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SETH KLARMAN

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SETH KLARMAN

PART ONE

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Lessons For Retail And Institutional Investors

This is the first part of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group.

Seth Klarman is virtually unknown outside value circles, despite his impressive record and value of assets under man- agement. On average Baupost has returned 19% p.a. despite holding a large portion of its assets in cash. During the financial crisis, Seth Klarman’s funds lost somewhere between 7% and 13%, certainly outperforming the majority of its hedge fund peer group.

The group then rebounded during 2009, returning 27%. At the end of the second quarter of this year, Baupost an- nounced yet another strong quarter, ending with the best month the group has had in terms of returns in more than five years, even though around 35% of the portfolio remained invested in cash. Around 14% of the portfolio was also invested in liquidating claims in the Lehman estate, according to the firm’s Q2 letter.

At year end 2013, Baupost Group had AUM of $approximately $30 billion.

These returns are certainly some of the best around. And of course, many investors have been left wondering how they can replicate such a strong performance.

Seth Klarman’s Investing style

Reading through Klarman’s speeches and letters to investors, you quickly discover that the hedge fund manager is not around to make a quick buck. Klarman’s strategy is built around the notion that financial markets are inefficient, a viewpoint held by other well-known value investors (Buffett, Graham).

Klarman is a traditional value investor, looking for companies, bonds, credit instruments and real estate opportunities that all trade below what he, and his analysts believe is intrinsic value. However, a margin of safety must be incorpo- rated. Seth Klarman it seems, will never chase a stock just because it’s the stock of the moment. Of course, Klarman also considers the word ‘investment’ to be the same as that set out by Benjamin Graham:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Like Buffett and more notably, Graham, Klarman takes the view that stocks are, at their most basic, a fractional in- terest in a business, not a chip in a casino. Therefore, patterns or performance cannot be modelled with any kind of accuracy, or predictability. Seth Klarman also references Graham’s ‘Mr Market’ analogy when he is talking about his investment process. Ask Mr Market for advice on how to make money and you’ll be led in the wrong direction. But if you look to Mr Market as an eccentric but useful counterparty, who will often, in a state of depression and panic,

offer to sell you a fractional interest in his business at a marked down price, you’re on the right track.

Further, Klarman like Buffett is acutely aware of how an investor’s time horizon affects performance. Indeed, Klar- man has made multiple references to the short-term nature of the fund management industry, how many investment

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managers have become fixated on short-term performance, increasing levels of speculation as they rush to catch market moves. In his preface to Security Analysis: Sixth Edition, Seth Klarman notes how the coverage of financial markets on dedicated news networks, ferments the view that investors should have a view on everything the market is doing, and that they should be aware of every market movement. Short clips of market movements push the culture that investment decisions can be made in under a minute. Of course, this makes Mr Market redundant.

Still, Klarman’s investments are made with a long-term horizon, with almost no trades made for short-term 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…”

A way of thinking Buffett himself preached as early as 1963:

“…Our business is one requiring patience. It has little in common with a portfolio of

high-flying glamour stocks

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…”

is to our advantage to have securities do nothing price

It

Seth Klarman’s Long-term beats short-term

There’s plenty of evidence to support the fact that long-term investments do outperform short-term trades.

Unfortunately, there’s no doubt that as a whole, the market is becoming more short-term. This chart details the av- erage holding period of stocks during the past 100 years. Today, the average holding period of a share is around 30 seconds. During the 40s the average holding period was ten years. The holding period of stocks has been in constant decline since the early sixties. Nevertheless, it is interesting to note that before the 1929 crash, the average stock hold- ing period had declined to less than one year. During the following decade the average holding period rocketed to ten years.

[Note: Seth Klarman noted within one of his recent speeches that the majority of 30-year Treasury bond holders, on average, only hold their bonds for several months.]

A second chart shows Asset Class Returns vs. The “Average Investor” over the past 20 years according to annual- ized returns. While not directly related to the chart above, the two are connected. On average, private investors have returned 2.5% per annum during the past two decades, underperforming hedge funds, the energy, healthcare, consumer staple and technology sectors as well as the S&P 500 on an annualized basis. Even Treasuries put in a stronger performance over the period. Japan was the only asset class that performed worse than the average inves- tor over the past two decades.

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SETH KLARMAN What do these two charts mean? Well, at the end of September, James O’Shaughnessy

What do these two charts mean? Well, at the end of September, James O’Shaughnessy of O’Shaughnessy Asset Man- agement, and author of what ‘What Works on Wall Street’, went on Bloomberg Radio’s, Masters in Business program. He discussed how his research showed that shorter holding periods generally had a negative effect on returns. While this conclusion does not directly relate to Seth Klarman, it does shed some light on how his strategy is able to out- perform.

Conclusion

This is just a brief overview of Seth Klarman and his investment strategy. Over the next few articles I will be taking a closer look at some of his investments and the way he goes about managing money. Stay tuned for part two.years.

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SETH KLARMAN

PART TWO

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Value Investing in a Turbulent Environment [1997-2001]

This is part two of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group.

One of the toughest times for Baupost was the late 90s. While the rest of the market surged, Baupost underper- formed and during 1998, the group lost a double-digit percentage, at a time when the wider market was reporting annual gains in excess of 20%.

The following is a timeline of Seth Klarman’s letters to Baupost’s investors from 1997 to 2001 and shows why value investors should keep a cool head in a rising market, stick to their principles and not go chasing market gains.

stick to their principles and not go chasing market gains. Bubbles forming 1997 was an odd

Bubbles forming

1997 was an odd year for Baupost. The dot-com boom was just beginning and the S&P 500 had started its climb into bubble territory. Baupost’s financial year ended on October 31 and for the twelve months to this date, the fund returned 27%, despite holding around 20% of assets in cash. For the twelve months ending October 31, the S&P 500 returned 32.1%.

