Studying how great investors act and how they have acted over their careers is a great way to improve your understanding of the markets.
I believe, however, that it takes both knowledge and experience to become a good investor. You don't become a good investor overnight just by reading; you need plenty of experience trading the markets to claim that you know what you are doing.
The importance of case studies
Reading and understanding case studies is an essential part of this whole process. Case studies of famous investors: Studying the investments they have made over their careers, why they made them in the first place, what went right and what went wrong.
It is easy to be misled about how investors like Warren Buffett (Trades, Portfolio) have thrived because they have been so successful at investing. What their story doesn't tell you is that there are tens of thousands of other investors out there who have all failed.
The experience of these investors who have failed and how they have failed is arguably more important.
This article is not about failure, though. It is a case study of two investments that Seth Klarman (Trades, Portfolio) described during an interview shortly after the financial crisis to students of the Ivey Business School.
These two descriptions give us a fascinating insight into his investment process. We know the team at Baupost spends a considerable amount of time analyzing every investment opportunity that comes their way, making sure the risk of loss is low and there is plenty of upside potential. Egregious mispricing opportunities are what Klarman and his team are looking for. Both of these cases seem to offer just that.
Oil and gas cash flows
The first case study is two holdings with similar traits.
These "oil and gas limited partnerships" attracted Baupost's attention because they were both off the beaten path, hidden from view from the rest of the market.
Klarman said both companies "hedged their production out for the next five years," but were trading at a significant discount to reserve value. "One trades at a little over half of its reserve value," he said, while the other, "trades at around a third of its reserve value unhedged." In both situations, the partnership units of these two entities were trading "equal to or below" the value of distributions for the next five years.
Because production was hedged, income was virtually guaranteed. "If you buy them now you will get all of your money back, and you will own this pile of reserves extremely inexpensively," Klarman told his audience. "If you look at it a different way, one of them has a current yield of 20% and the other one has a current yield of 30%."Â
30% internal rate of return
The second holding the highly respected value investor discussed had a similar setup. It is a misunderstood company with a guaranteed income stream, where the downside is limited, but the market does not seem to understand the upside potential for investors.
Klaman described the initial opportunity as a biotech company that invented a number of drugs and partnered with major companies, giving it a guaranteed royalty income stream.
Management then used this income to fund research and development for new treatments, expanding the pipeline. Unfortunately, the market did not think this strategy was worthwhile and gave the stock a low valuation. Management retaliated by deciding to spin off the royalty stream business.
"So the spin-off was the drug Discovery parent, which was losing a significant amount of money every year, but had a giant pile of cash and was investing that in finding new drugs," Klarman said. "The Royalty receiving entity was separated from the parent."
This spinoff didn't change the market's opinion of the two companies. The royalty business continued to struggle. Klarman did the work and discovered that the stock had a "30% IRR based on the collection of royalty streams that currently exists." The market was overlooking the business because it was a spinoff. Yes, the revenue stream from patents could have been disrupted, but that was something the team at Baupost was prepared for.
"You have some uncertainty that drugs could turn into problems, there could be challenges to the patent, but we are assuming very conservatively what could happen and think it is amazingly inexpensive," Klarman said.
Disclosure: The author owns no stocks mentioned.
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