SETH KLARMAN INTERVIEW BY CHARLIE ROSE 2011 (VALUE INVESTING)

Let me turn to, why is it that Margin of Safety, you can't get it except going to eBay? I knew that was a fact, but I still don't understand why.

You can get it, Charlie. I'll send you one.

Well, I know, I know, but is it true?

So Margin of Safety—the idea for Margin of Safety came when a business school classmate called me up and said, 'Hey, Seth, Virginia Smith here.' She was working at Harper & Row at the time, I think. 'And they've asked me to find aspiring authors. And would you like to write a book on investing?' And I said, 'I'll think about that. People have said they like my letters to clients. Maybe I should do it.' So I took the chance and wrote the book. They didn't do a very good job, didn't advertise it. Editors kept getting fired—I don't think because of me. And by the third editor, we finished the book. And then it sold about 5,000 copies and died out. So I did nothing for a while because it was dead. Harper's prediction was right temporarily.

And it died. And then it started to get a cult following. And I thought, 'Well, maybe I'll bring it back someday and raise money for charity.' And that's the truth. If I could sell a Wall Street edition for $500 or $1,000 and raise a million or two for charity, what a great thing. "You would do it at that time." And I've not found the time or energy to actually do that.

I think we could delegate this rather quickly. I'll have to get on that. What was it about Margin of Safety? Because in a sense, it's a term that you believe in. And according to what I read, it's a book that's on Warren Buffett's desk. And you both are great—I don't want to use the word disciples, but you're great followers of the teachings of Ben Graham.

I think it's probably on Warren's bookshelf under a pile of papers. I don't think Warren needs to read it anymore.

What was it, though?

I don't really know. I tried to write it to be accessible to the layperson or the professional entering the field. And so I tried to use layman's language and just make it accessible. It's certainly—the term is borrowed from Security Analysis, and it's meant to be in some ways an intellectual successor to Intelligent Investor, which was the more accessible of Graham's books. So I think it's just another book in that tradition.

More than that.

Maybe if people can't get something, they want it even more. Well, there may be a lot to that.

I think they call that supply and demand. You wrote recently the preface to the new edition of Security Analysis. Is that the right title, Security Analysis? What is it you want to say, and why has it remained, A, your lodestar, and secondly, sort of this remarkable—I mean, everybody knows, I've probably done more conversations with Warren Buffett than anybody alive, and we talk about it all the time, and how his own Ben Graham experience, and coming to Columbia, and what it meant to him. Help me understand why this has been such a profound series of principles that have made you, in investments, who you are today?

First of all, I wish I'd met Ben Graham. I never was fortunate enough to do that. I think Warren captured the idea himself in his 1964 article, 'The Superinvestors of Graham-and-Doddsville'. In it, he talks about value investing is like an inoculation. You either get it right away or you never get it. And I think it's just true. I actually think there's a gene for this stuff, whether it's a value investing gene or a contrarian gene. I think that everybody appreciates a bargain, but when the market's going down, most people overreact and get scared. 'My stock is going down. What am I going to do?' So if you're buying a sweater and it goes on sale from $400 to $150, you get excited when you get to the store.

But if you have a stock or you bought the sweater at $400, maybe you're not so happy. So I think for me, it's natural. But for a lot of people, it's fighting human nature. But it is true. It's what Warren Buffett said. When you find out about it, it's like being let in on this little secret. And so if you can remember that stocks aren't pieces of paper that gyrate all the time, that stocks are fractional interests in businesses, it all makes sense. It's almost like you have to slow the game down, like they talk about baseball speeding up on you. You need to slow it down. 'I can buy this thing for a huge fraction of what it's worth. What am I worried about if it goes down a little bit more?'

So, what's the gift here? Knowing what it's worth?

I think that the analysis is actually the easy part. When I speak to business school students, I tell them investing is the intersection of economics and psychology. The economics, the valuation of a business, is not that hard. The psychology—how much do you buy? Do you buy it at this price? Do you wait for a lower price? What do you do when it looks like the world might end?—those things are harder. And knowing whether you stand there, buy more, or something legitimately has gone wrong and you need to sell, those are harder things, and that you learn with experience. You learn by having the right psychological makeup in the first place.

Well, stop. What's the right psychological makeup that you have? Patience would be one. Willing to sit on cash would be another.

Value investors have to be patient and disciplined. But what I really think is you need not to be greedy. If you're greedy and you leverage, you blow up. Almost every financial blow-up is because of leverage. And then you need to balance arrogance and humility. And I'll explain what I mean. When you buy anything, it's an arrogant act. You're saying, 'The markets are gyrating, and somebody wants to sell this to me, and I know more than everybody else, so I'm going to stand here and buy it. I'm going to pay an eighth more than the next guy wants to pay and buy it.' That's arrogant. And you need the humility to say, 'But I might be wrong.' And you have to do that on everything.

But are you different than Warren in terms of how Warren has evolved and how you have evolved? I mean, obviously, I think Charlie Munger had some influence on Warren in understanding not just to look for the classic example of the cigarette butts, but to look at things that were reasonably priced with the belief that they could be—that there still was a margin of safety.

First of all, a lot of my Charlie Mungers are out here in the audience, so a lot of people here that I bounce ideas off of and we share thoughts.

