Seth Klarman (Trades, Portfolio) is one of the world's most successful value investors. He's also one of the most cautious hedge fund managers around.
Klarman is the manager of the Baupost hedge fund, and he's never 100% invested; his entire investment process is based on avoiding risk.
Critics might argue that by following this approach, Klarman is risking his performance. That is true, to a certain extent. If Klarman wanted to match or beat the market for multiple isolated years, he would need to invest 100% of assets every year.
But that's not what he is trying to do. Instead, Baupost's overriding long term aim is to generate a positive absolute performance year after year. Evidence suggests Klarman has been able to meet this goal with a cash balance exceeding 40% on some occasions.
The value manager believes that having a high level of liquidity is critical for investment success over the long term. Liquidity gives flexibility, and while it may also result in reduced returns during bullish market conditions, this is a price worth paying for the flexibility of cash, according to Baupost's manager.
In his book "Margin of Safety," Klarman wrote:
"Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. Few investors require a completely liquid portfolio that could be turned rapidly into cash. However, unexpected liquidity needs do occur. Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it."
He went on to say that investing is, in some ways, an "endless process of managing liquidity." Buying, selling, managing and collecting mature investments is all part of portfolio management.
This "liquidity cycle" serves an essential purpose, Klarman noted. Firstly, cash flowing into a portfolio can reduce opportunity costs and the costs of missed opportunities. Secondly, the periodic liquidation of parts of a portfolio has a cathartic effect:
"For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings.
'Dead wood' can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available."
Coming from an investor who has spent most of his time advocating a long-term investment horizon, this advice might seem out of place. However, as well as advocating a long-term investment horizon, Klarman has also always emphasized how important it is for investors to continually review their portfolios and make sure investments hold to the initial acquisition thesis. If the thesis changes, they should be sold.
Klarman isn't the only investor that's advocated this approach. Charlie Munger (Trades, Portfolio) also believes that it is crucial to break down your investment ideas regularly. Doing so will help you avoid falling into any value traps, while at the same time freeing up cash to take advantage of new opportunities.
This can be a hugely challenging psychological process. It requires critical thinking and the willingness to take a loss if a position isn't working out.
Both Klarman and Munger have built this into their investment processes. Klarman tends to target investment opportunities with an endpoint, such as liquidation situations or bonds. This gives a set date for value realization.
Munger, on the other hand, only invests when he's really sure that an opportunity is as good as it first appears. This means he only owns a few investments in his personal portfolio, but this limited number of holdings is easier to manage and understand.
Both of these are interesting models that accomplish the same goal.
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman: You Need to Have an Edge
- Anatomy of the Bear: How to Navigate Bear Markets
- Is There Value in the Oil Patch
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