinking. Like John Templeton said, it's impossible to produce superior performance unless you do something differently than the majority.

So it's probably not much of a surprise that value investors, like Clarmine go fishing for ideas and places where the average investor is likely to take a pass. Let's review some of the areas of inefficiencies that value investors target. So there are three main areas of investing niches that are mentioned in the book. The first one is securities selling at a discount to breakup or liquidation value. The second is rate of return situations. And the third is asset conversion opportunities. Now, there's multiple areas where these types of situations can be found.

You can use screeners to help identify potential liquidation plays. You can use resources like the Wall Street Journal to find information on mergers, tender offers, and other risk arbitrage transactions. And let's say you're interested in distressed assets or bankruptcies. In that case, you can look very, very closely at a company's published financial statements and documents to find these types of opportunities. However, all these require work, of course, and intention to find these opportunities that aren't going to be forced down your throat like, you know, a stock that's in the

Magnificent seven. Another thing that value investors obviously like to look for is businesses that are at 52-week lows. You can use the Yahoo Finance app. And on that app, you can filter for companies that are trading at 52-week lows. You can even filter by market quartile, sector, and region. And the best part is, it's completely free. Now, let's say you find an interesting opportunity. The next step is determine the reason that that opportunity exists in the first place. Clarman writes, if in 1990, you were looking for an ordinary four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least 300 grand.

If you learned of one available for 150 grand, your first reaction would not have been, what a great bargain, but what's wrong with it? And this is an exciting aspect of the stock market because there's just so many opportunities out there that not everyone understands or understands well enough to capitalize on. Additionally, there are other factors such as stocks that become orphaned because their share base becomes dissatisfied. All the shareholders exit the stock and then you're left with these broken stocks that can go nowhere for multiple years. But if you're willing to do the work, you can find some major

inefficiencies in the market where the market is seeing a business completely different than you do. Another area of inefficiency that Carmen mentions is in small caps, where shares are held closely, the float is small, volume is low, and they're very few market makers. Tax loss harvesting is another area of inefficiency. If a stock is unlikely to perform well during that time, investors might dump it for tax purposes, creating excellent opportunities if you're willing to be patient. Now, once we find an idea, obviously the work does not stop there. We then have to analyze the business. Claremann makes some interesting points about the amount of information that we need to know about a stock. This is something that has fascinated me a lot because I think it's really

easy to spend 20, 34 hours on a business if you want to, but there's only a certain amount of time in each day. And I think I agree with Carmen, who states that ultimately, even if you know everything there is to know about a business, it doesn't even actually equate to making a profitable or successful investment. To address this, Clarkman believes that the research process follows a Pareto principle, also known as the 80-20 rule. He thinks that 80% of the information is gathered during the first 20% of time spent. The key point here is that there's always a degree of uncertainty associated with every investment that we make. If you want investments that remove all that uncertainty, you're not going to get a margin of safety because all investors want a free lunch.

But if you're willing to bear some of the risk of that uncertainty, you can find some really, really good ideas with low downside. It's interesting because I found myself experiencing a lot of cognitive dissonance while reading this book, especially in the section on where to find ideas. I can honestly say that I've never looked for stocks trading at 52 week lows. And it's not because I think it's a bad strategy. It's just that I'm lucky enough to have an excellent stream of ideas coming my way. And I don't require more ideas. And while I can see that there are so many opportunities in stocks that are misunderstood as a result of something like a bankruptcy. It just doesn't interest me. While I'm investing to achieve financial independence, I also have

a lot of fun doing it in the way that I am specifically doing it. If I were to tell Seth what I was doing, he probably would say that he has a lot of fun digging through bankruptcy filings to find the next great opportunity. And he'd say that buying, you know, a bunch of high quality businesses that are maybe at a slight discount to intrinsic value just wouldn't get his juices flowing. So much of investing is based on your own personality and I think what excites you. Now, what excites you is also going to come from your own experiences. There's been times where I've tried to invest in what I would consider these kind of overly complex investments.

These are things where you have to conduct maybe a sum of parts calculation or investments that require you to understand the underlying value of assets while the business is not even turning a profit. But to be honest, these haven't been successful investments for me. I believe that my negative bias towards these types of investments probably led me to examine quality investments more closely. And these quality investments tend to be better understood by the market and don't necessarily offer a significant discount to intrinsic value compared to some of these other situations.

Now, the 10th chapter of this book deals with catalysts, marketing efficiencies, and institutional constraints. I think I've spoken quite a bit about marketing efficiencies and institutional constraints, so I won't beat a dead horse here. but he does have some really, really interesting points on catalysts that are vital to value investors. So, catalysts are crucial for value investors because often unlocking value doesn't come from ongoing operations, but from other activities such as spin-off, asset sales, share purchases, recapitalization, arbitrage, and even warrants.