Warren evolved through three stages. He went from buying cigar butts and getting the last few puffs for free, to buying great businesses at really cheap prices, to buying and holding great businesses at so-so prices, and maybe even this new area of buying weird securities from crappy businesses at better than market prices, like BofA preferred or whatever. I'm still in phase one. We're still buying cigar butts. There's a good business there in buying them, and it's a lot of fun. And that's what you're proud of? No, I feel like I have stunted growth, Charlie. You know what? I think Buffett's a better investor than me because he has a better eye towards what makes a great business. And when I find a great business, I'm happy to buy it and hold it.

Most businesses don't look so great to me.

But he also doesn't, I mean, he is not really focused on the gyrations of the stock every day.

Me neither. You're not either? I don't have a Bloomberg on my desk. I don't care.

You don't have a Bloomberg on your desk? No. Because you don't... Mike makes enough. Well, what's on your desk then?

A phone? Giant piles of paper that are at risk of falling on me at any moment, and I have a computer and a phone.

So tell us about your desk.

Half-filled water bottles.

But you sit at a trading desk. When you're not meeting either clients or people that are going to give you some information that might be relevant to what decisions you have to make, you're sitting at a trading desk.

Thinking big thoughts.

Are you really? It's not so much because you are reacting to the volatility of every market that you're invested in. Because if you were a value investor, my assumption would be that you're not looking to trade in every moment.

We're not traders. There's a wonderful story. Chris Browne at Tweedy, Browne tells a story of how they were interviewing somebody to come and to come join their firm. And after the interview, he's walking the fellow to the elevator. And the fellow says, 'You know, it's amazing here at Tweedy, Browne. At most firms, you can tell from the atmosphere in the place whether the market's up or the market's down. At Tweedy, Browne, you can't even tell if the market's open.' And I think it's like that at our firm. We're making medium- to long-term investments, three to five years or longer. And so we're not really that interested. The only reason we care about the gyrations is so we can buy something even cheaper.

Do you like bad times, then?

You know, we benefit from volatility.

And distressed debt and everything else.

We provide liquidity when people want to sell things in a hurry. Presumably, it's a transaction between consenting adults. When somebody owns a bond that was AAA and now is CCC, they want to sell. They want liquidity. Our rhythm is opposite most of the market's rhythm. We buy things when the market's down. We sell things when the market's up. Do I root for bad times? Of course not. I love our country.

I didn't mean it that way, bad times.

Is it frustrating when the market goes straight up and up and up as it did from '82 to '87? It was frustrating, and I worry because just at those times, it's when the little guy gets sucked in, and the little guy finds it irresistible when the market's going higher and higher. The little guy gets pulled in by stories from their neighbors, stories from the cocktail party, and they hear about how much money people are making in the market. Charlie, you probably know this, but the return from all mutual funds in the 1990s was 600 basis points higher than the average return from the investors in those funds during the same period. And that's because they get in at the wrong time and out at the wrong time.

So that's painful to me.

So what is your lesson?

That's why I wrote the book, to try to educate the average person, but only like a few hundred of them read the book.

I hope I'm going to get a copy of this book. Can you talk to us about your philosophy of timing? Is there no philosophy of timing because you're looking at value and that you understand value? Essentially, the big decision for you is the buy decision more than the sell decision.

Buying is easier. Selling is hard. Hard to know when to get out. There's no timing element. You can never tell how big a bargain you might get offered tomorrow. If somebody comes along and wants to sell you a dollar for 50 cents, you can never know if they'll want to sell it to you at 40 cents tomorrow. So you need to buy it and leave a little room to buy more, and maybe someday spend your last dollar and buy the bargain, and maybe it goes down before it goes up. So you always are checking and rechecking your work. The critical thing, the thing that would cause you to lose your confidence when you're doing that, would be if you realized a dollar wasn't a dollar. You thought it was worth a dollar, but Greece failed or the euro fell or collapsed, and all of a sudden your dollar is only 30 cents, and now what you thought was a bargain is overvalued.

So that's the dilemma. It's not so much figuring out what it's worth today; it's making sure it'll still be worth that same thing or approximately that same amount tomorrow.

What's the biggest mistake you ever made? Have you made it? Coming here tonight. Oh my God, after I prepared so hard? No.

You know, I've been very fortunate. If you're talking about at work, I've never really screwed up a lot. We went through tumultuous times. We stuck to our discipline. We've made mistakes. They often are where we underestimated the leverage in the situation. We didn't think it was that big a deal. Leverage can magnify your returns, but it also magnifies your losses. Getting in bed with bad people—we've had investments where...

These are interesting points—getting in bed with bad people.

How does that happen, and how do you avoid that?

A lot of stocks are cheap for a reason, and often a value investor will figure out the reason because everybody else has gotten sick of a management raping and pillaging a company, overpaying themselves, deploying capital poorly, taking advantage of the shareholders with, with free stock or huge options awards, or hiring their brother-in-law. So, so there are stocks that have been perennially undervalued because they're run by somebody who fits that profile. A novice value investor will come along and say, 'Well, that looks awfully cheap,' and Graham and Dodd didn't really place the quality of management as high as they might have, and so... Good managements add value. Good managements have lots of levers they can pull.

They can buy back stock when it's undervalued. They can use the stock as currency when it's overvalued. Bad managements will think only about themselves first. And so those are early lessons, but profound lessons that I learned and learned them well.