Seth Klarman

SETH KLARMAN
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PART ONE
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Lessons For Retail And Institutional Investors
This is the first part of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost
Group.
Seth Klarman is virtually unknown outside value circles, despite his impressive record and value of assets under management. On average Baupost has returned 19% p.a. despite holding a large portion of its assets in cash. During the
financial crisis, Seth Klarman’s funds lost somewhere between 7% and 13%, certainly outperforming the majority of
its hedge fund peer group.
The group then rebounded during 2009, returning 27%. At the end of the second quarter of this year, Baupost announced yet another strong quarter, ending with the best month the group has had in terms of returns in more than
five years, even though around 35% of the portfolio remained invested in cash. Around 14% of the portfolio was also
invested in liquidating claims in the Lehman estate, according to the firm’s Q2 letter.
At year end 2013, Baupost Group had AUM of $approximately $30 billion.
These returns are certainly some of the best around. And of course, many investors have been left wondering how
they can replicate such a strong performance.
Seth Klarman’s Investing style
Reading through Klarman’s speeches and letters to investors, you quickly discover that the hedge fund manager is not
around to make a quick buck. Klarman’s strategy is built around the notion that financial markets are inefficient, a
viewpoint held by other well-known value investors (Buffett, Graham).
Klarman is a traditional value investor, looking for companies, bonds, credit instruments and real estate opportunities
that all trade below what he, and his analysts believe is intrinsic value. However, a margin of safety must be incorporated. Seth Klarman it seems, will never chase a stock just because it’s the stock of the moment. Of course, Klarman
also considers the word ‘investment’ to be the same as that set out by Benjamin Graham:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.
Operations not meeting these requirements are speculative.”
Like Buffett and more notably, Graham, Klarman takes the view that stocks are, at their most basic, a fractional interest in a business, not a chip in a casino. Therefore, patterns or performance cannot be modelled with any kind of
accuracy, or predictability. Seth Klarman also references Graham’s ‘Mr Market’ analogy when he is talking about his
investment process. Ask Mr Market for advice on how to make money and you’ll be led in the wrong direction. But
if you look to Mr Market as an eccentric but useful counterparty, who will often, in a state of depression and panic,
offer to sell you a fractional interest in his business at a marked down price, you’re on the right track.
Further, Klarman like Buffett is acutely aware of how an investor’s time horizon affects performance. Indeed, Klarman has made multiple references to the short-term nature of the fund management industry, how many investment
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managers have become fixated on short-term performance, increasing levels of speculation as they rush to catch
market moves. In his preface to Security Analysis: Sixth Edition, Seth Klarman notes how the coverage of financial
markets on dedicated news networks, ferments the view that investors should have a view on everything the market is
doing, and that they should be aware of every market movement. Short clips of market movements push the culture
that investment decisions can be made in under a minute. Of course, this makes Mr Market redundant.
Still, Klarman’s investments are made with a long-term horizon, with almost no trades made for short-term profit:
“…If someone asked me to invest their money with the goal of turning a quick profit
over the next six or twelve months, I’d have no idea how…You might as well go to
a casino…”
A way of thinking Buffett himself preached as early as 1963:
“…Our business is one requiring patience. It has little in common with a portfolio of
high-flying glamour stocks...It is to our advantage to have securities do nothing price
wise for months, or perhaps years, why we are buying them. This points up the need
to measure our results over an adequate period of time. We suggest three years as a
minimum…”
Seth Klarman’s Long-term beats short-term
There’s plenty of evidence to support the fact that long-term investments do outperform short-term trades.
Unfortunately, there’s no doubt that as a whole, the market is becoming more short-term. This chart details the average holding period of stocks during the past 100 years. Today, the average holding period of a share is around 30
seconds. During the 40s the average holding period was ten years. The holding period of stocks has been in constant
decline since the early sixties. Nevertheless, it is interesting to note that before the 1929 crash, the average stock holding period had declined to less than one year. During the following decade the average holding period rocketed to ten
years.
[Note: Seth Klarman noted within one of his recent speeches that the majority of 30-year Treasury bond holders,
on average, only hold their bonds for several months.]
A second chart shows Asset Class Returns vs. The “Average Investor” over the past 20 years according to annualized returns. While not directly related to the chart above, the two are connected. On average, private investors
have returned 2.5% per annum during the past two decades, underperforming hedge funds, the energy, healthcare,
consumer staple and technology sectors as well as the S&P 500 on an annualized basis. Even Treasuries put in a
stronger performance over the period. Japan was the only asset class that performed worse than the average investor over the past two decades.
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What do these two charts mean? Well, at the end of September, James O’Shaughnessy of O’Shaughnessy Asset Management, and author of what ‘What Works on Wall Street’, went on Bloomberg Radio’s, Masters in Business program.
He discussed how his research showed that shorter holding periods generally had a negative effect on returns. While
this conclusion does not directly relate to Seth Klarman, it does shed some light on how his strategy is able to outperform.
Conclusion
This is just a brief overview of Seth Klarman and his investment strategy. Over the next few articles I will be taking
a closer look at some of his investments and the way he goes about managing money. Stay tuned for part two.years.
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PART TWO
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Value Investing in a Turbulent Environment [1997-2001]
This is part two of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group.
One of the toughest times for Baupost was the late 90s. While the rest of the market surged, Baupost underperformed and during 1998, the group lost a double-digit percentage, at a time when the wider market was reporting
annual gains in excess of 20%.
The following is a timeline of Seth Klarman’s letters to Baupost’s investors from 1997 to 2001 and shows why value
investors should keep a cool head in a rising market, stick to their principles and not go chasing market gains.
Bubbles forming
1997 was an odd year for Baupost. The dot-com boom was just beginning and the S&P 500 had started its climb
into bubble territory. Baupost’s financial year ended on October 31 and for the twelve months to this date, the fund
returned 27%, despite holding around 20% of assets in cash. For the twelve months ending October 31, the S&P 500
returned 32.1%.
Over the year, as U.S. markets reported their best performance in decades, Baupost’s performance was held back by
several underperforming Asian assets. Unfortunately, Baupost’s poor performance continued into the group’s 1998
financial year.
