Book Review #41: Margin of Safety: Author: Seth A. Klarman

This is the review of the book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor written by Seth A Klarman

In the introduction to the book, Mr.Klarman sets out two goals for writing this book. One is to highlight the investment pitfalls so that the investors could avoid them. Two is to explain why value investing method works and often works spectacularly.

Value investing is the strategy of investing in security trading at an appreciable discount from underlying value. This approach has a long history of delivering excellent returns with limited downside risk. It requires a great deal of hard work, strict discipline and a long-term investment horizon. Few are willing to put that effort.

This is not a book about investing, but about thinking about investing.

Investors are their own worst enemies by allowing greed and fear to drive their investment decisions.

This book contains 14 chapters divided into three sections. The first section covering the four chapters, discusses the investment pitfalls. This section explains the difference between investment and speculation and explains how the investor is impacted by Wall Street and Institutional Investors. This section explains how value investing opportunities get generated in the markets. Institutional investors frequently drive up or drive down the prices of the securities beyond their intrinsic value providing opportunities for value investors.

Investors must take sides. The easy side is that of following the herd, succumbing to greed, fear and short-term orientation. This approach considers stocks as a piece of paper to be bought and sold. The better choice is to consider stocks as fractional ownership of business and hold for long-term. Value investors focus on margin of safety that offers risk protection.

Section two, covering chapters five through eight, explores the philosophy of value investing. It covers the investment implications of risk aversion, the importance of margin of safety and the three underpinnings of value investing - bottom up approach to investment selection, an absolute-performance orientation and emphasis on risk. Section three covering chapters 9 through 14 covers the value investing process. This section covers evaluation, different opportunities and portfolio management strategies.

Value Investing is a discipline of buying securities at considerable discount from their current value and holding them until more of their value is realized. Element of bargain is key to the value investing process. Concept of Margin of Safety is the cornerstone of Value investing. Value Investing is not something that can be learned and applied gradually over time. It is either learned at once, or never fully learned. Value investing is intellectually challenging and rewarding discipline. The book provides many relevant examples to illustrate concepts.

The difference between investors and speculators is that while former considers stocks as a part of the business, the latter looks at it as a piece of paper. Investors buy or sell securities as the price moves away from value, while speculators transact based on the expected movement in the prices. Author makes a startling point that many of the 'Investment Advisors' are just speculators. Not only people, even assets can be investments or speculations. The differences is that investments like stocks and debt paper, throw of cash flow, while others like art and collectible are speculation since they do not throw any cash flow.

Since investors have to interact with Wall Street to trade in securities, it is important to understand some of the conflicts of interests between Wall Street and investor. Focus of Wall Street is profit maximization. Wall street thrives on up-front commission, so there is an emphasis on frequent trading. In addition, Wall Street has bullish bias, is focused on short-term and regularly props up investment fads. All of these impact the investor negatively. Institutional investors are a part of Wall Street that investors have to handle. Due to various constraints on these fund managers, predominantly their tendency to peg their performance relative to and index and not to absolute returns,  a retail investor need to understands the pulls and pressures on a fund manager. In addition to relative performance, others include group think, index investing, bureaucratic processes within their firm etc caps the returns that an Institutional Investor can get in the market.

The depth of analysis of each point is amazing. In chapter on Business Valuation, for example, nuances are clearly elaborated for each aspect of valuation. The section of Private - Market Value explains why valuations made by sophisticated business men can go wrong (clue: availability of cheap credit). The concept of liquidation value for example, differentiates between 'fire sale' and 'orderly liquidation'.

There are three ways to value a business. These are Net Present Value (NPV), Liquidation Value and Stock Market Value. The book talks about the concept of 'Reflexivity' as propounded by George Soros. The concept talks of market price as a determinant of the business value. He talks about the example of Citi Bank which was able to recapitalize at a good rate since the market perceived the bank to be strong.

Business value is determined by future events and future events are by their very nature unpredictable. That is the main reason why Value Investing puts a lot of emphasis on Margin of Safety.