Over the year, as U.S. markets reported their best performance in decades, Baupost’s performance was held back by several underperforming Asian assets. Unfortunately, Baupost’s poor performance continued into the group’s 1998 financial year.

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From January 1 1998, through April 30, 1998 the S&P 500 Index rose by 15.1% and from November (1997) to April (1998) the index gained 22.5%. Over the same four and six month periods, Baupost only returned 7.4% and 11.3% respectively.

At this point Seth Klarman noted that the U.S. equity market was acting irrationally. Still, Baupost’s cash weighting decreased over this period to 17%. Klarman was still finding opportunities across Europe. At the same time, Baupost brought a large number of out of the money put options on the S&P 500. The following is a timeline of Seth Klarman’s letters to Baupost’s investors from 1997 to 2001 and shows why value investors should keep a cool head in a rising market, stick to their principles and not go chasing market gains.

Making mistakes

1997 was an odd year for Baupost. The dot-com boom was just beginning and the S&P 500 had started its climb into bubble territory. Baupost’s financial year ended on October 31 and for the twelve months to this date, the fund returned 27%, despite holding around 20% of assets in cash. For the twelve months ending October 31, the S&P 500 returned 32.1%.

“ we had too much of our money in equities and too little cash during the year. Giv- en our recurrent fear of a severe market correction and spreading economic weak- ness, this required us to maintain expensive and imperfect hedges …”

Once again, Baupost’s relative poor performance continued into 1999. To October 31 1999 the group returned 8.3%, while over the same period the S&P 500 returned around 23.8%. By this period the group had closed almost all market hedges. Hedges as a percentage of Baupost’s overall portfolio had fallen to 0.2%, compared to a weighting of around 1.5% before the losses of 1998.

It quickly becomes apparent through Seth Klarman’s letters that Baupost’s favorite method of hedging market risk is by holding cash, ready for quick deployment when an opportunity presents itself. It should be noted that between the half-year point and full-year 1999, Baupost’s cash weighting fell from 42.1% of assets, to 32.2%. Klarman was still able to find value opportunities, despite what he called ‘the frothy market environment’. Indeed, during the second half of Baupost’s 1999 financial year, the group’s U.S. equity weighting increased from 31%, to 41%.

Seth Klarman’s Baupost Group nearing the top

As 2000 began and the dot-com bubble reached its peak, Baupost was falling behind but Seth Klarman kept buying U.S. equities, spending almost all of Baupost’s cash cushion. Baupost’s cash weighting had dropped to 4.6% of AUM by April 2000. 61.9% of Baupost’s assets were invested in U.S. stocks.

For the financial year ending October 27 2000, Baupost posted a return of 22.4%. The S&P 500 peaked during Sep- tember and by the time Klarman wrote his letter to investors during December, the market had fallen more than 13%

from its peak:

“ … Clearly, the Internet bubble has burst. Nearly all publicly traded Internet stocks have come up snake-eyes, and there is considerable doubt about whether there is or ever was a “new economy …” Seth Klarman

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Cash was only 15.7% of fund assets at the end of October 2000.

Market beating

“ I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone

can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes es-

pecially important

helps you find your bearings when reassuring landmarks are no longer visible …” Seth Klarman

it

As the dot-com bubble deflated during 2000, Seth Klarman and Baupost remained focused on value. It’s reasonable to assume, that given Baupost’s overweight position in U.S. equities, the fund would have suffered as markets crashed during 2000. This was not the case.

Baupost reported a great start to 2001. With a low cash allocation and an overweight position in U.S. equities, the fund returned 14.4% for the six months ended April 30 2001. Over the same period, the S&P 500 fell 9.1%, the tech-heavy Nasdaq fell 36.6% and the Dow rose 2.1%.

Why did value stocks outperform as the rest of the market collapsed?

“ In effect money has come out of technology stocks, driving them mostly lower but it has not left the market.

Instead, it has moved into “value” stocks, seeking more certain returns and downside protection. This is one mani- festation of the “stocks for the long-term” thinking that prevails among most professional and individual investors. Stocks will outperform other asset classes over the long term because they always have, the thinking goes, so the real risk is being out of, and not in, the market …” - Seth Klarman

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PART THREE

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Value Investing In A Market Bubble [1997-2001]

This is part three of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group. Part one can be found here and part two can be found here.

In part two of this series I covered Seth Klarman’s investing strategy during the late 90s. As the market was swept up in dot-com mania, Klarman kept a cool head and stuck to his strategy. Unfortunately, using this strategy, Baupost significantly underperformed the wider market from 1997 to 1999.

Nevertheless, with an overriding confidence in his own and his analysts’ abilities, Seth Klarman continued to buy U.S. equities right up until 2000. Aggressive buying activity pushed Baupost’s cash weighting down from 42.1% of assets at the half-year point of 1999, down to only 4.6% of AUM by April 2000, at a time when the market was hitting a new all-time high almost every day.

Based on this information, I thought it could be interesting to take a closer look at some of stocks Seth Klarman was buying during this period. The data is taken from Klarman’s year-end December 17, 1999 letter to Baupost’s investors.

Seth Klarman seeking value in spinoffs

One of the first investments Seth Klarman mentioned within his year end 1999 letter, is a depressed post-spinoff situation. Tenneco Inc (NYSE:TEN). split itself in two to unlock value. The larger spinco, Pactiv Corporation, manu- factured food storage and trash bags, with a leading market share in many other plastic packaging products. After the spin, Pactiv’s shares slumped and the company’s valuation fell to a level that was too hard to pass up. Klarman brought when the company was trading at around ten time’s after-tax earnings and about five-and-a-half time’s pretax cash flow.

The other spinco was Tenneco Automotive, which manufactured branded shock absorbers and mufflers.

