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Robert Stephens, CFA
Robert Stephens, CFA
Articles (374) 

Seth Klarman on Investing After a Stock Market Gain

A focus on value could lead to efficient capital allocation

June 24, 2020

The S&P 500 has risen 40% since reaching its March 2020 low, despite the economys increasingly uncertain outlook.

This could cause a quandary for value investors. They may be tempted to keep hold of and add to their existing positions. However, at the same time, they are likely to be concerned about the potential impact of a weak economy on their portfolios performance.

Baupost Group founder Seth Klarman (Trades, Portfolio) has a successful track record in apportioning his capital. In my opinion, his insistence on obtaining a margin of safety and his willingness to sell overvalued stocks could be useful strategies to adopt in todays market conditions.

Selling existing holdings

The stock markets recent gains mean that some companies could now be overvalued. Even if they are still trading below their highest levels from earlier in the year, their financial prospects may have deteriorated due to the economys weak outlook.

Therefore, selling certain stocks could be the better option. It could mean that you are able to reapportion the sales proceeds to other stocks that are priced at a greater discount to their intrinsic value.

Holding stocks simply because they have risen recently could be detrimental to your returns. It can lead to an opportunity cost, since you will miss out on companies that offer better value for the money.

As Klarman once said, "Selling, in particular, can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it.

Seeking a margin of safety

It may be tempting to buy stocks without assessing their valuations following the markets recent rise. You may feel that because investor sentiment is improving, there is scope for further price increases.

However, a rising stock market means that the margins of safety on offer could be narrower than they were previously. A smaller margin of safety provides a reduced "buffer zone" in case potential risks come to fruition, or a companys performance disappoints. Therefore, investing now may be riskier than it was a few months ago when stock prices were lower.

Demanding a wide margin of safety could protect your capital against risks in an uncertain economic environment. It may also force you to wait for more attractive prices that could appear during a volatile period for the stock market.

As Klarman once said, Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.

Market efficiency

The stock markets volatile performance in 2020 has highlighted its inefficiency. Investors have been highly emotional in response to concerns about the economys outlook, and then with regard to its potential recovery.

Market inefficiencies are likely to remain a constant over the long run. Investors usually overreact during periods of economic growth and decline. Therefore, there may be buying opportunities ahead for value investors due to the uncertain future faced by the economy. Its challenging prospects may allow investors to capitalize on rapidly-changing sentiment among their peers to purchase quality companies when they trade at low prices.

Klarman has previously highlighted that market inefficiency is likely to remain present over the long run, saying, "I think markets will never be efficient because of human nature.

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