The main challenge for a value investor is the possibility of a continuous erosion of value. To handle this challenge, investor can do three things. One, always perform conservative valuation giving a lot of stress on worst case scenarios, two, demand a greater than discount between the price and value in order to make new investments or hold current positions and three, invest in those assets that will realize its value in the near to medium term. Value Investor should avoid investing if they are not sure when the market will discover the intrinsic valuation of the investment.

Margin of Safety is the corner stone of Value Investing. It is defined as the difference between the price paid for a security and its intrinsic business value. Investors  can achieve margin of safety in the following ways. By buying at a discount to business value, preferring tangible assets over intangible ones, by replacing current holdings as better opportunities come along and selling when price reaches value, holding cash till a better opportunity appears and by giving preference to good managements and finally following sound diversification.

The later chapters talk of various Value Investing opportunities like Catalysts, Complex Securities, Bankruptcies, Distressed Assets, Spinoffs etc. The details are too complex to be summarized here.

From the perspective of individual investor, the author has some suggestions. One is to stay in touch with the market regularly, second is to reduce risk by diversification. While staying in touch with the market, an investor should be detached from the day to day fluctuations.  Author talks of a set of 10-15 securities for effective diversification. Hedging is another way to reduce risk, but it can turn out to be expensive.

Once an investor identifies a value investing opportunity, he should invest only part of his portfolio in that. He should 'average down' as the price falls. Author says that if the investor is not planning to average down, he should not invest in that security at any price. Many investors buy a security and apply stop loss. Mr.Klarman thinks that stop loss is a proxy for lazy analysis.

Unfortunately for the retail investor, Mr.Klarman do not have any positive words. Investing is hard and it needs effort and time, that many retail investors do not have. So the suggestion is to invest in market through mutual funds, brokers and money managers.

In other words, Institutional Investors......

This ends the review of the book. If you want to learn more, read the section 'Chapter Summary' below

Chapter Summary

Introduction:

I have chosen to begin this book with an assessment of where other investors go wrong, This book does not provide a formula for investment success. 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. It is important to understand why the rules work. Most investors focus on return ignoring the risk of potential loss. Value investors focus on protection of capital by focusing on Margin of Safety which allows room for error and bad luck. Margin of safety is required because valuation is imprecise, future is unpredictable and investors can make mistakes. Since value investing protects against risk, the best time to become a value investor is when market is falling.

Chapter 1 explains the difference between investors and speculators. To investors stocks represent a fractional ownership of business. They transact securities that offer an attractive risk reward ratio. Investors believe that over the long run security prices tend to reflect fundamental of the business. Investors in a stock expect to profit in at least one f the three possible ways. From free cash flow generated by the business, increase in multiples and by the narrowing the difference between price and value. Speculators on the other hand, buy and sell securities based on the expected price action based on the behaviour of others. For them securities are a piece of paper. Speculators are obsessed with guessing the direction of stock prices. Many investment professional are nothing but speculators. The author tells the story of 'trading sardines' versus 'eating sardines' to explain speculation. Viewing stocks as piece of paper precludes rigorous fundamental analysis. Speculative activity can erupt in Wall Street at any time and is not identified as such immediately.

Even assets can be catagorized as investments or speculations. Both can be purchased from market and both fluctuate in price. The main difference is that investments throw cash flow, but speculations do not. For example, stock is an investment, gold and other collectibles is speculation. Value of speculations fluctuations solely based on supply and demand since they do not throw any cash flow.

In financial market it is important to be an investor and not a speculator. Successful investor is unemotional taking advantage of the opportunity provided by the greed and fear of others. They respond market with calculated reason. Investors use the opportunities provided by Mr.Market, without looking up to him for investment guidance. It is important for investors to differentiate the stock price fluctuation from underlying business reality.

