Over the years, I have written dozens or possibly hundreds of different articles on Seth Klarman (Trades, Portfolio) and how he invests. These articles have looked at his investment strategy and investment history from a variety of different angles, but the one thing they all have in common is the fact that none of them are identical.
And this is reflective of Klarman's strategy.
When he invests, he never uses the same methodology to evaluate different companies. Indeed, he never uses the same method to evaluate one company; he uses a variety of different metrics to come across a range of different intrinsic values and then calculates his entry price based on this range.
Klarman's value process
In a video Q&A session with students of the Ivey Business School shortly after the financial crisis, the highly respected value investor gave us some more insight into this approach.
He was responding to a question from a student, who asked how Baupost used some of the most popular metrics in the financial world -- the weighted average cost of capital and return on invested capital -- in its calculations of intrinsic value.
Klarman responded that he believes there is a certain "circularity" to these evaluation metrics because they are linked to stock and bond prices. He went on to say that because the weighted average cost of capital changes based on stock and bond prices, it can be an extremely misleading way of trying to value a business. "That is similar to saying when the price is high it is justified and when the price is low it is justified. So we don't believe in that..." he told the students.
After telling listeners what he does not do, the author of "Margin of Safety" explained the method used by the team at Baupost to evaluate securities and calculate intrinsic value.
If you are looking for a shortcut, I am afraid you will not be able to find it here. "We look at the business a lot of a different ways," Klarman said before continuing: "You can't really have a single point of value. you need a range of value so you look at replacement cost, and you look at book value, and you look at the present value of cash flows and you look at multiples of P/E or price to cash flow. You look at the sum of the parts. you look at private market value."
It seems that the team at Baupost tries to consider every possible outcome for the securities they are analyzing. There is no set template for analysis; they look at each company from multiple different perspectives to try to calculate a range of intrinsic values. If the stock is trading below this range, then "It is perhaps quite interesting," Klarman says.
But why take this research-intensive approach? Well, it seems it is all part of Klarman's effort to try and gain an edge over the rest of the market. He went on to say that he believes the greatest opportunities are often "around the edge of things," and the best way to find bargains is to look at assets differently. If everyone is looking at something in a certain way, they are all going to see the same result. For example, "The world thinks about something as a business; we think about it as a pile of assets," he said.
This is a fascinating insight into Klarman's investment process and goes a long way to explaining why he has been able to achieve the outstanding returns he has, while the rest of the market has struggled. He ended this section of the Q&A session with an example of how difficult it is to analyze equities, using a car as an example:
"I often say to people that if you drive a car, and even if you know exactly everything about the car...you still don't know what it is worth. It could be about $2,000 or $5,000. So, how do you know what a gigantic complicated business is worth to an exact dollar value per share? Nobody could know that."
I think this quote neatly summarizes what KlarmanÂ thinks about equity markets and how he has developed his strategy as a result.
Disclosure: The author owns no share mentioned.