Seth Klarman – ETF’s Provide Value Investors With A Distinct Advantage. Here’s Why.

Seth Klarman – ETF’s Provide Value Investors With A Distinct Advantage. Here’s Why.
By Hedge Funds [CC BY 3.0], via Wikimedia Commons

One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Seth Klarman.

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Back in February this year, Klarman released The Baupost Group’s 2016 year end letter in which he discusses the impact of ETF’s on the hedge fund industry and why ETF’s present long-term value investors with a distinct advantage. It’s a must read for all investors.

Here’s an excerpt from that letter:

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At mid-year, 11.6% of the S&P 500 was held by index funds and index ETFs, up from 4.6% a decade ago. This trend away from active stock picking, if anything, accelerated in 2016. ETFs now exceed $3.2 trillion in assets and are changing the financial landscape. Over the last 12 months, while $131 billion has flowed out of all U.S. mutual funds, $249 billion has flowed into U.S. ETFs. Meanwhile, five of the world’s seven most heavily-traded equity securities are ETFs.

But ETFs are not without their own risks. According to the Financial Times, “Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.” Large concentrations of ownership in a small number of ETFs has left corporate ownership increasingly concentrated. And because of the high volume of ETFs, short-term trading has become even more dominant. John Bogle, the founder and retired CEO of Vanguard, points out that 12% of a typical stock turns over each year, compared with 880% turnover for ETFs. Similarly, Nikolaos Panigirtzoglou, a global markets strategist at JP Morgan in London, warns that the inflows into ETFs will make markets more brittle, susceptible to more severe crashes, and less efficient.

One of the perverse effects of increased indexing and ETF activity is that it will tend to “lock in” today’s relative valuations between securities. When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).

Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings. Conversely with money pouring into market indices, stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it. This should give long-term value investors a distinct advantage. The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.


This original article was posted by Johnny Hopkins at The Acquirer's Multiple.

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The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates. It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization. The Acquirer’s Multiple® is calculated as follows: Enterprise Value / Operating Earnings* It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT. Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations. Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up. Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC. He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law. Articles written for Seeking Alpha are provided by the team of analysts at, home of The Acquirer's Multiple Deep Value Stock Screener. All metrics use trailing twelve month or most recent quarter data. * The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”
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