Seth Klarman is one of the world's most astute investors. At the helm of one of the largest hedge funds in the world - Baupost, his book Margin of Safety has a cult following.
Here is some of his investing advice that has been taken from his book, newsletters and interviews over the years.
1) Don’t focus predominantly on return, focus on risk first.
The real pain occurs on the downside. When your portfolio is down by 50% you stare into an abyss and wonder if you are going to lose it all.
Focus on multiple scenarios. What can go wrong? How much can you lose?
Always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
Don’t think of risk in the academic sense of beta. Risk is the probability of losing and how much you can lose if you lose.
Volatility is not risk. Volatility creates opportunities.
Uncertainty is not risk. Sometimes great uncertainty - such as in the fall of 2008 - drives securities prices to especially low levels, which make them less risky investments.
2) Don’t get fooled by price.
The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance.
The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
[Private-Market value is an investor's assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety (from the Seth Klarman’s book Margin of Safety).]
If you don't overpay for it, your downside is protected. If you purchase it at a discount, you have a real margin of safety.
Price is perhaps the single most important criterion in sound investment decision making. Risk is not inherent in an investment; it is always relative to the price paid. Every security or asset is a “buy” at one price, a “hold” at a higher price, and a “sell” at some still higher price.
3) Don’t ignore valuations.
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. Value in relation to price, not price alone, must determine your investment decisions.
The cheapest security in an overvalued market may still be overvalued. You wouldn't want to settle for an investment offering a safe 10% return if you thought it very likely that another offering an equally safe 15% return would soon materialise.
An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available.
A stock trading at one-half of its underlying value may be attractive, but another trading at one-fourth of its worth is a better bargain. This dual discipline compounds the difficulty of the investment task for value investors compared with most others.
4) Don’t let a down market upset you.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Don’t forget that stocks aren't pieces of paper that gyrate all the time --they are fractional interests in businesses. And if you can buy “this thing” for a huge fraction of what it's worth, why must you be worried if it goes down a little bit more?
5) Don’t ignore psychology.
Investing is the intersection of economics and psychology.
The economics, the valuation of the business, is not hard. That is the easy part. The tough part is the psychology -- How much do you buy? Do you buy it at this price? Do you wait for a lower price? What do you do when it looks like the world might end?
While time and experience helps you move up the learning curve, it does help to have right psychological make up in the first place.
Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear.
6) Don’t get carried away by the big picture; think bottom up investing.
Macro investing must take a backseat to individual investment ideas.
Most of the investment world has a top-down orientation. How is the economy going to do? How are foreign currencies going to do? How are interest rates going to do? It is not totally extraneous, but investments must be analyzed bottom up one at a time.
It is incredibly difficult to have an accurate record of macro investing which has been efficiently translated to make it relevant to industries and companies, and be early so that the stock prices have not already moved to reflect your viewpoint.
7) Don’t let short-term underperformance divert your attention.
Long-term investment success is pursued at the price of short-term underperformance. When markets are rising, speculative investments may perform well. The payoff from a risk-averse, long-term orientation is–just that–long term. It is measurable only over the span of many years, over one or more market cycles.
Investing amidst failing markets is the best way to build positions at great prices, but this strategy can cause short-term underperformance. Buying as prices are falling can look stupid until sellers are exhausted and buyers who held back cannot effectively deploy capital except at much higher prices.
Short-term underperformance should not trouble you; indeed, because it is the price that must sometimes be paid for longer-term outperformance.
Patience and discipline can make you look foolishly out of touch until they make you look prudent and even prescient. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgement to know when it is time to swing.
8) Don’t go overboard with diversification.
Maintain sufficient but not excessive diversification. To quote Klarman: "Owning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once. This is particularly true if that market is trading at record levels of valuation, supported more by money flows than by fundamentals, as happens sometimes.”
9) Don’t try timing the market.
While it is always tempting to try to time the market and wait for the bottom to be reached, such a strategy has proven over the years to be deeply flawed.
The price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.
Most investors take comfort from a calm, steadily rising market; a roiling market causes panic. But these conventional reactions are inverted. When all feels calm and prices surge, the market may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one’s stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset’s lower market valuation.
People should be highly skeptical of anyone’s, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur.
10) Don’t let greed dominate your thought process.
Never hold on for the last nickel. You make a big mistake when you do that. We never assume something will go past its fair value. We let someone else make the last dollar or two. We always sell too soon.
This selling discipline allows him to rebuy a stock after it drops. It also helps him avoid the psychological damage of watching an unrealized profit disappear due to greed.
Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.
