Seth Klarman’s Take On Value Investing

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It’s a testament to his reputation among fundamental investors that Seth Klarman’s out-of-print 1991 book Margin of Safety, published less than a decade after he founded the Baupost Group, is now a collectors’ item that will run you a couple grand on eBay, but then his career has never been typical. With a few years’ experience under Michael Price and Max L. Heine at Mutual Share Corporation and a fresh MBA from Harvard, Klarman was given the opportunity to start a new investment management firm from the ground up. Instead of climbing the ranks at someone else’s firm, he was immediately in the hot seat, but you wouldn’t know it from the way he invests. Patient, contrarian, and always focused on absolute value, Seth Klarman has delivered annualized returns in the high teens for more than thirty years without worrying about how he’s doing relative to the rest of the market.

Seth Klarman: Rejecting the strong EMH, leaning on compounding

To understand Seth Klarman’s approach to investing, it’s important to understand where he stands on one of the most contentious economic theories among investors, the efficient market hypothesis (EMH). EMH is usually explained as the belief that the market is able to price in all information about a security, but Klarman breaks it down into three different versions. The weak form, which says that past prices don’t help you predict future security prices, the semi-strong form, which says that public information doesn’t help you to predict future prices, and the strong form, which says that no information of any kind will help you predict future prices because everything is accounted for by the market.

You’ll have a hard time finding a financial professional who believes in the strong form (which is why we have laws against insider trading), but the first two are more up in the air. Seth Klarman accepts the weak form, which excludes technical analysis from his investment toolbox, but rejects the second. He argues that since most investors are unable or unwilling to carry out thorough analysis of the assets underlying securities, fundamental investors can take advantage of mispricing when it crops up.

Seth Klarman also understand that if he can make steady gains, compounding will cause his clients’ assets to appreciate immensely, if not quickly, as long as he can avoid major losses.

“It is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success,” he writes in Margin of Safety. “An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.”

Even though the second investor has outperformed in nine years out of ten, the first will have the better returns over the long run by accepting lower returns in exchange for fewer losses.

How Seth Klarman’s view sets him apart

These two differences, believing that fundamental analysis has incremental value for investors (and rejecting the EMH) and relying on compounding to work its magic over the years, go a long way to explaining the other things that set Seth Klarman apart from most investors.

First of all, Seth Klarman understands that buying mispriced securities can take a long time to pan out as you wait for the market to catch up to your view or for some other event (eg bankruptcy, M&A activity) that lets you realize gains. Unlike typical yield-chasing investors, or the harried managers who work for them, Klarman is already set to take a longer view of his investments.

But it also explains why Seth Klarman isn’t interested in relative performance metrics, at least not on a quarter-by-quarter, year-by-year basis. Since he doesn’t trust the prices that Mr. Market is quoting him, it doesn’t make any sense to measure his own performance against those quotes. Fund managers should beat the market in the long run, and Klarman has, but sometimes that means stepping back while the market overinflates.

Seth Klarman considers his fund to have profited when it moves on an attractive investment, just like a manufacturing firm that counts profits when it earns them as opposed to when the invoice gets paid, even if it doesn’t show up as cash in hand right away. That means that when residential mortgage backed securities and distressed debt were dirt cheap in 2009 and Seth Klarman increased Baupost’s position in them to about half the fund, it was a great year even if the results weren’t immediately obvious to outsiders.

Speaking of cash in hand, one of Seth Klarman’s most surprising strategies is to sit on cash when others go on a spending spree, with sometimes as much as half of Baupost’s assets under management uninvested.

“Absolute-performance-oriented investors,” he writes, “will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met.”

It’s not that Seth Klarman holds cash because he thinks the economy is overheating or the stock market is close to a top, it’s that he has the patience to wait until he finds a great opportunity; when there are fewer opportunities to be found, the result is that he doesn’t invest as heavily.

Unlike the ‘value-style’ approach that looks for stocks cheaper than their immediate peers, for Klarman a real value investor is someone that follows a similarly patient, disciplined approach.

“Value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities,” he explains. “Second, value investing is absolute-performance-, not relative performance oriented. Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right.”

Sources: Grant’s Interest Rate Observer, Baupost letter to investors, public documents

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