Klarman margin of safety pdf

The pressure to retain clients exerts a stifling influence on institutional investors. Since clients frequen tly replace the worst-performing managers and since money managers live in fear of this , most managers try to avoid standing apart from the crowd.

Those with only average results are considerably less likely to lose accounts than are the worst performers. The result is that most money managers consider mediocre performance acceptab le. Although unconventional decisions that prove successful could generate superior investment performance and result in client additions, the risk of mistakes, which wo uld d iminish performance and possibly lead to client departures, is usually considered too high.

The Short-Term, Relative-Perfonnance Derby Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative -performance derby. Fund managers at one institution have suffered the distraction of hourly performance calculations: numerous managers are provided daily comparisons of their results with those of managers at other firms.

Frequent comparative ranking can only reinfo rce a short-term investment perspective. It is understandably difficul t to maintain a long -term view when, faced with the penalties for poor short-term performance, the longterm view may well be from the une mployment line.

The short-term orientation of money managers may be exacerbated by the increasing popularity of pension fund consultants. These consultants evaluate numerous money managers, compare their performances, contrast their investment styles.

Because their recommend ations can have a significant influence on the health of a money management business, the need to impress pension fun d consultants may add to the short-term performance pressures on money managers. Vhat is a relative-performance orientation? Money managers motivated to outperform an index or - reer group of managers may lose sight of whether their investts are attractive or even sensible in an absolute sense. Rather than making sensible judgments about a tractiveness of specific stocks and bonds, they try to guess iat others are going to do and then do it first.

The task becomes singly intricate: guess what the other guessers may guess. Is it fault of managers who believe clients want good short-term , rman ce regardless of the level of risk or the impossibility - e task? There is ample blame th to share. Attempting to outperform the market in the short run is e since near-term stock and bond price fluctuations are ranand because an extraordinary amount of energy and talent - ready being applied to that objective. The effort only disa m oney manager from finding and acting on sound longo portunities as he or she channels resources into what is dally an unwinnable game.

Only brokers benefit from the. You should be no more satisfied with a money manager w ho does not eat his or her own cooking. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surp rising that so many Roma n arches have survived. Money managers who invested their own assets in parallel with clients would quickly abandon their relative-performance orientation.

Intellectual honesty would be restored to the institutional investment process as the focus of professional investors wo uld shift from trying to outguess others to maximizing returns under reasonable risk constraints. If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overva lua tion and market fads wo uld less likely be carried to excess.

Investments would only be made w hen they presented a compelling opportuni ty and not simply to keep up with the herd. Impediments to Good Institutional Investme nt Perfonnance One major obstacle to good instituti onal inv estment performance is a sho rtage of time. There is more information avai lable. Thinking about and digesting all this material, urse, would take considerably longer. He or she assumes a per. This helps explain why institutional rarely make unconventional investments.

It also 5. The multidimensional risk ing too long is usually less than the risk in selling too o. First, many investments are illiquid, and disposing of ins titutional-sized positions depends on more than simply the desire to do so. Second, selling creates additional work as sale proceeds must be reinvested in a subsequent purchase.

Retaining current holdings is much easier. With so many demands on their time, money managers have little incen tive to crea te additional work for themselves. Finally, the Securities and Exchange Commission SEC , the governmental agency wi th regu latory responsibility for mutual funds, regards portfolio turnover unfavorably.

Mutual fund managers thu s have yet another reason to avoid selling. Many large insti tutional inves tors separate analytical responsibilities from po rtfolio-management duties, with the portfolio managers senior to the ana lysts.

This approach is conducive to mistakes since the people making the decisions have not personally analyzed the securi ties they are buying and selling.

Moreover, the analysts who do have direct knowledge of the underlying companies may be swayed in their recommenda tions by any apparent top-down bias manifested by the portfolio managers. There is one other impediment to good institutional investment performance: institutional portfolio managers are human beings.

In addition to the influences of the investment business, money managers, despi te being professionals, frequen tly fall victim to the same forces that opera te on ind ividu al investors: the greedy search for qu ick and easy profits, the comfort of consens us, the fear of falling prices, and all the others. The twin burdens of ins titutional baggage and human emotion can be difficu lt to overcome.

