How is Seth Klarman (Trades, Portfolio) acting in the current market environment? This is a question I've been asking myself recently, as I've watched investors rush to dump stocks in all parts of the market.
Klarman is one of the best value investors alive today. Unlike Warren Buffett (Trades, Portfolio), who has been forced to adapt his strategy away from value, towards quality and growth due to the size of Berkshire Hathaway, Klarman still loosely follows Benjamin Graham and David Dodd's principles of value investing -- buying businesses and assets at a deep discount to intrinsic value.
Klarman is always on the lookout for value, wherever it can be found. His search never ends. He's also well aware of the whims of Mr. Market. Klarman will not rush to buy a security, even if he thinks it offers value. Instead, he will wait for the market to provide a better price.
Klarman laid out his strategy for acting in a bear market in his 2008 year-end letter to investors. Part of the letter was republished in Value Investor Insight back in February 2009. The article, titled "The Value of Not Being Sure," compiled some key extracts from the letter, where Klarman outlined his three tips for investing successfully in a bear market.
Timing the market
After outlining the rough principles behind Graham's "Mr. Market" analogy (which I won't go into here as that could be another article altogether), Klarman briefly outlines the "ago-old showdown" between greed and fear that emerges after a severe downturn:
"As 2009 gets underway, we expect a steady diet of bear market rallies and financial market volatility, as economic woes and continued deleveraging vie with government intervention and bargain-hunting in a continuation of the age-old showdown between greed and fear."
He goes on to say that in this environment, it is impossible to try to time the market. This is Klarman's first tip for buying stocks in "the throes of a bear market." Rather than trying to time the market, investors should put money to work at prices they think are attractive, and be prepared for more volatility:
"Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better."
It's all about the process
Klarman's next piece of advice to investors to focus on their process, not the outcome. In a bear market, it can be very easy to give up on investing as everything falls in value. But this approach will only lead to losses. Klarman writes that institutional investors should keep in mind the fact that the only things they can control are "their investment philosophy, investment process, and the nature of their client base." In a bear market, it is "so easy" for one's investment process to break down, Klarman continues, but this virtually guarantees failure.
Sticking to your process and strategy is key if you want to survive a bear market:
"Investing is hard enough. Success virtually requires that a process be in place that enables intellectual honesty, rigor, creativity, and integrity."
The value of not being sure
Finally, Klarman advises readers to appreciate the principle of uncertainty in volatile markets. This final piece of advice is probably the most valuable, but at the same time, it is the most difficult to describe and put into action.
The key takeaway is this: Investing is not a precise science; it is an art, and investors must appreciate this fact. The investment landscape is vast and unpredictable. Businesses can fail overnight. A change in sentiment can drive stock prices down for no reason. A natural disaster could cripple a company financially. Investors need to understand and appreciate this uncertainty, and always remember that they could be wrong:
"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security’s price begins to reflect full value, because we are never sure that our thesis will be precisely correct. While we typically concentrate our investments in the most compelling situations measured by reward compared to risk, we know that we can never be fully certain, so we diversify. And, in the end, our uncertainty prods us to work harder and to be endlessly vigilant."
Disclosure: The author owns shares in Berkshire Hathaway.
