Margin of Safety

Margin of Safety is a book about value investing.

As I already read The Intelligent Investor – written by the "father" of value investing, Benjamin Graham – there wasn't much new in Margin of Safety. But still, it was interesting to see what another successful practitioner of value investing has to say about this topic. Plus there were some ideas new to me. As the book is more than 20 years old (published in 1991) I hope the author will write a second edition one day and tell us what he learned since.

My notes

Introduction

Avoiding where others go wrong is an important step in achieving investment success.

Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.

To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don't when they don't.

Investors are sometimes their own worst enemies. When prices are generally rising, for example, greed leads investors to speculate, to make substantial, high-risk bets based upon optimistic predictions, and to focus on return while ignoring risk. At the other end of the emotional spectrum, when prices are generally falling, fear of loss causes investors to focus solely on the possibility of continued price declines to the exclusion of investment fundamentals.

[An] important reason to examine the behavior of other investors and speculators is that their actions often inadvertently result in the creation of opportunities for value investors.

There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.

Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. [...] Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.

The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.

Where Most Investors Stumble

Speculators and Unsuccessful Investors

To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. They transact when they think they know something that others don't know, don't care about, or prefer to ignore. They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk.

Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses. Investors in a stock thus expect to 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; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value.

Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth [...]. They buy securities because they "act" well and sell when they don't.

Speculation offers the prospect of instant gratification; why get rich slowly if you can get rich quickly? Moreover, speculation involves going along with the crowd, not against it. There is comfort in consensus; those in the majority gain confidence from their very number.

Trading in and of itself can be exciting and, as long as the market is rising, lucrative. But essentially it is speculating, not investing. You may find a buyer at a higher price – a greater fool – or you may not, in which case you yourself are the greater fool.

Just as financial-market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations. [...] Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.

Investments, even very long-term investments like newly planted timber properties, will eventually throw off cash flow. A machine makes widgets that are marketed, a building is occupied by tenants who pay rent, and trees on a timber property are eventually harvested and sold. By contrast, collectibles throw off no cash flow; the only cash they can generate is from their eventual sale.

The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought. This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns. Such logic can fail at any time.

Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason.

[...] financial-market participants must choose between investment and speculation. Those who choose investment are faced with another choice, this time between two opposing views of the financial markets. One view [...] is that the financial markets are efficient and that trying to outperform the averages is futile. Matching the market return is the best you can hope for. [...] The other view is that some securities are inefficiently priced, creating opportunities for investors to profit with low risk.

The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.

It is vitally important for investors to distinguish stock price fluctuations from underlying business reality.

Value in relation to price, not price alone, must determine your investment decisions.

Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.

Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. [...] Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news. Finally greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.

Many investors greedily persist in the investment world's version of a search for the holy grail: the attempt to find a successful investment formula. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success. [...] Despite the enormous effort that has been put into devising such formulas, none has been proven to work.

Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.

The Nature of Wall Street Works Against Investors

The point I am making is that investors should be aware of the motivations of the people they transact business with; up-front fees clearly create a bias toward frequent, and not necessarily profitable, transactions.

A great many of those who work on Wall Street view the goodwill or financial success of clients as a secondary consideration; short-term maximization of their own income is the primary goal.

Investors must never forget that Wall Street has a strong bullish bias, which coincides with its self-interest. Wall Street firms can complete more security underwritings in good markets than in bad. Brokers, likewise, do more business and have happier customers in a rising market. [...] When a Wall Street analyst or broker expresses optimism, investors must take it with a grain of salt.

Wall Street research is strongly oriented toward buy rather than sell recommendations.

Investors naturally prefer rising security prices to falling ones, profits to losses. It is more pleasant to contemplate upside potential than downside risk. Companies too prefer to see their own shares rise in price; an increasing share price is viewed as a vote of confidence in management, as a source of increase in the value of management's personal shares and stock options, and as a source of financial flexibility, facilitating a company's ability to raise additional equity capital.

Overvaluation is not always apparent to investors, analysts, or managements. Since security prices reflect investors' perception of reality and not necessarily reality itself, overvaluation may persist for a long time.

Investment bankers in Wall Street firms are constantly creating new types of securities to offer to customers. Occasionally such offerings both solve the financial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, that is, the generation of fees and commissions.

All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues. There will always be cycles of investment fashion and just as surely investors who are susceptible to them.

It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad becomes dangerous, however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying businesses.

The Institutional Performance Derby: The Client Is the Loser

Today institutional investors dominate the financial markets, accounting for roughly three-fourths of stock exchange trading volume. All investors are affected by what the institutions do, owing to the impact of their enormous financial clout on security prices. Understanding their behavior is helpful in understanding why certain securities are overvalued while others are bargain priced and may enable investors to identify areas of potential opportunity.

Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance.

What is a relative-performance orientation? Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor's 500 Index, or against other investors' results.

