Seth Klarman (Trades, Portfolio) is undoubtedly one of the best value investors alive today. He built his investment strategy on the traditional value investing principles first put forth by the godfather of value investing, Benjamin Graham. But over the years as the investment world has changed and adapted, Klarman has modified his investment strategy as well.
One of his primary developments is that he is no longer looking for deep-value stocks. Instead, the Boston-based manager of Baupost Group is looking for equities that he believes are unloved and underappreciated by the rest of the market -- each stock must have some hidden value for Klarman to invest.
Klarman'Â process
Valuation is just part of Klarman's process. As he described in a lecture at the Ben Graham Centre for Value Investing at the Richard Ivey School of Business several years ago, there are three main pillars to the strategy he employs.
The first of these three main pillars is, undoubtedly, the most important: a keen focus on risk. Klarman incorporates risk analysis into everything he does. He is only looking for equities where the risk of permanent capital impairment is zero. Even if there is a slightly elevated chance of a total loss, he is not willing to invest. It is essential when evaluating risk to consider a range of outcomes, not just one specific scenario that may or may not cause a company to run out of money. Klarman believes that investors should consider many different situations and not obsess about one single estimate and whether this estimate may or may not cause bankruptcy.
Companies are dynamic, living institutions. Threats to their existence and profitability are always emerging. There is never going to be one Achilles' heel for businesses. Investors need to keep an eye on all factors and try and gauge the probability of all different scenarios unfolding. Put simply, risk is the probability and size of losing in different situations; it is not volatility. Klarman is a fan of worrying, but only worrying about the right things, which in this case are potential bankruptcy threats.
Second, Klarman warned investors not to chase performance. The world is geared toward analyzing and criticizing relative performance, as mutual funds and hedge funds gather assets only if they can show outperformance. Klarman is not concerned about beating the market. He wants only to be able to achieve a positive absolute return. He said in the lecture that being satisfied with losing just 18% while the rest of the world is losing 20% is "insane." If you focus on risk reduction, returns will look after themselves, he said.
Third and final pillar of Klarman's investment strategy is what he calls his bottom-up orientation. Much like Warren Buffett (Trades, Portfolio) and other notable value investors, Klarman is concerned solely about each company's underlying fundamentals; he is not worried about macroeconomics, interest rate forecasts or themes. Instead, Klarman's entire investment strategy is built around finding undervalued stocks using bottom-up analysis. He has found that Baupost has been able to gain an edge by investing from the bottom up and working out the risk-reward profile of investments. This involves analyzing all the potential outcomes for that individual security under different stress-test scenarios.
These three pillars are not difficult to follow and understand. In reality, the main structure of Klarman's investment strategy is relatively simple. He uses bottom-up analysis to find undervalued securities with a minimal risk of total loss, and he targets only a positive annual return, with no pressure to outperform an index. There's little else to it than that. The returns speak for themselves: Klarman has produced average annual returns of 20% for investors over the past two decades. Simple is often the best strategy.
Disclosure: The author owns no share mentioned.
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Seth Klarman: Investing Is a Zero-Sum Game - Don't Be on the Losing Side
