Following my recent discussion of Seth Klarman (Trades, Portfolio)'s investment process, and how he goes about evaluating companies, I want to take a look back through his historic investor letters to try and give some examples and case studies of how he deploys his strategy in real life.
Unfortunately, the available letters are not that detailed. The "Margin of Safety" author likes to keep his thorough analysis to himself and his analysts at Baupost, for obvious reasons, but he does give us a broad outline of some investments made over the last several decades. And these are enough to give us some idea of how he works his strategy in the market environment.
A range of values
As a brief reminder, in my previous piece, I covered a lecture given by Klarman to students of the Ivey Business School. When he was asked by one of the students to explain how he uses the weighted average cost of capital and his calculations, Klarman replied that he does not like to use one single metric to evaluate businesses. Instead, he relies on a selection of different fundamental data points to compute a range of intrinsic values. The stock is only attractive to him if it is trading significantly below the lower bound of this range.
Here's a recap of what he said:
"We look at the business a lot of a different ways...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."
We do have some examples of this kind of analysis. In his December 1999 letter to investors, Klarman shared great insight into the kind of stocks he was buying at the time, possibly in an attempt to reassure investors that he was still seeking out value in an "unprecedented market environment."
Klarman case studies
One example given was Chargeurs (XPAR:CRI, Financial), what Klarman describes as a "French company which processes and trades in wool and produces fabrics."
In the description that follows, we can see the multi-pronged investment approach in action. Klarman noted the company's management was "proactive in taking measures to maximize shareholder value." These efforts included "the repurchase of a large number of shares."
In addition to the efforts by management to unlock value, the stock was also cheap, valued at "approximately seven times earnings." On top of this, the business was "generating substantial free cash flow from operations." Looking at these three brief points, it seems Klarman believed the business was undervalued on a price-earnings basis, a free cash flow basis and compared to management's stewardship of the company. Three very different metrics all point to the same conclusion.
Another great case study is that of Octel, one of several spin-off situations featured in the Baupost portfolio toward the end of the last century.
According to the year-end 1999 letter, this company was the dominant worldwide producer and marketer of a fuel additive that made gasoline "leaded," an industry Klarman described as in decline because leaded petrol was being phased out around the world. The upside was that this was a highly cash generative business with a 90% market share. On top of this, management was buying back around 10% of the outstanding stock every year.
The risks to this investment were twofold. First, there was the risk that the phase out of leaded fuel accelerated, making the company's only product virtually redundant. Second, there was a risk (as there always is) that "the company's abundant cashflow is squandered on foolish acquisitions." We can assume Klarman modeled out both of these risks before concluding that, with the stock trading at three times current after-tax earnings, the valuation more than compensated for the risks to the investment case.
These are just two of the investments profiled in the December 1999 letter to investors, but I believe they give a great insight into Klarman's way of thinking. I highly recommend reading the whole letter for more insight.
Disclosure: The author owns no stocks mentioned.
Read more here:
- How Seth Klarman Value Businesses
- Seth Klarman Buys 2, Piles Further Into PG&E and Fox in 3rd Quarter
- Cheap Stocks Are Not Always Value Stocks
Seth Klarman Buys 2, Piles Further Into PG&E and Fox in 3rd Quarter
Cheap Stocks Are Not Always Value Stocks
Seth Klarman Buys 2, Piles Further Into PG&E and Fox in 3rd Quarter
Cheap Stocks Are Not Always Value Stocks
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