Chapter 2 discusses the various conflicts of interests between  Wall Street and the investors. Wall street has three principal activities, trading, investment banking and merchant banking. As traders they earn a commission for bringing buyers and sellers together. As investment bankers they arrange fo the purchase and sale of entire companies by others, underwrite new securities etc. As merchant bankers, they commit their capital while acting as principal investment banking operations. While Wall Street perform beneficial acts like helping expanding businesses raise capital and provide liquidity to market, there are some conflicts of interests that an investor has to be aware. The first conflict is the up-front fees and commissions. This means that it is in the interest of Wall Street to trade more frequently. As an investment banker, Wall Street often over prices the securities in search for additional commission revenue. Since Wall Streets makes more money from underwriting than from secondary market operations, another conflict is its reliance on IPOs to secondary market trades. Another conflict of interest is the focus of Wall Street on short-term profit maximization leading to excessive transactions.  Another conflict of interest is the Bullish Bias of Wall Street. Money is in bullishness. Due to this there is more focus on returns and less on the risks. In addition there are regulatory interventions like ban on short sales, lower circuit filter etc that increases the upward bias. Another bias is the frequent investment fads that Wall Street props up.

Chapter 3 talks about the impact of Institutional Investors in the market. Many retail investors trust them with their money and hence it is important to understand their behaviour in detail.

Understanding their behaviour will help the investor in identifying opportunities for value investing. Following are the aspects plaguing many IIs.

• Short-term relative performance orientation.: Measuring investment performance not against absolute standards, but against a broad market index. Due to this clients experience mediocre returns. This is worsened by the facts that many IIs do not have personal money invested in their funds
• Groupthink leading to sharing of mediocrity
• Compensation based on AUM and not on returns
• Frequent performance reviews
• Bureaucratic decision making process due to which they hold investments for longer than necessary. Another aspect of this is the constraints placed on the fund manager by the asset selection criteria.
• Constraint on selling due to, one, some investments are illiquid and selling may not be simple, two, selling creates additional work since they will have to invest money in other opportunities and three, authorities consider portfolio turnover unfavorably.
• Failure to take unconventional investment decision leading to point 2 above
• As human beings institutional managers are also prone to all the follies of the common investor.
• Expectation to remain fully invested at all times, leading to the the managers interpreting their tasks as stock picking and not buying at the right price. This could lead to pile up of sub-standard investments. 
• Window dressing, to make Portfolio look attractive just before quarterly review
• Index investing leading to mindless investing

Investment fads can destroy investor wealth. Nothing explains the pernicious effects of junk bonds than the case of Junk bonds that became a fad in 1980s.

 The greed and possibly the ignorance of individual investors, the short-term orientation of institutional investors, and the tendency of Wall Street to maximize its self-interest above all came together in the 1980s to allow a $200 billion

By 1990, however, the concept of newly issued junk bonds had been exposed as seriously flawed, defaults reached record levels, and the prices of many issues plunged.

Historically many financial-market innovations have gained widespread acceptance before being exposed as ill conceived

What is unique about junk bonds is the speed and magnitude of their rise; their strong and pernicious influence on other securities, on financial markets, and on the behavior of businesses; and their continued popularity in the face of large investor losses.

Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor (A. Klarman, Seth)

This chapter is intended as a cautionary tale, an illustration of how seriously misguided investor thinking can become.

Two decades earlier Hickman had shown that a well-diversified, low-grade bond portfolio could earn a greater rate of return than a high-quality bond portfolio; in other words, the higher yields on low-rated securities would more than compensate for capital losses from any defaults.1 This opportunity existed because risk-averse investors shunned low-grade bonds regardless of potential ‘ return. Hence such bonds traded at depressed prices, and low prices, not high coupons, were the driving force behind the attractive returns. As we shall see, the legitimate opportunity in a virtual handful of distressed securities that were overlooked by others was carried to excess when Milken extrapolated from a historical relationship to an entirely new type of security. After graduating from the Wharton School,

The yield on low-rated bonds was obviously high. The new, radical claim was that the risk was also low: losses from defaults would be more than offset by incremental yield. This claim of a low default rate was central This claim of a low default rate was central to the bullish case for junkbonds

Another prerequisite to the establishment of a new-issue junk-bond market then was Milken’s promise of liquidity. Milken promised buyers that he would

Unfortunately newly issued junk bonds were not the low-risk instruments that buyers were led to believe. They have, in fact, very different risk and return characteristics from fallen angels. Specifically, newly issued junk bonds offer no margin of safety to investors. Trading around par value, they have very limited appreciation potential, but unlike high-grade bonds trading near par, they have substantial downside risk.

