A thousand dollars.
That’s how much Seth Klarman’s book, Margin of Safety, regularly sells for online.
You see, Klarman is a bit of a value investing legend. He’s often likened to Warren Buffett when it comes to investment style and philosophy, so much so that Klarman is even referred to as the Oracle of Boston, aping Buffet’s own “Oracle of Omaha” moniker. He’s written one book, and it’s out of print, so you can probably forget about getting your hands on one.
What is value investing?
Value investing is an investment strategy wherein investors buy stocks trading at a price lower than their intrinsic value. The idea is that if you can buy something for a price cheaper than its actual worth then you’re already ahead of the game. A value investor is a bit like your grandmother at the store with a fistful of coupons.
Nana only buys what’s on discount.
Story of Seth Klarman
Seth Klarman is an American hedge fund manager, billionaire and bearded man. He heads Baupost Group, a private investment partnership, a company he’s steered to great success over the last thirty odd years.
Baupost has grown since its humble beginnings in 1982, reaching $29 billion in assets under management as of 2016. The firm took its name from the four founders– William Poorvu, Howard Stevenson, Jordan Baruch and Isaac Auerbach. They put up the initial capital, $27 million, and were looking for a money manager but all the initial candidates seemed off to them. The prospective hires were far too interested with what everyone else was doing.
Except for Klarman. He was quite green though, his only work experience being an internship at Mutual Shares – a value investing mutual fund. He did however have an interest in investing from a young age. His first stock purchase, at age 8, was shares of Johnson & Johnson. He studied at Cornell and then went to Harvard Business School for his MBA. It was by chance he took a class with William Poorvu – who recognized Klarman to be one of the smartest people in the room. Poorvu was impressed enough by him to consider him for the role.
Klarman’s curiosity, drive and intelligence won out; the founders decided to make him their main man. Interestingly he was only paid $35,000 a year to start, about $90,000 in 2017 dollars. A first year associate on Wall Street makes about the same amount.
It paid off spectacularly. With Klarman at the helm, Baupost are nearly unstoppable; they’ve averaged 16.4% per year over 33 years. In that time, Seth Klarman would have grown $10,000 invested with him into more than $ 1.5 million.
The most amazing thing: he’s done this while routinely being more conservative than most other hedge fund managers in his peer group. Klarman is not averse to parking 30-50% of his funds in cash.
He’s clearly not afraid to do things differently. Klarman has closed his doors to new investors after a focus on building a client list of sticky customers – university endowments and pension funds likely to stand by him as he enacts his strategy rather than pull out funds at the first sign of trouble. That’s why those were the only types of clients he would take on when he opened his fund to new investors (for the last time) back in 2008, raising a whopping $4 billion.
The philosophy
Above all, Klarman is a value investor in the mold of Ben Graham and Warren Buffett. He believes that stocks represent ownership in a business; as a result, there’s a certain level of respect and due diligence that needs to occur before buying a share of any company.
He knows the market can be irrational and that it’s important to ignore the herd, put your head down and do your homework.
Here are Klarman’s core beliefs – the ones that helped him become one of the most respected men in the investment community.
Look for Mispricing
Seth Klarman is like that annoying customer who finds the one item in your store that you mislabeled and insists you honor the listed price. He’s all about searching for, and finding mispriced assets in the market.
When you find mispriced assets, you begin to tip the scales in your favor. That’s why Seth Klarman likes to look at troubled companies or businesses going through bankruptcy. People tend to stay away from looking too closely so Klarman has an instant advantage because he’s willing to do the legwork required to value them.
Establish a Margin of Safety
A margin of safety represents the amount below its intrinsic value that a company is trading for.
Picture a diamond ring from Tiffany’s. It’s beautiful, and looks incredibly elegant sitting in that iconic, blue box. Its price tag reads $20,000. You, however, are a diamond expert and you know that it takes $4000 in labor and associated costs to mine a diamond that size. Furthermore you know that it takes another $1000 to clean, shape and size the rock. The setting and packaging are $500 total. All in, that diamond ring should cost $5500 –that is its intrinsic value. The rest is just marketing.
Calculating the intrinsic value of a company is highly subjective and complex but if you can buy a business for less than its intrinsic value then you’re better able to control your risk. Intuitively, there’s a lot of risk in buying a company that is worth $5 for $5000. There’s much less risk buying a business worth $10,000 for $100.
That’s what Klarman does. He tries to figure out what a business is actually worth. He uses traditional metrics to do so, looking at measures such as price-to-book value, price-to-cash flow, and dividend yield, but he doesn’t live or die by them. A stock trading a two-thirds of its book value is not an automatic buy, even if it does have a margin of safety, because there’s no guarantee the stock price will appreciate.
Embrace Complexity
If a space seems convoluted and complex, then Seth Klarman wants to get involved. He believes that the added difficulty inherent in analyzing these niches keeps other investors at bay. He’s not afraid to dig around in ditches of distressed debt, or sort through sacks of suspicious spin-offs for a good deal.
Distressed debt and spinoffs tend to have low prices. Spin-offs in particular– subsidiaries that are orphaned from their parent companies – are attractive to deep value investors because of a couple reasons:
· Data delays: the financial data for spun-off companies aren’t always readily available at your fingertips. The average investor may not be aware the company exists until the “official” data comes in two or three months down the line.
· Underselling: the incentives for senior execs at spinoffs can get out of whack. The nature of their stock option deals pushes these powerful players to artificially hold down share prices.
Consider the case of Facet Biotech.
Klarman took a hefty stake in the biotech company, a spinoff from PDL BioPharma, in 2008. Klarman snagged his shares for an average price of $9 per share at a time when the company had nearly twice that amount (per share) in net cash. It’s like buying a vault with $10,000 in it for $5000.
Klarman sold his shares, 1.5 million of them, in 2010 at a price of $27. In just two years he managed to triple his bet by investing in a spinoff.
Bonds Instead of Stocks
Value investors aren’t known for investing in bonds. When you think bond investor you think of people like Bill Gross but Klarman doesn’t shy away from buying debt. He touts their safety and reliability as positive reasons for purchasing them.
In times of economic turmoil it can make sense to hold bonds. In 2008 Klarman’s equity position was $2 billion (around 7%), the rest in bonds and cash. By 2009 his equity position shrunk to about $1.5 billion.
When Klarman isn’t sure about something he doesn’t invest just to invest. He bides his time and waits to strike.
Eschew Emotion
A lot of investing is not about how much of a genius you are. Instead a lot of it has to do with how effectively you control your risk. Good investing is making sure you don’t lose money.
Warren Buffet often says that his first rule of investing is to not lose money. His second rule? Don’t lose money.
It’s clear that Klarman takes this advice to heart. He advises that to become a successful investor, one has to leave emotion out of it. It affects your judgment, causing you to make bad decisions. Emotional investors sell when the markets move against them, and buy when their imaginations run wild at the prospect of riches.
Here at Value Stock Guide, we encourage investors to focus on the fundamentals of the business and ignore emotional biases that tend to color our investment decisions, much to our detriment. Here are 5 cognitive traps you fall into that can destroy your returns
Instead, do you homework. Know the reason you are investing and the conditions under which you will either buy or sell a particular company. Then, stick to it. Write it down so you don’t waver.
These are the lessons Seth Klarman used to become one of the richest men in the world. Follow these key principles of investing and you’ll be ready to tackle the hedge funds of the world yourself. To learn more about his value investing philosophy, consider getting your hands on Seth Klarman’s book, Margin of Safety. It is out of print but lucky investors’ maybe able to find a copy in their libraries or online.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.