There's one passage from the book that really stood out to me because it effectively combined catalysts with market inefficiencies and institutional constraints to paint a much clearer picture of what a great opportunity might look like. For context here, he's speaking about a spinoff of a business called Intertan, from its parent company, the Tandy Corporation. An institutional investor managing a billion dollars might hold 25 security positions worth approximately $40 million each. Such an investor might have owned 1 million Tandy shares trading at $40.

He or she would have received a spinoff of about 200,000 intertan shares, having a market value of $2.2 million. A $2.2 million position is in, significant to this investor. Either the stake in Intertan will be increased to the average position size of 40 million, or it will be sold. Selling the shares is the path of least resistance, since the typical institution investor probably knows little and cares even less about intertan. Even if that investor wanted to, though, it is unlikely that he or she could accumulate $40 million of Intertan stock, since that would amount to 45% of the company at prevailing

market prices. And that almost certainly would violate a different construction. rate about ownership and control. Now, because of these constraints, many of Tandy's institutional shareholders just ended up dumping their Intertan shares. As a result, Intertan received no Wall Street publicity and brokers had pretty much no interest in promoting the stock. But all that selling created a massive mispricing. And shares that were worth $11 in 1986 peaked at about $63 by 1989. He details some very exciting deals and misunderstood opportunities in Chapter 12. So if you enjoy topics such as distressed securities and bankruptcies, I'd highly suggest you read that chapter. One note that I had on the chapter that really stood out to me was how businesses that are

emerging from bankruptcy can often become low-cost competitors in an industry. Claren points out that these businesses are forced by creditors to become better businesses. And they do this by doing a few things. So the first thing is selling unprofitable facilities or business lines. They can get rid of or renegotiate above market leases. And then lastly, they can do things such as restating assets, which usually means writing them down. And when they do this, this can cause a decrease in depreciation charges, which obviously affects the bottom line.

Now, all this can result in increased cash flows and higher cash balances. Sometimes a business that might pay a dividend to preferred shareholders will halt it, which also allows it to improve its balance sheet. And lastly, many bankrupt firms have valuable net operating loss carry forwards, which can provide a pretty significant future cash boost. So let's talk about these NOLs because they can be very valuable to companies, even if they aren't coming out of bankruptcy. A great example is Uber. So Uber became profitable only in 2023, but had reported tens of billions in negative net income before that. So as of the end of Q4, 2024, they have over $30 billion in net operating loss

carry forwards. So they can use these NOLs to reduce their taxable income, which is going to result in a lower future income tax expense. Now, the final theme of the book that I want to talk about here concerns portfolio management. Clarmine's thoughts on diversification are very well aligned with the portfolio construction of many, many legendary investors. So he believes that, you know, you only need 10 to 15 positions to offer yourself enough diversification to protect yourself. Similar to Buffett and Munger, he believes that over diversification, you know, being in

100 plus companies, is completely unnecessary. So, Clarman writes, my view is that an investor is better off knowing a lot about a few investments than knowing a little about each of a great many holdings. This is great advice for all investors, especially those who have day jobs and are investors. If you want to follow your business closely and understand them very, very well, it's impossible to do that with 100 businesses. It's probably impossible to do it with 50 businesses. But, you know, 10 to 15 is doable if you're willing to put in a few extra hours each week.

Another great quote by Claremond regarding risk management and diversification is diversification after all is not how many different things you own, but how different the things you do own are in the risks that they entail. This quote serves as a very valuable reminder for those heavily invested in multiple businesses, I think within the same industry. If that one industry makes up, let's say, 50% of your investments and that entire industry goes through a period where it suffers, your net worth is likely to take a very, very large hit as well. Now, another interesting concept that Seth brings up concerns trading. So don't get it wrong. He's definitely not a trader, but obviously you must be willing to buy and sell stocks at different times and different prices.

So there's always a degree of trading involved. Now, Claremont makes a good point that in the long run, investing is generally a positive sum activity. But in the short run, it's a zero-sum game. If a buyer receives a bargain, it's because a seller is selling at a low price and the buyer is beneficiary. And if the buyer overpays, then the seller is the beneficiary. Another point brought up in the book is the importance of staying in touch with the market. So it's important not to take the coffee can approach according to Carmen. He thinks there are just too many things going on. And if you choose to ignore valid information, you can easily lose a lot in a position. And I completely agree with this. As much as coffee canning has gained in popularity lately, I think that the world of business