Tenneco Automotive was a market share leader in nearly all of its products and markets, for this reason the company should have traded at a high valuation. However, from a market cap. of several billion dollars pre-spin, the company’s value declined to only $200 million post spin, pushing it out of the S&P 500 and forcing many fund managers to sell their holdings, depressing the company’s valuation. Seth Klarman started buying when the company was trading at four times after-tax earnings - a great value opportunity. Tenneco still exists today.

Another spinoff situation that attracted Seth Klarman’s attention was Harcourt General. Harcourt had spun off its non-core business to become a pure play publishing and computer-based learning businesses. The group was forecast- ing long-term earnings growth of 12% to 15% per annum and traded at roughly half of net asset value as estimated by Baupost’s analysts. What’s more, Harcourt’s management had most of their net worth invested in the company.

A final spinoff situation for the year was Chemfirst, a specialty chemical company born as a spinco. The company was trading at five times estimated cash flow, management owned a large portion of stock and the company was actively repurchasing its own stock.

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Deep value

Aside from special situations and spinco’s, Seth Klarman was still finding value in the wider market throughout much of 1999. As many market participants focused on high-growth tech stocks during 1999, many ‘boring companies’ flew under the radar and this is where Klarman was able to find value.

Stewart Enterprises, Inc. (NASDAQ:STEI) was (and still is) a leading death-care provider and was acquired for Seth Klarman’s portfolio, during or before 1999.

Stewart was acquired at a time when the death-care industry in general was recovering from a debt-fuelled expansion binge and a decline in death rates. Insider buying, a multiple of six times after tax earnings and a new management team were all reasons that convinced Seth Klarman to start buying. Stewart still exists today but it’s the company’s smaller peer, Carriage Services, Inc. (NYSE:CSV) that looks attractive at present levels. See: Carriage Services, Inc. (CSV): Attractive investment In Deathcare

Two European companies acquired for Baupost’s portfolio during 1999 were Chargeurs and Saab. Chargeurs a French company which traded in wool as well as fabrics and Saab is a Swedish defense company -- they both still exist today.

Saab was one of Europe’s smallest remaining independent defense companies, which put it below the below the radar screen of most investors. Chargeurs was a small-cap was struggling to recover from the Asian crisis but was working to unlock shareholder value. Neither Saab nor Chargeurs was a distressed value situation. Indeed, Saab was expand- ing through acquisitions and had just started selling its aircraft to the international market. Chargeurs was the market leader in nearly every market in which it operated, generated substantial free cash flow from operations and was gob- bling up stock. Chargeurs was trading at seven times earnings and Saab at a similar valuation.

Special situations

Finally, two special situations that were acquired for Baupost’s portfolio.

Trustor Corporation was a company going through liquidation, which had cash assets and legal claims against a for- mer executive who committed embezzlement. The total value of cash and legal claims amounted to more than the company’s share price, lining Baupost up for a substantial liquidation distribution.

The other special situation was the debt of Maxwell Communications, another liquidation situation. The company was selling off assets to pay down debt making liquidation distributions at the same time.

Conclusion

One trend to note the links the majority of these investments is the fact that Seth Klarman not only liked stocks that were trading at a lowly valuation, but he also sought companies with market leading positions and managements teams with plenty of skin in the game.

How did these investments work out for Baupost? Well, for the financial year ending October 27 2000, when the wider market was falling, Baupost posted a return of 22.4%. During the first half of 2001, with a low cash allocation and an overweight position in U.S. equities, the fund returned 14.4% for the six months ended April 30 2001. U.S. equity indices reported double-digit declines during the same period.

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As noted within part two, these returns were possible as after the dot-com bubble burst, investors rushed to sell hot tech stocks, buying value instead, seeking more certain returns and downside protection.

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PART FOUR

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The Patient Investor

The following content is based on an interview Seth Klarman gave to financial journalist Jason Zweig at the CFA Institute 2010 annual conference. The interview was published within the September issue of the Financial Analysts Journal 2010. A copy of the interview script can be found here.

The influence of Graham and Dodd

Those of you who have been following this series so far will have noticed that Klarman’s investments, while value ori- entated, do not exactly conform to the strict value investing criteria set out by Graham and Dodd. This does not just apply to Klarman. Buffett is often described as a follower of Graham and Dodd but the Oracle of Omaha’s earlier investments, while inspired by Graham and Dodd, required activism to unlock value.

When quizzed on his strategy, Klarman stated that he views Graham and Dodd’s work as template for investing, rather than a detailed road map:

I think of Graham Dodd, however, it’s not just in terms of investing but

also in terms of thinking about investing. In my mind, their work helps create a

template for how to approach markets, how to think about volatility in markets as being in your favor rather than as a problem, and how to think about bargains and

where they come from

about the sourcing of opportunity as a major part of what we do—identifying where we are likely to find bargains. Time is scarce. We can’t look at everything…”

work of Graham and Dodd has really helped us think

When “

The

This template as it were, has helped build confidence in his own abilities, buying when others are fearful and holding through both the good times and the bad. For example, in parts two and three of this series I looked at Klarman’s trading throughout the turn-of-the century dot-com bubble and subsequent crash. Klarman kept buying both in the run up to 2000 and the years after, finding value while the rest of the market suffered. A strategy he followed through- out the 2008/2009 financial crisis. In fact at one point during 2009, around a third of Baupost’s assets were invested undervalued credit instruments, which had seen their values unfairly written down by the wider selloff. Was it easy for Klarman to keep buying while the rest of the market plummeted?:

Yes, “

what most people think they are. They aren’t pieces of paper that trade, blips on a screen up and down, ticker tapes that you follow on CNBC. Investing is buying a fractional interest in a business and buying debt claims on a business…”

it was easy. It is critical for an investor to understand that securities aren’t

Your “

dence, if you’ve made too many mistakes, if you are down too much, it becomes very easy to say, “I can’t stand being down more than this.” Avoiding round trips [buying and selling] and short-term devastation enables you to be around for the long term…”

Psychology as an investor is always important. If you lose your confi-

When asked why he believes that so many value investors underperformed during the 2008/2009 period, Klarman replied:

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“ the pressure to be fully invested at all times. When the markets are fairly ebul-

lient investors tend to hold the least objectionable securities rather than the truly significant bargains…”

A trap almost all investors have fallen into at one point or another.

