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Seth Klarman’s Investment Framework

Margin of safety and risk aversion is Seth Klarman’s central

investment tenet. And risk aversion begins with defining a margin of safety for

your investments. In his book Margin of

Safety,
Klarman outlines three of the best ways to build a winning stock

portfolio:



·

Consider

the risk and downside associated with the investment before focusing on

potential returns.



·

Perform

a bottom-up approach on individual companies while ignoring the industry and

its connections with the economic cycle as a whole.



·

Evaluate

how the company achieves its returns and research why revenues and profits have

increased or decreased year by year.



The key to downside risk protection



In the current financial market

environment, unprecedented things are happening with surprising regularity. This is as true for our preparations

for financial disaster as for any other kind.

And when the memories of disaster,

along with worry and diligence, dim over time, it leads to complacency in

investors. Complacent investors naturally focus more on benefits and the focus

on benefits will lessen the concern over what could go wrong. It

is important to prepare your investments for stormy times and one way to do

this is to consider the downside protection an investment offers. Downside protection starts with understanding the

risks associated with the investment. When

the risks are identified, then the best course of action is developing a plan

for protecting against those downsides. One of the most

popular forms of downside protection is investing with a margin of safety.



As Klarman writes in Margin

of Safety
, "A margin of safety is achieved when securities are

purchased at prices sufficiently below underlying value to allow for human

error, bad luck, or extreme volatility in a complex, unpredictable and rapidly

changing world."

Klarman,

when giving a margin of safety, drives towards investments that provide adequate

balance sheet cash and low-risk collateral.

A

margin of safety doesn't guarantee an

investment will generate high returns but it provides room for error in an investor’s

judgment. In particular, it provides a cushion against any miscalculations

that may occur.

Miscalculations,

no doubt, will be inevitable because an investment’s intrinsic value is subject

to various interpretations by investors, which affect how large a margin of

safety investors will choose to set. In general, the bigger the margin of

safety set by investors, the less likely investors will suffer losses.



Why use bottom-up approach



Bottom-up investing focuses more on analyzing a specific

company and less on the the financial markets and economy as a whole. With

bottom-up investing, a thorough review of the company is done, paying close

attention to factors like financial stability and the conduct of management. This approach is commonly used

during instances where we think that individual companies can do well in an

industry that is not performing well. They pose great opportunities for value

investors because these types of companies are ones most likely to be

overlooked by the average investor.



Most investors naturally choose top-down investing, a

strategy focused on investing according to the market cycles and economic

environment, which tends to be a better measure of how the stock market is

performing as a whole. However, economies and industries are often too complex

for investors to gain useful insight.



Bottom-up investors ignore the markets and focus on specific

dynamics to get ahead of the game. They evaluate factors like competitive

advantage and management reputation.



Klarman

said the following to investors in his Baupost letter earlier this year: “Our

disciplined risk aversion throughout 2011 enabled us to avoid dangerous

temptations and remain focused on investments in our areas of strength and

competitive advantage.” Competitive advantage

comes down to two questions. Can the company raise prices for their products

while maintaining sales in a competitive environment? Can it continue to retain

customers as the business undergoes operational and technological changes? One

aspect for investors to keep in mind is that of technological change, a

constant threat to industries like retail stores and mobile communications. Best

Buy (BBY) used to be the go-to place where customers could shop for electronic

appliances but internet retail took that away. RIM (RIMM) used to be a model

company that produced phones for email on-the-go but competitors like Apple

(AAPL) and Google (GOOG) upped the ante and took away the value of RIM’s

products. These kinds of circumstances show that keeping up with trends

on a regular basis is a vital part of bottom-up investing.



Management reputation explains a company’s business model, a

measure of how the business makes a profit while delivering value to its

stakeholders. If

there is one theme that continually runs through the public statements of

billionaire investor Warren Buffett, it is the principle that investors should

only consider investing in companies with managers of competence and integrity. Buffett explains

that he likes managers who stick to doing what the company does best. He

declares, “The best business returns are usually achieved by companies that are

doing something quite similar today to what they were doing five or ten years

ago.” On the contrary, Buffett suggests investors to avoid companies with

managers who pursue growth for growth’s sake and acquisitions for the sake of

owning more. Like Buffett, Klarman is a deep value investor who thinks more

bottom-up than top-down.



Develop a framework for decision making



Outstanding investment returns are, indeed, hard to achieve.

But once investors take care of the risks and understand a company better, it

is possible to develop a strategy for generating better returns. Investors can increase

their chances at bigger returns by gaining an idea on how much cash a business

is generating, where it is coming from, and whether its origin is sustainable. According to Klarman, a company's share price often

fluctuates significantly in the absence of fundamental developments, such as

when a sizeable seller needs cash quickly. So how can investors

determine the sustainability of cash within the business? Reading through the

financial statements, focusing on the line items that affect cash generation,

and trying to remember key statistical numbers are just a few of the key steps.





When investors find the information they need, they need to

dig deeper into those numbers by examining sub-statements and reports that say

something about the numbers. These steps, taken altogether, will form the

foundation of a unique investing strategy for each value investor. Over time,

Klarman discovered a great strategy that produced a top-of-the-line stock

portfolio.



Four of Klarman’s stocks include PDLBioPharma (PDLI), Ituran

Location and Control (ITRN), BP (BP), and Microsoft (MSFT). What these

companies have in common are annually increasing total revenues, annually increasing

cash flows, and gradually decreasing operating expenses and debt. Additionally,

they show a clear value focus with P/E ratios no greater than 15. And even when

stocks like these go through a troubling period brought on by a sagging economy

or major scandal, they have an ability to bounce back.



The following sums up what Klarman tries

to do at Baupost: “We are always long-term oriented. We never attempt to gauge

near-term market movements; we have no edge there. We strive to make long-term

investments that have truly compelling risk-reward characteristics. We are

never afraid to stand apart from the crowd. We stick to our game plan, and

focus on areas where we are skilled and experienced.”



An investment framework

like Klarman’s is necessary to develop a winning portfolio. The framework

should include principles through which ideas and decisions are filtered. A sound investment process, most of the time

will lead to a good investment result. But ultimately, investor success in the long term is

shaped by how well we can develop and utilize our skills over time to

understand companies better.

About the author:

Matthew Indyke and Brian Zen
SUPERINVESTOR.net is an investment research co-op for next-generation super investors, analysts, and advisors.

Visit Matthew Indyke and Brian Zen's Website


Rating: 4.0/5 (30 votes)

Comments

Cornelius Chan
Cornelius Chan - 1 year ago
Excellent article. Thanks!
superguru
Superguru - 1 year ago
Klarman invests in cigar butts, many of which do not survive. So he is willing to take 100% downside risk.

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