Seth Klarman (Trades, Portfolio)'s latest letter to investors of his Baupost hedge fund is a timely reminder that we are not in a typical market environment.
Anyone who's paid close attention to the investor's writing over the past few decades will know that this is a man who is a dedicated value investor. He's also extremely smart and has a deep understanding of financial markets.
No limitations
Baupost is a relatively unique vehicle because there are virtually no limitations on where it can invest. The hedge fund can own stocks, distressed debt, insurance claims, real estate and credit default swaps. Wherever the fund sees value, it is happy to take a position.
That being said, Klarman's favorite asset is cash. Over the years, he has repeatedly declared his love for cash, and at the end of 2019, Baupost's cash balance was 31%, which is around average for the firm.
Since Baupost's annual letter for 2019 was published, there's been quite a lot of focus on Klarman's comments with regards to value investing. In the letter, he laments the struggles of value over the past few years. He then goes on to declare that the style will return to fashion at some point in the future.
However, what most articles on the letter have failed to highlight are Klarman's comments on the rising number of value opportunities in the market.
Value still exists
While the main indexes are trading close to all-time highs, outflows from active funds to passive instruments are having a profound impact on smaller, "unloved" stocks. Klarman reports in his letter that "capital outflows of late seem to be resulting in less efficient pricing, and emergent bargains are becoming even more compelling for those who can hang on and grow their exposures."
The value investor goes on to declare that in this environment, Baupost remains fixed on its long-term investment objectives. "For Baupost," Klarman wrote, "investing is not a sprint but a marathon... Over the long run, major mispricings are eventually corrected -- the share price and value of a business tend to converge -- because short-term illusions are pierced, and enduring characteristics become more apparent."
We can learn a lot from these words. Klarman's entire investment strategy is based on reducing risk. He's happy to buy good companies if they are trading at good prices.
The higher the price of the company, the higher the chances are that it won't produce attractive returns. This has been a factor of investing for decades. If you buy a stock at a low valuation, there is a much higher chance that it will generate an outsized return with a reduced level of risk.
Lots of attractively priced high-quality companies
Looking at his comments, it appears that Klarman is suggesting the current market environment is throwing up lots of attractively priced high-quality companies that long-term value investors can commit capital to without taking on too much risk.
These companies are unlikely to outperform the market in the short term, especially if money continues to flow into passive index tracker funds (which benefits large-cap tech stocks disproportionately), but over the next five or ten years, there is a good chance that this anomaly will correct itself.
Critics of this argument will say that just because a stock is cheap, it does not necessarily mean it is a good investment, and it could remain cheap for the next ten years.
That is true. However, it is better to own a high-quality cheap business for a decade than trying to speculate on the share price of a low-quality enterprise just because it is popular with the rest of the market and seems to be growing at a rapid clip.
Value investing is not just about buying cheap stocks. It is about buying good businesses at attractive prices.
Read more here:
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