Seth Klarman: Out of date

Graham-Dodd’s investment road map has helped Seth Klarman keep his cool in times of market stress. But despite their invaluable teachings, Klarman actually believes that their work is now somewhat out-of-date:

“ The world is different now than it was in the era of Graham and Dodd. The

business climate is more volatile now. The chance that you buy very cheap and that it will revert to the mean, as Graham and Dodd might have expected, is probably lower today than in the past…”

Whether or not this view is correct is up for debate. However, the developments in technology over the past 80 or so years since Benjamin Graham started teaching at the Columbia Business School, have seriously changed the way equity and debt markets operate. The availability of information has also reduced the amount of mispriced securities there are available in the market place.

Nevertheless, Baupost’s average holding period remains similar to that as defined by Graham-Dodd and Buffett:

“ With the exception of an arbitrage or a necessarily short-term investment, we

enter every trade with the idea that we are going to hold to maturity in the case of a bond and for a really long time, potentially forever, in the case of a stock. Again, if you don’t do that, you are speculating and not investing…”

On other topics

Seth Klarman weighed in on several other topics in his interview with Zweig, which have little to do with value invest- ing but provide some interesting food for thought.

For example, when quizzed on the topic of commodities, Seth Klarman believes that commodities, with the possible exception of gold, can never be true investments because they don’t produce cash flow.

If “

not purely dependent on what a future buyer might pay, then it’s an investment. If

an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation…”

an asset has cash flow, or the likelihood of cash flow in the near term and is

Klarman was also quizzed on the topics of short selling by hedge funds and HFT. On these two subjects Seth Klar- man issued some interesting nuggets of advice.

“…Short sellers are the market’s police officers. If short selling were to go away, the market would levitate even more than it currently does…”

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On the topic of HFT:

Seth Klarman: I don’t understand the worry about computers selling stocks at a penny, other than it creates a false sense of calm in investors’ minds that the markets won’t be volatile, which would be a false sense of well-being be- cause markets are, and should sometimes be, volatile. If someone wants to sell me a stock worth 50 bucks for a penny, it doesn’t bother me at all. I don’t think it should bother any of us.

Zweig: What about the problem of individual investors who had market orders in and just got crushed?

Seth Klarman: Nobody should ever put in a market order. It doesn’t make sense because the market can change rap- idly.

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PART FIVE

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Looking For Opportunities

he information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

The first and most important step in the process of value investing is finding investments.

Unfortunately, in today’s world it is both easier and harder than it has ever been before to find attractive value invest- ments. Blogs, screening tools financial databases and forums have all made the investing process easier but they have also made it harder.

There’s now more noise than ever before, which can cloud judgment and causes you to question yourself, while the freedom of information enables investors to discover and act on value opportunities quickly, rapidly closing the valu- ation gap.

Klarman notes that value investing has three main offshoots and these are the situations where investors should look for opportunity

Firstly, securities selling at a discount to breakup, or liquidation value -- the traditional value play. Then there are rate- of-return situations (tender offers, mergers, or spin offs where the rate-of-return can be calculated with a certain de- gree of accuracy. And finally, asset-conversion opportunities. Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions.

Of course, the data required to calculate the possible return on investment for all of these three situations can be found in newspapers and online, although further research should always be conducted. The list of stocks hitting a 52-week low is always helpful. But In the end there’s nothing better than good old-fashioned hard work when it comes to evaluating a securities true value.

Like all good books on investing, Klarman does not offer a sure-fire way to find value investments. Instead, he pro- vides a guide around which you can formulate your own plan. For regular readers of this series this will come as no surprise.

Seth Klarman - What comes next

Once you’ve found your bargain stock, it’s time to find out why the stock is in fact cheap. To quote Klarman:

“…If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?”…”

“…A bargain should be inspected and reinspected for possible flaws…”

Market inefficiencies can be created by short-term market movements or other reasons hidden below the surface. However, once the reason for mispricing becomes clear, the case for investment becomes even stronger as the out- come is more predictable.

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The acquisition of mispriced securities makes value investors contrarian by their very nature but as Klarman notes, holding a contrarian opinion is not always in the investors’ best interests and should be viewed with skepticism. As always, it should be established why the company is cheap compared to its peers and the wider market.

How much analysis is enough analysis?

Klarman does not shy away from the fact that investing, especially value investing, when done right is nothing but hard work. Nevertheless, there are limitations to how much preparation an investor can do before acquiring a stock.

For example, a potential investor can spend weeks researching a potential investment, the company, its market, com-

but there will always be some information that slips under the

radar. Further, even if an investor were to know all the facts about their possible acquisition, there is no guarantee that he or she would ultimately profit.

petitors, products, management compensation etc

The value of fundamental analysis is subject to diminishing marginal returns. The 80% of available information is gathered in the first 20% of time spent on the project. All in all, there is no simple answer to the question of how much analysis is enough. Most investors search tirelessly for certainty and precision, although low valuations are usu- ally a result of high uncertainty. Value investors are looking for low valuations, so they must be prepared to take on some uncertainty. To quote Margin of Safety directly:

“…By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowl- edge and are well rewarded for bearing the risk of uncertainty…”

Research is about separating the wheat from the chaff, and there is a lot of chaff in this world. Often there is no immediate buying opportunity, today’s research is for tomorrow’s buying opportunity. There is no substitute for con- tinual high-quality research:

investment program will not long succeed if high-quality research is not performed on a continuing basis…”

an

Seth Klarman - Insider activity

Klarman also notes at insider buying activity can be a key indicator of when to buy a stock. There are many reasons why managers will sell stock, there’s only one reason why they will buy on the open market. Insider buying can be a great tool in deciding whether or not a company is a great investment at present levels, a trend I’ve looked into before.

