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Seth Klarman on the Art of Complex Deep Value Investing

September 27, 2006

Seth A. Klarman, President of The Baupost Group, averaged about 20% per year for 24 years with only one negative year. This digest of Seth A. Klarman’s investment strategies and practices is mainly based on a guest lecture by superinvestor Seth Klarman at Columbia Business School and his book, Margin of Safety. Many sections here are not Klarman’s exact words, but our digest of the distilled essence of his investment methods. (The following is an exclusive excerpt from Superinvestor Digest’s September issue.)

LOOK FOR MISPRICING

¨ “If only one word is to be used to describe what Baupost does, that word should be: ‘Mispricing’. We look for mispricing due to over-reaction,” said Seth Klarman.

¨ “At Baupost, we constantly ask: ‘What should we work on today?’ We keep calling and talking. We keep gathering information. You never have perfect information. So you work, work and work. Sometimes we thumb through ValuLine. How you fill your inbox is very important,” said Klarman.

  • Look for forced selling, supply-demand imbalance.
  • “Investors can not predict when business values will rise or fall. Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods.”
  • “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,” wrote Klarman.

FOCUS ON THE RISK BEFORE FOCUSING ON THE RETURN

¨ Seth Klarman’s foremost principle of operation is to maintain a high degree of risk aversion.

  • Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1.
  • Klarman believes that the primary goal of value investors is to avoid losing money.
  • There are three key elements of Klarman’s value-investment strategy.
  • A bottom-up approach, searching via fundamental analysis.
  • Absolute return strategy.
  • Pay attention to risk.

¨ If you have $1 million and we flip a coin: head, you win an additional $1 million. Tail, you lose your $1 million. In terms of probability, this is a fair bet. But few people would be willing take this bet due to the possibility of losing everything.

¨ [SiD Notes] 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.

¨ 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.

¨ 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?”

  • Keep some cash in the side pocket so there will be no forced liquidation. Duration of the investment should be equal to the duration of the capital.

RISK = (AMOUNT OF LOSS) X (PROBABILITY OF LOSING)

  • Klarman defines risk as both (1) how much is the potential loss and (2) what is the probability of losing.
  • An investor can counteract risk by diversification, hedging (when appropriate) and invest with a margin of safety.

¨ To Klarman, using beta and volatility to measure risk is nonsense. “Beta = 0.7. What the hell doesn’t that mean?” asks Klarman.

¨ 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.

¨ However, if you short a stock, your loss would be bigger and bigger. The amount of your potential loss is infinite.

  • Klarman doesn’t do “long and short”. They bought puts on Korean Government Bonds to sell the bonds at par.
  • The greater the risk, does not necessarily mean the greater the return. Risk erodes returns because of losses.
  • Klarman believes that the long-short crap is trying to make things too complicated.
  • A Value Investment Philosophy: Klarman stresses that the future is unpredictable. Investors must be prepared for any eventuality. The river may overflow its banks only once or twice in a century, but you still buy flood insurance.
  • 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.

THINKING ABOUT “AUTHENTIC” VALUE INVESTING

  • "I think growth investing is a stupid style. Bet on the two horse at Philadelphia Park and you'll do well from time to time," said Seth Klarman.
  • Beware of value pretenders. These investors apply a dip strategy. They buy what's down, not what's cheap.
  • Look at investments as "fractional ownerships."
  • No book or lecture alone will turn anyone into a successful value investor. Value investing requires a great deal of hard work, unusually strict discipline and a long-term investment horizon.
  • Klarman believes that his book, Margin of Safety, is a blueprint that, if carefully followed, offers a good possibility of investment successes with limited risk. He describes the book as one about "thinking about investing."
  • Understand why things work. Memorizing formulas is not enough.
  • Study the behavior of investors and speculators. Their actions "often inadvertently result in the creation of opportunities for value investors." 

THREE WAYS TO INVESTMENT PROFITS

  • From the free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.
  • From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.
  • Or by closing the gap between share price and underlying business value.

SEARCH STRATEGY

¨ Spin-offs: Complete lack of information in spin-offs.

¨ Forced selling by index funds.

¨ Forced selling by institutions: Big mutual funds are often forced to sell tainted names.

¨ Disaster De Jour: accounting fraud, earnings disappointment,

¨ Bankruptcy: Unfavorable leases can be terminated. Bond investors tend to sell the recycled equity in a hurry.

¨ Graham-and-Dodd deep value: Discount to breakup value, P/CF < 10.

¨ 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.

¨ 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.

  • No self-imposed constrains. No capitalization requirements.
  • Adversity and uncertainty create opportunity.

VENTURE INTO COMPLEXITY

  • If the security is hard to understand and time consuming, many of the analysts and institutions will shy away from it. He identifies this as "fertile ground" for research.
  • Spin-offs: The goal of a spin-off is for the former parent company to create greater value as a whole by spinning off businesses that aren't necessarily in their strategic plans. There is complexity and the 2 to 3 month time lag of data flow to the computer databases.
  • Bankruptcies: Look for Net Operating Losses as a potential benefit. The beauty of investing in bankrupt companies is again the complexity of the analysis. During a bankruptcy, costs get leaner and more focused, cash builds up and compounds with interest. This cash buildup can simplify the process of reorganization, because all agree on the value of cash.

About the author:

Dr. Zen
Brian Zen, CFA, PhD, author of "Superinvestor Lecture Notes", serves as Chief Investment Strategist at Zenway Group, a New York-based registered investment advisory firm providing asset management services, training Certified Securities Appraisers (CSA), and teaching Graham-Buffett Value Investing. Previously, Brian served as vice president at JPMorgan Chase and portfolio manager at Prudential-Bache Securities and Janney Montgomery Scott, while teaching graduate-level investment analysis at St. John's University. Brian was a Bernard Baruch Fellow and graduated summa cum laude from Bernard M. Baruch College. He is also a graduate of Columbia University's executive program in value investing. Brian appreciates your feedback at: bzen@zenway.com

Visit Dr. Zen's Website


Rating: 4.0/5 (74 votes)

Comments

vooch
Vooch - 8 years ago
Yan (or Brian),

Thank you very much for your post. I'm a Klarman fan!

I really appreciate it.

Thanks,

Vooch

jimmyrhee
Jimmyrhee - 8 years ago
Brian,

Thanks for sharing your research on great investors.

Tersely put: It's very insightful!

Big thanX!
cecorrell
Cecorrell - 8 years ago
Thanks for sharing your investment knowledge with us.I'm an fellow investor in TRMM ,of which Seth Klarman and The Baupost Group are Big Holders.Having bought TRNN,recently and upon researching Top Holders I'm glad to find I'm in the company of stock experts ,who also see value in the formentioned company.
remilbautista
Remilbautista - 8 years ago
This is a very useful site. Thank you
Bob Wade
Bob Wade - 7 years ago
I like his philosophy

Please leave your comment:


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