When it comes to value investing, Seth Klarman (Trades, Portfolio) is without a doubt one of the foremost authorities on the subject.
Klarman's specialty is research; he's willing to go the extra mile to uncover value wherever it can be found. This is Klarman's edge. Unlike a significant portion of other active managers, who don't research opportunities on a granular level, Klarman and his team at Baupost have a rigorous due diligence process, which means they can spot opportunities most other analysts might miss.
Klarman has never really laid out his whole analysis process or checklist for what he looks for in a particular investment. If you look through Baupost's equity portfolio, you'll see a collection of securities with mixed credentials; some seem to offer immediate value, others not so much. So it's always interesting to read through any insight Klarman has given into his process over the years.
One resource I recently stumbled on is this article on Klarman in the SuperInvestor Digest. The article is a summary of a lecture Klarman gave to students at the Colombia Business School in 2003, which outlines some of his processes. The comment has been intertwined with other insights provided over the years.
The full report is 11 pages long, so I've only included two stages of his research process below.
Incomplete information versus thorough research
"No matter how extensive your research, no matter how diligent and smart you are, the diligence has shortcomings. Some information is always elusive; hence you need to live with incomplete information. Knowing all the facts does not always lead to profit."
"Use the '80/20 rule.' The first 80% of the research is gathered in the first 20% of the time spent finding that research."
"Business information is not always made available, and it is also 'perishable.' High uncertainty is frequently accompanied by low prices. By the time uncertainty is resolved, prices are likely to have risen," said Klarman.
Klarman believes that you can make decisions quicker, with out all of the information, and take advantage of the time others use to look and delve into the same information. This extra time can cause the late and thorough investor to pay a higher price for a clearer and cheerer consensus.
"Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat. The research process itself, like the factory of a manufacturing company produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market," he wrote in 'Margin of Safety.'
Research today, will provide the fruits of tomorrow. While Buffett thrives on "masterful inactivity" and sitting on a few permanent investments, Klarman believes that an investment program will not succeed if "high-quality research is not - performed on a continuing basis."
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Reinspect the bargain for possible flaws
"If you see a company selling for what you consider to be a very inexpensive price, ask yourself, 'What is wrong with this company?' Just like Charles Munger advised: 'Invert, always invert.'"
"A bargain should be inspected and reinspected for possible flaws," advised Klarman. "Possible flaws might be the existence of contingent liabilities or maybe the introduction of a superior product by a competitor."
"Value investing by its very nature is contrarian: They are typically initially wrong, since they go against the crowd, and the crowd is the one pushing up the stock prices. Value investors will, for a period of time (and sometimes a long time at that) will likely suffer 'paper losses.'”
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