Indeed, according to Catalyst, research by H. Nejat Seyhun published in, Investment Intelligence from Insider Trad- ing, The MIT Press, 1998, from 1975 to 1994, stocks following insider buying outperformed the market by 4.5%, while stocks following insider selling underperformed the market by 2.7%. These results are based on an exhaustive data set, capturing information on insider trading in all publicly traded firms over two decades, around one million transactions!

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Seth Klarman - Conclusion

All in all, Klarman’s writing on finding value investment can be summed up as follows. There are three value situa- tions, the traditional value play, the rate-of-return and asset-conversion. Once the situation is identified, consistent high quality research should be conducted to figure out why the situation qualifies as a value play, although investors should be prepared to accept a certain degree of uncertainty. Insider buying is a great way to get an inside view on the state of the business.

Stay tuned for Seth Klarman part five.

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PART SIX

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Yield Pigs

The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.

“There are countless example of investor greed in recent financial history. Few, however, were as relentless as the decade-long “reach for yield” of the 1980s.” -- Seth Klarman

Greed and the Yield Pigs of the 1980s, was not only a chapter of Margin of Safety but a also warning; a warning that today’s investors seem to have forgotten. Early in the 80s, the double-digit yield on government securities gave inves- tors the false notion that double-digit returns were the norm. This way of thinking drove investors to sacrifice credit quality for higher yields when interest rates started to decline, similar to the environment we are in today.

“Yield pigs” became a term for investors who were susceptible to any investment product that promised a high cur- rent rate of return, without properly assessing the risk that the product carried. Seth Klarman uses Margin of Safety to try an prevent investors from becoming yield pigs, warning that if high yield assets were indeed low risk, they wouldn’t be offering a high yield in the first place.

In order to achieve higher levels of return, above that of U.S. government securities (the “risk-free” rate), increasing levels of risk must be taken in line with the premium over the risk-free rate. Higher risks will often erode capital. Of course, higher returns for higher risk only applies on average and over time; as returns of the wider market will justify.

Seth Klarman wrote the following statement during February 1992:

“…These days, however, I don’t believe investors are being compensated suffi- ciently to venture beyond risk-free instruments…”

At this time, the yield spread of the Credit Suisse High Yield Index versus Treasuries stood at around 544 bps. Over the past 26 years the median spread has fallen to a similar level. There are only three times during the past two decades (after the dot-com bubble and 2008/09) where the yield on junk bonds has exceeded the 800 bps spread mark over Treasuries (I am making the assumption here, based on Seth Klarman’s buying activities, that a spread of 800 bps over Treasuries is enough to compensate for the risk of investing in junk). During both of these periods we know Seth Klarman was buying distressed junk debt. He has avoided the sector when yields have traded lower.

Today’s market

The environment Seth Klarman was describing during 1992 has many similarities to today’s market. Seth Klarman describes the trend of the yield pig, desperate for yield, throwing money at stocks, despite the high valuation and historically low dividend yield. This statement, published by Morningstar earlier this year implies that the same is hap-

pening in today’s market:

“…With rates at all-time lows investors have been forced into higher risk asset classes such as equities to maintain the same level of income. Defensive equities with stable and rising dividends have become a target for yield-hungry investors who might not otherwise consider the stock market at all…”

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But what if you have no option? Many investors strive to live off the income from their investments and are being forced to take on extra risk, in order to achieve the level of income required to sustain their lifestyle. Seth Klarman’s advice on the matter:

“ I would advise people to ignore conventional wisdom and consume some

principal for a while, if necessary, rather than to reach for yield and incur the risk

of major capital loss…”

Unfortunately, in today’s world where interest rates have been so low for so long, this advice isn’t practical. If risk- adverse investors had taken this advice several years ago, they will have seen the majority of their capital erased if they had just lived off the cash. Still, if you’ve no other option:

to short-term U.S. government securities, federally insured bank CDs, or

money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable…”

Stick “

While this advice was given in the early 90s, it is still relevant in today’s environment.

Conclusion

Seth Klarman may have written his piece on yield pigs in the early 90s, but it is extremely relevant in today’s market. The key take away is that investors should not chase yield, it’s better to preserve capital rather than risk capital for a lower-than-acceptable rates of return and high levels of risk.

While interest rates are low now, there’s no guarantee that rates will remain low forever (no matter what some econo- mists might think). It’s better to preserve you capital than take on additional risk for a return that is unlikely to com- pensate you for the additional risk. It’s better to wait for a time when you can carefully place your bets, buying debt with only the most financially stable companies at an attractive rate of interest.

I should state that this article is not designed to be investment advice, from the author, or ValueWalk.

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PART SEVEN

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Wall Street Is The Average Investors Worst Enemy

The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Invest- ing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.

Wall Street is plagued by conflicts of interest and short-term bias, which does nothing to improve the performance of the average investor according to Seth Klarman. The issue of trading costs, fees and management charges all act as conflicts of interest -- Wall Street gets paid for what it does, not how well it does it (this refers to all wealth man- agers, not just those on Wall Street).

There’s a wealth of information out there that shows trading costs, can have a drastic effect on performance there- fore, the portfolios that trade the least outperform. However, for Wall Street this is a catch-22 as brokers are paid to trade, and the broker who makes no trade all year, may be labeled as lazy by his client.