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From January 1 1998, through April 30, 1998 the S&P 500 Index rose by 15.1% and from November (1997) to April
(1998) the index gained 22.5%. Over the same four and six month periods, Baupost only returned 7.4% and 11.3%
respectively.
At this point Seth Klarman noted that the U.S. equity market was acting irrationally. Still, Baupost’s cash weighting
decreased over this period to 17%. Klarman was still finding opportunities across Europe. At the same time, Baupost
brought a large number of out of the money put options on the S&P 500.
The following is a timeline of Seth Klarman’s letters to Baupost’s investors from 1997 to 2001 and shows why value
investors should keep a cool head in a rising market, stick to their principles and not go chasing market gains.
Making mistakes
1997 was an odd year for Baupost. The dot-com boom was just beginning and the S&P 500 had started its climb
into bubble territory. Baupost’s financial year ended on October 31 and for the twelve months to this date, the fund
returned 27%, despite holding around 20% of assets in cash. For the twelve months ending October 31, the S&P 500
returned 32.1%.
“... we had too much of our money in equities and too little cash during the year. Given our recurrent fear of a severe market correction and spreading economic weakness, this required us to maintain expensive and imperfect hedges …”
Once again, Baupost’s relative poor performance continued into 1999. To October 31 1999 the group returned 8.3%,
while over the same period the S&P 500 returned around 23.8%. By this period the group had closed almost all market
hedges. Hedges as a percentage of Baupost’s overall portfolio had fallen to 0.2%, compared to a weighting of around
1.5% before the losses of 1998.
It quickly becomes apparent through Seth Klarman’s letters that Baupost’s favorite method of hedging market risk is
by holding cash, ready for quick deployment when an opportunity presents itself. It should be noted that between the
half-year point and full-year 1999, Baupost’s cash weighting fell from 42.1% of assets, to 32.2%. Klarman was still able
to find value opportunities, despite what he called ‘the frothy market environment’. Indeed, during the second half of
Baupost’s 1999 financial year, the group’s U.S. equity weighting increased from 31%, to 41%.
Seth Klarman’s Baupost Group nearing the top
As 2000 began and the dot-com bubble reached its peak, Baupost was falling behind but Seth Klarman kept buying
U.S. equities, spending almost all of Baupost’s cash cushion. Baupost’s cash weighting had dropped to 4.6% of AUM
by April 2000. 61.9% of Baupost’s assets were invested in U.S. stocks.
For the financial year ending October 27 2000, Baupost posted a return of 22.4%. The S&P 500 peaked during September and by the time Klarman wrote his letter to investors during December, the market had fallen more than 13%
from its peak:
“ … Clearly, the Internet bubble has burst. Nearly all publicly traded Internet stocks
have come up snake-eyes, and there is considerable doubt about whether there is or
ever was a “new economy …” Seth Klarman
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Cash was only 15.7% of fund assets at the end of October 2000.
Market beating
“ ... I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone...
can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important...it helps you find your bearings when reassuring landmarks are no longer visible …” Seth Klarman
As the dot-com bubble deflated during 2000, Seth Klarman and Baupost remained focused on value. It’s reasonable
to assume, that given Baupost’s overweight position in U.S. equities, the fund would have suffered as markets crashed
during 2000. This was not the case.
Baupost reported a great start to 2001. With a low cash allocation and an overweight position in U.S. equities, the fund
returned 14.4% for the six months ended April 30 2001. Over the same period, the S&P 500 fell 9.1%, the tech-heavy
Nasdaq fell 36.6% and the Dow rose 2.1%.
Why did value stocks outperform as the rest of the market collapsed?
“ ... In effect money has come out of technology stocks, driving them mostly lower but it has not left the market.
Instead, it has moved into “value” stocks, seeking more certain returns and downside protection. This is one manifestation of the “stocks for the long-term” thinking that prevails among most professional and individual investors.
Stocks will outperform other asset classes over the long term because they always have, the thinking goes, so the real
risk is being out of, and not in, the market …” - Seth Klarman
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PART THREE
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Value Investing In A Market Bubble [1997-2001]
This is part three of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost
Group. Part one can be found here and part two can be found here.
In part two of this series I covered Seth Klarman’s investing strategy during the late 90s. As the market was swept
up in dot-com mania, Klarman kept a cool head and stuck to his strategy. Unfortunately, using this strategy, Baupost
significantly underperformed the wider market from 1997 to 1999.
Nevertheless, with an overriding confidence in his own and his analysts’ abilities, Seth Klarman continued to buy U.S.
equities right up until 2000. Aggressive buying activity pushed Baupost’s cash weighting down from 42.1% of assets
at the half-year point of 1999, down to only 4.6% of AUM by April 2000, at a time when the market was hitting a
new all-time high almost every day.
Based on this information, I thought it could be interesting to take a closer look at some of stocks Seth Klarman was
buying during this period. The data is taken from Klarman’s year-end December 17, 1999 letter to Baupost’s investors.
Seth Klarman seeking value in spinoffs
One of the first investments Seth Klarman mentioned within his year end 1999 letter, is a depressed post-spinoff
situation. Tenneco Inc (NYSE:TEN). split itself in two to unlock value. The larger spinco, Pactiv Corporation, manufactured food storage and trash bags, with a leading market share in many other plastic packaging products. After
the spin, Pactiv’s shares slumped and the company’s valuation fell to a level that was too hard to pass up. Klarman
brought when the company was trading at around ten time’s after-tax earnings and about five-and-a-half time’s pretax
cash flow.
The other spinco was Tenneco Automotive, which manufactured branded shock absorbers and mufflers.
Tenneco Automotive was a market share leader in nearly all of its products and markets, for this reason the company
should have traded at a high valuation. However, from a market cap. of several billion dollars pre-spin, the company’s
value declined to only $200 million post spin, pushing it out of the S&P 500 and forcing many fund managers to sell
their holdings, depressing the company’s valuation. Seth Klarman started buying when the company was trading at
four times after-tax earnings - a great value opportunity. Tenneco still exists today.