The other side of this coin is that bonds trading below par have more upside price potential than bonds trading at par.

Other things being equal, then, newly issued junk bonds carry greater risk of loss with lower potential return than fallen angels,

Meanwhile a number of other devices had been used by junk-bond underwriters to postpone the financial day of reckoning. One trick of the trade was to raise as much as 25-50 percent more cash than was immediately

Widespread issuance of non-cash-pay (zero-coupon or pay-in-kind) securities also served to reduce the reported junk-bond default rate temporarily. The obvious reason is that non-cash-pay securities are less likely to default prior to maturity than cash-pay bonds since the absence of cash interest payment requirements eases the issuers’ debt-service burden.

The default rate was offered by underwriters, approved by academics, and accepted by investors as a proxy for investor losses from junk bonds that went bad.

it also ignored the fact that defaults and investor losses are not the same thing. A fallen angel that defaults, for example, has not so far to drop as a junk bond trading at par.

Owners of the junk bonds issued by the many companies whose interest expenses were greater than their pretax profits were able to claim to have earned interest income in excess of the profits earned by the underlying businesses. As long as investors were willing to purchase

At the same time the sermon shifted from the low historical rate of default to a new theme: junk bonds as the economic salvation of America. Our country’s nagging problems of slow growth, declining productivity, and diminished international competitiveness would quickly be solved through increased junk-bond issuance. The argument was that junk bonds could finance small, unknown companies that would not otherwise have been able to attract capital; such companies would innovate, grow, and create jobs, invest, and then grow some more.

they were also gaining stature as the enemy of the large and well-established corporation.

To justify the use of junk bonds in corporate takeovers, large corporations were depicted as inefficient, administratively bloated, or even corrupt, and in desperate need of new managerial blood. While

led to increasing multiples being paid for corporate assets. This is because buyers armed with other people’s money developed a skewed view of risk and return compared with that of buyers using their own money and were therefore willing to pay higher and higher prices.

Most junk-bond buyers and issuers were probably unaware that they were implicitly assuming a great deal about the ongoing health of the economy and the junk-bond market. Many junk-bond issuers, for example, had razor-thin or nonexistent interest coverage

The pervasive optimism of investors led to a relaxation of investment standards.

typical interest coverage ratio for newly issued junk bonds declined drastically between 1980 and 1988 to the point where it fell below 1.0-that is, pretax earnings were less than interest expense for the average new junk issue. The ratio of debt to net tangible assets grew threefold over the same period to a level where issuers owed twice as much as the book value of their assets.

Junk-bond issuers, underwriters, and investors each abandoned established standards of value for new, less rigorous criteria.

Zero-coupon and PIK debt, which accrue interest rather than paying it currently in cash, severed this tether of financial responsibility

Such issuers can have liabilities that exceed assets and be unable to meet debt-service obligations in cash yet remain in business, giving an appearance of financial health.

Chapter 5 teaches the reader to Define their Investment Goals. In investing 'Don't lose money' means 'over several years an investment portfolio should not be exposed to appreciable loss of capital'. It is difficult because the speculative urge lying inside each of us is very strong. An investor is more likely to do well by achieving consistently good returns with little downside risk than by achieving volatile and superb returns at a risk of loss of capital.  Targeting returns focuses the investor on upside potential than on downside risk, a point made by William Bernstein. In the long run, stock prices are linked to the business value. Since stock prices are tethered to an intangible value, any amount of returns can be predicted by modifying the targeted share price. This is a losing game. Rather than focusing on returns, a value investor must target risk. Return from any investment must be commensurate with the risk taken to achieve the return. Unfortunately most of the investment approaches do not target risk. Only one that focusses on risk is Value Investing Approach.

