Why Value Investors Are Different

Seth Klarman describes the qualities every value investor should have

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May 24, 2017
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From time to time, it pays to read the writings of value investor Seth Klarman (Trades, Portfolio). Over the years, Klarman has written thousands of pages of advice for investors on the topic of value investing and the psychology of investing, which provides some great insight for investors of all experiences.

Klarman on value investors

One of Klarman’s most memorable pieces is an op-ed published in the Feb. 15, 1999 issue of Barron’s. The piece is titled "Why Value Investors Are Different" and serves as a great reminder to all investors that markets can, and regularly do, become overvalued, at which point it may be best to sit back and watch the madness play out.

The article starts by detailing Warren Buffett (Trades, Portfolio)’s first purchase of Washington Post stock (now Graham Holdings Co. (GHC, Financial)) during the 1973 to 1975 bear market:

“The most dramatic and valuable lesson from the fabulous (and still counting) 50-plus-year investment career of Warren Buffett is the legendary account of his steadfast conviction amidst the 1973-75 bear market. He correctly identified by 1973 that the shares of companies such as the Washington Post were selling for but a fraction of the underlying business value represented by those shares. He observed that numerous buyers would readily pay several times the prevailing market price of Washington Post stock to buy the entire company...”

Klarman goes on to explain the reason why he picked this example is because “it evokes the memory of what happens in bear markets.” Specifically, “good bargains become even better bargains.” The Washington Post example is an excellent description of Buffett’s staying power, which helped him build the fortune he has today.

If Buffett had been panicked by the falling market in 1974 and 1975, he might have not only failed to add to his holdings but conceivably, might have also been forced out of his steadily dropping position.

Buffett did not care about what the rest of the market thought about the Washington Post, he just “valued the business and brought a piece of it at a sizeable discount.” Was he worried about risk? “Of course he was, but not those risks that were most pertinent to the shorter-term orientated, more rigidly constrained investors who were unwittingly making him wealthier every time they sold another share… Risk for them is not being stupid but looking stupid. Risk is not overpaying, but failing to overpay for something everyone else holds. Risk is more about standing apart from the crowd than getting clobbered, as long as you have a lot of company.”

Ignore the rest of the market

According to Klarman, the ability to ignore what the rest of the market is saying and invest in unloved securities despite deteriorating sentiment is what makes value investors different. He writes that value investors must have a “necessary arrogance” to make investment decisions that run contrary to wider market sentiment.

This arrogance, however, “must be tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard-working.”

The article goes on to describe the imaginary world of mega-growth fund manager Buff T. Warren, who, after racking up years of impressive performance figures, continues to buy high-growth stocks at high prices.

Klarman says, “Occasionally, one of Buff’s shooting stars falls to earth; fortunately, his compatriots at other mutual funds probably owned it in about the same proportion…He blows it out…he knows all his compadres are thinking the same thing and blowing it out too.”

Klarman’s point here is Warren is successful not because he is thinking differently to the rest of the mutual fund industry, but because the balance of the fund industry is buying the same stocks. Lost in his world is the art of contrary thinking, and even if his opinions differed to those of the rest of the industry, it is likely he would be out of a job.

The irony is Buffett’s portfolio would look similar to that of the fictitious Warren, but Buffett would be sitting on much larger profits as he would have been in before the rest of Wall Street. Put simply, it pays to act differently and in a contrarian nature. But to be able to succeed at this endeavor, you need to have plenty of patience and conviction in your own ideas.

Disclosure:Ă‚ The author owns no stock mentioned.

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