When it comes to understanding the investment principles of Seth Klarman (Trades, Portfolio), there are two prongs to his strategy that I believe are usually overlooked by investors.
Indeed, everyone knows Klarman for his landmark text on value investing, "Margin of Safety," and the investment ideas that are contained within. But when you really dig down into his strategy you'll find there is a lot more to the way he invests than just buying cheap stocks with a wide discount (margin of safety) to their intrinsic value.
And the to prongs that I believe are most overlooked are his keen focus on risk and willingness to hold cash.
Risk and cash
It is very easy to say that to be a successful value investor you have to buy stocks trading at a discount to intrinsic value. Dig deeper into this statement though, and you soon realize that, in fact, to be a successful value investor, you need to focus on risk more than anything else. This is what so many other investors seem to misunderstand.
As the quote from Klarman below suggests, risk control should be every investor's first priority, if you focus on risk, the returns will follow suit:
"An investor, looking for a specific return over time, does not make that goal achievable. Targeting investment returns leads investors to focus on potential upside rather on downside risk. Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk."
The above quote is taken from an article published in the Superinvestor Digest at the beginning of September 2006. The article pulls together a selection of quotes from a lecture given by Klarman to Columbia Business School close to the publication date.
"Most investors looks at a falling stock and think that things are getting worse and the uncertainty or risk is going higher. That kind of herd mentality must be reversed for an investor to become successful. As a stock falls big time, the risk should be less. As the stock goes lower and lower the risk would become less and less. If you back up the truck and buy 51% of the company, you would be able to force the outcome with control. That's the benefit of averaging down."
As well as some discussion on risk, in the lecture, Klarman =discussed his love of cash. What's really impressive about Klarman's market-beating performance over the years is that he has been able to smash the market while holding a large percentage of assets (on occasion as much as 45%) in cash.
So many other investors and asset managers are afraid to follow this approach because a high cash weighting could be interpreted as lazy, or it could cost valuable percentage points in performance.
Baupost is unique because it has a group of closely aligned investors who won't pull money at the first sign of trouble. The average investor should seek to replicate this style. As Klarman said:
"Cash is the ultimate risk aversion. But clients are uncomfortable about it. Why people should pay a money manager to hold cash? They are paying the manager to wait for the opportunity to invest."
Holding cash also gives you optionality. It means that you won't be forced in/out of a position at the wrong time. Klarman described this as follows:
"Keep some cash in the side pocket so there will be no forced liquidation. The duration of the investment should be equal to the duration of the capital."
These quotes are given from the point of view of an asset manager, but they are equally relevant to the average investor. In business, cash is king and in the investment world, it is no different.
Cash gives you options, flexibility and acts as a great hedge against market moves.
Disclosure: The author owns no share mentioned.
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