Seth Klarman – Value Investing Is A Large-Scale Arbitrage Between Security Prices And Underlying Business Value

Baupost 2017 letter

The one book that all investors should read is Margin of Safety, by Seth Klarman. A new copy of Klarman’s book is going to set you back around $1000 on Amazon and used copies can be bought for around $750. But it’s money well spent if you wish to be a successful value investor.

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

There’s a great piece in the book where Klarman illustrates how value investing is a large-scale arbitrage between security prices and underlying business value. He also explains some of the reasons why the gap narrows between price and value. Klarman concludes the chapter with his thoughts on why value investing is simple but difficult to implement for most investors. Here’s an excerpt from the book:

A central tenet of value investing is that over time the general tendency is for underlying value either to be reflected in securities prices or otherwise realized by shareholders. This does not mean that in the future stock prices will exactly equal underlying value. Some securities are always moving away from underlying value, while others are moving closer, and any given security is likely to be both undervalued and overvalued as well as fairly valued within its lifetime. The long-term expectation, however, is for the prices of securities to move toward underlying value.

Of course, securities are rarely priced in complete disregard of underlying value. Many of the forces that cause securities prices to depart from underlying value are temporary. In addition, there are a number of forces that help bring security prices into line with underlying value. Management prerogatives such as share issuance or repurchase, subsidiary spinoffs, recapitalizations, and, as a last resort, liquidation or sale of the business all can serve to narrow the gap between price and value. External forces such as hostile takeovers and proxy fights may also serve as catalysts to correct price/value disparities.

In a sense, value investing is a large-scale arbitrage between security prices and underlying business value. Arbitrage is a means of exploiting price differentials between markets.

If gold sells for $400 per ounce in the U.S. and 260 pounds per ounce in the U.K. and the current exchange rate is $1.50 to the pound, an arbitrageur would convert $390 into pounds, purchase an ounce of gold in the U.K. and simultaneously sell it in the U.S., making a $10 profit less any transaction costs. Unlike classic arbitrage, however, value investing is not risk-free; profits are neither instantaneous nor certain.

Value arbitrage can occasionally be fairly simple. When a closed-end mutual fund trades at a significant discount to underlying value, for example, a majority of shareholders can force it to become open-ended (whereby shares can be redeemed at net asset value) or to liquidate, delivering underlying value directly to shareholders. The open-ending or liquidation of a closed-end fund is one of the purest examples of value arbitrage.

The arbitrage profit from purchasing the undervalued stock of an ongoing business can be more difficult to realize. The degree of difficulty in a given instance depends, among other things, on the magnitude of the gap between price and value, the extent to which management is entrenched, the identity and ownership position of the major shareholders, and the availability of credit in the economy for corporate takeover activity.

Conclusion

Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

Article by Johnny Hopkins, The Acquirer's Multiple



About the Author

The Acquirer's Multiple
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 acquirersmultiple.com. 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 acquirersmultiple.com, 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.”