Category Archives: Seth Klarman

Thoughts on Seth Klarman’s Discussion

Yesterday, I posted Cameron Wright’s excellent notes on Seth Klarman’s discussion with Jason Zweig of The Wall St. Journal at the CFA Institute Annual Conference on May 18, 2010. I reread the notes this morning and offer the following observations.

1. Seth Klarman is an exceptionally gifted investor and thinker. It is worth seeking out and studying everything he has written on investing. (In the future, I will put together a post on links to his writings – stay tuned.)

2. Klarman notes that the investing business is more competitive now than it was when Ben Graham operated. We should never lose site of the fact that whenever we buy an investment there is someone on the other side of the trade. We must assume that the person is both (very) intelligent and (very) well informed. To win at this game, we must limit our purchases to times when we know we have an edge. This could be through superior insight, for example, as a result of a good research and hard work, or because it is obvious that the reason the other party is selling has nothing to do with the underlying value of the asset, i.e. market panic, forced redemptions, etc.

3. Klarman is investing in asset classes that are well beyond traditional stocks and bonds. Many, if not most, of these alternative asset classes are difficult to buy, especially for individual investors. Don’t fret that there are ways to make money that are outside of your circle of competence. The answer is not to blindly follow investors like Klarman into areas you do not understand; this won’t work. Rather, focus on your own circle of competence and find an edge. As Munger says, you may not be able to become a world-class musician or tennis player, but you can, with patience and hard work, become the best plumber in Bemidji, MN.

4. Great investors do not beat the market every quarter or every year. Even the best have periods of underperformance. What value investing has on its side is logic. If you consistently purchase undervalued instruments at a margin of safety, the results will take care of themselves. This may play out in a lumpy fashion, but in the end will yield good results.

5. Klarman and his analysts spend their time looking for irrational sellers. Why? Because when someone is selling for an irrational reason you have an edge.

6. If you forget that securities are claims on a business, you will be much more susceptible to selling into a down market.

7. Great summary of the investment process: “1.) Find compelling bargains, not slight bargains. 2.) Test everything with sensitivity analyses. 3.) Prepare to be wrong.”

8. Klarman is more worried about the macro-economy that at any point in his career. My take on this is 1) to demand an even larger margin of safety in your investments, 2) go back over your research to confirm that your investment theses are sound, 3) don’t be averse to holding a material amount of cash in your portfolio as a simple hedge or if you cannot find compelling bargains, and 4) temper growth projections in all valuation models. In short, don’t reach. Consider the downside first and foremost.

9. Great quote: “Wall St. exists to make money, not to benefit Baupost. I know that Wall St. will always try to take our money, I go in with open eyes, you need to think “Caveat Emptor” when dealing with Wall St.

10. When Klarman buys a stock, he expects to hold it forever. Reminds me of Buffett who said, “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”

11. Another great quote: “At some price, an asset is a buy, at another it’s a hold, and at another it’s a sell.”

12. Book recommendations: “The Intelligent Investor, Greenblatt’s You Can Be A Stock Market Genius, Whitman’s Aggressive Conservative Investor, Anything from Jim Grant, Roger Lowenstein has not written a bad book, anything from him. Also Michael Lewis, who also hasn’t written a bad book either, but specifically MoneyBall which will go down as a definitive book on investing. Also Too Big to Fail is good.”

Seth Klarman on What Can Go Wrong (and a few thoughts on how to mitigate risks)

In part 2 of the “Wisdom of Seth Klarman” article from Distressed Debt Investing, which I posted on October 9, 2009, there is a great quote about what can go wrong with your investments. If you study Klarman, it is clear that he thinks about risks before rewards, and he takes seriously his commitment to preserve the hard earned capital of his investors.

“For most investments, much can go wrong, including numerous factors beyond an investor’s control: the economy, the markets, interest rates, the dollar, war, politics, tax rates, new technology, labor problems, competition, litigation, natural disasters, fraud, dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these risks can be hedged, often only imprecisely and always at some cost. Other factors are under an investor’s control, but are not always controlled: discipline; consistency; remaining within your circle of competence; matched duration of client capital with underlying investments; prudent diversification; reacting rationally to news or market developments; and of course, not overpaying”

I want to add a few thoughts on how investors can hedge against the risks that Klarman lists.

1. Study economic history and the history of markets. For example, Buffett is a great student of the history of markets and has commented that the Long Term Management blowup was a repeat of Northern Pacific in 1903. He has also commented that he finds many MBAs lacking in their knowledge of financial history. As Twain said, “History doesn’t repeat itself, but it rhymes.”

2. Always invest with a margin of safety. Graham has written that all investing comes down to these three words. Buffett has said repeatedly that Chapter 20 on the Margin of Safety in The Intelligent Investor, along with Chapter 8 on market fluctuations, is the most important thing ever written about investing.

3. Become increasingly cautious and fearful as the general market averages rise. Use basic common sense indicators to measure market valuation, such as the yield of the S&P 500 to that of 10-year U.S. Treasuries and the ratio of the market’s capitalization to U.S. GDP.

4. Look for investments that are not highly correlated with the general market averages. In the 50’s and 60’s, Buffett used control investing and arbitrage for this purpose. He also found a way to hedge multiple compression in his holdings of undervalued large cap stocks, although he does not disclose the specific technique.

5. Don’t be adverse to holding cash if you cannot find opportunities with downside protection and a mathematical expectancy that meets your investment hurdle rate.

6. Having a meaningful percentage of your companies’ earnings come from outside the U.S. is a way to hedge against future devaluation of the dollar.

7. Having companies that have the ability to raise prices and that have modest maintenance capex requirements along with high returns on invested capital can help hedge against inflation.

8. Avoid companies whose earnings are exposed in a material way to countries with political instability or capricious application of the law.

9. Invest in companies that have a clearly identifiable sustainable competitive advantage.

10. Carefully read the 10K’s, 10Q’s and proxy stamements to understand risks to the company, such as litigation and under-funded pension obligations.

11. Pay attention to free cash flow in addition to GAAP earnings and learn to detect financial statement fraud, for example by studying Financial Shenanigans by Howard Schilit.

12. Look for companies whose management has a meaningful ownership of the company’s stock, and, ideally, where management has purchased stock in the open market as opposed to option grants. Judge management by its actions, not its rhetoric.

13. Use extreme caution with companies that are exposed to technical obsolescence or short-term creative disruption.

14. If you don’t have conviction or its too complex, take a pass. There are plenty of other opportunities out there.

15. Think about risks first and rewards second. As 2008 proved, years of gains can be wiped out quickly and successful track records humbled when risk is not managed or given its proper due. Always consider what “black swan(s)” is present in your portfolio or strategy.

The Wisdom of Seth Klarman

Kudos to the blog Distressed Debt Investing for putting together an outstanding four-part series on the wisdom of Seth Klarman. Klarman not only has one of the best records in the business on an absolute basis, but also has done so by deftly managing the risk exposure of his portfolio. He is a clear and consistent thinker who is not swayed in the least by fashion or irrational exuberance.

Part 1

Part 2

Part 3

Part 4

Some Thoughts on Selling

Selling is an important part of the overall discipline of value investing. At the risk of oversimplifying things, value investors generally fall into one of two camps: those who sell their holdings when they reach intrinsic value and those who hold indefinitely, as long as the intrinsic value continues to grow.

Examples of investors in the first group are David Einhorn and Seth Klarman. Investor and writer Vitaliy Katsenelson has written a book called Active Value Investing which argues that investors should sell stocks when they reach intrinsic value because we are likely to be in a long-term range-bound market. His argument is worth considering.

Klarman has said that he frequently sells too early. I suspect that this due not only to his aversion to speculating, but also because of his understanding of intrinsic value. Klarman, like Graham before him, sees intrinsic value not as a specific precise number, but as a range of values. Therefore, it makes sense to sell as the stock price move up into the lower end of this range of values. Otherwise, the higher the price goes, the more you become dependent on the “greater fool” to bail you out.

The best known example of the second camp (buy and hold) is Warren Buffett. Another example is the Tweedy, Browne Company. A major incentive for this approach is that it defers capital gains taxes into the future, in effect getting an interest-free loan from the government. (Obviously, this is only an advantage for taxable holdings.) Buffett did not practice this approach in his partnership and would typically sell when a holding reached intrinsic value.

Why the change for Buffett? I think there are several reasons. First, the opportunities for Graham style asset plays diminished with time as the shock of the great depression faded and equities regained popularity with a new generation of investors. Second, Buffett began to focus on “good” businesses that had the capability of growing intrinsic value at a high rate over a long period of time. (During the Buffett partnership, most of the money was made from the stock price closing the gap between the purchase price and intrinsic value as opposed to growth in intrinsic value.) Also, as Buffett’s capital ballooned it became increasingly impractical to jump in and out of stocks. In addition, as Buffett became very wealthy he began to value the relationships with the management and owners of his holdings, for example with Kay Graham at the Washington Post.

Buffett has long favored the outright purchase of a business, if possible, because it allows him to control capital allocation. His emphasis on buy-and-hold has allowed him to create a competitive advantage vis-a-vis competing buy-out firms. He is able to attract and be first-in-line on a number of deals because the sellers know Berkshire will allow management to stay in place and run the business as they see fit and they needn’t fear the business will be dismantled or leveraged up.

So, how can we reconcile the two camps? I don’t think we need to. They both can work. The important thing, as with all investing, is to carefully think through your position in advance. Having a sell strategy will then help provide a framework against emotional reactions in the “heat of battle”. Also, it doesn’t need to be an “all or nothing” proposition. It would be perfectly rational to have mixture of long-term holdings that were increasing intrinsic value over time and event driven asset plays that you intend to sell when they reach your estimate of intrinsic value.

Also, regardless of which approach you adopt, there can be times when selling is the only rational thing to do. This occurs when a stock reaches a state of extreme overvaluation. In this case, take your profits. It makes no sense to hold a stock whose price anticipates a decade or more of robust growth in the intrinsic value of the underlying business.

Another time to consider selling is if you find a stock that is materially more undervalued than an existing holding. There is no set rule of thumb here, but, as a general guideline, I would say that it makes sense to do if, all else being equal, you can double your earnings yield. For example, if a given portion of your investing capital is earning X, redeploy it if you can find an opportunity where it would earn 2X. This should more than cover capital gains taxes, especially if they are long-term, and provide you with some margin of safety in your decision.