Another spinoff situation that attracted Seth Klarman’s attention was Harcourt General. Harcourt had spun off its
non-core business to become a pure play publishing and computer-based learning businesses. The group was forecasting long-term earnings growth of 12% to 15% per annum and traded at roughly half of net asset value as estimated
by Baupost’s analysts. What’s more, Harcourt’s management had most of their net worth invested in the company.
A final spinoff situation for the year was Chemfirst, a specialty chemical company born as a spinco. The company was
trading at five times estimated cash flow, management owned a large portion of stock and the company was actively
repurchasing its own stock.
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Deep value
Aside from special situations and spinco’s, Seth Klarman was still finding value in the wider market throughout much
of 1999. As many market participants focused on high-growth tech stocks during 1999, many ‘boring companies’ flew
under the radar and this is where Klarman was able to find value.
Stewart Enterprises, Inc. (NASDAQ:STEI) was (and still is) a leading death-care provider and was acquired for Seth
Klarman’s portfolio, during or before 1999.
Stewart was acquired at a time when the death-care industry in general was recovering from a debt-fuelled expansion
binge and a decline in death rates. Insider buying, a multiple of six times after tax earnings and a new management
team were all reasons that convinced Seth Klarman to start buying. Stewart still exists today but it’s the company’s
smaller peer, Carriage Services, Inc. (NYSE:CSV) that looks attractive at present levels. See: Carriage Services, Inc.
(CSV): Attractive investment In Deathcare
Two European companies acquired for Baupost’s portfolio during 1999 were Chargeurs and Saab. Chargeurs a French
company which traded in wool as well as fabrics and Saab is a Swedish defense company -- they both still exist today.
Saab was one of Europe’s smallest remaining independent defense companies, which put it below the below the radar
screen of most investors. Chargeurs was a small-cap was struggling to recover from the Asian crisis but was working
to unlock shareholder value. Neither Saab nor Chargeurs was a distressed value situation. Indeed, Saab was expanding through acquisitions and had just started selling its aircraft to the international market. Chargeurs was the market
leader in nearly every market in which it operated, generated substantial free cash flow from operations and was gobbling up stock. Chargeurs was trading at seven times earnings and Saab at a similar valuation.
Special situations
Finally, two special situations that were acquired for Baupost’s portfolio.
Trustor Corporation was a company going through liquidation, which had cash assets and legal claims against a former executive who committed embezzlement. The total value of cash and legal claims amounted to more than the
company’s share price, lining Baupost up for a substantial liquidation distribution.
The other special situation was the debt of Maxwell Communications, another liquidation situation. The company
was selling off assets to pay down debt making liquidation distributions at the same time.
Conclusion
One trend to note the links the majority of these investments is the fact that Seth Klarman not only liked stocks that
were trading at a lowly valuation, but he also sought companies with market leading positions and managements teams
with plenty of skin in the game.
How did these investments work out for Baupost? Well, for the financial year ending October 27 2000, when the wider
market was falling, Baupost posted a return of 22.4%. During the first half of 2001, with a low cash allocation and
an overweight position in U.S. equities, the fund returned 14.4% for the six months ended April 30 2001. U.S. equity
indices reported double-digit declines during the same period.
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As noted within part two, these returns were possible as after the dot-com bubble burst, investors rushed to sell hot
tech stocks, buying value instead, seeking more certain returns and downside protection.
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PART FOUR
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The Patient Investor
The following content is based on an interview Seth Klarman gave to financial journalist Jason Zweig at the CFA
Institute 2010 annual conference. The interview was published within the September issue of the Financial Analysts
Journal 2010. A copy of the interview script can be found here.
The influence of Graham and Dodd
Those of you who have been following this series so far will have noticed that Klarman’s investments, while value orientated, do not exactly conform to the strict value investing criteria set out by Graham and Dodd. This does not just
apply to Klarman. Buffett is often described as a follower of Graham and Dodd but the Oracle of Omaha’s earlier
investments, while inspired by Graham and Dodd, required activism to unlock value.
When quizzed on his strategy, Klarman stated that he views Graham and Dodd’s work as template for investing,
rather than a detailed road map:
“...When I think of Graham Dodd, however, it’s not just in terms of investing but
also in terms of thinking about investing. In my mind, their work helps create a
template for how to approach markets, how to think about volatility in markets as
being in your favor rather than as a problem, and how to think about bargains and
where they come from...The work of Graham and Dodd has really helped us think
about the sourcing of opportunity as a major part of what we do—identifying
where we are likely to find bargains. Time is scarce. We can’t look at everything…”
This template as it were, has helped build confidence in his own abilities, buying when others are fearful and holding
through both the good times and the bad. For example, in parts two and three of this series I looked at Klarman’s
trading throughout the turn-of-the century dot-com bubble and subsequent crash. Klarman kept buying both in the
run up to 2000 and the years after, finding value while the rest of the market suffered. A strategy he followed throughout the 2008/2009 financial crisis. In fact at one point during 2009, around a third of Baupost’s assets were invested
undervalued credit instruments, which had seen their values unfairly written down by the wider selloff. Was it easy for
Klarman to keep buying while the rest of the market plummeted?:
“...Yes, it was easy. It is critical for an investor to understand that securities aren’t
what most people think they are. They aren’t pieces of paper that trade, blips on a
screen up and down, ticker tapes that you follow on CNBC. Investing is buying a
fractional interest in a business and buying debt claims on a business…”
“...Your Psychology as an investor is always important. If you lose your confidence, if you’ve made too many mistakes, if you are down too much, it becomes
very easy to say, “I can’t stand being down more than this.” Avoiding round trips
[buying and selling] and short-term devastation enables you to be around for the
long term…”
When asked why he believes that so many value investors underperformed during the 2008/2009 period, Klarman
replied:
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“... the pressure to be fully invested at all times. When the markets are fairly ebullient investors tend to hold the least objectionable securities rather than the truly
significant bargains…”
A trap almost all investors have fallen into at one point or another.
