How do you become the world’s best known investor – well, Warren Buffett spends 80% of his time reading and thinking.

This is a series dedicated to Warren Buffett and his belief that we can all become smarter at investing (and life) by reading.

In this fifth part of the series, Going to Bed Smarter, I highlight 7 key points made by Seth Klarman in his preface to, what is  known as the bible of value investing, Security Analysis by Graham and Dodd.

The Backdrop

The midcaps and small caps have been slaughtered this year. The large caps, which were the safe haven so far this year have seen a steep fall over the last few days.

It is important to keep sanity in today’s extremely difficult market. The success in stock markets is as much about psychology as about analysis.

I thought, to keep my sanity, it is not a bad idea to go back to basics. I decided to re-read “Security Analysis’ by Benjamin Graham and David Dodd. The bad news is, with more than 700 pages, it is not an easy book to read.

There is good news. The preface to the sixth edition by the billionaire Investor, Seth Klarman is an absolute gem and even if you only read this, it provides a lot of clarity.  

There is no substitute for reading this preface yourself. There are so many interesting thoughts that what will appeal to you could be very different for what appealed to me.

For those of us who are long term investors, I have put together the following key points which in this tough market will help keep our sanity.

• You cannot lose Hope

“At the root of Graham and Dodd’s philosophy is the principle that the financial markets are the ultimate creators of opportunity.”

If you are not hopeful it is better not to be a long term Equity investor

• In the short-term, Market can be wrong

“Sometimes the markets price securities correctly, other times not. Indeed, in the short run, the market can be quite inefficient, with great deviations between price and underlying value.”

“Unexpected developments, increased uncertainty, and capital flows can boost short-term market volatility, with prices overshooting in either direction. “

• Stick to your Principles,  especially when the going gets tough

“Even in the worst of markets, Graham and Dodd remained faithful to their principles, including their view that the economy and markets sometimes go through painful cycles, which must simply be endured. They expressed confidence, in those dark days, that the economy and stock market would eventually rebound.”

• There is no substitute for detailed research

“The most successful value investors combine detailed business research and valuation work with endless discipline and patience, a well-considered sensitivity analysis, intellectual honesty, and years of analytical and investment experience.”

• But, research can be wrong, as it is difficult to predict the future

“The outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes. “

• Humility and a regular monitoring of your thesis is essential

“Sometimes a stock becomes cheap for good reason: a broken business model, hidden liabilities, protracted litigation, or incompetent or corrupt management. Investors must always act with caution and humility, relentlessly searching for additional information while realizing that they will never know everything about a company.”

• Balance Sheet analysis is a reliable way of assessing downside

“And for investors in the equity and debt of underperforming companies, balance sheet analysis remains one generally reliable way of assessing downside protection.”

“Astute observers of corporate balance sheets are often the first to see business deterioration or vulnerability as inventories and receivables build, debt grows, and cash evaporates.”

Ok all this is fine, but do you have what it takes?

Here is an extremely important point Seth Klarman makes about being a long term Value Investor.

“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.”

For those who are not aware, Seth Klarman, is one of the most famous Value Investor. Born in 1957, he is the chief executive of the Baupost Group.

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Back to Basics with the Masters