theThoughtful Investor

1 MARGINOFSAFETYRisk-AverseValueInvestingS trategiesforthe ThoughtfulInvestorSethA. arperBusin essiiiADivisionofHarperColl;l'IsP~bli$hm ContentsAcknowledgmentsIntroductionIWher eMos tInvestorsStumb leixxiii11 SpeculatorsandUns uccessful Investors32 TheNatureof WallStreetWorksAgainstInvestors193 TheInstitutionalPerformance Derby: TheClien tIstheLoser3S4 Delusionsof Value:Th eMythsandMisconceptionso fJunkBondsinthe1980s55 IIAV alue-InvestmentPhilosophy795 DefiningYour Investment Goals816 ValueIn ve stin g: TheImportanceof a Marginof Safety877 At the Root ofaValue-InvestmentPhilosophy1058 TheArtofBusinessValuation118 IIITheValue-InvestmentProcess1499 InvestmentResearch:TheChallengeof FindingAttractiveIn ves tm en ts15110 AreasofOpportunityfor ValueInvestors:Catalysts,MarketInefficie ncies,andInstitutionalConstraints16211 InvestinginThriftConversions18212 InvestinginFinanciallyDistressedandBankr uptSecurities18913 PortfolioManagementandTrading20914 InvestmentAlternativesfortheIndividualIn vestor222 Glossary229 Bibliog raphy241 Index243 AcknowledgmentsWhilealwaysinterestedinth eworkingsof WallStreet,Iwasextremelyfortunatein my first real job tohavetheopportunitytoworkalongsideMicha el Priceandthe late (nowMutualSeriesFund,Inc.)

2 MyunclePaulFriedmanalwaysencouragedmyint erestininvest-ingandhelpedmelandthatjob. years atHarvardBusiness toMax' MBA atHarvard, start-upinvestment-managementfirm inCambridge,Massachusetts,presentedtheop portunitytobeginbuildinganinvestmenttrac k recordearlyin my it wasthatI joinedBillPoorvu,IsaacAuerbach,JordanBar uch,HowardStevenson, ofmycolleagues-Howardinparticular-wentou ton a long,thinlimb to bet on meandmy abilities,notonlytomanagetheirownmoneybu talso that of their familiesandclosefriends,whichwasperhapst hegreateract of beassociatedwithsuchknowledgeable,energe tic,warm, has alsobeena privilegetoworkalongsidePaulO'Leary,Davi dAbrams,andnowTom Knott, mybrilliantanddedicatedixXACKNOWLEOCMENT S investmentteamandin-housedoublesgame. I amgratefultoeach ofthemfor hismanyinsightsandobservations, anumberofwhichappearinoneform orano ther in the finestclientsa in shallresp ecttheirprivacybynotnamingthem,theirpati ence, interest,andsupporthave havebroughtm eintocontactwithmanyof the finestpeople in theinvestmentbusin ess,on boththebuysideandthe sells id e.

3 I amg rat eful to eachofthemforteachingmesomuchaboutthisbu sinessandfor puttingupw ithmewhenI washaving a are toonumeroustothankin d ivid ually,lowe each ofthema dow ish tothankthepeoplewhohaveb eenespeciallyhelpfulwith collea guesatBaupost-c-Howard,David,Paul,andTom -eachreviewedth emanuscriptas itnearedcompletionasdidfoursp ecial friends, Lou Lowenstein,DavidDarst, HenryEmerson, and Bret Promso n. Anumber ofotherfriendsmade veryhelpfulsugg estionsatearlier stagesofthis project. Jess Ravich, inparticular,offeredmany valuableinsightsinto thejunk-bondan dbankruptcy sections . Finally,JimGrant,p erhapsw itho u t realizin git, i nspiredmeto thankeachofthemfor theirh elp ,andfar moreimportant,I ife, BethKlarman , offered the freshp erspectiveof anon-financial-professionalas she devotedlyreadeverychapterandmadenumerous helpfulrecommendation madeeveryaccommodati ontohelpfreeu p time forme to devote tothisprojectandurgedme topresson to comp letio nth emanytimeswhenprogress thankherfor being a father, HerbKlarman, was perhapsthe mostcarefulreaderofmultiple draftsof thismanusc is atruecrafts-manof theartofwriting,andhiscommen ts are literallyincor-poratedoneverypageof thisbook.