Seth Klarman: Out of date
Graham-Dodd’s investment road map has helped Seth Klarman keep his cool in times of market stress. But despite
their invaluable teachings, Klarman actually believes that their work is now somewhat out-of-date:
“... The world is different now than it was in the era of Graham and Dodd. The
business climate is more volatile now. The chance that you buy very cheap and that
it will revert to the mean, as Graham and Dodd might have expected, is probably
lower today than in the past…”
Whether or not this view is correct is up for debate. However, the developments in technology over the past 80 or
so years since Benjamin Graham started teaching at the Columbia Business School, have seriously changed the way
equity and debt markets operate. The availability of information has also reduced the amount of mispriced securities
there are available in the market place.
Nevertheless, Baupost’s average holding period remains similar to that as defined by Graham-Dodd and Buffett:
“... With the exception of an arbitrage or a necessarily short-term investment, we
enter every trade with the idea that we are going to hold to maturity in the case of
a bond and for a really long time, potentially forever, in the case of a stock. Again,
if you don’t do that, you are speculating and not investing…”
On other topics
Seth Klarman weighed in on several other topics in his interview with Zweig, which have little to do with value investing but provide some interesting food for thought.
For example, when quizzed on the topic of commodities, Seth Klarman believes that commodities, with the possible
exception of gold, can never be true investments because they don’t produce cash flow.
“...If an asset has cash flow, or the likelihood of cash flow in the near term and is
not purely dependent on what a future buyer might pay, then it’s an investment. If
an asset’s value is totally dependent on the amount a future buyer might pay, then
its purchase is speculation…”
Klarman was also quizzed on the topics of short selling by hedge funds and HFT. On these two subjects Seth Klarman issued some interesting nuggets of advice.
“…Short sellers are the market’s police officers. If short selling were to go away,
the market would levitate even more than it currently does…”
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On the topic of HFT:
Seth Klarman: I don’t understand the worry about computers selling stocks at a penny, other than it creates a false
sense of calm in investors’ minds that the markets won’t be volatile, which would be a false sense of well-being because markets are, and should sometimes be, volatile. If someone wants to sell me a stock worth 50 bucks for a penny,
it doesn’t bother me at all. I don’t think it should bother any of us.
Zweig: What about the problem of individual investors who had market orders in and just got crushed?
Seth Klarman: Nobody should ever put in a market order. It doesn’t make sense because the market can change rapidly.
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PART FIVE
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Looking For Opportunities
he information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor.
The first and most important step in the process of value investing is finding investments.
Unfortunately, in today’s world it is both easier and harder than it has ever been before to find attractive value investments. Blogs, screening tools financial databases and forums have all made the investing process easier but they have
also made it harder.
There’s now more noise than ever before, which can cloud judgment and causes you to question yourself, while the
freedom of information enables investors to discover and act on value opportunities quickly, rapidly closing the valuation gap.
Klarman notes that value investing has three main offshoots and these are the situations where investors should look
for opportunity
Firstly, securities selling at a discount to breakup, or liquidation value -- the traditional value play. Then there are rateof-return situations (tender offers, mergers, or spin offs where the rate-of-return can be calculated with a certain degree of accuracy. And finally, asset-conversion opportunities. Financially distressed and bankrupt securities, corporate
recapitalizations, and exchange offers all fall into the category of asset conversions.
Of course, the data required to calculate the possible return on investment for all of these three situations can be
found in newspapers and online, although further research should always be conducted. The list of stocks hitting a
52-week low is always helpful. But In the end there’s nothing better than good old-fashioned hard work when it comes
to evaluating a securities true value.
Like all good books on investing, Klarman does not offer a sure-fire way to find value investments. Instead, he provides a guide around which you can formulate your own plan. For regular readers of this series this will come as no
surprise.
Seth Klarman - What comes next
Once you’ve found your bargain stock, it’s time to find out why the stock is in fact cheap. To quote Klarman:
“…If in 1990 you were looking for an ordinary, four-bedroom colonial home on a
quarter acre in the Boston suburbs, you should have been prepared to pay at least
$300,000. If you learned of one available for $150,000, your first reaction would
not have been, “What a great bargain!” but, “What’s wrong with it?”…”
“…A bargain should be inspected and reinspected for possible flaws…”
Market inefficiencies can be created by short-term market movements or other reasons hidden below the surface.
However, once the reason for mispricing becomes clear, the case for investment becomes even stronger as the outcome is more predictable.
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The acquisition of mispriced securities makes value investors contrarian by their very nature but as Klarman notes,
holding a contrarian opinion is not always in the investors’ best interests and should be viewed with skepticism. As
always, it should be established why the company is cheap compared to its peers and the wider market.
How much analysis is enough analysis?
Klarman does not shy away from the fact that investing, especially value investing, when done right is nothing but
hard work. Nevertheless, there are limitations to how much preparation an investor can do before acquiring a stock.
For example, a potential investor can spend weeks researching a potential investment, the company, its market, competitors, products, management compensation etc.. but there will always be some information that slips under the
radar. Further, even if an investor were to know all the facts about their possible acquisition, there is no guarantee that
he or she would ultimately profit.
The value of fundamental analysis is subject to diminishing marginal returns. The 80% of available information is
gathered in the first 20% of time spent on the project. All in all, there is no simple answer to the question of how
much analysis is enough. Most investors search tirelessly for certainty and precision, although low valuations are usually a result of high uncertainty. Value investors are looking for low valuations, so they must be prepared to take on
some uncertainty. To quote Margin of Safety directly:
“…By the time the uncertainty is resolved, prices are likely to have risen. Investors
frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty…”
Research is about separating the wheat from the chaff, and there is a lot of chaff in this world. Often there is no
immediate buying opportunity, today’s research is for tomorrow’s buying opportunity. There is no substitute for continual high-quality research:
“...an investment program will not long succeed if high-quality research is not
performed on a continuing basis…”
Seth Klarman - Insider activity
Klarman also notes at insider buying activity can be a key indicator of when to buy a stock. There are many reasons
why managers will sell stock, there’s only one reason why they will buy on the open market. Insider buying can be a
great tool in deciding whether or not a company is a great investment at present levels, a trend I’ve looked into before.
