Seth Klarman is widely considered to be one of the best value investors of all-time. He has been able to achieve such outstanding Returns for his investors because of his focus on finding undervalued securities and focusing on risk more than anything else.
Controlling risk, limiting risk and risk management are always at the forefront of his investment strategy and this really comes through in his investor letters.
Klarman 2017 letter on
- the danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
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For example, in his December 1996 letter to investors of Baupost, the hedge fund Klarman still manages today, he wrote:
"The primary risk of entering new investment areas is unfamiliarity itself: the rules of the game might be unfamiliar or changing; others that have been in the area longer might have a significant advantage; and to paraphrase Warren Buffett, if you look around the poker table and cannot identify the patsy, it is probably you. Cognizant of this risk, we have worked diligently to understand new areas, as well as existing participants, do before we enter, utilizing external resources when necessary. We have entered timidly, probably foregoing some opportunities but ensuring that we had time to gain comfort and any expertise we were lacking." -- December 1996 letter to investors of Baupost
He goes on to say that as well as having a good understanding of the investment environment you are part of, to reduce the risk investors must also place a "constant emphasis" on investment fundamentals. Specifically:
"Risk is also mitigated by both our constant emphasis on investment fundamentals and on knowing why each investment we make is available at a seeming bargain price. We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest." -- December 1996 letter to investors of Baupost
Seth Klarman believes that risk management is one of the primary underlying principles of value investing. Investing with a margin of safety is vital for success, and part of establishing a margin of safety is buying at a purchase price where downside risk is limited. In this scenario, if you buy cheap enough, "you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favor," according to Klarman:
"The main underlying principle of value investing is that you should invest in undervalued securities because they alone offer a margin of safety. Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains. Value investors should buy assets at a discount, not because a business trading below its obvious liquidation value will actually be liquidated, but because if you have limited downside risk from your purchase price, you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favor. If an undervalued stock drops after you buy it and you are confident in your analysis, you simply buy more. All of these points apply equally well regardless of the market on which a stock trades or where a company does business." -- December 1997 letter to investors of Baupost
In the late 1990s, when the US was gripped by the dot-com bubble, value was hard to come by, but this didn't put Klarman off investing. Instead, rather than give up on value investing, he started looking outside the United States for opportunities, something other value investors avoided because of the uncertainties about investing overseas.
However, Klarman was happy to deploy some of his investors' capital around the world because of his strict focus on risk management.
In a letter to investors issued towards the end of 1997, he noted that while many investors did feel uncomfortable investing in foreign companies, it was no different to owning US investments in the 1920s and 30s "idea of management running a company for the purpose of maximizing shareholder value was a totally "foreign" concept."
He goes on to say that this idea didn't really hit the mainstream until the late 1980s, and yet many of the greatest investors of all time made billions in the years prior. "No one was arguing that you shouldn't be a value investor then, when Warren Buffett, Max Heine, Tweedy Browne, and Ruane Cuniff were building their brilliant track records," Klarman summarizes.
This is why Klarman saw more potential for profit at home than overseas:
"I frequently hear the argument that the rules are different overseas: the accounting murky, the annual reports unreadable, the currencies sometimes unhedgable. All of these points are fair, but, rather than being arguments to avoid foreign markets, they are instead arguments to embrace them. After all, as an investor, you never have perfect information, and the biggest profits are always available (just as they have been in the U.S.) when competition and information are scarce. The payoff to fundamental analysis rises proportionately with the difficulty of performing it."
To a certain extent, this is still true today. If you are willing to do the extra research and focus on risk management, there are tremendous opportunities in undeveloped markets where other value hunters are afraid to venture.
This originally appeared on ValueWalkPremium.com