This is part four of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group. Parts one, two, three and four can be found at the respective links below. To ensure you do not miss the rest of the series sign up for our free newsletter.
Seth Klarman – Part five: Looking for opportunities
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.
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 investments. 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 valuation 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 degree 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 provides 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 outcome is more predictable.
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, competitors, products, management compensation etc.. 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.
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 usually 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 knowledge 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 continual high-quality research:
“…an investment program will not long succeed if high-quality research is not performed on a continuing basis…”
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 Trading, 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!
Seth Klarman – Conclusion
All in all, Klarman’s writing on finding value investment can be summed up as follows. There are three value situations, 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.