Indeed, according to Catalyst, research by H. Nejat Seyhun published in, Investment Intelligence from Insider Trading, The MIT Press, 1998, from 1975 to 1994, stocks following insider buying outperformed the market by 4.5%,
while stocks following insider selling underperformed the market by 2.7%. These results are based on an exhaustive
data set, capturing information on insider trading in all publicly traded firms over two decades, around one million
transactions!
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Seth Klarman - Conclusion
All in all, Klarman’s writing on finding value investment can be summed up as follows. There are three value situations, the traditional value play, the rate-of-return and asset-conversion. Once the situation is identified, consistent
high quality research should be conducted to figure out why the situation qualifies as a value play, although investors
should be prepared to accept a certain degree of uncertainty. Insider buying is a great way to get an inside view on
the state of the business.
Stay tuned for Seth Klarman part five.
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PART SIX
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Yield Pigs
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
“There are countless example of investor greed in recent financial history. Few, however, were as relentless as the
decade-long “reach for yield” of the 1980s.” -- Seth Klarman
Greed and the Yield Pigs of the 1980s, was not only a chapter of Margin of Safety but a also warning; a warning that
today’s investors seem to have forgotten. Early in the 80s, the double-digit yield on government securities gave investors the false notion that double-digit returns were the norm. This way of thinking drove investors to sacrifice credit
quality for higher yields when interest rates started to decline, similar to the environment we are in today.
“Yield pigs” became a term for investors who were susceptible to any investment product that promised a high current rate of return, without properly assessing the risk that the product carried. Seth Klarman uses Margin of Safety to
try an prevent investors from becoming yield pigs, warning that if high yield assets were indeed low risk, they wouldn’t
be offering a high yield in the first place.
In order to achieve higher levels of return, above that of U.S. government securities (the “risk-free” rate), increasing
levels of risk must be taken in line with the premium over the risk-free rate. Higher risks will often erode capital. Of
course, higher returns for higher risk only applies on average and over time; as returns of the wider market will justify.
Seth Klarman wrote the following statement during February 1992:
“…These days, however, I don’t believe investors are being compensated sufficiently to venture beyond risk-free instruments…”
At this time, the yield spread of the Credit Suisse High Yield Index versus Treasuries stood at around 544 bps. Over
the past 26 years the median spread has fallen to a similar level. There are only three times during the past two decades
(after the dot-com bubble and 2008/09) where the yield on junk bonds has exceeded the 800 bps spread mark over
Treasuries (I am making the assumption here, based on Seth Klarman’s buying activities, that a spread of 800 bps over
Treasuries is enough to compensate for the risk of investing in junk). During both of these periods we know Seth
Klarman was buying distressed junk debt. He has avoided the sector when yields have traded lower.
Today’s market
The environment Seth Klarman was describing during 1992 has many similarities to today’s market. Seth Klarman
describes the trend of the yield pig, desperate for yield, throwing money at stocks, despite the high valuation and
historically low dividend yield. This statement, published by Morningstar earlier this year implies that the same is happening in today’s market:
“…With rates at all-time lows investors have been forced into higher risk asset
classes such as equities to maintain the same level of income. Defensive equities
with stable and rising dividends have become a target for yield-hungry investors
who might not otherwise consider the stock market at all…”
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But what if you have no option? Many investors strive to live off the income from their investments and are being
forced to take on extra risk, in order to achieve the level of income required to sustain their lifestyle. Seth Klarman’s
advice on the matter:
“... I would advise people to ignore conventional wisdom and consume some
principal for a while, if necessary, rather than to reach for yield and incur the risk
of major capital loss…”
Unfortunately, in today’s world where interest rates have been so low for so long, this advice isn’t practical. If riskadverse investors had taken this advice several years ago, they will have seen the majority of their capital erased if they
had just lived off the cash. Still, if you’ve no other option:
“...Stick to short-term U.S. government securities, federally insured bank CDs, or
money market funds that hold only U.S. government securities. Better to end the
year with 98% of your principal intact than to risk your capital roofing around for
incremental yield that is simply not attainable…”
While this advice was given in the early 90s, it is still relevant in today’s environment.
Conclusion
Seth Klarman may have written his piece on yield pigs in the early 90s, but it is extremely relevant in today’s market.
The key take away is that investors should not chase yield, it’s better to preserve capital rather than risk capital for a
lower-than-acceptable rates of return and high levels of risk.
While interest rates are low now, there’s no guarantee that rates will remain low forever (no matter what some economists might think). It’s better to preserve you capital than take on additional risk for a return that is unlikely to compensate you for the additional risk. It’s better to wait for a time when you can carefully place your bets, buying debt
with only the most financially stable companies at an attractive rate of interest.
I should state that this article is not designed to be investment advice, from the author, or ValueWalk.
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PART SEVEN
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Wall Street Is The Average Investors Worst Enemy
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
Wall Street is plagued by conflicts of interest and short-term bias, which does nothing to improve the performance
of the average investor according to Seth Klarman. The issue of trading costs, fees and management charges all act
as conflicts of interest -- Wall Street gets paid for what it does, not how well it does it (this refers to all wealth managers, not just those on Wall Street).
There’s a wealth of information out there that shows trading costs, can have a drastic effect on performance therefore, the portfolios that trade the least outperform. However, for Wall Street this is a catch-22 as brokers are paid to
trade, and the broker who makes no trade all year, may be labeled as lazy by his client.
Seth Klarman is well aware of this catch-22 situation and does everything he can to discourage investors from dealing with Wall Street. Seth Klarman’s average holding period for his investments is indefinite, reducing the need to
rack up trading fees that eat away at return
Seth Klarman on short-termism
On top of the need and commissions eating away at returns, Seth Klarman writes that Wall Street is increasingly
focused on short-term returns, which are driven by an up-front-fee orientation. Brokers, traders, and investment
bankers all find it hard to look beyond the next transaction, when the current one is so lucrative regardless of merit.