Chapter 6 discusses the importance of margin of safety in Value Investing. VI is a discipline of buying securities at considerable discount from their current value and holding them until more of their value is realized. Element of bargain is key to the value investing process. Discipline is the key to VI. It calls for challenging the conventional wisdom. Value investors are discerning. Value investors will not invest in things they cannot understand. Value investors are patient. They do not invest till Value investors compare every new opportunity with their current holdings and sell the current holdings if the new opportunity is better. There are many challenges to VI. For one, The Business Value do not remain constant. It changes due to credit cycle -where money  becomes cheaper or expensive as credit is loosened or tightened, Inflationary environment - Inflation is complex to analyse, when interest rises it lowers valuation, but during inflation companies may report higher profitability hence valuation can be high, deflationary environment normally lowers the valuation.

The main challenge for a value investor is the possibility of a continuous erosion of value. To handle this challenge, investor can do three things. One, always perform conservative valuation giving a lot of stress on worst case scenarios, two, demand a greater than discount between the price and value in order to make new investments or hold current positions, three, invest in those assets that will realize its value in the near to medium term, avoid investing if you are not sure when the market will discover the intrinsic valuation of the investment. (This is happening to real estate companies in India, they have been undervalued for a long time now)

Margin of safety is at the core of value investing. 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. While some VIs find value intangible assets like Patents, author says by their very nature of traceability and reusability, tangible assets provide a better margin of safety.

Investors can achieve margin of safety in the following ways. By buying at a discount to business value, preferring tangible assets over intangible ones, by replacing current holdings as better opportunities come along and finally by selling when price reaches value, holding cash till a better opportunity appears and by giving preference to good managements and finally following sound diversification.

Investors must know why an investment is undervalued, that is the only way to know when situation changes

Value investing is predicated on efficient market hypothesis being wrong. Time and again the stocks tend to be mispriced due to information asymmetry. You are likely to find value investing opportunities outside the large cap space. Behaviour of Institutional investors due to constraints can create value opportunities.These include stocks being removed from an index, selling by large cap funds of a small cap spinoff, dividend mutual funds dumping a company that missed dividends, investment grade bonds being sold off after being downgraded a notch, year end tax selling and quarterly window dressing are all examples.

Value investing is a large-scale arbitrage between price of a security and its underlying value. The arbitrage profit from purchasing an undervalued stock of an ongoing company may be difficult to realize. It depends on the magnitude of gap between price and value, extent to which management is entrenched, the identity and ownership position of major shareholders and the availability of credit to support takeover.

Chapter 7 discusses value investment philosophy. There are three elements to value investment philosophy - bottom up approach, absolute versus relative returns and risk aversion.

Most of the investors follow top down approach This involves predicting the future correctly, draw correct conclusions, correctly identify attractive investments based on the conclusions, correctly purchase the specific security and finally be early in buying these securities. There is no margin of safety in top down approach. Top down investors are not buying based on value, they are buying based on a concept, theme or brand.

Value investor looks at security level to identify bargains. Bottom up approach is easier since you do not have to make any forecasts. Another difference between the two approaches is the reason for holding cash. Value investors hold cash waiting for best opportunities, while top down investors hold cash when they sell the stocks expecting a market decline.

Since value investors know exactly why they are buying a stock, they can easily determine when the factors change. On the other hand, top down investors find it difficult to know when their bets are no longer valid.

The following are the challenges of using Beta as a measure of risk. One, it views risk from the perspective of market prices and do not consider business specific risks. Two, it ignores the price. For example Infosys at 400 is less risky that when it is at 700. Three, Beta doesn't consider special situations that can make a security risky.  Four, Beta considers downside risk equal to upside potential. Five, Beta fails to distinguish between temporary price fluctuation due to market factors and permanent price drop due to business factors.

