Seth Klarman (Trades, Portfolio) is a billionaire value investor who helped set up Boston-based Baupost Group, an investment partnership with almost $30 billion in assets under management. Known for his aversion to leverage and general risk-avoidance, he rigidly adheres to a set of rules and principles in his investment process. The well-known book "Value Investing: From Graham to Buffett and Beyond" has an entire chapter dedicated to Klarman, which described his philosophy in detail.
Evaluate risk first
“A gain of 10 percent with no possibility of loss may be more attractive on a risk-adjusted basis than an expected return of 15 percent with a meaningful possibility of material capital loss. Risk also needs to be considered within the context of return… He [Klarman] does not employ naked short selling as a strategy, fearing the skewed risk of unlimited loss on a short position that moves higher. He will commit a portion of his funds to buying put options on a stock index, to hedge against a broad decline in the market. But that strategy is genuinely buying an insurance policy, a cost that will slightly reduce returns if everything works as intended but will offer some protection should the market drop”.
While this can sound almost trivial, the truth of the matter is such risk-aversion is far from the norm in the investing world. Particularly in times of low volatility, such as during the incredible bull market run that began after the 2016 election, market participants tend to get complacent and lose sight of the systemic risks that can accumulate in the economy. Expectations become overextended and the temptation to lever up increases, particularly in the professional investment management community where fund managers are competing against one another.
Motivated sellers
“Klarman tries to improve his chances by finding situations that exist outside the normal buy and sell world of the secondary (stock and bond) markets. The feature on which he places most emphasis is what might be called a motivated seller, someone who, as Klarman puts it, is selling for a noneconomic reason. Motivated selling has many sources. Probably the most obvious occurs when a stock is expelled from a major index. These stocks are sold into the market by motivated sellers - funds that look not at all at the companies’ fundamentals but merely at the fact that they are no longer in the index".
The proliferation of trend-following and automated investment strategies has definitely increased the amount of motivated selling taking place in the market. A stock dropping out of the S&P 500 is certainly one good example of an event that can precipitate a selloff of an otherwise solid company. Other examples include stocks of spinoff companies that are dumped by owners of the original parent and funds selling off the stock of a company entering bankruptcy (because their charter may not allow them to hold such securities).
Missing buyers
“The other side of the motivated seller advantage is a situation in which there are only a few other buyers considering the same asset for purchase. One of Warren Buffett (Trades, Portfolio)’s more notable aphorisms is that if you have been in a poker game for thirty minutes and still don’t know who the patsy is, you can be fairly certain it’s you. Klarman’s variant is that he never wants to show up at an auction to discover that all the other bidders are more knowledgeable and have a lower cost of capital than he does. In those cases, he would wonder why it was he who ended up owning the asset”.
In other words, the fewer people bidding for an asset, the better. This is why value is often found in underfollowed companies, or in the debt of distressed businesses, and why popular glamour stocks are very rarely a repository of value. An important point to bear in mind is that what is popular and unpopular will change over time as more and more individuals flock to the suddenly-performing value play that no one was talking about six months ago. For this reason, it is important to not become overly attached to any particular stock, and to always be looking for new and unexplored areas.
Disclosure: The author owns no stocks mentioned.
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