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PART ONE
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SETH KLARMAN
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, Klarmans 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, Id have no idea howYou 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...It is to our advantage to have securities do nothing price
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
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What do these two charts mean? Well, at the end of September, James OShaughnessy of OShaughnessy Asset Management, and author of what What Works on Wall Street, went on Bloomberg Radios, 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 outperform.
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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PART TWO
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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. Bauposts 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, Bauposts performance was held back by
several underperforming Asian assets. Unfortunately, Bauposts poor performance continued into the groups 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, Bauposts 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 Klarmans letters to Bauposts 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. Bauposts 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. Given our recurrent fear of a severe market correction and spreading economic weakness, this required us to maintain expensive and imperfect hedges
Once again, Bauposts 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 Bauposts 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 Klarmans letters that Bauposts 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, Bauposts 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
Bauposts 1999 financial year, the groups U.S. equity weighting increased from 31%, to 41%.
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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 especially important...it helps you find your bearings when reassuring landmarks are no longer visible Seth Klarman
As the dot-com bubble deflated during 2000, Seth Klarman and Baupost remained focused on value. Its reasonable
to assume, that given Bauposts 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 manifestation 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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Deep value
Aside from special situations and spincos, 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
Klarmans 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 its the companys
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 Bauposts 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 Europes 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 expanding 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 gobbling 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 Bauposts portfolio.
Trustor Corporation was a company going through liquidation, which had cash assets and legal claims against a former executive who committed embezzlement. The total value of cash and legal claims amounted to more than the
companys 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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SETH KLARMAN
PART FOUR
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... the pressure to be fully invested at all times. When the markets are fairly ebullient 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.
On other topics
Seth Klarman weighed in on several other topics in his interview with Zweig, which have little to do with value investing 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 dont produce cash flow.
...If an asset has cash flow, or the likelihood of cash flow in the near term and is
not purely dependent on what a future buyer might pay, then its an investment. If
an assets value is totally dependent on the amount a future buyer might pay, then
its purchase is speculation
Klarman was also quizzed on the topics of short selling by hedge funds and HFT. On these two subjects Seth Klarman issued some interesting nuggets of advice.
Short sellers are the markets police officers. If short selling were to go away,
the market would levitate even more than it currently does
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PART FIVE
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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.
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PART SIX
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Yield Pigs
The information below is based on Seth Klarmans out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully youll 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
todays investors seem to have forgotten. Early in the 80s, the double-digit yield on government securities gave investors 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 current 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 wouldnt
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 dont believe investors are being compensated sufficiently 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 Klarmans 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.
Todays market
The environment Seth Klarman was describing during 1992 has many similarities to todays 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 happening in todays 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 Klarmans
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 todays world where interest rates have been so low for so long, this advice isnt practical. If riskadverse 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 youve no other option:
...Stick 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
While this advice was given in the early 90s, it is still relevant in todays environment.
Conclusion
Seth Klarman may have written his piece on yield pigs in the early 90s, but it is extremely relevant in todays market.
The key take away is that investors should not chase yield, its 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, theres no guarantee that rates will remain low forever (no matter what some economists might think). Its better to preserve you capital than take on additional risk for a return that is unlikely to compensate you for the additional risk. Its 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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SETH KLARMAN
PART SEVEN
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Many of the same factors that contribute to a bullish bias can cause the financial markets, especially the stock market, to become and remain overvalued...Since
security prices reflect investors perception of reality and not necessarily reality
itself, overvaluation may persist for a long time
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PART EIGHT
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...Reported book value, earnings, and cash flow are, after all, only the best guesses
of accountants...Projected results are less precise still...You cannot appraise the
value of your home to the nearest thousand dollars. Why would it be any easier to
place a value on vast and complex businesses?...if 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
This is clearly a warning to all those who invest based on book values and stated financial figures alone. Its 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.
Its here that Seth Klarman even criticizes Benjamin Grahams an approach to valuations. Grahams back-of-theenvelope estimate of a companys 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 fluctuations. 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, its not easy for investors to distinguish temporary volatility, from price movements related to business 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 you are buying sound value at a discount, do short-term price fluctuations
matter? In the long run they do not matter much; value will ultimately be reflected
in the price of a security
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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SETH KLARMAN
PART NINE
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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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...investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone elses 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
However, unless you have the time and the knowledge to calculate how much value there is in complex liquidations
situations, theres little chance that the average investor will be able to profit from company liquidations. Still, theres
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 Mutual 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 debtors 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.
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PART TEN
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Portfolio Management
So far most of this series has been devoted to Seth Klarmans 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 youve 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 Klarmans take on portfolio management.
The information below is based on Seth Klarmans out of print book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor; hopefully youll find some useful tips.
...All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever - Seth Klarman
Portfolio liquidity
Seth Klarmans 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 companies. 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 todays 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 portfolio 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.
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...My view is that an investor is better off knowing a lot about a few investments
than knowing only a little about each of a great many holdings. Ones very best
ideas are likely to generate higher returns for a given level of risk than ones hundredth or thousandth best idea
But when it comes to hedging, Seth Klarmans view on the topic is not as well defined. Hedging can be useful but:
...Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment
However:
...When the cost is reasonable, however, a hedging strategy may allow investors to
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
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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
Conclusion
That concludes this series on Seth Klarman. I hope youve found it useful, if not, its always handy to remember that
while we dont all hold the same opinions, considering a diverse range of insights will make us better investors.
Next week Im starting a series based on the life and investing style of legendary Canadian value investor, Peter Cundill.
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