I keep a file with notes I’ve collected that I try to read every few months to keep my head focused on what is important when investing. I recently read again parts a transcript of a guest lecture done by Seth Klarman, President of The Baupost Group. Mr. Klarman has done ok for himself having averaged about 20% per year for almost 25 years with only one negative year.
Given the fantastic returns Klarman has provided investors while also always focusing on downside risk we should listen carefully whenever he is generous enough to share his wisdom.
Klarman on where to find investment opportunities:
1) Spin-offs: Complete lack of information in spin-offs.
2) Forced selling by index funds.
3) Forced selling by institutions: Big mutual funds are often forced to sell tainted names.
4) Disaster De Jour: accounting fraud, earnings disappointment. Adversity and uncertainty create opportunity.
5) Bankruptcy: Unfavorable leases can be terminated. Bond investors tend to sell the recycled equity in a hurry.
6) Graham-and-Dodd deep value: Discount to breakup value, P/CF< 10.
7) Catalyst: tender, Dutch auction, spin-off. There are lots of competition from many event-driven hedge funds. Savings and loans conversions are often undervalued because they are only available to depositors and insiders.
8) Real estate: During the slump of 1992, the government had not been sophisticated sellers of real estate. You could buy properties at half of building costs. And there are far less competition in real estate.
Clearly Klarman has a lot of different tools in his kit to work with. He will look at spin-offs, bankruptcies, real estate and on and on. This is a style that is not going to be easy to imitate given his wide range of expertise. I think this is why Charlie Munger has said that Buffett keeps getting better and better. Investing is a game where cumulative knowledge pays off. Something you learned 10 years ago might be useless for a decade, but when a similar situation pops up again you are ahead of the game because you have seen it before.
Klarman also makes some important comments about risk and how focusing on it should be the most important thing an investor does:
a) Klarman’s foremost principle of operation is to maintain a high degree of risk aversion.
b) Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1. (must have borrowed from Buffett)
c) Klarman believes that the primary goal of value investors is to avoid losing money.
d) The key is (1) to limit your bets on situations where the probability of winning is way above 50% and (2) the downside is limited.
e) Cash is the ultimate risk aversion. But clients are uncomfortable. Why people should pay a money manager to hold cash? They are paying the manager to wait for the opportunity to invest.
f) Think of the asset-under-management as if it is your own money. What other people think doesn’t matter any bit. Ignore questions like “How does it look to our clients and peers?”
g) To Klarman, using beta and volatility to measure risk is nonsense.
h) As a stock falls big time, the risk should be less. As the stock goes lower and lower, the risk would become less and less. If you back up the truck and buy 51% of the company, you would be able to force the outcome with control. That’s the benefit of averaging down.
i) An investor looking for a specific return over time, does not make that goal achievable. Targeting investment returns leads investors to focus on potential upside rather on downside risk. Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.
If an investor always makes investment decisions with priority number one being to not lose money it would be very difficult over time to not achieve at least satisfactory returns. If that rule were to be combined with the patience to wait until those low risk opportunities are also very cheap all the better.
Given the fantastic returns Klarman has provided investors while also always focusing on downside risk we should listen carefully whenever he is generous enough to share his wisdom.
Klarman on where to find investment opportunities:
1) Spin-offs: Complete lack of information in spin-offs.
2) Forced selling by index funds.
3) Forced selling by institutions: Big mutual funds are often forced to sell tainted names.
4) Disaster De Jour: accounting fraud, earnings disappointment. Adversity and uncertainty create opportunity.
5) Bankruptcy: Unfavorable leases can be terminated. Bond investors tend to sell the recycled equity in a hurry.
6) Graham-and-Dodd deep value: Discount to breakup value, P/CF< 10.
7) Catalyst: tender, Dutch auction, spin-off. There are lots of competition from many event-driven hedge funds. Savings and loans conversions are often undervalued because they are only available to depositors and insiders.
8) Real estate: During the slump of 1992, the government had not been sophisticated sellers of real estate. You could buy properties at half of building costs. And there are far less competition in real estate.
Clearly Klarman has a lot of different tools in his kit to work with. He will look at spin-offs, bankruptcies, real estate and on and on. This is a style that is not going to be easy to imitate given his wide range of expertise. I think this is why Charlie Munger has said that Buffett keeps getting better and better. Investing is a game where cumulative knowledge pays off. Something you learned 10 years ago might be useless for a decade, but when a similar situation pops up again you are ahead of the game because you have seen it before.
Klarman also makes some important comments about risk and how focusing on it should be the most important thing an investor does:
a) Klarman’s foremost principle of operation is to maintain a high degree of risk aversion.
b) Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1. (must have borrowed from Buffett)
c) Klarman believes that the primary goal of value investors is to avoid losing money.
d) The key is (1) to limit your bets on situations where the probability of winning is way above 50% and (2) the downside is limited.
e) Cash is the ultimate risk aversion. But clients are uncomfortable. Why people should pay a money manager to hold cash? They are paying the manager to wait for the opportunity to invest.
f) Think of the asset-under-management as if it is your own money. What other people think doesn’t matter any bit. Ignore questions like “How does it look to our clients and peers?”
g) To Klarman, using beta and volatility to measure risk is nonsense.
h) As a stock falls big time, the risk should be less. As the stock goes lower and lower, the risk would become less and less. If you back up the truck and buy 51% of the company, you would be able to force the outcome with control. That’s the benefit of averaging down.
i) An investor looking for a specific return over time, does not make that goal achievable. Targeting investment returns leads investors to focus on potential upside rather on downside risk. Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.
If an investor always makes investment decisions with priority number one being to not lose money it would be very difficult over time to not achieve at least satisfactory returns. If that rule were to be combined with the patience to wait until those low risk opportunities are also very cheap all the better.
