Seth Klarman (Trades, Portfolio) is widely considered to be one of the best value investors of the past few decades.
His book, "Margin of Safety," which is now out of print, is arguably the second-best value investing book in the world after Benjamin Graham's legendary text, "The Intelligent Investor."
Klarman's advice on value investing is always worth listening to, no matter how long ago he made the comments.
The guru's recent letters to investors of his hedge fund, Baupost, are always well covered in the media. However, his earlier letters attracted much less attention when they were first published.
These letters contain some fascinating nuggets of information from the legendary value investor.
Valuable insight
Klarman has always cautioned against using a relative performance orientation.
Instead, he believes investors should always be targeting an absolute positive performance, rather than just trying to beat the market.
In his 1990 letter to investors, Klarman explained why:
"We have always cautioned against a relative performance orientation, and while it is at times uncomfortable to stand apart from the crowd, we would rather be uncomfortable than poorer. Increasingly, our portfolio is oriented away from market-sensitive securities in favor of event-sensitive securities with catalysts in place to realize value. More of our portfolio is in fixed income securities than ever before; we are delighted to have senior credit status, a high current income and a fixed-maturity while earning rates of return more typically earned on equity investments. We have frequently pointed out the difficulty of evaluating investment performance. In particular, while it is easy to compare returns, it is difficult to assess risk. After investments are made… return is known, but no more is known about risk than before."
Put simply, it seems Klarman was trying to explain that he'd rather have a lower, predictable positive return than invest in a stock that may have the ability to produce a large return, but with no predictability over when the return may materialize, or if it will be positive.
Later in the letter, he revisited this relative value principle. He explained that the hedge fund always wanted to own "the best values." He wrote:
"We always want to own the best values, the most undervalued securities. If that means that we have to sell something we bought a month ago to buy something better, we will. If that means taking a loss on something we expect will recover in order to buy something even cheaper, we will. Buying the best relative value accomplishes two things. It ensures that you will earn the highest possible return over time by continuously purchasing the best bargains. More importantly, this maximizes one's margin of safety, thereby minimizing risk for the portfolio."
Summing up
These are just two insights from Klarman's 1990 letter, and they're also only two quotes from his lengthy career as a hedge fund manager. Nevertheless, they sum up his investment strategy quite well. Klarman has never been interested in chasing the rest of the market; he's only interested in value.
That means Klarman won't buy companies just because everyone else is. He wants to own securities that he knows and understands, and that also have an upcoming catalyst.
Historically, this has meant that he's owned a lot (around a third of Baupost's portfolio) of credit investments. These assets are a lot more straightforward to value (particularly with senior secured securities) and usually have a fixed realization date (either redemption or liquidation).
This strategy might be challenging for the average investor to replicate, but we can still learn a lot from Klarman's approach to the market.
Read more here:
- Warren Buffett on Options Trading and Black-Scholes
- Hunting for Deep Value in Frontier Markets
- Why Is Buffett Not Interested in Buying Real Estate?
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