One of the reasons why Seth Klarman (Trades, Portfolio) has earned the reputation he has in the value community is the fact that he's not afraid to make big bets on seemingly complex or unsavory investments. Investments like Enron.
Klarman's Enron trade has become one of his most profitable of all time. He dived into the company's debt when the rest of Wall Street was rushing to get out, and over the next several years, Baupost and its investors reaped the rewards.
Classic case study
The Enron case study is an excellent example of Klarman's research-driven value process. In a speech at the Columbia Business School in 2006, Klarman told his audience he was able to buy into the company at a distressed valuation because big mutual funds were "selling like mad." They didn't want investors to see the position on their books at the end of the year.
Klarman was able to take advantage of this environment because he does not have to report his positions to investors. That also gave him an edge against other third-party players who had exposure to the bankrupt energy business, but didn't want to be associated with the collapse. As Klarman explained:
"In a bankruptcy with a lot of hair, a lot of complexity, very hard to analyze, a lot of litigation, a lot of uncertainty, and so much stigma that everybody that owned Enron wanted out of it after it filed. That within that year, huge amounts – huge percentage of the claims – not only bonds, not only bank debt, but even company claims. Enron did a lot of energy trading. So there were major energy companies like Enron or Shell, or I don't know who or pipeline companies that were all selling claims against Enron at cents on the dollar. As I said, 15 cents even 10 cents on the dollar."
These businesses were also unable, or unwilling, to try and understand what Enron was, and what would be left for creditors after the bankruptcy. Klarman says he had one analyst work for four years on the numbers to try and figure out the assets and liabilities of Enron's "over 1,000 subsidiaries."
This analyst calculated that while Enron's liabilities exceeded its assets, even in the worst-case scenario, the debt was not worth the price the market had attributed to it:
"The simple math of a bankruptcy – forgetting about senior debt and subordinated debt – is your recovery on your debt is assets divided by liabilities. So if you have $16 billion of asset value and you have $50 billion of liabilities, you get 32 cents on the dollar. If you have $100 billion of liabilities, you get 16 cents on the dollar. If you have $25 billion of liabilities, you get 64 cents on the dollar...And our analysis was always that the recoveries would be from the mid-30s to the mid-40s. Over time, we've actually gotten more optimistic and now think eventually the recoveries will be well over 50."
Lessons learned
Klarman gave this speech in 2006. Enron filed for bankruptcy in 1999. Seven years later, this was still Baupost's most substantial investment, according to the guru.
Most individual investors cannot afford to spend four years studying a company's financials, but we can learn from this case study. Klarman saw a deeply distressed situation and researched the opportunity carefully, analyzing the risk and reward from every angle, before taking a position.
When he was sure the debt was extremely undervalued, he acted with conviction and waited for his thesis to play out.
Baupost used the same approach with Lehman Brothers a few years later. That's another trade that's yielded healthy rewards for Klarman and his investors.
Read more here:
- Seth Klarman and Charlie Munger on How to Research Companies
- Seth Klarman Explains why Investors Need an Edge in Today's Market
- Warren Buffett: Waht to Look For in an Annual Report
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