Seth Klarman is well aware of this catch-22 situation and does everything he can to discourage investors from deal- ing with Wall Street. Seth Klarman’s average holding period for his investments is indefinite, reducing the need to rack up trading fees that eat away at return

Seth Klarman on short-termism

On top of the need and commissions eating away at returns, Seth Klarman writes that Wall Street is increasingly focused on short-term returns, which are driven by an up-front-fee orientation. Brokers, traders, and investment bankers all find it hard to look beyond the next transaction, when the current one is so lucrative regardless of merit.

Of course, in today’s world of low-cost online brokers, the issue of fees and a short-term focus driven by these fees is less apparent than it once was. Nevertheless, it’s easy to notice Wall Street’s short-term view, the overriding impor- tance of quarterly earnings and the constant commentary supplied by financial news channels.

Seth Klarman - A bullish bias

Seth Klarman writes that investors should, at all times, remember that Wall Street has a bullish bias. Wall Street can conduct more IPO’s in a bull market and brokers get more business from new clients. It’s a Wall Streeters job to be optimistic and bullish, that’s why there are always more “buy” ratings out there than “sell” ratings. As Seth Klarman puts it:

“…Perhaps this is the case because anyone with money is a candidate to buy a stock or bond, while only those who own are candidates to sell. In other words, there is more brokerage business to be done by issuing an optimistic research re- port than by writing a pessimistic one…”

It can also be assumed that many investors don’t like to admit their own mistakes, so they are not willing to pay for research that tells them they are wrong.

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“… Many of the same factors that contribute to a bullish bias can cause the finan-

Since

security prices reflect investors’ perception of reality and not necessarily reality itself, overvaluation may persist for a long time…”

cial markets, especially the stock market, to become and remain overvalued

Seth Klarman on investment fads

It’s not only single securities that can become overvalued, whole industries can see their valuations rocket as they be- come an investment fad and note, when an industry is in fad mode, very few Wall Streeters will call the fad out. The e-cig, marijuana and solar industry are three current example. However, in the words of Seth Klarman:

“…It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad become dangerous however, when share prices reach levels that are not supported by the conservatively ap- praised values of the underlying business…”

Seth Klarman on the downfall of money management

“…The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve…”

With Wall Street focused on short-term benchmarks and performance, Seth Klarman writes that the Street has now lost the ability to management money over the long-term. Pension funds and institutions are now the greatest stock- holders in terms of volume, outnumbering private investors but institutions are no more qualified that private inves- tors to look after your money. As Seth Klarman writes:

“…If the behaviour of institutional investors weren’t so horrifying, it might actu-

ally be humorous

the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance…”

prevalent mentality is consensus, groupthink. Acting with

The

Seth Klarman notes that Wall Street is a performance derby. Many institutional managers are all trying to improve their relative performance and keep it equal to, or greater than an index. But the money managers are also faced with several self-imposed constraints. Such as illiquidity; institutional investors will not spend days researching a small-cap illiquid stock that may, or may not become a winner, they move with the rest of the group. Pressure to be fully invested is another constraint; unlike many fund managers, Klarman keeps around a third of his portfolio in cash.

Further, the overly narrow categorization of stocks in the intuitional investment business (emphasis on rigidly defined categories) restricts returns; the best, and undiscovered, opportunities lie outside the clearly defined categories, hidden away from institutional investors. When the opportunities are discovered by institutional investors, it is often too late. Other factors that constrain performance include the use of index funds, or as Seth Klarman puts it, the mindless acquisition of stocks on the basis that the efficient market hypothesis holds true. (Unsurprisingly, Seth Klarman is not a supporter of the EMH. His returns over the past few decades support his conclusion that the EMH does not hold true.)

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Seth Klarman: Conclusion

But what’s the point of all the above information? Many readers will know that Wall Street is bias and has a short- term focus, therefore cannot be trusted. So how can value investors benefit? As usual, Seth Klarman has the last say on the matter:

must try to understand the institutional investment mentality for two

reasons. First, institutions dominate financial market trading; investors who are ignorant of institutional behavior are likely to be periodically trampled. Second, ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by the investment elephants can be rewarding ”

Investors “

On a final note, one of the most surprising statements Seth Klarman made in this part of the book was the revelation that when he wrote Margin of Safety, an increasing number of money managers were investing in stocks with little to know in-depth fundamental research. An extremely concerning revelation.

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PART EIGHT

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The Margin of Safety

The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.

Most, if not all value investors will have heard of the Margin of Safety; buying undervalued securities that trade at a wide discount to their underlying value. Key to this process is the, what Seth Klarman calls, “the element of a bar- gain”. 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, so that you are still able to profit even if your estimate of the underlying value is incorrect. However, it’s often difficult for investors to maintain the discipline of only investing when the discount is wide enough:

The “

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…”

greatest challenge for value investors is maintaining the required discipline.

Seth Klarman notes that value investors have to keep the discipline, no matter how bad things many seem. Earlier in this series, I covered Seth Klarman’s performance in the run up to the dot-com bubble, where Baupost significantly underperformed the wider market, reporting single-digit gains (and even losses) while the wider market surged higher. Throughout this turmoil, Seth Klarman kept his cool and stuck to his value investing principles.

Over the short-term, there may be periods where the value approach seems outdated and ill conceived. However, over the long-term, the devoted advocates of the strategy are rewarded and the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it. The message here is stick to your principles, don’t over trade and believe in the value discipline.

On the subject of maintaining the value discipline, Seth Klarman notes that many investors are often pressured into investing prematurely; the cheapest security in an overvalued market may still be overvalued. It is often the case that another opportunity to buy will come along soon, offering a better return for your money.

Nevertheless, value alone is not sufficient, investors must choose only the best absolute values among those that are currently available. Oddly, this is where Seth Klarman actually advocates increased trading, or rebalancing.