is just so fiercely competitive that you have to stay on top of everything you own at nearly all times. When it comes to trading, there are only really two parts to it. You know, there's buying and they're selling. Let's look at the buy side first. So there are multiple things to consider when buying a stock and they all revolve around a central theme. Avoid succumbing to greed. Greed prompts us to do foolish things, such as buying companies at peak optimism when expectations are as high as they've ever been. This sets businesses up to disappoint investors, which can result out in some massive potential losses. On the matter of position sizing, Clarkman believes you shouldn't take a full position right away. That way, you leave yourself the ability to add to a position if the

price drops. Averaging down can actually be a really good strategy if you're right about the value of a business. I've had success averaging down and up, but if I actually had to choose one, I'd probably take averaging up as that's been the most successful strategy for me. The selling aspect of Klarman strategy is what you'd expect from a true value investor. Sell when the price reaches intrinsic value. When this happens, your margin of safety disappears and your upside goes down. But his main point is that you must sell based on a deep understanding of value. If you don't know what something is worth, it's hard to know when to sell because you won't know how wide that gap is between the price and the value. While I track the value and price of the business I own,

I do not actually sell because price and value converge. Most of the time. The reason I do this is because the businesses I own have what I think are dynamic values. So I'm looking for businesses where the value is likely to increase steadily over a multi-year time period. Let's say I buy something that I think is worth $10 for $5. Let's say three years goes by and that stock is now priced at $10 and I sell it and I make a great profit. Cool. But what if that company is still performing well after those three years and is actually improved substantially from three years ago. Let's say the mode is widening. Let's say margins are improving and maybe cash flows are rising at increased rates. Perhaps after three years, the business will now be worth $20. Would I still

sell it for $10? No, because I'm searching for businesses that will increase an intrinsic value and can hopefully compound its value in the future. If you're looking at these traditional value investments that have zero growth in their cash flows, then I think what I'm doing makes no sense, right? Because after three years, the business is unlikely to be worth more in the future after it re-rates. That's why things like assets are so important about investors, because these are often the primary drivers of a business's value versus the performance of the actual business. Now, the final chapter of the book discusses alternative investments for individual investors. It's more about how investors can find other assets or people to invest their money in on their

behalf. He covers mutual funds and money managers. I don't think he discusses much that you haven't heard about. in terms of mutual funds, but he has some pretty interesting commentary on individual money managers that I think is very insightful. When selecting a money manager, the most important thing to do is understand exactly what they're doing, evaluate the validity of their approach, and then assess their integrity. Once you feel you have an idea on those few things, you should look to understand a few

things. Are they personally invested in the same fund as you are? What percentage of their net worth is it? Is it 1% or 100%? Are they treating their clients fairly? How have managers results been since they reached their current assets under management? Have they decreased or stayed the same? This can help you understand whether they're trying to outperform the market or accumulate assets

under management. Find out if they're willing to take a hit in the short term for a long-term game. This will help you understand if they're basing their performance against an index or on an absolute basis. The next session he discusses is excellent because I think it helps you evaluate a potential investment manager, but it can also be used on yourself to assess, your own individual performance. So he has a long list of questions that I want to share here. How long of a track record is there? Was it achieved over one or more market and economic cycles?

Was it achieved by the same person who will manage your money and does it represent the complete result of this manager's entire investment career or only the results achieved during some favorable period? Did this manager invest conservatively in down markets or did the clients lose money? Were the results fairly steady over time or were they volatile? Was the record they produced a result of one or two spectacular successes or numerous moderate winners? If this manager's record turns mediocre after one or two spectacular successes are excluded, is there a sound reason to expect more home runs in the future? Is this manager still following the same strategy that was employed to achieve their past success?

Was the investment in the underlying portfolio risky, for instance, in over-leverage companies? And lastly, how did the manager reduce portfolio risk? Was it via diversification, hedging, or bonds, etc.? Now, the reason that I like this is I think it can really help determine someone's skill in investing. If you run this list of questions on yourself, I'm sure you're going to come up with some fascinating areas of investing that you might observe as being your own strength or weaknesses. To wrap up today's episode, I'll share a couple questions that really stand out to me, which are, how has my performance been in both up and down cycles?

Did I lose less money than the market in down cycles and equal money to the market and up cycles? Have the good years been a result of outlier events, such as having one stock making up the bulk of your returns, is your current strategy to do the same as what achieved your past returns, and am I focused on what I can lose from each of my investments? That's all I have for you today. If you'd like to interact with me on Twitter, please follow me at Irrational MRKTS or on LinkedIn under Kyle Greve. If you enjoy my episodes, please don't hesitate to let me know how I can improve your listening experience. Thanks again for tuning in. Bye-bye. Thank you for listening to TIP. Make sure to follow, we study billionaires on your favorite podcast app and never miss out on episodes.

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