4 Ithank himforh alsowantto thankmymother, MurielKlarman,forteachingme to ask Imustacknowledgetheextraordinaryefforts of MarkGreenberg, myeditoratHarp erBusiness,andMitchTuchman,my developmentaleditor,inimprovingthismanus criptin somany ways. I thankthemboth for their help in seeing this projectto fruition. I alsoowethanksto Martha Jewett,whomadehelpfulcommentson anearlydraft,andspecialthanksto Virginia Smith,whoproposedthis project out of the Fiorenza, MikeHammond, andSusieSpero were ofenormousassistancewiththe typingandretypingof umerouseditorial suggestions andhelpedtopreparethe glossary. this, full responsibilityforerrorsmust bebornebythe author. I hopethosethat remainareminorandfew fferentapproachesthat offer little or norealprospect oflong-termsuccessandconsiderablechanceo fsub stan tial not coherent in vestmen tprogramsat allbutinsteadresemble speculationoroutrigh tga mbli n g.

5 Inves tors arefrequ en tlyluredbytheprospectofq uickandeasygainandfallvictimto themanyfads of inwritingthis book a retwofold . In the firstsectionIidentifymanyof the pitfallstha t many gowrong, I hope to helpin vestor slearntoavoidtheselosin theremainderof thebookIrecommendonep a r ticula rp a thfor investorsto follow-ava l u e- in vestm ves tin g,thestrategyofinvesting in securi tiestradingatanappreciable discount fromu nd er lyin gvalue,hasa longh is-tory of deliveringexcellent i nvestmen t resultswithverylimiteddow ns id e risk. Thisbookexpl ainsthephilosophyof valuein ves tin gand ,perhapsmor eimportantly, thelogicbehinditinanattempttodemonstrate w hyitsu cceed swhileothera p pro ach es chose ntobeginthisbook,notwitha discussion ofwha tvaluein vestors dorigh t, but with anassessment ofwhereo th er investorsgowrong, formanymoreinvestorsloseth eir\'\Tayalongtheroadtoin vest men t successthanreachth eas yto straybuta con tinu ousefforttoremaindisci-xiiixivINTRODUCTI ON plined.

6 Avoidingwhereothersgowrongis , it ,as severalof myfriendshave ,whyIwouldwriteabookthatcouldencour agemorepeopletobecom e 'tIrunthe risk of encouragingincreasedcompetition, therebyreducingmyowninvestmentreturns?Pe rhaps,butIdonotbelievethis willhappen. For onething,valueinvestingis notbeingdi scu ssedhere forthe firsttime. WhileI havetriedto buildthecase foritsomewhatdiffer-entlyfrommyp redecessorsandwhilemyprecisephilosophyma yvaryfromthatof othervalu einvestors, anumberof theseviewshavebeenexpressedbefore,notabl ybyBenjaminGrahamandDavidDodd,whomore than fiftyyearsagowroteSecurityAnalysis,regar dedbymany as the bible ofvalueinves t-ing. Thatsingleworkhasilluminatedthewayfor ,alessacademicdescriptionof , the chairmanof BerkshireHathaway,Inc.,and astudent of Graha m, is regardedasto d ay' has writtencountlessarticlesandshareholderan dpartnershiplettersthattogetherar ticulate hisvalue-investmentphilosophy coherently and brilliantly.