Of course, in today’s world of low-cost online brokers, the issue of fees and a short-term focus driven by these fees
is less apparent than it once was. Nevertheless, it’s easy to notice Wall Street’s short-term view, the overriding importance of quarterly earnings and the constant commentary supplied by financial news channels.
Seth Klarman - A bullish bias
Seth Klarman writes that investors should, at all times, remember that Wall Street has a bullish bias. Wall Street can
conduct more IPO’s in a bull market and brokers get more business from new clients. It’s a Wall Streeters job to be
optimistic and bullish, that’s why there are always more “buy” ratings out there than “sell” ratings. As Seth Klarman
puts it:
“…Perhaps this is the case because anyone with money is a candidate to buy a
stock or bond, while only those who own are candidates to sell. In other words,
there is more brokerage business to be done by issuing an optimistic research report than by writing a pessimistic one…”
It can also be assumed that many investors don’t like to admit their own mistakes, so they are not willing to pay for
research that tells them they are wrong.
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“… Many of the same factors that contribute to a bullish bias can cause the financial markets, especially the stock market, to become and remain overvalued...Since
security prices reflect investors’ perception of reality and not necessarily reality
itself, overvaluation may persist for a long time…”
Seth Klarman on investment fads
It’s not only single securities that can become overvalued, whole industries can see their valuations rocket as they become an investment fad and note, when an industry is in fad mode, very few Wall Streeters will call the fad out. The
e-cig, marijuana and solar industry are three current example. However, in the words of Seth Klarman:
“…It is only fair to note that it is not easy to distinguish an investment fad from a
real business trend. Indeed, many investment fads originate in real business trends,
which deserve to be reflected in stock prices. The fad become dangerous however,
when share prices reach levels that are not supported by the conservatively appraised values of the underlying business…”
Seth Klarman on the downfall of money management
“…The great majority of institutional investors are plagued with a short-term, relative-performance orientation and
lack the long-term perspective that retirement and endowment funds deserve…”
With Wall Street focused on short-term benchmarks and performance, Seth Klarman writes that the Street has now
lost the ability to management money over the long-term. Pension funds and institutions are now the greatest stockholders in terms of volume, outnumbering private investors but institutions are no more qualified that private investors to look after your money. As Seth Klarman writes:
“…If the behaviour of institutional investors weren’t so horrifying, it might actually be humorous...The prevalent mentality is consensus, groupthink. Acting with
the crowd ensures an acceptable mediocrity; acting independently runs the risk of
unacceptable underperformance…”
Seth Klarman notes that Wall Street is a performance derby. Many institutional managers are all trying to improve
their relative performance and keep it equal to, or greater than an index. But the money managers are also faced with
several self-imposed constraints. Such as illiquidity; institutional investors will not spend days researching a small-cap
illiquid stock that may, or may not become a winner, they move with the rest of the group. Pressure to be fully invested
is another constraint; unlike many fund managers, Klarman keeps around a third of his portfolio in cash.
Further, the overly narrow categorization of stocks in the intuitional investment business (emphasis on rigidly defined
categories) restricts returns; the best, and undiscovered, opportunities lie outside the clearly defined categories, hidden
away from institutional investors. When the opportunities are discovered by institutional investors, it is often too late.
Other factors that constrain performance include the use of index funds, or as Seth Klarman puts it, the mindless
acquisition of stocks on the basis that the efficient market hypothesis holds true. (Unsurprisingly, Seth Klarman is
not a supporter of the EMH. His returns over the past few decades support his conclusion that the EMH does not
hold true.)
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Seth Klarman: Conclusion
But what’s the point of all the above information? Many readers will know that Wall Street is bias and has a shortterm focus, therefore cannot be trusted. So how can value investors benefit? As usual, Seth Klarman has the last say
on the matter:
“...Investors must try to understand the institutional investment mentality for two
reasons. First, institutions dominate financial market trading; investors who are
ignorant of institutional behavior are likely to be periodically trampled. Second,
ample investment opportunities may exist in the securities that are excluded from
consideration by most institutional investors. Picking through the crumbs left by
the investment elephants can be rewarding...”
On a final note, one of the most surprising statements Seth Klarman made in this part of the book was the revelation
that when he wrote Margin of Safety, an increasing number of money managers were investing in stocks with little to
know in-depth fundamental research. An extremely concerning revelation.
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PART EIGHT
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The Margin of Safety
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
Most, if not all value investors will have heard of the Margin of Safety; buying undervalued securities that trade at a
wide discount to their underlying value. Key to this process is the, what Seth Klarman calls, “the element of a bargain”. In other words, it’s key to establish a margin of safety that not only enables you to make a sufficient profit, but
also gives a wide enough discount from the underlying value, so that you are still able to profit even if your estimate of
the underlying value is incorrect. However, it’s often difficult for investors to maintain the discipline of only investing
when the discount is wide enough:
“...The greatest challenge for value investors is maintaining the required discipline.
Being a value investor usually means standing apart from the crowd, challenging
conventional wisdom, and opposing the prevailing investment winds. It can be a
very lonely undertaking…”
Seth Klarman notes that value investors have to keep the discipline, no matter how bad things many seem. Earlier in
this series, I covered Seth Klarman’s performance in the run up to the dot-com bubble, where Baupost significantly
underperformed the wider market, reporting single-digit gains (and even losses) while the wider market surged higher.
Throughout this turmoil, Seth Klarman kept his cool and stuck to his value investing principles.
Over the short-term, there may be periods where the value approach seems outdated and ill conceived. However, over
the long-term, the devoted advocates of the strategy are rewarded and the value approach works so successfully that
few, if any, advocates of the philosophy ever abandon it. The message here is stick to your principles, don’t over trade
and believe in the value discipline.
On the subject of maintaining the value discipline, Seth Klarman notes that many investors are often pressured into
investing prematurely; the cheapest security in an overvalued market may still be overvalued. It is often the case that
another opportunity to buy will come along soon, offering a better return for your money.
Nevertheless, value alone is not sufficient, investors must choose only the best absolute values among those that are
currently available. Oddly, this is where Seth Klarman actually advocates increased trading, or rebalancing.
“... Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings
as new opportunities appear, even if that means realizing losses on the sale of
current holdings…”
The Art of Business Valuation
Of course, achieving an appropriate margin of safety is entirely dependent upon the ability of the investor to be
able to place an appropriate value on the underlying business. In a warning to potential investors, Seth Klarman
states that:
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“...Reported book value, earnings, and cash flow are, after all, only the best guesses
of accountants...Projected results are less precise still...You cannot appraise the
value of your home to the nearest thousand dollars. Why would it be any easier to
place a value on vast and complex businesses?...if expert analysts with extensive
information cannot gauge the value of high-profile, well-regarded businesses with
more certainty than this, investors should not fool themselves into believing they
are capable of greater precision when buying marketable securities based only on
limited, publicly available information…
This is clearly a warning to all those who invest based on book values and stated financial figures alone. It’s also the
basis of the margin of safety principle. Seth Klarman is wary of figures such as net present value and the internal rate
of return, they are only as accurate as the figures and assumptions used to calculate them.
It’s here that Seth Klarman even criticizes Benjamin Graham’s an approach to valuations. Graham’s back-of-theenvelope estimate of a company’s liquidation value, net-nets was based on imprecise values -- this is why he often
discounted figures on the balance sheet to arrive a discounted liquidation value, a suitable and appropriate margin of
safety.
Price fluctuations
On another note, Seth Klarman sets out to warn investors not to give too much weight to day-to-day market fluctuations. Many investors consider price fluctuations to be a significant risk, but in reality these temporary price
fluctuations are not a risk; not in the way that permanent value impairments are, and then only for certain investors
in specific situations.
Unfortunately, it’s not easy for investors to distinguish temporary volatility, from price movements related to business fundamentals. In this case, the reality may only become apparent after the fact. Still, as always, Seth Klarman is
looking for long-term outperformance, not short-term trading patterns:
“...If you are buying sound value at a discount, do short-term price fluctuations
matter? In the long run they do not matter much; value will ultimately be reflected
in the price of a security…”
Conclusion
In summary then the margin of safety principle is key for all value investors but investors should be wary of stated
financial figures. Short-term price volatility is irrelevant for long-term investors and as long as you are investing with
a wide enough margin of safety, even a change in the underlying business fundamentals can save you from total
disaster.
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PART NINE
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Areas of Opportunity for Value Investors
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
In part five of this series I looked at the method Seth Klarman uses for finding value opportunities. In this part, I’m
looking at where Klarman believes the best investments can be found and what situations create the most lucrative
opportunities for value investors.
When looking for opportunities, Seth Klarman isn’t looking for anything obvious. He notes that the easier an undervalued security is to understand, the more obvious it becomes to other investors and as a result, the opportunity
disappears quickly. So, the best opportunities are often hidden, forcing investors to work harder and dig deeper to
find undervalued opportunities.
One way of unlocking value Seth Klarman loves to make use of, is the emergence of a company from bankruptcy.
Owners of senior debt usually receive distributions from the bankruptcy that exceed the value of the marketable
securities they initially purchased. Seth Klarman has been able to double his money over the past five or so years by
buying the debt of Lehman Brothers after it collapsed.
Seth Klarman used the same strategy with the debt of Enron. Baupost brought Enron debt for 10 to 15 cents on the
dollar, after an analyst worked on the company for four years studying the potential risk reward potential. The analyst
concluded that the debt was worth between 30 and 50 cents on the dollar. 50 cents worked out to be about right.
The right moment
Value investors are always waiting for a catalyst to drive a re-rating of shares and unlock value. In Warren Buffett’s
early days, he was able to achieve such impressive returns as some of his biggest positions were activist plays, whereby
he purchased a big position and then fought with the company until he got his way, unlocking value. Unfortunately,
most small-scale investors can’t act this way, so they may have to wait years for value to be unlocked. That key catalyst,
which can ignite the stock price and unlock value is often unexpected. With this in mind, Seth Klarman is looking for:
“...securities with catalysts for value realization is therefore an important way for
investors to reduce the risk within their portfolios, augmenting the margin of
safety achieved by investing at a discount from underlying value…”
Such value creating opportunities can be as simple as spin-off or stock buybacks and these are signs that managements are shareholder orientated, they want to achieve the best value for investors by deploying capital effectively.
Corporate liquidations
One of the most complex situations where Seth Klarman likes to look for value is the corporate liquidation bargain
bucket. Why is this the case? Well it comes back to the fact that the best opportunities for profit in the value universe,
are those that others avoid. In other words:
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“...investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone else’s discard with a few puffs left
on it and smokes it. Needless to say, because other investors disparage and avoid
them, corporate liquidations may be particularly attractive opportunities for value
investors…”
However, unless you have the time and the knowledge to calculate how much value there is in complex liquidations
situations, there’s little chance that the average investor will be able to profit from company liquidations. Still, there’s
nothing stopping you if you feel the risk/reward is right.
Seth Klarman does offer some help here, for those investors willing to take the risk. He quotes Michael Price of Mutual Series Fund, Inc., and his three stages of bankruptcy.
The first stage, the initial Chapter 11, is the time of greatest uncertainty but perhaps also of greatest opportunity for
investors. In this stage, uncertainty persists and the business is a mess, many holders have dumped their stock at overly
depressed prices to get out as fast as possible. Stage one offer the most risk but the most reward.
The second stage is the involving the negotiation of a plan of reorganization. By this point analysts know roughly
how bad/good the situation is but there is still much uncertainty.
The third stage is the finalization of a reorganization plan and the debtor’s emergence from bankruptcy. This stage
can be viewed as a risk-arbitrage situation; investors and traders know roughly how much they will receive and what
risk there is of the deal falling through. The lowest and most predictable returns are available in the third stage, after
the reorganization plan becomes publicly available.
The stage at which you want to get involved depends entirely of your knowledge of the situation and appetite for risk.