Chapter 8 talks of Business Valuation. The reported valuation numbers like book value, earnings and cashflow are best guesses of accountants. Also value is not static. It changes over time with different macro-economic factors. The business value cannot be precisely estimated, but the apparent precision offered by mathematical formulae like NPV and IRR can lull investors forgetting that these are based on assumptions of cash flow far into the future.The other assumptions in valuation could be regarding future, different intended uses of the asset and different discount rates used.

Three valuation methods that author finds useful are Net Present Value (NPV) - valuing the cashflows of a going concern, and its offshoot Private Market Value, the value paid by a sophisticated buyer of the business, Liquidation value - the expected proceeds if the company were to be sold off, an offshoot of which is Breakup value that values each components of the business separately and Stock Market Value - the estimated price at which a company will sell in stock market.

Two aspects of valuation are Expected Growth in earnings and Discount Rate. If future cashflow is predictable, NPV can be very accurate. However cashflow depends on many factors like market share, the volume growth, pricing power, brand loyalty etc, each of which can be assumptions. Growth investors face many challenges One, they show higher confidence in their ability to predict future value than is warranted. Two, even small differences from one's estimate can have catastrophic consequences. Three, since many investors are focused on such companies, the prices may go up lowering the margin of safety. Four, investors tend to oversimplify growth into a single number, while it is based on many factors. Just as an example, earnings growth can come from more units being sold due to increase in population or it may also be due to increased usage by the existing customers. It could also be due to increased market share or due to price increases. While some of these are predictable, others are less so.

Investors by nature are overly optimistic of the future. Since future is unpredictable, value investors have to be conservative in their assumptions of growth as well as discount rates.

The other factor in valuation is the discount rate. The more conservative you are, the higher rate you will use to discount future cash flows. The discount rate should depend on Investor's preferance of present consumption over future returns, his risk profile, the risk of investment under consideration and on the returns available from other comparative investments. However, investors often simplify and use 10% as discount rate.

When interest rates are low, investors pay high multiples assuming rates to remain low.

Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

Given many valuation methodologies, which one to choose. Depends on the company, NPV may be a good approach to value a company with stable cash flows, liquidation method may be used to value a company selling well below its book value, a mutual fund may be valued at stock market price. Sometimes you may used different methods for different units of a conglomerate. Ideally multiple methods should be applied and the lowest value chosen.

A wild card in valuation is the theory of reflexivity propounded by George Soros. It says that stock prices can influence the valuation, rather than the other way round. For example, an undercapitalized bank, trading at high multiple can raise cheap capital in the market based on its price multiple. On the other hand if the stock was trading at low multiples, it would not have been able to raise funds leading to bankruptcy. In this case, the stock multiple acted as the valuation cue for the bank. It could be true for a highly leveraged company with impending redemption. Good market perception can help it raise funds to honor the redemption. Sometimes managers accept the market value as a signal of the business value and may issue additional shares at values lower than market thereby worsening the situations. A bad market can depress prices lowering the liquidation value, thus becoming a self fulfilling prophesy.

The author gives reasons why valuation based on Earnings, Book Value and Dividend Yield are easily manipulated by crooked management. He suggests not to trust such valuations.

Chapter 9 discusses identifying value investing opportunities. Author says that many a times, investors spent lot of time in analyzing fully priced securities which do not hold potential. Good investment ideas have to be ferreted out diligently. Sometime the value investing opportunities are plenty, but most often they are limited.

Value investing opportunities arise from three groups of securities; securities selling at discount to liquidation or breakup value, rate-of-return situations and asset conversion opportunities. The first group can be easily identified through computer screening methods. Rate of return situation arise when you know the exit prices and approximate timeframe at the time of investment. Risk arbitrage like mergers, tender offers etc form one such type of opportunity. The information about such investments is already available in the press.