Implications of Portfolio Size Insti tutional investors are caught in a vicious circle. The more money they manage, the more they earn. However, there are. The p rincipal reason is th at goo d investmen t ideas are in short supply. Most of the m ajor mon ey m anagement firms cons ider only. These inst itutions cannot justify analyzing small and med ium-sized companies in which only modest amounts could ever be invested.

To avoid owning illiquid positions, investments ight be limited to no more than 5 percent of the outstanding hares of anyone company. In comb ination these ru les im ply -ning sha res of companies with a m inimum market capital::z. This one is not, however, a comp letely arbitrary rule adopted by managers; the size of the rortfolio dictates such a rest riction.

Unfor tunately for the client s : large money managers, like the one in this example, tho usands of companies are automatically excluded from investeeent consi de ration regardless of ind ivid ual merit. Self-Imposed Constraints on Institutional Investors Iost institutiona l investors are lim ited by a number of other self-imposed constraints.

In response to the prudent-man standa rd and sim ilar rules of accep tability, many inst itutions have unposed restr ictions on the ir portfolios. Some establish limits on the cash com ponent of a po rtfolio. Others may exclude mvestmen t in stocks selling be low five do llars a share, secu ri-.

Remain Fully Invested at All Times The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock picking, not market timing; they believe that their clients have made the markettiming decision and pay them to fully invest all funds under their management.

Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments.

Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost-foregoing the next good opportunity to invest-and the risk of. Remaining fully invested at all times is consistent with a relative-performance orientation.

Funds that would otherwise be idle must be invested in the market in order not to underperform the market. Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value.

They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined. Overly Narrow Categorization A common mistake institutional investors make is to allocate their assets in to overly narrow categories.

The portion of a portfolio that is targeted for equity investments, for example, cannot typically own bonds of bankrupt companies. Money assigned to junk-bond managers will be invested in junk bonds and nothing else, even when attractive opportunities are lacking. A municipal-bond portfolio will not usually be allowed to own taxable debt instruments. Such emphasis on rigidly defined categories does not make sense.

For example, a bond of a bankrupt company at th e right price may have the risk and return characteristics of an equity investment. Equities such as utility stocks may demonstrate the stable cash- flow characteristics of highquality bonds. Allocating money into rigid categori es simplifies investment decis ion making but only at the potential cost of lower returns. For one thing many attractive investments may lie outside traditional categories. Also, the attractive historical returns that d raw in vestors to a particular type of investment may have bee n achieved before the category was identified as such.

By the time leveraged buyouts LBOs became a sought-after category of institutional investment, for example, the high returns available from the early deals were no longer av ailable. Window Dressing Windo w dressing is the practice of making a portfolio look good for quarterly reporting p urposes.

They also may sell positions with significant unrealized losses so that clients will not be reminded of major mistakes month after month. Such behavior is clearly uneconomic as well. Even so, as depressed issues drop fu rther in price, attractive opportunities may be created for val ue investors. Perhaps as a response to the difficulties of successfully managing instituti onal portfolios, a number of pro fessiona l investors have abandoned fundamental analysis entirely.

Rather than overcoming the problems of professional money ma nagement, however, they have compounded them. The remainder of this chapter describes their activit ies. The Abandonment of Fundamental Investment Analysis by Institutional Investors Ove r the past several years there has been an enormous increase in the amount of mo ney managed by people who knowingly ignore the underlying fundamentals of the investments owned.

Academic notions, such as the efficient-market hypothesis and the cap ital-asset-pricing mo de l three of whose most voc iferous proponents received the Nobel Prize for economics in , support these new investment strategies. Indexing is the primary investment outlet for investors who believe in these ideas. Practices such as tactical asset alloca tion, portfolio insurance, and program trading share to a greater or lesser extent the same di sregard for investing based on company-by-company fundamentals.

Portfolio Insurance Many ins titu tional investors are forever seeking to uncover a magic formula for investment success. A successful form ula would grea tly simplify their lives; investing would become effor tless, marketing would be a cinch, and they would almost. The institutions persist in their search, but their mission is both ill-conceived and expensive for their client guinea pigs.

By way of example, in widespread popularity accrued to a technique that ostensibly allowed investors to truncate the downside risk of a portfolio of stocks in exchange for a slight reduction in potential return. This technique, cleverly labeled portfolio insurance, was hailed by Wall Streeters as a tool for risk reduction. It had the effect of encouraging institutional investors to buy stocks and remain fully invested despite the historically high market valuation that prevailed in the fall of Portfolio insurance was, in fact, a simplistic notion dressed up in mathematical and computerized lingo.

