Seth Klarman – Margin of Safety – Trading Sardines and Eating Sardines

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One of our favorite investors here at The Acquirer’s Multiple is Seth Klarman. Klarman wrote one of the best books ever written on investing called Margin of Safety. Such is the popularity of Margin of Safety that at the time of writing there are 12 used copies selling for $1349 and 6 new copies selling for $1779.

One of my favorite parts of his book focuses on what he calls, Trading Sardines and Eating Sardines: The Essence of Speculation.

Klarman writes when purchasing stocks, “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.”

Here’s an excerpt from Klarman’s book, Margin of Safety, in which he discusses the importance of doing your homework and avoiding speculation when it comes to investing:

There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand.
These are not eating sardines, they are trading sardines.”‘

Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading. 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. Today many financial-market participants, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a “greater-fool game,” buying overvalued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price.

There is great allure to treating stocks as pieces of paper that you trade. Viewing stocks this way requires neither rigorous analysis nor knowledge of the underlying businesses. Moreover, 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.

Value investors pay attention to financial reality in making their investment decisions. Speculators have no such tether.

Since many of today’s market participants are speculators and not investors, business fundamentals are not necessarily a limiting factor in securities pricing. The resulting propensity of the stock market to periodically become and remain overvalued is all the more reason for fundamental investors to be careful, avoiding any overpriced investments that will require selling to another, even greater fool.

Speculative activity can erupt on Wall Street at any time and is not usually recognized as such until considerable time has passed and much money has been lost. In the middle of 1983, to cite one example, the capital markets assigned a combined market value of over $5 billion to twelve publicly traded, venture capital-backed Winchester disk-drive manufacturers. Between 1977 and 1984 forty-three different manufacturers of Winchester disk drives received venture-capital financing. A Harvard Business School study entitled “Capital Market Myopia” calculated
that industry fundamentals (as of mid-1983) could not then nor in the foreseeable future have justified the total market capitalization of these companies.

The study determined that a few firms might ultimately succeed and dominate the industry, while many of the others would struggle or fail. The high potential returns from the winners, if any emerged, would not offset the losses from the others. While investors at the time may not have realized it, the shares of these disk-drive companies were essentially “trading sardines.” This speculative bubble burst soon thereafter, with the total market capitalization of these companies declining from $5.4 billion in mid-1983 to $1.5 billion at year-end 1984. Another example of such speculative activity took place in September 1989.

The shares of the Spain Fund, Inc., a closed-end mutual fund investing in publicly traded Spanish securities, were bid up in price from approximately net asset value (NAV)—the combined market value of the underlying investments divided by the number of shares outstanding—to more than twice that level. Much of the buying emanated from Japan, where underlying value was evidently less important to investors than other considerations. Although an identical portfolio to that owned by the Spain Fund could have been freely purchased on the Spanish stock market for half the price of Spain Fund shares, these Japanese speculators were not deterred.

The Spain Fund priced at twice net asset value was another example of trading sardines; the only possible reason for buying the Spain Fund rather than the underlying securities was the belief that its shares would appreciate to an even more overpriced level. Within months of the speculative advance the share price plunged back to prerally levels, once again approximating the NAV, which itself had never significantly fluctuated.

For still another example of speculation on Wall Street, consider the U.S. government bond market in which traders buy and sell billions of dollars’ worth of thirty-year U.S. Treasury bonds every day. Even long-term investors seldom hold thirty year government bonds to maturity. According to Albert Wojnilower, the average holding period of U.S. Treasury bonds with maturities of ten years or more is only twenty days.’

Professional traders and so-called investors alike prize thirty-year Treasury bonds for their liquidity and use them to speculate on short-term interest rate movements, while never contemplating the prospect of actually holding them to maturity.

Yet someone who buys long-term securities intending to quickly resell rather than hold is a speculator, and thirty-year Treasury bonds have also effectively become trading sardines.

We can all wonder what would happen if the thirty-year Treasury bond fell from favor as a speculative vehicle, causing these short-term holders to rush to sell at once and turning thirty-year Treasury bonds back into eating sardines.

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