Seth Klarman (Trades, Portfolio) is one of the most respected value investors alive and practicing the art of value investing today.
Over the years his investment letters and interviews have provided thousands of quotes and unlimited information for value investors who want to learn more and improve their investing process. Here is a look back at some of his quotes and how I've incorporated his advice into my own investing.
Incorporating Klarman's advice
Klarman's advice on the topic of value investing is plentiful, but actually taking that advice and implementing it in your own strategy is the hard part. Some of his quotes can be quite cryptic, and he rarely, if ever, issues direct advice to investors on how to invest or which investments to buy.
Combing through his previous letters to investors, there have only been a few select occasions when he actually laid out the investment thesis Baupost ran through before initiating a position.
One of the most thorough descriptions of the investments in the Baupost portfolio can be found in his year-end 1999 letter to investors. In it, he listed a number of investments that the hedge fund owned at the end of the year, a time when the rest of the market was obsessed with internet stocks trading at high valuations based on nothing more than hope they could become leading companies in the new web economy. In comparison, Klarman was happy to buy old-world economy stocks trading at discount valuations. Octel Corp. was one:
"Octel was spun-off from Great Lakes Chemical Corporation in 1998 and has not succeeded in attracting investor interest ... Octel has recently consolidated its position and now controls in excess of 90% of the worldwide TEL market. The company is currently buying back around 10% of its stock per year. There are two primary risks - that the phase-out goes much more quickly than the 15-20% annual decline that management anticipates or that the company's abundant cash flow is squandered on foolish acquisitions rather than being used to pay down debt and buy back stock. At three times current after-tax earnings, valuation more than compensates for these risks."
I picked this example because it illustrates one of the most valuable pieces of advice Klarman has given, and a bit of information I use when evaluating every single investment before it makes its way into my portfolio.
"Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place."
Octel was trading at three times after-tax earnings when Klarman decided to buy. This valuation provided a huge margin of safety, but more importantly, it limited the downside. The stock could fall by 50% or even 70% and it would still be unbelievably cheap.
When I look at an investment, I always ask myself, would I be happy holding it if it fell 50% or more? If the answer is no, I quickly move on. This Klarman-inspired view is designed to make sure I invest only in companies I believe are cheap, and avoid businesses that have shaky balance sheets or managers that do not have skin in the game. Following this path also helps me adhere to another piece of Klarman wisdom:
"By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy."
If I make sure I am comfortable taking the risk of a 50% share price drop before investing, I already have a loose strategy in place for when the market drops. And I'm comfortable riding out market gyrations because my strategy is built with a long-term focus as Klarman has recommended:
"A truly long-term orientation is not just in your mind, but also in your structure."
My entire equity portfolio is separate from day-to-day finances, so the risk of having to sell at the bottom in a panic to cover living costs is virtually zero. These are a few pieces of advice from Seth Klarman (Trades, Portfolio) that I have incorporated into my own investment strategy.
Disclosure: The author owns no share mentioned.
Using Michael Porter to Find Better BusinessesÂ
Liberty Global: A Potentially Deeply Undervalued Special SituationÂ
