Seth Klarman (Trades, Portfolio) is, in my opinion, one of the best value investors of all time. He excels at finding value wherever it can be found, and he's willing to put in the legwork to search under every rock to find hidden value, no matter how complex the opportunity is to understand. If there's money to be made, Klarman will try and find it.
It has been reported that Klarman is currently raising money from his investors to take advantage of opportunities cropping up in the current market. That suggests he's found some bargains that are worth buying after the market's recent slump.
Buying securities at a significant discount
"Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of the bargain is key to the process."
The most prominent problem investors face in the current market environment is uncertainty. The global outbreak of Covid-19 has sent markets into a tailspin because it is difficult to predict what impact the combined supply and demand shock will have on the global economy.
In this environment, traditional value metrics such as cash flows, earnings and dividend growth have become mostly irrelevant. Instead, investors must look to asset values (aka liquidation value) to determine a company's underlying value.
Klarman has plenty of experience of this. Therefore, his guidance could be highly valuable for investors seeking value in the current market.
Klarman's four tips for liquidation value investing
According to Klarman, there are four main points investors should be aware of when using liquidation value to analyze an investment opportunity.
First off, investors need to understand the difference between an orderly liquidation process and a fire sale. A fire sale can have a significant impact on liquidation values. Companies that don't have a lot of financial flexibility can be forced into liquidation fire sales, as they have to raise cash at any price. In these scenarios, reported asset values go out the window. Companies can only get what others are willing to offer for the assets.
The best way to avoid these situations is to stick with companies that have low levels of borrowing relative to assets. If a business has a high level of debt, lenders can end up dictating the situation. That is never a good outcome. This applies to both companies and individual investors' balance sheets.
Klarman's second piece of advice is to be aware of the impact of operating losses on working capital. Company financial statements only provide a snapshot of a business's financial position at one point in time.
As such, while it may look as if a business is well funded based on year-end statements, these figures may be several months out of date. Rising losses will deplete cash balances at an alarming rate. This is especially true in the current environment, when many businesses have lost 100% of their income. Revenues have collapsed, but costs will be harder to reduce. This will reduce financial flexibility and erode liquidation value.
Off-balance-sheet liabilities are another area investors need to keep an eye on, according to Klarman. Underfunded pension plans and subsidiaries loaded with debt can be particularly damaging.
Klarman reportedly made a lot of money for his investors by working through the complexities surrounding Enron and Lehman Brothers' collapse and buying their debt. He believed the debt was worth more than the market was implying based on an analysis of these companies' off-balance-sheet businesses and assets. As it turns out, he was right.
Finally, Klarman believes investors should be aware of the value of intangible assets. Tangible assets such as retail assets or industrial equipment often have multiple uses, which means they can be sold off and repurposed in the worst-case scenario. That makes liquidation value more reliable. Intangible assets such as goodwill and brand value are harder to repurpose. That denotes the margin of safety and net asset value are less reliable.
Disclosure: The author owns no share mentioned.
Read more here:
- Personal Finance Lessons From Warren Buffett's Clayton Homes
- Warren Buffett's 2008 Letter: 4 Tips for Investors in Uncertain Times
- Warren Buffett's Advice From 2009: Focus on the Market's Long-Term Potential
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