Financial distressed securities, corporate recapitalizations etc fall under the category of asset conversion opportunities. In this case the investor's holdings are exchanged for other securities. There are many sources from where one can get information on such securities.

Other sources of such information are 52 week low lists and price / volume shockers. Once a company drops dividend, it can throw up opportunities. Once they find an idea, investor should maintain skepticism and probe further for the reason of undervaluation. There may be real reason for the undervaluation that investor is not aware of. Once he knows the reason for undervaluation, he should be happy.

Behaviour of Institutional Investors creates opportunities. Some will not invest in risk-arbitrage situations, some will not invest in low priced stock, small companies which are not tracked by IIs etc could be potential opportunities. Year end selling could create opportunities.

As contrarians, Value Investors should look for opportunities where herd is selling. It also means that VIs are more likely to suffer paper losses immediately post their investment. Not only are contrarians wrong, they may be wrong more often and for longer periods than others. Herd behaviour can cause opportunities only when herd can affect the outcome. It is very important for the VI to understand this subtle difference.

One area that can signal opportunity is when management is buying shares of their company. This information is publicly available. Investors should look for the incentive structure of the company. If management is paid for raising the share prices of the company, that is one where money should be invested.

Chapter 10 discusses various Value Investment opportunities like Catalysts, Market Inefficiencies and Institutional Constraints. Catalysts are those events that precipitate the market realization of underlying value. Some of the catalysts like selling assets are internal to the organizations, but others like change in voting control are external. There are many examples of catalysts, often called as special situations. Presence of catalysts reduce risk since the price value gap is closed relatively quickly. While full catalyst is the best, even partial catalysts like spinoffs serve dual purposes. One they transfer value to the investor and two, they signal management focus on shareholders.

Complex securities are those with unusual contractual cash flow characteristics.  They distribute cash contingent on a future event. Rights issue is another opportunity to an alert Value Investor.

Spinoffs are another VI opportunity. Spinoff is the distribution of shares of a subsidiary company to the shareholders of the parent company. Spinoffs help parent company to divest businesses that no longer fits strategic objective.

They present attractive opportunity since immediately after Spinoff, the shares of the spunoff companies are bound to trade at low prices as markets discover their value. Many shareholders of the Spinoffs sell their shares quickly for the same reason the parent company did and because they know nothing about it. Large institutional investors will sell spinoffs since they may be too small for them. Index funds will sell spinoffs since they are not in the index.

Wall street do not follow spinoffs. The analysts following parent company may not follow spinoffs that are in different industry. Sometimes management wants to keep the share prices down. Another reason spinoffs are valuable in the initial stages is because there is an information lag.

Due to all these reasons, Spinoffs present a great value investing opportunity and the opportunity is the most valuable in the first few weeks of trading.

Chapter 11 talks of investing in thrift conversions. I don't think this is applicable in India, so I did not find it interesting.

Chapter 12 discusses investing in financially distressed and bankrupt securities. The issues that must be considered while investing in securities of financially distressed or bankrupt companies is greater in number and complexity. In addition to earnings, investors in these securities must also consider availability of cash to meet debt repayments, likely restructuring alternatives,

Financial distress is usually caused by shortfall of cash to meet operating needs and scheduled debt repayments. Many bankrupt companies continue normal business operations under protection from its creditors. In many cases the company that filed for bankruptcy has hit bottom and in many cases begins to recover.

There are three potential alternatives for a company deep in debt. Continue to pay principal and interest, restructure or default and file for bankruptcy. A potential investor must consider these three scenarios before investing. Companies can continue to repay debt by cost cutting, asset sales etc, but these may erode value. They restructure may include exchanging the old debt with new debt at a lower interest rate or with preference shares. One of the challenges in restructuring is that debt holders cannot be compelled to do anything. Even a single debt holder can theoretically derail the restructuring initiative.

A bankrupt company tend to conserve cash due to cost cutting, stoppage of debt repayment and preferred dividends etc. In addition carried forward losses will reduce future tax liabilities, selling of unrelated subsidiaries will bring in cash,

One attractive benefits of bankruptcy is that reorganization process can unlock value.