There are no winners in the short-term, relative-performance derby. Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. The effort only distracts a money manager from finding and acting on sound long-term opportunities as he channels resources into what is essentially an unwinnable game.

Institutional investors are caught in a vicious circle. The more money they manage, the more they earn. However, there are diseconomies of scale in the returns earned on increasingly large sums of money under management; that is, the return per dollar invested declines as total assets increase. The principal reason is that good investment ideas are in short supply.

Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost – foregoing the next good opportunity to invest – and the risk of appreciable loss.

Absolute-performance-oriented investors [...] will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in 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.

Allocating money into rigid categories simplifies investment decision making but only at the potential cost of lower returns. For one thing many attractive investments may lie outside traditional categories. Also, the attractive historical returns that draw investors to a particular type of investment may have been achieved before the category was identified as such.

Value investing is predicated on the belief that the financial markets are not efficient. Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities. To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that "in any sort of a contest – financial, mental or physical – it's an enormous advantage to have opponents who have been taught that it's useless to even try."

Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. [...] Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers.

Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s

An investor in a U.S. Treasury bill [...] can be confident that income and principal will be paid at maturity. A junk zero-coupon bond, however, is a gamble; no cash is paid until maturity, at which point it either pays or defaults.

We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation. As surely as this will happen, it is equally certain that no bells will toll to announce the excess.

[...] avoiding losses is the most important prerequisite to investment success.

A Value-Investment Philosophy

Defining Your Investment Goals

Warren Buffett likes to say that the first rule of investing is "Don't lose money", and the second rule is, "Never forget the first rule".I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

[...] the actual risk of a particular investment cannot be determined from historical data. It depends on the price paid.

[...] it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.

Investment returns are not a direct function of how long or hard you work or how much you wish to earn. [...] An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.

Targeting investment returns leads investors to focus on upside potential rather than on downside risk. Depending on the level of security prices, investors may have to incur considerable downside risk to have a chance of meeting predetermined return objectives.

While the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one's estimate of future share prices.

Value Investing: The Importance of a Margin of Safety

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents.

Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available.

The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds.

Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky. Hence few value investors will own shares of technology companies. Many also shun commercial banks, which they consider to have unanalyzable assets, as well as property and casualty insurance companies, which have both unanalyzable assets and liabilities.

[...] the cheapest security in an overvalued market may still be overvalued.

Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen.

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.

Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies.

Why do stock prices tend to depart from underlying value, thereby making the financial markets inefficient? There are numerous reasons, the most obvious being that securities prices are determined in the short run by supply and demand. The forces of supply and demand do not necessarily correlate with value at any given time. Also, many buyers and sellers of securities are motivated by considerations other than underlying value and may be willing to buy or sell at very different prices than a value investor would.

A central tenet of value investing is that over time the general tendency is for underlying value either to be reflected in securities or otherwise realized by shareholders. This does not mean that in the future stock prices will exactly equal underlying value. Some securities are always moving away from underlying value, while others are moving closer, and any given security is likely to be both undervalued and overvalued as well as fairly valued within its lifetime. The long-term expectation, however, is for the prices of securities to move toward underlying value.

In a sense, value investing is a large-scale arbitrage between security prices and underlying business value. [...] Unlike classic arbitrage, however, value investing is not risk-free; profits are neither instantaneous nor certain.

At the Root of a Value-Investment Philosophy

There are three central elements to a value-investment philosophy. First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities. Second, value investing is absolute-performance-, not relative-performance oriented. Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

[...] value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits.

Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear. A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available.

[...] bottom-up investors are able to identify simply and precisely what they are betting on. The uncertainties they face are limited: what is the underlying business worth; will that underlying value endure until shareholders can benefit from its realization; what is the likelihood that the gap between price and value will narrow; and, given the current market price, what is the potential risk and reward? Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. When the underlying value changes, when management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value, a disciplined investor can reevaluate the situation and, if appropriate, sell the investment.

In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.

[...] greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses.

There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.

Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.

The Art of Business Valuation

[...] business value cannot be precisely determined. Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value.

Any attempt to value businesses with precision will yield values that are precisely inaccurate.

Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish. To fundamentally oriented investors, the value of a security to the buyer must be greater than the price paid, and the value to the seller must be less, or no transaction would take place. The discrepancy between the buyer's and the seller's perceptions of value can result from such factors as differences in assumptions regarding the future, different intended uses for the asset, and differences in the discount rates applied. Every asset being bought and sold thus has a possible range of values bounded by the value to the buyer and the value to the seller; the actual transaction price will be somewhere in between.

While a great many methods of business valuation exist, there are only three that I find useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. [...] The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. [...] The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. [...] Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today's.

Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help to establish the probability that those cash flows will be received. By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.

In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value. Cash [...] is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories [...] is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. [...] The liquidation value of a company's fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flows, either in the current use or in alternative uses. Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner.

A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business's underlying assets, a liquidation is one way for investors to realize profits.