Simply put, the way portfolio insurance was supposed to work was that whenever the stock market declined by 3 percent, investors were to sell stock-index futures a market basket of stocks to be delivered at a future date to eliminate any further exposure to the market.

In theory, then, the most that any investor could lose, no matter how much the market declined, was the first 3 percent. When prices staged a recovery, investors would repurchase the futures contracts and reestablish exposure to the market. The obvious flaw is that past stock market fluctuations are not a useful guide to future performance.

Just because the market declines 3 percent does not mean that it is about to drop further. If the market were to stage a sustained decline, investors would clearly benefit from eliminating market exposure.

If a 3 percent decline were followed by a market recovery, however, investors would be forced to repurchase the futures and lock in a loss. In the event that market volatility is much greater than expected, the theory of portfolio insurance collapses, as repeated 3 percent losses are sustained. Moreover, the market does not always rise and fall in an orderly fashion. As impractical as portfolio insurance is for anyone investor, it becomes qui te dangerous when large numbers of investors engage in it.

With too many practitioners, frantic selling of stock index fu tures by portfolio insurers could drive futures prices below the underlying stock prices, making it profitable for arbitrageurs to buy the cheap futures and sell the underlying stocks. Such selling would put additional pressure on stock prices, perhaps necessitating more fut ures sales by portfolio insurers. A vicio us circle could ensue.

This is exactly what happened on Monday, October 19, This selling drove the fu tures as much as 10 percent below stock prices, creating an attractive opportunity for arbitrageurs to buy fu tures and sell stocks. This selling drove share prices even lower, triggering more sales of futures by hapless portfolio insurers.

The notion that you could escape downside risk by selling futures was dis credited in a couple of hours that day. Portfolio insurance had lured people who were no t comfortable wi th the risks of stocks in to buying and holding them. An apparently conservative st ra tegy designed to prevent loss played an important role in the wo rst debacle in recent financial history. Tactical Assel Allocation By , wit h portfolio insurance discredited, ins titutional investors returned to their computers searching for new formulas.

Now their goa l was to find a clear signal that would indicate whe ther stocks or bonds were the better buy. Although the search for this answer has preoccupied investors over the years, it is unlikely tha t a computer could ever be programmed to ma ke wha t is clearly a judgment call.

Yet what would have been cons idered a crackpot scheme if adopted by an individual. Tactical asset allocation begins with a reasonable premise: there are times when bonds are a better buy than stocks and other times when the opposite holds true, and good investors should watch for opportunities.

Unfortunately the appropriate relationship between bond yields and stock prices cannot be incorporated into a computer program. There are simply too many variables to allow investors to determine a relationship today that will apply under every future scenario. Another problem with tactical asset allocation is in its implementation. Neither the stock nor the bond market is infinitely deep.

Vast sums cannot be instantaneously switched from one area to the other without moving the markets and incurring considerable transaction costs as well.

Just because an asset allocation model dictates a portfolio decision does not mean that the implementation of that decision is feasible.

To illustrate this point, consider the actions of Renaissance Investment Management, Inc. Treasury bills into the stock market. Whether or not the computer conveyed good market timing, it had not been programmed to trade well.

Index Funds: The Trend Toward Mi ndless Investing An im portant stock ma rket development in the past several years has been the rush by institutional investors in to indexing.

Indeed this trend may be a major factor in the sign ificant divergence between the performances of large-capitaliza tion and small-capitalization stoc ks between and An index fund manager does not look to buy or sell even at attractive p rices.

Even more unusual, index fund managers ma y never have read the financ ial statements of the companies in w hich they invest and may not even know what businesses these com panies are in. Indexing has become increasingly popular among pension funds, en dowments, an d other long-term investment pools for several reasons. Indexing guara ntees matching the performance of the securities in the index although it also guarantees not outperfor m ing it. Since the average institutiona l investor has underp er formed the ma rke t for the past decade, and since all investors as a gro up mu st match the market because they collectively own the entire ma rket, matching it may seem attractive.