There are three stages of Bankruptcy. The first stage is immediately after filing is the time of greatest uncertainty and potentially most rewarding. Second stage of bankruptcy, negotiations for reorganization begin sometime later. The final stage of the process occurs when clarity emerges on reorganization. The best bargains occur in the early stages and lower but more predictable returns accrue in the third stage.

There are risks attached to investing in financially distressed and bankrupt securities. One, the rate of return is dependent on timing. Companies in some industries are more prone to failure after bankruptcy than others. For example, asset rich companies can survive better than those in the services sector.

Investors in such companies must make price a primary criterion. Efficient market theory do not work in this case because the market of such securities can be very limited. Investors in such companies must focus on the balance sheet. The first step is to value the assets of the company. The assets must be divided into two parts., assets of the ongoing business and assets available to creditors post reorganization, such as excess cash, assets available for sale, investments in securities etc.

The investor must go beyond the balance sheet while analyzing assets and liabilities. Off balance sheet assets may include IP, real estate valued at historical cost etc. Off BS liabilities may include underfunded pension plan, claims from government agencies and other contingent liabilities. Author recommends that investors should avoid common stock of bankrupt companies. 

Chapter 13 discusses Trading and Portfolio Management. Portfolio management encompasses trading as well as regular review of one's holdings. In addition, it includes maintaining  diversification, hedging, and managing portfolio cashflow and liquidity. Investment requires relentless continuity. Investor should always demand a premium for illiquidity. Longer the duration of investment, greater the liquidity premium.

In market liquidity could be a mirage. Stocks that look highly liquid when market is high will tend to become illiquid at the first sign of market correction. The paradox is between return and liquidity. Having liquidity reduces risk, but without invested, the cash cannot give any return.

Investment is a process of managing liquidity. Investor starts with highly liquid cash and moves it to illiquid investments. When the investments meet target, they are sold and are converted to liquidity again. This process has the effect of removing complacency from investors, once they have cash in hand, they are forced to look for investment opportunities again.

Portfolio diversification can be used to reduce risk. Author suggests a diversification with about 15 companies. Diversification is not about the number of securities you own, but it is about how different these securities are.

Hedging can reduce market risk. Since hedging entails costs, it may not be prudent to hedge all the time.

Investment is a function of price. Since price is determined by Mr.Market, it is important to stay in touch with the market. As per the author, Buy and Hold for long-term is a misguided strategy. Financial markets are prodigious creators of investment opportunities. While being in touch with the market, it is also important to maintain one's detachment.  Another drawback of being in touch with market is the proximity to brokers who may give a lot of recommendations making the investor jittery.

Single most important factor in trading is handling price fluctuations. Investors should desist from buying 'Full Position', in one shot. This helps to average down if the price declines. Author makes an interesting point. Before you make an investment, you ask yourself a question. "Will I buy more of this stock if the prices go down?". If the answer is 'Yes', then invest part of the funds and average down. If the answer is 'No' then do not invest any money in that stock

The rule for selling is simple. All investments are ripe for selling at the right price. Decision to sell must be based on underlying business value. It also depends on alternate investment opportunities available. Author  thinks that using stop loss is not a good idea. It is a proxy for laziness of analysis.

The final chapter 14 discusses Investment Alternatives for the Individual Investor. Author is very pessimistic about the profit opportunities for individual investor. Stock Market is a full time job. Sporadic effort will not work. Individual investor has three options: Mutual Funds, Discretionary Stockbrokers and Money Managers (PMS).

Investors should prefer no load over load funds. Open ended funds are better than close ended funds because of the ability to realize money at NAV. However, MF managers are subject to relative performance race. Also many MFs attract 'Hot' money. Some Mutual Funds have long-term value orientation. These are the good funds.

The chapter gives some good criteria to evaluate money managers. It is important to track their performance on an ongoing basis.