“ Value investors continually compare potential new investments with their cur-

rent holdings in order to ensure that they own only the most undervalued oppor- tunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings…”

The Art of Business Valuation

Of course, achieving an appropriate margin of safety is entirely dependent upon the ability of the investor to be able to place an appropriate value on the underlying business. In a warning to potential investors, Seth Klarman states that:

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Reported “

of accountants

value of your home to the nearest thousand dollars. Why would it be any easier to

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…

place a value on vast and complex businesses?

cannot appraise the

book value, earnings, and cash flow are, after all, only the best guesses

Projected

results are less precise still

if

You

This is clearly a warning to all those who invest based on book values and stated financial figures alone. It’s also the basis of the margin of safety principle. Seth Klarman is wary of figures such as net present value and the internal rate of return, they are only as accurate as the figures and assumptions used to calculate them.

It’s here that Seth Klarman even criticizes Benjamin Graham’s an approach to valuations. Graham’s back-of-the- envelope estimate of a company’s liquidation value, net-nets was based on imprecise values -- this is why he often discounted figures on the balance sheet to arrive a discounted liquidation value, a suitable and appropriate margin of safety.

Price fluctuations

On another note, Seth Klarman sets out to warn investors not to give too much weight to day-to-day market fluc- tuations. Many investors consider price fluctuations to be a significant risk, but in reality these temporary price fluctuations are not a risk; not in the way that permanent value impairments are, and then only for certain investors in specific situations.

Unfortunately, it’s not easy for investors to distinguish temporary volatility, from price movements related to busi- ness fundamentals. In this case, the reality may only become apparent after the fact. Still, as always, Seth Klarman is

looking for long-term outperformance, not short-term trading patterns:

If “

matter? In the long run they do not matter much; value will ultimately be reflected in the price of a security…”

you are buying sound value at a discount, do short-term price fluctuations

Conclusion

In summary then the margin of safety principle is key for all value investors but investors should be wary of stated financial figures. Short-term price volatility is irrelevant for long-term investors and as long as you are investing with a wide enough margin of safety, even a change in the underlying business fundamentals can save you from total disaster.

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PART NINE

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Areas of Opportunity for Value Investors

The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.

In part five of this series I looked at the method Seth Klarman uses for finding value opportunities. In this part, I’m looking at where Klarman believes the best investments can be found and what situations create the most lucrative opportunities for value investors.

When looking for opportunities, Seth Klarman isn’t looking for anything obvious. He notes that the easier an un- dervalued security is to understand, the more obvious it becomes to other investors and as a result, the opportunity disappears quickly. So, the best opportunities are often hidden, forcing investors to work harder and dig deeper to find undervalued opportunities.

One way of unlocking value Seth Klarman loves to make use of, is the emergence of a company from bankruptcy. Owners of senior debt usually receive distributions from the bankruptcy that exceed the value of the marketable securities they initially purchased. Seth Klarman has been able to double his money over the past five or so years by buying the debt of Lehman Brothers after it collapsed.

Seth Klarman used the same strategy with the debt of Enron. Baupost brought Enron debt for 10 to 15 cents on the dollar, after an analyst worked on the company for four years studying the potential risk reward potential. The analyst concluded that the debt was worth between 30 and 50 cents on the dollar. 50 cents worked out to be about right.

The right moment

Value investors are always waiting for a catalyst to drive a re-rating of shares and unlock value. In Warren Buffett’s early days, he was able to achieve such impressive returns as some of his biggest positions were activist plays, whereby he purchased a big position and then fought with the company until he got his way, unlocking value. Unfortunately, most small-scale investors can’t act this way, so they may have to wait years for value to be unlocked. That key catalyst, which can ignite the stock price and unlock value is often unexpected. With this in mind, Seth Klarman is looking for:

securities “

with catalysts for value realization is therefore an important way for

investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value…”

Such value creating opportunities can be as simple as spin-off or stock buybacks and these are signs that manage- ments are shareholder orientated, they want to achieve the best value for investors by deploying capital effectively.

Corporate liquidations

One of the most complex situations where Seth Klarman likes to look for value is the corporate liquidation bargain bucket. Why is this the case? Well it comes back to the fact that the best opportunities for profit in the value universe, are those that others avoid. In other words:

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in liquidations is sometimes disparagingly referred to as cigarbutt in-

vesting, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors…”

investing “

However, unless you have the time and the knowledge to calculate how much value there is in complex liquidations situations, there’s little chance that the average investor will be able to profit from company liquidations. Still, there’s nothing stopping you if you feel the risk/reward is right.

Seth Klarman does offer some help here, for those investors willing to take the risk. He quotes Michael Price of Mu- tual Series Fund, Inc., and his three stages of bankruptcy.

The first stage, the initial Chapter 11, is the time of greatest uncertainty but perhaps also of greatest opportunity for investors. In this stage, uncertainty persists and the business is a mess, many holders have dumped their stock at overly depressed prices to get out as fast as possible. Stage one offer the most risk but the most reward.

The second stage is the involving the negotiation of a plan of reorganization. By this point analysts know roughly how bad/good the situation is but there is still much uncertainty.

The third stage is the finalization of a reorganization plan and the debtor’s emergence from bankruptcy. This stage can be viewed as a risk-arbitrage situation; investors and traders know roughly how much they will receive and what risk there is of the deal falling through. The lowest and most predictable returns are available in the third stage, after the reorganization plan becomes publicly available.

The stage at which you want to get involved depends entirely of your knowledge of the situation and appetite for risk.

Rights offerings and spinoffs

Rights offering and spin offs are two other situations where value can be found. An aggressive selloff following the announcement of a rights issue can be an opportunity, if you’re willing to do the work to establish where value can be found.