Indexing offers the additional benefits of very low transaction costs as there is almost no trading and low management fees as the tas k requires virtually no thought or action. Another reaso n for the trend toward indexing is that many institu tiona l investors and pension funds believe in the efficient-ma rke t hypothesis. This theory holds that all information about securities is d isseminated and becomes fully reflected in.

It is therefore futile to try to outperform the market. A corollary of this hypothesis is that there is no value to incremental investment research. By contrast, value investing is predicated on the belief that the financial markets are not efficient.

Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities. To value investors the concept of indexing is at best silly and at worst quite hazardous. Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.

Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them. Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover.

Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they.

Yet even very large cap italization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day tha t a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock wo rth more today than yesterday. In effect, people are willing to pay more for that stock jus t because it has become part of an index.

There are now a number of such funds. Such stocks usually have only limited liquidity, and even a small amoun t of buying or selling activity can greatly influence the market price.

When small-cap italizat ion-stock indexer s receive more funds, their buying will push prices higher; when they experience redemptions, their selling w ill force prices lower. By unavoidably bu ying high and selling low, sma ll-stock indexers are almost certa in to underperform their indexes. Other perverse effects of indexing are now emerging with increasing frequency.

He or she is indifferent to whether the index rises or falls in va lue, other than to the extent that fees are based on total managed assets valued at market prices. This means that in a proxy contest, it makes no real difference to the manager of an index fund whether the d issidents or the incumbent management wins the fight, even though the ou t-.

By choosing indexing, investors have implicitly expressed the belief that their vote in a proxy contest could make no predictable financial difference anyway Ironically, even if ind exers wanted to vote in a direction that maximized value, they would ha ve absolutely no idea wh ich way that would be because index fund managers typically have no fundamental investmen t knowledge about the stocks they own.

I believe that ind exing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almos t certainly decline relative to thos e that have been exclud ed. Conclusion Investors must try to understand the institutional investment mentality for two reasons.

First, institutions dominate financialmarket trading; investors who are ignorant of institutional behavior are likely to be periodically trampled. Second, ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by the investment elephants can be rewarding. Investing without understanding the behavior of institutional investors is like driving in a foreign land without a map.

You may eventually get where you are going, but the trip will certainly take longer, and you risk getting lost along the way. Louis Lowenstein, unpublished manuscript. Jonathan R. Berkshire Hathaway, Inc. In addition to the impact on investors, this has frightening implications for economic efficiency in the United States. The junk-bond boom would not h ave occurred w ith out the enthusiastic acceptance of financial-mar ket participants.

Alth ough unproven ove r a comp lete economic cycle, newly issued ju nk bonds were ha iled as a safe investment that provided a very attractive retu rn to investors. By , however, the concept of newl y issu ed junk bonds had been exposed as seriously flawed, defaults reached record levels, and the prices of many issues plunged.

Even so, the junkbond market staged a su rprising recovery in early ; many of the flaws that had resulted in tens of billions of do llars of losses were once aga in being ignored. H istorically many financial-market innovat ions have ga ined widespread acceptance before being exposed as ill conceived. What is unique about junk bonds is the sp eed and ma gnitude of their rise; the ir strong an d pe rnicious influ ence on othe r securities, on finan cial markets, and on the behavio r of busin esses; and th eir continued po pularity in the face of large investor losses.

Perhaps m ost im portant, junk bon ds gave an upward propulsion to busin ess valuation, as time- tested analytical standards and tru sted ya rds ticks of va lue came to be eit her overlooked by investors or aba nd oned for ne w and unproven ones.

This chapter is intende d as a cau tionary tale, an illustration of how seriously misguided investor thinking can become.

The junk-bond debacle was no great surp rise. The junk-bond market not on ly existed but actually thrived in the face of continued criticism an d repeated warnings. The self-interes t of the pa rticipants in its perpetuation was so great, how ever, that they used their collective influence to effectively stave off for a numb er of years the growing wei ght of evidence ag ains t junk bonds. Braddock H ickman. Two decad es earlier Hickman had shown th at a wel l-diversified, low -grade bond portfolio cou ld earn a greater rate of return tha n a hig h-q ual ity bond portfolio; in other w ords, the higher yields on low-rated securities would mo re th an compensate for capital losses from any defaul ts.

