If relatively unknown to retail investors, it is because Seth Klarman prefers flying under the radar. But when he does express his views, either publicly or via his newsletters, institutional investors across the globe scramble to heed them.
In the first quarter of this calendar year, he raised concerns about a looming asset price bubble and “nosebleed valuations” in certain stocks. "Any year in which the S&P 500 jumps 32% and the Nasdaq 40% while corporate earnings barely increase should be a cause for concern, not for further exuberance. On almost any metric, the U.S. equity market is historically quite expensive.” A few months ago, he commented that “investors have been seduced into feeling good”.
In his out-of-print book Margin of Safety, that has a cult following and sells for over $1,500 on Amazon.com, he writes about stock prices and reality. The real success of an investment must not be confused with its success in the stock market. A rise in the stock price does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall does not necessarily reflect adverse business developments or value deterioration.
Hence his advice: Value in relation to price, not price alone, must determine your investment decisions.
Klarman runs one of the world’s largest hedge funds- the Baupost Group, which has racked up 19% annualised gains in three decades (according to ValueWalk). It’s not just the performance that makes him exceptional, it’s his very approach.
At heart, Klarman is a value stock picker. He pays deep attention to risk, is leery of leverage, and has no qualms about holding huge amounts of his portfolio in cash. At any given time, it will not be unusual to see around 30-50% of his portfolio parked in cash. He believes that value investing is not designed to outperform in a bull market. It is in a bear market that the value investing discipline becomes important and helps you find your bearings when reassuring landmarks are no longer visible. It is joked that he is probably the most patient hedge fund manager in the world and can sit on a fairly static portfolio for months without getting restless.
The ingredient to his success
Klarman is of the view that value investing is simple to understand but difficult to implement. It requires a great deal of hard work, unusually strict discipline, and a lot of patience. He believes very few have the proper mindset to succeed.
Since 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. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation.
When securities prices are steadily increasing, a value approach is usually a handicap; out-of-favour securities tend to rise less than the public's favourites.
The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.
Emotional investors and speculators inevitably lose money; but investors who take advantage of the market’s periodic irrationality have a good chance of enjoying long-term success.
Klarman adheres to Benjamin Graham's margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won't derail an investment.
Very simply put, his investing style is “mispricing due to overreaction”. He picks up securities that trade at a wide discount to their underlying value, what he 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. This way, you are able to profit even if your estimate of the underlying value is incorrect. Value investors invest with a margin of safety that protects them from large losses in declining markets.
Herein lies Klarman's secret. He will only make an investment if he is extremely confident that it won't lose much value, even if his initial investment thesis proves to be wrong.
But he also notes that investors can be pressured into investing prematurely; the cheapest security in an overvalued market may still be overvalued. This is where the discipline of a value investor comes in which will enable him to wait for an opportunity to buy, offering a better return for money.
Seth Klarman's advice to investors....