True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

The Value-Investment Process

Investment Research: The Challenge of Finding Attractive Investments

While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities.

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available.

A bargain should be inspected and reinspected for possible flaws. Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price. Perhaps there are contingent liabilities or pending litigation that you are unaware of. Maybe a competitor is preparing to introduce a superior product. When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable.

No matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information.

In most instances no one understands a business and its prospects better than the management. Therefore investors should be encouraged when corporate insiders invest their own money alongside that of shareholders by purchasing stock in the open market. It is often said on Wall Street that there are many reasons why an insider might sell a stock, but there is only one reason for buying.

Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints

The attraction of some value investments is simple and straightforward: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value. Ordinarily, however, the simpler the analysis and steeper the discount, the more obvious the bargain becomes to other investors.

Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced.

Risk arbitrage is a highly specialized area of value investing. Arbitrage [...] is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. Risk arbitrage, however, involves investing in far-from-riskless takeover transactions. Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long-term arbitrage, also fall into this category. Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.

Spinoffs often present attractive opportunities for value investors. A spinoff is a distribution of the shares of a subsidiary company to the shareholders of the parent company. [...] Spinoffs permit parent companies to divest themselves of businesses that no longer fit their strategic plans, are faring poorly, or adversely influence investor perceptions of the parent, thereby depressing share prices.

Spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less.

Investing in Thrift Conversions

The mechanics of a mutual-to-stock conversion are fairly simple. Depositors in a converting thrift have a preemptive right to purchase shares. Management is typically granted the right to purchase shares alongside depositors. Remaining shares are offered to the general public, with preference sometimes given to customers or to anyone living in the thrift's geographic area.

Unlike any other type of initial public offering, in a thrift conversion there are no prior shareholders; all of the shares in the institution that will be outstanding after the offering are issued and sold on the conversion.

Unlike many IPOs, in which insiders who bought at very low prices sell some of their shares at the time of the offering, in a thrift conversion insiders virtually always buy shares alongside the public and at the same price. Thrift conversions are the only investment in which both the volume and price of insider buying is fully disclosed ahead of time and in which the public has the opportunity to join the insiders on equal terms.

Of course, fundamental investment analysis applies to thrifts as it would to other businesses. Thrifts incurring high risks, such as expanding into exotic areas of lending or venturing far from home, should simply be avoided as unanalyzable. Thrifts speculating in newfangled instruments such as junk bonds or complex mortgage securities should be shunned for the same reason. A simple rule applies: if you don't quickly comprehend what a company is doing, then management probably doesn't either.

Investing in Financially Distressed and Bankrupt Securities

In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, the effect of financial distress on business results; the availability of cash to meet upcoming debt-service requirements; and likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. Similarly, investors in bankrupt securities must develop a thorough understanding of the reorganization process in general as well as the specifics of each situation being analyzed.

Investing in bankrupt securities differs from investing in companies operating normally. An obvious difference is that in a solvent company, an investor can be relatively certain of what belongs to whom. In a bankruptcy the treatment of valid claims is precisely what is to be decided in court: the disposition of the assets is to be determined by the owners of the liabilities who, along with the equity owners, will receive the assets either directly or more typically in the form of newly issued securities of the reorganized debtor.

The risk of investing in financially distressed and bankrupt securities varies with the specifics of each situation. At the riskiest end of the spectrum are highly competitive or fashion-oriented businesses dependent on a limited number of their key personnel and owning few tangible assets; companies that sell customized or user-specific products; and financial companies that are particularly dependent on investor and customer confidence. [...] At the low-risk end of the spectrum are overleveraged capital-intensive debtors, possibly having monopoly or near-monopoly positions in their industries, and businesses producing homogeneous or undifferentiated products.

Price decline alone does not make a security a bargain; an appreciable discount from underlying value is also required.

Investing in bankrupt and financially distressed securities is a sophisticated, highly specialized activity. Each situation offers its own analytical challenges, risks, and opportunities.

My main point is that an extensive search for opportunities combined with insightful analysis can uncover attractive investment opportunities in all kinds of interesting places.

Portfolio Management and Trading

All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever.

Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. Few investors require a completely liquid portfolio that could be turned rapidly into cash. However, unexpected liquidity needs do occur. Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it.

Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is, with cash that he is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.

My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea.

Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.

There is nothing inherent in a security or business that alone make it an attractive investment. Investment opportunity is a function of price, which is established in the marketplace.

The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. When others panic and sell at prices far below underlying business value, they create buying opportunities for value investors.

The single most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising.

One half of trading involves learning how to buy. In my view, investors should usually refrain from purchasing a "full position" (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to "average down", lowering their average cost per share, if prices decline.

Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he was in the purchase decision.

Indeed, there is only one valid rule for selling: all investments are for sale at the right price.

Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available. [...] It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargain. By contrast, you would not want to sell a stock at a gain if it were still significantly undervalued and if there were no better bargains available.

Investment Alternatives for the Individual Investor

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