Would average annual gains of about 20% since 1982 get your attention? If yes, then you should harken to the words of Seth Klarman (Trades, Portfolio), as reported by Stephen Horan, Robert R. Johnson and Thomas Robinson in their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors."
1982 was the year Klarman began managing the Baupost Group, a hedge fund capitalized mainly by his professors at Harvard Business School (the company name comes from the first letters of the professors’ surnames). Since then, Klarman has turned their $27 million of seed funding into one of the biggest hedge funds in the world. Baupost has long been closed to new investors; its focus has been on big endowment funds, like those of Harvard, Yale and Stanford.
Klarman has been highly praised by Warren Buffett (Trades, Portfolio); the authors wrote, “Perhaps the greatest compliment paid to Seth Klarman was in response to a question posed to Warren Buffett by a student in Bob Johnson’s portfolio practicum course at Creighton University in fall 1992. When asked which young investment professionals he was impressed with and who he felt might be the next Warren Buffett, Mr. Buffett replied without hesitation, 'Seth Klarman.'”
Like Benjamin Graham and Buffett before him, Klarman is a value investor and a leading one. But he diverges from Graham and Buffett in a couple of important ways: big cash holdings and a willingness to invest in all sorts of securities.
Cash
First, he keeps much of his portfolio in cash. In the summer of 2012, the cash balance was 30% and previously it had gone as high as 50%. As the authors note, it’s quite unusual for hedge fund managers to hold much cash and, in practice, they do the opposite—they borrow money to give themselves leverage. Klarman has said he holds more cash than other managers because he is risk-averse, and he likes being able to buy when others are forced to sell.
Like Graham, Klarman insists on a margin of safety when he invests. In fact, he thinks margin of safety is so important that he wrote a book about it. In the book, he emphasized the need to avoid losses.
Further, he only buys when he can get a very significant discount on a stock that is selling for less than its intrinsic value. It’s an approach that demands patience and discipline, but when it works (as it usually does), there is a high probability he will reap great value over a long holding period.
Klarman will not be rushed into buying an asset, and he has observed that individual value investors get into trouble when there are no compelling deals available. He has used Buffett’s analogy of a baseball game in which there are no balls or strikes, so batters do not have to swing at any pitches until they’re ready. Like these batters who can watch dozens or hundreds of pitches pass across the plate without swinging, investors can ignore any number of investment opportunities until something very good comes along.
The authors added, “What that means is that he is willing to forgo some returns in the short-run to wait for the big opportunities.” Such a big opportunity arrived in 2008, and Baupost was one of only a few firms that had enough capital and scale to buy a lot of assets from distressed sellers.
Diverse assets
Klarman does not restrict himself to just stocks or bonds, he is willing to look at anything in the investment world. During and after the 2008 credit crisis, he invested in securitized debt, private commercial real estate and liquidations. He also uses derivative securities; in response to the government’s quantitative easing, he bought out-of-the-money put options to hedge against inflation. He called this cheap insurance for tail risk.
But even when buying insurance, he had an eye on the prize. The authors reported the puts would have expired worthless if long-term interest rates had risen to 6% or 7%. If rates had gone up to 10%, however, Baupost would have done well. And if interest rates got away and went over 20%, Klarman would have reaped returns of 50 to 100 times his initial investment.
Conclusion
In chapter 12 of "Strategic Value Investing: Practical Techniques of Leading Value Investors," the authors are showing some of the many flavors of value investing. They have referred to Graham as the father of value investing and the father of financial analysis.
He had—and has—many followers, including some of the very biggest names in the investing universe. But even so, his followers have gone in diverse directions while staying within some broad guidelines.
Klarman has followed the master in his dedication to margin of safety, the all-important gap between intrinsic value and market price. At the same time, he has diverged from Graham in two important ways: He likes to hold a high proportion of his portfolio in cash to take advantage of opportunities that might arise, as they did during the big selloff in 2008.
Klarman is also willing to move away from stocks and bonds and into securities that are mostly unknown, and feared, by many value investors. For this guru, securitized assets and derivatives are just another way of making and delivering outstanding returns.
It is important to note that since this book was published in 2014, Klarman’s returns have drastically slipped, as shown in this TipRanks chart:
Read more here:
- Strategic Value Investing: Warren Buffett
- Strategic Value Investing: Benjamin Graham
- Strategic Value Investing: Relative Valuation
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