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Rupert Hargreaves
Rupert Hargreaves
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Seth Klarman: Why Value Investing Works

Thoughts from the value investor's 1997 letter to Baupost investors

February 23, 2021

One of the best resources available to investors, in my opinion, is the historical letters Seth Klarman (Trades, Portfolio) wrote to investors of his hedge fund, The Baupost Group, from 1996 to around 2002.

Throughout this time frame, the market experienced one of its most volatile periods on the record. The dot-com bubble and the subsequent crash made value investors look bad on the way up, but they were handsomely rewarded on the way down. Growth investors were handsomely rewarded on the way up, but they struggled when the market fell.

Klarman has always been a value investor, so this was a particularly trying period for the hedge fund manager. This comes across in his letters to investors. As such, his advice and correspondence over this time can be used as a sort of roadmap to help investors navigate other periods of market excess.

Baupost's investor letters

In 1997, Baupost returned 20.7% while holding 20% of net assets in cash. The fund underperformed the S&P 500 during this period, which returned 32%.

In his letter, Klarman explained that the fund deployed capital throughout the year into businesses that Baupost thought were undervalued. It stayed away from companies that it believed were overvalued, selectively deploying capital into "wonderful, long-term values."

The problem with buying stocks without any consideration of their underlying fundamentals, the value investor explained, is that it becomes difficult to stick with these investments in times of uncertainty.

"I must remind you that value investing is not designed to outperform in a bull market," the hedge fund manager wrote. "In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors." However, he went on to add that value investing only really becomes important in a bear market:

"It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk. In a stormy market, the value investing discipline becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible. In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don't like their charts. But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value."

That is the critical advantage of value investing over other styles of investing. Other types of investing do work. Momentum investing can produce high returns, and so can growth investing.

The trouble is, while these strategies can make returns for a period, they will stop eventually. And when they stop working, there's nothing to hold on to when the market turns against you. No investor can ever predict the future. It's impossible to say what's going to happen next for equities. That's why value works, according to Klarman:

"And, because you cannot tell what the market is going to do, a value investment discipline is important because it is the only approach that produces consistently good investment results over a complete market cycle."

Of course, when Klarman talks about value investing, he's referring to the principle of buying an asset for less than it's worth, not buying stocks that look cheap on some arbitrary metric such as price-book or price-earnings.

These days, companies with low traditional valuation metrics are often struggling or failing businesses that deserve a low valuation. The key is to have an edge in the market and look for value where others may not be able to find it.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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