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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Seth Klarman Explains Graham-Style Value Investing

The Baupost Group founder gives a history lesson for investors

November 24, 2020

Like many other value investors, Seth Klarman (Trades, Portfolio) owes a debt of gratitude to Benjamin Graham. Graham, who in 1934 published "Security Analysis" (often considered to be the Bible of value investing), laid down the groundwork for investors like Warren Buffett (Trades, Portfolio) and Klarman who would follow him later on. In a 2009 interview (with the appropriately named Ben Graham Center for Value Investing), Klarman broke down Graham's investing philosophy and explained why the best investors don't just follow a rigid set of rules.

Liquidation value is what matters most

Graham's big insight was to value businesses with reference to how much could theoretically be recouped from a total sale of all of its assets. Klarman explained this idea in greater detail:

"The classic principle that Graham espoused is the 'net-net working capital test', where he said that if you can buy a stock for less than two thirds of its net working capital [working capital minus liabilities], that that would be a real bargain. The reason for this is that you're basically buying the business for less than its liquidation value. It doesn't mean you'll actually liquidate the business, but it means that if someone wanted to do so, you would have a risk-free profit."

Moreover, not only does the investor in a Graham-style net-net have the security of knowing that their investment is protected by the value of the assets in the business, they also have the potential for greater returns if the company does turn around and start to do better. This rule of thumb was very useful during the Great Depression - when Graham outperformed many of his peers - because investor sentiment was so depressed that there were many businesses that were selling for less than the value of the assets stated on their balance sheets.

This approach is arguably less relevant in today's economy, when many businesses derive value from intangible assets, but there are still many markets where it can yield good returns. For instance, many American value investors have looked abroad in places like China and Eastern Europe for businesses that sell at below book value.

With that being said, Klarman doesn't believe that one should aim to become a successful investor simply by following a simple set of rules - "painting by numbers," as he calls it. Why follow a mathematical formula when you can apply your own logic and reasoning to find the companies that offer the best bargains? After all, not every company that seems cheap is actually well priced. Many are value traps - maybe they have bad inventories, or maybe their receivables cannot be recouped, or maybe the value of their assets is simply overstated.

There are around 6,000 publicly traded companies on the New York Stock Exchange and the Nasdaq today, and most of them are not worth your time at all. It is, therefore, prudent to weed out the weaker options early on using some kind of systematic thinking. Learning how to apply mathematical formulas and valuation ratios is important if you want to narrow down the universe of potential investments, but you should never solely rely on them. Many of the best investors today merge a quantitative "filter" with their own critical thinking. Value investing is an art as much (and possibly more) as it is a science.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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