Hence such bon ds traded at depressed prices, and low. As we shall see, the legitima te oppor tuni ty in a virtual handful of distressed securities that were overlooked by othe rs was carried to excess when Milken extra polated from a historical relationship to an entirely new type of security. He soon became one of the most knowledgeable--and visible-c-people on Wall Street in the high-yield market. The arguments in favor of high-yield-bond investing represented a radical depa rture from the conventional wisdom of the early s.

In the afterma th of the recession and bear market, investors were generally loathe to incur credit risk. Milken overcame investor reluctance by p urportedly demonstrating tha t investment in low- rated securities historically provided higher total returns than could be earned on investment-grade securities. 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 de fau lt rate was centra l to the bullish case for junk bonds-a case that comes apart under even casual scrutiny. Fallen-angel bonds typically are illiquid, and potential buyers are put off by the fear of being virtually locked into their invest ments.

Milken promised buyers tha t he would make a ma rke t in all of his deals, ensuring liquidity. In the early days of the new-issue junk-bond market a grea t amount of paper was traded back and. Milken shaped financial history by pioneering the issuance of junk bonds, glossing over the major differences between fallen ange ls and new issues. This required an enormous leap of faith, one which Milken made and was able to persuade others to make as well.

Unfortunately newly issued junk bonds were not the low-risk ins truments that buyers were led to believe. They have, in fact, very different risk and return characteristics from fallen angels.

Trading around par valu e, they have very limited appreciation potential, but unlike high-grade bonds trading near par, they have substantial downside risk.

A fallen angel, by contras t, trades cons iderably below par and thus has less downside risk than newly issued junk bonds of comparable credit quality. The other side of this coin is that bonds trading below par have more upside price potential than bonds trading at par. If underlying credit quality improves or if interest rates drop, discount bonds have room for substantial apprecia tion; bonds trading at par, by con tras t, are usually subject to call prior to maturity and thus have very limited upside potential.

O ther things being equal, then, newly issued junk bonds carry greater risk of loss with lower potential return than fallen an gels, an important dis tinction that Milken failed to make, at least publicly.

Of course, even the most overleveraged junk-bond issuers do not default immediately; it takes time to run short of cash. A handful of issue rs, such as Braniff, Inc.

Bonds such as theirs were referred to as NFCs [no first coupons]. For most of the s the default-rate numera tor the volume of junk-bond defaults occurring in a given year lagged behind the rapidly growing denominator the total amount of junk bonds outstanding during that year.

It was only when issuance Virtually ceased in that the deterioration in credit quality was reflected in default-rate statistics. One trick of the trade was to raise as much as pe rcent more cash than was immediately needed by issuers in order to fund upcom ing cash-flow shortfalls. Needless to say, propping up marginal credits in th is way he lped maintain a low reported default rate, as it had when banks employed the device to put off de fau lts by their less-developed country LDC borrowers.

Widespread issuance of non-cash-pay zero-coupon or payin-kind securities also served to reduce the reported junk-bond de fau lt rate temporarily. Yet while such bonds allay the possibility of default for some issuers, they do no t reduce it permanently.

Indeed, such securities may be more likely than cash-pay securities to defau lt ultimately beca use they accrue a growing debt burden that is no t being serviced and is often unserviceable from current cash flows. The absence of default during a period when it is only being postponed is hardly a sign of fiscal health. An issuer of non-. In early , even as the market was collapsing, Ed Altman edited The High Yield Debt Market, an anthology of more than a dozen recent articles mostly lauding junk-bond issuance and investment.

Such upbeat analyses, sometimes financed by the leading high-yield underwriters, failed to take into account the serious flaws in the default-rate calculation. 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. Not only was its calculation an exercise in science fiction, 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. The default rate also failed to incorporate the financial impact of voluntary exchange offers and restrucwrings in which bondholders accepted impairment of their claims without an actual default having taken place. As long as investors were willing to purchase bonds on such terms, there were new underwritings to be done.

And as long as the yield illusion was perpetuated, investors kept buying the bonds. The tremendous growth of the market was accompanied by a buildup of the junk-bond infrastructure on Wall Street. If investors themselves failed to discern the attractiveness of junk.

By discarding old measurements of valuation and creating new ones and by mastering the art of optimistically projecting and compounding results further and further into the future, Wall Street was able to generate demand to match and at times even to exceed the burgeoning supply of junk bonds. What had started as an attempt to generate fees and commissions from the sale of bonds began by the mids to take on the characteristics of a moral crusade.