7 Investorswhohavefailed to heedsuch wise couns el are unlikely to list , I ampainedbythe disastrousinvestmentresultsexperiencedby greatnumbersof unsophist icatedoru ndi sciplined canpersuadejusta few of themtoavoiddangerousinvestmentstrategies andadoptsoundonesthatare designedtopreserveandmaintaintheir hard -earnedcapital, Iwill be shouldhav e a widerinfluenceoninvestorbehavior, thenI wouldgladlypay the price of amodestdiminution in myowninvestm ent thisbookalonewill notturnanyone into a suc-cessful investingrequires a g reatdealo fhardwork,unusuallystr ictdi scipline, and along-ter m invest are willingandable todevote sufficien t timeIntroductionxvandeffortto becomevalueinvestors,andonlya frac tionofthosehavethe propermind-set to su refire for-m ula forinvestmentsuccess. Thereis, of course, no such form u-la.

8 Ratherthisbook is ablueprin tthat,if carefully followed ,offers agoodpossibilityofinvestmen t successwith limit believethis is asmuch as investorscan reasonablyhope this will be considered,not abookabout investing,buta bookaboutthinking most eight ,some investorsmemorizea few formu-las or rulesandsupe rficiallyappearcompetent but do not reallyunderstandwhat they are doing. Toach ievelong-term successovermanyfinanc ialmarketandeconomiccycles,observingafew rulesis quicklyinthe investmen tworldforthatapproachto neces-sary insteadtounderstandthe rationalebehindtheru lesinorde rtoappreciatewhytheyworkwhentheydoanddon 'twhentheydon' couldsimplyassertthat value investingworks,butI hopetoshowyouwhyit worksandwhymostotherapproachesdo terplanetaryvisitorslanded on Earthandexaminedtheworkingsofour financialmarketsandthebehaviorof financ ial-marketpar ticipan ts, theywould no doubt questiontheintelli-gence ofthe plane t'sinhabitan ,the financialmarketplacewherecapital i s allocatedworldwide,isin manyways just a up-front fees oneverytransaction.

9 Wall Streetdearly is more concernedw iththevolumeof activity thanits ionandendowmentfundsresponsiblefor thesecurityandenha nce-mentoflong-term retirement,educationa l,andphilanthropicresourcesemployinvestm entmanagerswhofrenetically trad elong-termsecuritieson a very short-termbasis, each trying tooutguessand consequen tlyoutperformothersdoingthesamething. Inaddition,hundredsof billionsofdollarsare inves tedinvirtualor completeignoranceofunderlyingbusinessfun da-mentals,of tenusing indexing strateg iesdesignedto avoid sig-xviINTRODUCTION nificantunderperformanceat the cost of ue n tlydemonstrateaninabilitytomakelon g-terminvestment numberofreasonsfor this:amongthemtheperformancepressuresfac edby institutionalinvestors,thecompensationst ructureof WallStreet,andthefrenziedatmosphereof the financial markets.

10 Asa result,investors,particularlyinstitution a l investors,becomeenmeshedin ash ort-term relative-performancederby,wherebytempora rypricefluctuationsbecomethe ,alreadyfocusedonshort-termre turns,frequentlyareattractedto thela testmarke tfadsas asourceof fast buc k is great, andmanyinvestorsfind itdifficult to ,forexample,greedleadsinvestorstospecula te,tomake sub stantial,high-riskbets baseduponopti-misticpredictions,andto focus on returnwhile ignori theotherendof theemotiona lspectrum,whenpricesaregenerallyfalling, fear of loss causes investors to focussolely onthep ossibilityof continuedpricedeclinesto themarket environ-ment,manyinves torsseeka -na terealityis that investmentsuccesscannotbecapturedin amathematicalequationor acomputer firstsectionofthisbook,chapters1 th rough 4,examinessomeof t heplaces exploresthedifferencesbetweeninves tingandspeculationandbetweensuccessfulan dunsuccessful investors,examininginparticularthe role looks atthewayWall Street, withits short-termorientation,conflictsofinteres t,andupwardb ias,maximizesitsownbestint erests,whicharenotnecessarilyalso those.