Additionally, spinoffs can create value in the same way. Often it is the case that institutions will sell the spinco, as it does not conform to their investing criteria, artificially depressing the stock price and valuation -- here’s where the value can be found as prices are artificially depressed. In part three of this series I took a look at some of the spinoff situations Seth Klarman profited from in the late 90s.

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PART TEN

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Portfolio Management

So far most of this series has been devoted to Seth Klarman’s investing strategy, detailing what he looks for in an investment and how to invest with a value slant. However, as all seasoned investors will know, while finding attractive investments is tough and time consuming, portfolio management on a day-to-day basis can make, or break a strategy. Even if you’ve made great stock picks, over trading, selling too early, or failing to keep up with economic/company specific developments can eat away at returns.

With this in mind, the final part of this series is devoted to Seth Klarman’s take on portfolio management.

The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.

investors must come to terms with the relentless continuity of the invest-

ment process. Although specific investments have a beginning and an end, portfo- lio management goes on forever…” - Seth Klarman

All “

Portfolio liquidity

Seth Klarman’s Baupost is well known for its large cash weighting, which at some points has exceeded 40%. For value investors, a high level of liquidity is extremely important, especially when investors build positions in illiquid compa- nies. More often than not, value can only be found in illiquid assets as best opportunities usually fly under the radar. It can take years to realize results and the last thing you want to do is sell too early.

However, the opportunity cost of liquidity is high, so no investment portfolio should be completely liquid either. This is especially relevant in today’s environment. The rate of return on cash balances held within brokerage accounts is, in many cases, negligible. Even near-term cash like instruments and money market funds do not offer an attractive rate of return for cash balances. For example, the S&P 500 currently yields 1.86% on average, while the Fidelity Cash Management account currently offers an interest rate of 0.07%.

Of course, how cash you hold is dependent upon your investing style and existing portfolio of investments. A portfo- lio of blue chips can be turned into cash quickly, to take advantage of opportunities. While venture capital investments may take months to liquidate so a large cash balance is required.

Reducing portfolio risk

Portfolio “

ing into account diversification, possible hedging strategies, and the management of portfolio cash flow. In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors…”

management requires paying attention to the portfolio as a whole, tak-

The two specific methods Klarman makes use of to hedge portfolio risk is the use of hedging, through derivatives and diversification. How many stocks should you hold to be suitable diversified? In Seth Klarman’s view ten to 15 is suitable. The reason for such a small portfolio size:

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My “

than knowing only a little about each of a great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hun-

dredth or thousandth best idea…”

view is that an investor is better off knowing a lot about a few investments

But when it comes to hedging, Seth Klarman’s view on the topic is not as well defined. Hedging can be useful but:

However:

Hedges “

ing for a hedge is as poor an idea as overpaying for an investment…”

can be expensive to buy and time-consuming to maintain, and overpay-

When “

take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits…”

the cost is reasonable, however, a hedging strategy may allow investors to

The Importance of Trading

Buying at the right price is critical for a value investor. Therefore, trading is central to value-investing success. Simply put, trading is the process of taking advantage of mispricings. Opportunities arise when other investors panic and companies at prices far below underlying business value, creating buying opportunities for value investors.

Stay in Touch with the Market

While some investors are comfortable buying and forgetting for the long-term, according to Seth Klarman’s princi- ples, such a strategy seems misguided today. Financial markets are erratic and are more so today than they have been at any point in the past. It’s now easier than ever before to buy and sell securities, which has only made the market more volatile as participants rush in and out of positions.

Even when Margin of Safety was written, Seth Klarman noted that many investors were actually buying and selling se- curities with little or no fundamental knowledge of the underlying businesses. So, when Mr Market throws his toys out the pram, investors panic and opportunities to buy at discounted price present themselves at a rapid pace. A high level of liquidity, coupled with a knowledge of day-to-day market movements can result in plenty of value opportunities.

Buying: Leave Room to Average Down

As Seth Klarman explains:

The “

tion to price fluctuations

my view, investors should usually refrain from purchasing a “full position” (the maximum dollar commitment they intend to make) in a given security all at once

half of trading involves learning how to buy. In

single most crucial factor in trading is developing the appropriate reac-

One

Buying a partial position leaves reserves that permit investors to “average down,”

the security you are

considering is truly a good investment, not a speculation, you would certainly want

lowering their average cost per share, if prices decline

If

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to own more at lower prices. If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place…”

Selling: The Hardest Decision of All

Anyone over the age of 18 can buy a stock. The hardest part is selling. Some investors have targets on when to sell, if the P/B value hits one, or P/E exceeds 15. These are rules Seth Klarman considers to be useless. Just like deci- sions to buy, decisions on when to sell must be based on the business’ underlying value, which will of course change constantly.

It may be silly to wait for full value realization. For example, missing out on half a point of profit when other oppor- tunities are available is not the end of the world. It’s be better to take profits and reinvest with a new, wider margin of safety. Stop losses should not be used, a view held by most value investors:

Some “

ginally below their cost

side risk, it is, in fact, crazy

merits of a particular investment better than he or she does…” (What happened to Mr Market? Using stop losses puts him in control.)

user of this technique acts as if the market knows the

this strategy may seem an effective way to limit down-

investors place stop-loss orders to sell securities at specific prices, usually mar-

Although

a

Making the decision to sell is tough, it requires constant work to value the underlying business. Still, deciding on when to sell is without a doubt more important than deciding on when to buy.

If “

If you are speculating in securities trading above underlying value, when do you take a profit or cut your losses? Do you have any guide other than “how they are acting,” which is really no guide at all?”

you haven’t bought based upon underlying value, how do you decide when to sell?

Conclusion

That concludes this series on Seth Klarman. I hope you’ve found it useful, if not, it’s always handy to remember that while we don’t all hold the same opinions, considering a diverse range of insights will make us better investors.

Next week I’m starting a series based on the life and investing style of legendary Canadian value investor, Peter Cun- dill.

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