Investors wanted to believe that they could achieve returns much higher than ever before with no greater, and possibly even lower, risk. 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.

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. Although only a small proportion of all junk-bond issuers actually fit this description, and despite the obvious difficulty that such companies would have servicing large amoun ts of high-yield debt, these were the broad strokes painted by Milken, his colleagues, a number of academics, and many in the media.

At the same time that junk bonds were being portrayed as the friend of the small and otherwise unfinanceable business, they were also gaining stature as the enemy of the large and well-established corporation. Armed with billions of dollars in newly available cash, junk-bond-financed takeover artists and financia l operators were suddenly in a position to buy almost any company in the country.

To jus tify the use of junk bonds in corporate takeovers, large corporations were depicted as ineffi-. While there were certainly kernels of truth in this characterization of corporate America, there was only scant consideration of whether the imposition of a staggering debt burden was the best remedy for this particular ailment. Moreover, virtually no one noticed or cared that junk bonds were no longer fulfilling their former, highly publicized role of financing small companies.

It seems incredible that anyone could get away with the portrayal of junk bonds as a kind of financial aspirin good for what ails you. Nevertheless, Milken had legions of loyal followers, many of whom he had helped make incredibly rich. Albeit to a lesser degree than Milken, they too were now beneficiaries of the booming junk-bond market. The greatest irony in the whole junk-bond story may be that one of the biggest finan cial swindles of all time , newly issued junk bonds, had by the end of the s come to enmesh every major Wall Street firm alongside Drexel Burnham Lambert.

Long after the demise of Drexel. Early Successes of Junk-Bond Investors Led to Unrealistic Expectations Self-fulfilling prophesies contributed to the successful junkbond experiences of the early to mids.

The increasing availability of nonrecourse junk-bond debt in which the lender looks only to the borrowing entity for payment led to increasing multiples being paid for corporate assets. This is because. Business valuations started to increase at the same time; the economy was rebounding from the recession, and interest rates were falling from their early s peak.

Economic growth boosted operating results for many junkbond issuers; declining interest rates allowed a number of issuers to refinance on advantageous terms. Even bad deals were bailed out by a growing economy and higher business valuations, reinforcing the notion of a low default rate. Early investors did well, emboldening others; subsequent deals were performed at still higher multiples of earnings and cash flow.

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 ratio of pretax earnings to interest expense and insufficient cash flow to meet upcoming debt-principal repayments.

Issuers and investors alike assumed that cash flow would always grow and that upcoming maturities could be refinanced. If growth did not materialize or if credit proved unavailable, a financial restructuring or bankruptcy filing would result.

High-yield bonds were not purchased by cautious investors, however, but by optimistic, short-term-oriented, and gullible ones. It is not surprising that junk-bond holders did not expect an economic downturn or credit contraction; if they had, they would not have bought junk bonds. The pervasive optimism of investors led to a relaxation of investment standards. A study by Barrie Wigmore, a limited partner at Goldman Sachs, showed that the typical interest coverage ratio for newly issued junk bonds declined drastically between and to the point where it fell below l.

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. In other words, regard less of any possible merits of earlier issues, the junk bonds of the late s were bound to fail simply because the issuers were routinely overpaying for corporate assets.

High-Yield Bond Mutual Funds Individual inves tors in the s sought to preserve the high nominal returns to which they had recently become accustomed.

These yield pigs were vulnerable to the hype that surrounded the junk-bond market, a vulnerability exacerbated by the favorable treatment given to high-yield bonds by the media.

Many of these investors found their way into one of the many high-yield mutual funds that came into existence. These funds appeared to offer professional management, diversification, low transaction costs, and prudence, even as their prospectuses assuming anyone read them understated or even ignored the risks of junk-bond investment. Competition among the mutual funds centered around the identity of the management company e.

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Click Download or Read Online button to get margin-of-safety book now. Find great deals on eBay for seth klarman margin of safety. Shop with confidence. There are plenty of options and bonus settings to completely adx driver what you do … The Margin of Safety explains the philosophy of value investing, and perhaps more importantly, the logic behind it, demonstrating why it succeeds while other approaches fail.

Save it to your desktop, read it on your tablet, or email to your colleagues. Seth Klarman is a famous value investor who runs Baupost Group, which manages billion. Although he has long kept a low public profile, he is considered a giant within investment circles.