Excerpts from Seth Klarman's preface to Security Analysis

 

A curated list of the best quotes from Seth Klarman's 2008 Preface to the sixth edition of Benjamin Graham's book, Security Analysis.

On Technology

"In an era of rapid technological change, investors must be ever vigilant, even with regard to companies that are not involved in technology but are simply affected by it. In short, today's good businesses may not be tomorrow's."

"Good businesses are generally considered those with strong barriers to entry, limited capital requirements, reliable customers, low risk of technological obsolescence, abundant growth possibilities, and thus significant and growing free cash flow."

On Alternative Investments

"In recent years, some people have attempted to expand the definition of an investment to include any asset that has recently-or might soon-appreciate in price: art, rare stamps, or a wine collection. Because these items have no ascertainable fundamental value, generate no present or future cash flow, and depend for their value entirely on buyer whim, they clearly constitute speculations rather than investments."

On The Competition

"Of course, for those value investors who are truly long term oriented, it is a wonderful thing that many potential competitors are thrown off course by constraints that render them unable or unwilling to effectively compete."

"In heady times, few are sufficiently disciplined to maintain strict standards of valuation and risk aversion, especially when most of those abandoning such standards are quickly getting rich. After all, it is easy to confuse genius with a bull market."

"Another modern development of relevance is the ubiquitous cable television coverage of the stock market. This frenetic lunacy exacerbates the already short-term orientation of most investors. It foments the view that it is possible-or even necessary-to have an opinion on everything pertinent to the financial markets, as opposed to the patient and highly selective approach endorsed by Graham and Dodd."

On Academics

"Oddly enough, despite 75 years of success achieved by value investors, one group of observers largely ignores or dismisses this discipline: academics."

"Of course, for value investors, the propagation of these academic theories has been deeply gratifying: the brainwashing of generations of young investors produces the very inefficiencies that savvy stock pickers can exploit."

Note: Klarman also comments here on academic theories such as Beta, CAPM and MPT; as well as the Efficient Market Hypothesis.

On Company Management

"Investors also expend considerable effort attempting to assess the quality of a company's management. Some managers are more capable or scrupulous than others, and some may be able to manage certain businesses and environments better than others. Yet, as Graham and Dodd noted, "Objective tests of managerial ability are few and far from scientific.""

On Growth Stocks

"An age-old difficulty for investors is ascertaining the value of future growth. In the preface to the first edition of Security Analysis, the authors said as much: "Some matters of vital significance, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject.""

"There is a significant downside to paying up for growth or, worse, to obsessing over it. Graham and Dodd astutely observed that"analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.""

"Indeed, failed growth stocks are often so aggressively dumped by disappointed holders that their price falls to levels at which value investors, who stubbornly pay little or nothing for growth characteristics, become major holders."

On Leverage

"Just as leverage enhances the return of successful investments, it magnifies the losses from unsuccessful ones. More importantly, nonrecourse (margin) debt raises risk to unacceptable levels because it places one's staying power in jeopardy."

On Value Investors

"While it might seem that anyone can be a value investor, the essential characteristics of this type of investor-patience, discipline, and risk aversion-may well be genetically determined. When you first learn of the value approach, it either resonates with you or it doesn't."

"As Warren Buffett said in his famous article The Superinvestors of Graham-and-Doddsville, "It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn't take at all. It's like an inoculation. If it doesn't grab a person right away, I find you can talk to him for years and show him records, and it doesn't make any difference.""

"Generations of value investors have adopted the teachings of Graham and Dodd and successfully implemented them across highly varied market environments, countries, and asset classes."

On Value Investing

"In the words of Graham and Dodd,"The price [of a security] is frequently an essential element, so that a stock may have investment merit at one price level but not at another.""

"Value investors, therefore, should not try to time the market or guess whether it will rise or fall in the near term. Rather, they should rely on a bottom-up approach, sifting the financial markets for bargains and then buying them, regardless of the level or recent direction of the market or economy. Only when they cannot find bargains should they default to holding cash."

"Graham and Dodd's principles-such as the stability of cash flow, sufficiency of return, and analysis of downside risk-allow us to identify real estate investments with a margin of safety in any market environment."

"Even complex derivatives not imagined in an earlier era can be scrutinized with the value investor's eye."

Endorsing Value Investing

"The real secret to investing is that there is no secret to investing. Every important aspect of value investing has been made available to the public many times over, beginning in 1934 with the first edition of Security Analysis."

"The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever. So long as people succumb to this aspect of their natures, value investing will remain, as it has been for 75 years, a sound and low-risk approach to successful long-term investing."

"In a rising market, everyone makes money and a value philosophy is unnecessary. But because there is no certain way to predict what the market will do, one must follow a value philosophy at all times."

"While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology."