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.

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

  1. Parth

    Hey Greg,

    I can back to this post to find some nuggets that I might have missed. I wanted to know if you can tell me where did you find the information on bullet # 4. If it is one of the partnership letters then can you tell me which one?

    Thanks,

    Parth

    Reply

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