I recently stumbled across an archive video interview with students of the Ivey Business School in which Seth Klarman (Trades, Portfolio) talks about his investment process. The video is separated into two sections. First is a lecture from the "Margin of Safety" author and then a Q&A session, in which he takes a series of questions from the watching students and gives extremely detailed answers on each.
Klarman gave this interview at a significant time in the financial world. It was 2009, when the financial crisis was just getting started, and the world still had years of recovery ahead of it. Klarman was making the most of the opportunities offered to him at the time, deploying billions of dollars in cash to take advantage of undervalued equity opportunities.
The interview is full of insights for value investors, but one piece of advice from Klarman stands out to me more than most. When asked in the Q&A session if he knew why value stocks seem to be performing better than growth equities even though value traditionally outperforms during periods of market stress as growth struggles, Klarman responded:
"When I think about value and growth, I think about something very different to what the academics have modeled in their studies. I don't think that stocks trading at the lowest P/Es in the market are the value and highest P/Es are growth. I think it is much more nuanced than that. For one thing, you can have a high P/E when you're not growing at all, and when your earnings keep dropping. So I would sort of say that companies that are growing fast are growth while companies that are very cheap are value. Sometimes the growth stocks are the value stocks. So I don't understand a lot of the conventional thinking behind that."
This is only part of the answer. In all, Klarman blames three different factors for value's underperformance. Still, we can learn the most from the above. He went on to say that heading into the financial crisis, a lot of financial stocks looked cheap just because analysts were forecasting explosive earnings growth. This made them look like value stocks at first glance, but if you did any level of work on them, you would realize that the growth is coming from an unsustainable source.
There are two takeaways from this. First, you should never take a low multiple at face value. There is a usually a reason why a stock is trading at a discount valuation. Nine times out of 10 it deserves it. Also, just because a stock has a high price-earnings ratio does not mean that it does not offer value. As Klarman said, "Sometimes the growth stocks are the value stocks." There are many different figures to consider when analyzing equities. If it were as simple as just buying those stocks with the lowest price-earnings multiples, it would be too easy.
Just like Warren Buffett (Trades, Portfolio), Klarman has made a fortune for himself by ignoring the rest of the market and investing according to his own rules: closing the doors and being greedy when others are fearful. The only reason he has been able to achieve the record that he has is by ignoring conventional wisdom. It is this kind of perspective that allows him to think outside the box and come up with innovative ideas.
It has also prepared him to learn and change with the rest of the world, however. He takes nothing at face value and will only make an investment decision when he is 100% satisfied when the opportunity offers value. It is always worth paying attention to this leader in the world of value investing.
Disclosure: The author owns no share mentioned.
Read more here:Â
Walter Schloss on Diversification and Macro Economics
Seth Klarman's 3 Pillars of Investing
Seth Klarman: Why You Need to Get Used to Holding Cash
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