5 Lessons From Seth Klarman
Seth Klarman is one of the most followed value investors ever and one of the most successful hedge fund managers of all time. The founder of Baupost Group, the $ 27 billion hedge fund has achieved stellar returns for investors over his career, with Business Insider reporting that since 1983, Klarman has made his investors net gains of $ 22.6 billion. In percentage terms, on average Baupost has returned 19% p.a., even though the fund tends to have a large cash allocation.
During the financial crisis, Seth Klarman (Trades, Portfolio)’s funds lost somewhere between 7% and 13%, certainly outperforming the majority of its hedge fund peer group.
However, despite this impressive record, Seth Klarman (Trades, Portfolio) is virtually unknown outside value circles.
Dissecting Seth Klarman‘s Strategy
Over the years, I have written over 50 articles and conducted thousands of hours of research onSeth Klarman (Trades, Portfolio) and his investment strategy. I have also written a short e-book on Klarman’s background, his trading strategy and some of his greatest investments.
All my work on Klarman has given me a very detailed insight into his investment strategy and investors who are looking to replicate his style need to pay attention to a few key points.
First of all, it is unlikely the average investor will ever be able to replicate Klarman’s returns. This is because Seth Klarman (Trades, Portfolio) runs a highly concentrated portfolio with distressed debt making up a large percentage of assets. These debt positions are mostly unavailable to the average investor. Other assets, such as real estate, also form part of Baupost’s portfolio.
That is not to say that the average investor cannot learn anything from Klarman’s style. Indeed, Seth Klarman (Trades, Portfolio)’s strategy is built around the notion that financial markets are inefficient, a view held by other well-known value investors such as Warren Buffett (Trades, Portfolio) and Benjamin Graham. To truly exploit financial market inefficiencies, investors must do two things; 1) they need to be patient and wait for the right opportunity before committing themselves; 2) the need to invest with a long-term time horizon and not be swayed by short-term market fluctuations. This is the second lesson investors can learn for Klarman – do not rush to enter a position and do not be in a hurry to make a 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…” – Seth Klarman (Trades, Portfolio)
“…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…” – Warren Buffett (Trades, Portfolio)
The third lesson is yet another lesson Warren Buffett (Trades, Portfolio) and Benjamin Graham have both tried to preach to their respective followings. By buying a share in a business, you are becoming an owner of that business and therefore, you should act as a business owner. Business owners do not check the value of their business every five minutes and do not rush to sell at the first sign of trouble.
The Margin of Safety
The fourth and probably most valuable lesson investors should learn from Seth Klarman (Trades,Portfolio)’s writing is the concept of the margin of safety. The margin of safety is perhaps the most important element in value investing, but is all too often overlooked by investors looking to make a quick buck and not doing their research properly.
All value investors should know and understand the margin of safety. The principle was first written about by Benjamin Graham and is based on the concept of buying securities that trade at a wide discount to their underlying value. To apply the margin of safety principle correctly, you need to implement what Seth Klarman calls, “the element of a bargain.”
“The element of a bargain” is a margin of safety that not only enables you to make a sufficient profit, but the gap between intrinsic value and the entry price 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.
In his book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” Klarman says many investors are often pressured into investing prematurely. However, the cheapest security in an overvalued market may still be overvalued and it is always the case that another opportunity will arrive at some point in the future. There is no point jumping into something just because it looks cheap relative to the rest of the market.
Calculating the margin of safety is a precise art. The calculated intrinsic value is only so good as the numbers used to arrive at the final figure:
“…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…” – Seth Klarman (Trades,Portfolio) Margin of Safety
The Fifth and Final Lesson
That quote brings me on to the fifth and final Seth Klarman lesson: The imprecise nature of markets. The one theme that is very apparent in all of Klarman’s writings is that he is very skeptical of equity markets. He believes they are highly inefficient and therefore, does not trust them to place an appropriate value on any asset. With this being the case, Klarman is always looking to use the most conservative set of numbers available. He is never overly optimistic and is always doubtful that a high-growth company can meet lofty expansion targets.
Furthermore, Klarman is never willing to rush into something to make a quick buck. Everything is analyzed, discounted and approached in a controlled manner. He always keeps a substantial cash buffer (20% or more) to take advantage of any opportunities that may arise and only invests where there is a wide margin of safety to an already discounted intrinsic value.
This approach may seem rigorous and time-consuming, but Klarman’s returns speak for themselves.
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