Seth Klarman (Trades, Portfolio) is considered to be one of the world’s best value investors. Klarman’s Boston-based hedge fund Baupost has achieved an average annual return of 20% for investors since inception despite the fact the fund usually holds around 20% of assets in cash.
These impressive returns despite the fund’s high cash weighting have earned Klarman a reputation as one of the market’s most astute investors, and his thoughts, published within Baupost’s quarterly and full-year letters, are always hot topics among investors of all disciplines.
Plenty of experience
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Klarman has been investing through multiple market environments, which means he is more experienced than most when it comes to riding out both bull and bear markets. Therefore, Klarman’s letters during periods of market excess and also periods of market distress are highly informative for the investor who wants to understand how to invest during uncertain times.
Today, there are a good deal of investors who believe the market is overvalued; with this in mind I thought it might be a good idea to take a look back at one of Klarman’s letters from the early 2000s when the tech bubble was still rife, and many value investors would have had a hard time finding opportunities in the market.
Baupost significantly underperformed the wider market from 1997 to 1999, but Klarman was undeterred by this poor performance, and he continued to buy U.S. equities right up until the year 2000. At a time when many believed value investing was dead and growth stocks were the future, Klarman ploughed money into value equities driving Baupost’s cash weighting down from 42.1% of assets at the half-year 1999 to 4.6% of AUM by April 2000, a time when the market was hitting a new all-time high almost every day.
Klarman wasn’t using his cash to chase the market higher. He was finding opportunities under rocks and placing high conviction bets on these opportunities.
Most of these opportunities, according to Klarman’s letters at the time, were companies that had fallen out of fashion, businesses that did not meet the demands of high-growth tech investors. These opportunities include spinoffs and so-called "boring companies" – businesses such as Stewart Enterprises, a death care provider that was certainly no internet stock superstar but was active in one of the most defensive businesses ever known.
Finding value in spinoffs
Spinoffs particularly attracted Klarman’s attention. Specifically, companies like Tenneco Inc. (NYSE:TEN), which split itself in two to unlock value. The larger spinco, Pactiv Corp., manufactured food storage and trash bags with a leading market share in many other plastic packaging products. After the spin, Pactiv's shares slumped, and the company's valuation fell to a level that was too hard to pass up. Klarman bought when the company was trading at around 10 times after-tax earnings and about 5½ times pretax cash flow.
Tenneco Automotive was the other spinco. This business also suffered from post-spin selling. From a market capitalization of several billion dollars, the company’s value declined to only $200 million after the spinoff, pushing it out of the Standard & Poor's 500 and forcing many funds to sell. Klarman started buying when the company was trading at four times after-tax earnings – an excellent value opportunity. Harcourt General and Chemfirst were two other spinoffs acquired at single-digit multiples with high insider ownership and appealing long-term growth forecasts.
Other high conviction bets included two liquidation situations where Klarman’s research showed the underlying assets were worth significantly more than quoted company market capitalizations.
Outside the U.S.
Not only was Klarman finding value in the U.S. during this period, but he also invested in Europe acquiring Chargeurs (XPAR:CRI) – a French company trading wool and other fabrics – and Saab (OSTO:SAAB B), a Swedish defense business. At the time, both were trading at around seven times earnings despite an impressive record of historic growth.
The key takeaway from Klarman’s year-end 2000 letter is that no matter what the market environment, investors can always find value somewhere. In the dot-com bubble, old-fashioned, boring businesses offered value as well as spinoffs and special situations. Today, similar opportunities will exist; it just depends on how much time and effort you are willing to put in to look under the rocks.
Disclosure: The author owns no stock mentioned.
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