Rights offerings and spinoffs
Rights offering and spin offs are two other situations where value can be found. An aggressive selloff following the
announcement of a rights issue can be an opportunity, if you’re willing to do the work to establish where value can
be found.
Additionally, spinoffs can create value in the same way. Often it is the case that institutions will sell the spinco, as it
does not conform to their investing criteria, artificially depressing the stock price and valuation -- here’s where the
value can be found as prices are artificially depressed. In part three of this series I took a look at some of the spinoff
situations Seth Klarman profited from in the late 90s.
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PART TEN
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Portfolio Management
So far most of this series has been devoted to Seth Klarman’s investing strategy, detailing what he looks for in an
investment and how to invest with a value slant. However, as all seasoned investors will know, while finding attractive
investments is tough and time consuming, portfolio management on a day-to-day basis can make, or break a strategy.
Even if you’ve made great stock picks, over trading, selling too early, or failing to keep up with economic/company
specific developments can eat away at returns.
With this in mind, the final part of this series is devoted to Seth Klarman’s take on portfolio management.
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
“...All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever…” - Seth Klarman
Portfolio liquidity
Seth Klarman’s Baupost is well known for its large cash weighting, which at some points has exceeded 40%. For value
investors, a high level of liquidity is extremely important, especially when investors build positions in illiquid companies. More often than not, value can only be found in illiquid assets as best opportunities usually fly under the radar.
It can take years to realize results and the last thing you want to do is sell too early.
However, the opportunity cost of liquidity is high, so no investment portfolio should be completely liquid either. This
is especially relevant in today’s environment. The rate of return on cash balances held within brokerage accounts is,
in many cases, negligible. Even near-term cash like instruments and money market funds do not offer an attractive
rate of return for cash balances. For example, the S&P 500 currently yields 1.86% on average, while the Fidelity Cash
Management account currently offers an interest rate of 0.07%.
Of course, how cash you hold is dependent upon your investing style and existing portfolio of investments. A portfolio of blue chips can be turned into cash quickly, to take advantage of opportunities. While venture capital investments
may take months to liquidate so a large cash balance is required.
Reducing portfolio risk
“...Portfolio management requires paying attention to the portfolio as a whole, taking into account diversification, possible hedging strategies, and the management
of portfolio cash flow. In effect, while individual investment decisions should take
risk into account, portfolio management is a further means of risk reduction for
investors…”
The two specific methods Klarman makes use of to hedge portfolio risk is the use of hedging, through derivatives
and diversification. How many stocks should you hold to be suitable diversified? In Seth Klarman’s view ten to 15 is
suitable. The reason for such a small portfolio size:
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“...My view is that an investor is better off knowing a lot about a few investments
than knowing only a little about each of a great many holdings. One’s very best
ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea…”
But when it comes to hedging, Seth Klarman’s view on the topic is not as well defined. Hedging can be useful but:
“...Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment…”
However:
“...When the cost is reasonable, however, a hedging strategy may allow investors to
take advantage of an opportunity that otherwise would be excessively risky. In the
best of all worlds, an investment that has valuable hedging properties may also be
an attractive investment on its own merits…”
The Importance of Trading
Buying at the right price is critical for a value investor. Therefore, trading is central to value-investing success. Simply
put, trading is the process of taking advantage of mispricings. Opportunities arise when other investors panic and
companies at prices far below underlying business value, creating buying opportunities for value investors.
Stay in Touch with the Market
While some investors are comfortable buying and forgetting for the long-term, according to Seth Klarman’s principles, such a strategy seems misguided today. Financial markets are erratic and are more so today than they have been
at any point in the past. It’s now easier than ever before to buy and sell securities, which has only made the market
more volatile as participants rush in and out of positions.
Even when Margin of Safety was written, Seth Klarman noted that many investors were actually buying and selling securities with little or no fundamental knowledge of the underlying businesses. So, when Mr Market throws his toys out
the pram, investors panic and opportunities to buy at discounted price present themselves at a rapid pace. A high level
of liquidity, coupled with a knowledge of day-to-day market movements can result in plenty of value opportunities.
Buying: Leave Room to Average Down
As Seth Klarman explains:
“...The single most crucial factor in trading is developing the appropriate reaction to price fluctuations...One half of trading involves learning how to buy. In
my view, investors should usually refrain from purchasing a “full position” (the
maximum dollar commitment they intend to make) in a given security all at once...
Buying a partial position leaves reserves that permit investors to “average down,”
lowering their average cost per share, if prices decline...If the security you are
considering is truly a good investment, not a speculation, you would certainly want
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to own more at lower prices. If, prior to purchase, you realize that you are unwilling to
average down, then you probably should not make the purchase in the first place…”
Selling: The Hardest Decision of All
Anyone over the age of 18 can buy a stock. The hardest part is selling. Some investors have targets on when to sell,
if the P/B value hits one, or P/E exceeds 15. These are rules Seth Klarman considers to be useless. Just like decisions to buy, decisions on when to sell must be based on the business’ underlying value, which will of course change
constantly.
It may be silly to wait for full value realization. For example, missing out on half a point of profit when other opportunities are available is not the end of the world. It’s be better to take profits and reinvest with a new, wider margin of
safety. Stop losses should not be used, a view held by most value investors:
“...Some investors place stop-loss orders to sell securities at specific prices, usually marginally below their cost...Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy...a user of this technique acts as if the market knows the
merits of a particular investment better than he or she does…” (What happened to Mr
Market? Using stop losses puts him in control.)
Making the decision to sell is tough, it requires constant work to value the underlying business. Still, deciding on when
to sell is without a doubt more important than deciding on when to buy.
“...If you haven’t bought based upon underlying value, how do you decide when to sell?
If you are speculating in securities trading above underlying value, when do you take a
profit or cut your losses? Do you have any guide other than “how they are acting,” which
is really no guide at all?”
Conclusion
That concludes this series on Seth Klarman. I hope you’ve found it useful, if not, it’s always handy to remember that
while we don’t all hold the same opinions, considering a diverse range of insights will make us better investors.
Next week I’m starting a series based on the life and investing style of legendary Canadian value investor, Peter Cundill.
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