Advice from Seth Klarman

​Seth Klarman is the chief executive and portfolio manager of the Baupost Group which he founded in 1982.  He is a deep value investor who has outperformed the market by a wide margin over the past 38 years.  Over the years I have read everything I can find on his investing approach and I always pay attention to what he is buying and selling when his 13-F filings are released (Feb, May, Aug, Nov). ​

Warren Buffett likes to buy wonderful companies at fair prices.  Seth Klarman is happy to buy average companies at wonderful prices.  
Following are my notes on Klarman:     

• Speculating vs. Investing
  • No one knows what the market will do so trying to predict it is a waste of time
  • Market timing is speculating
  • Investors have a good chance of achieving long term success; speculators are likely to lose money over time
  • Investments throw of cash flow; speculations do not
  • Successful investors are unemotional and use greed and fear of others for their benefit
  • Prices move up and down for two reasons
    • Change in business reality (or perception of change)
    • Short term supply and demand
  • Greed leads people to seek shortcuts to success
• Defining Investment Goals
  • Avoiding loss is key
  • Focus on risk first and return second
  • A substantial loss can greatly impact standard of living while a comparable gain may not improve it commensurately
  • Consistent “good” returns over a long period of time are better than excellent returns followed by a meaningful decline
    • A 50% decline in one year requires a 100% increase to break even.  This could take twelve years in a low return world
    • 16% for a decade is worth more than 20% for nine years and a 15% loss in year ten
  • Focus on approach, not outcome. 
    • Having an annual return goal can encourage unreasonable risk taking
  • A significant ongoing commitment of time is a prerequisite for successful long term value investing
• Margin of Safety
  • Difficult to analyze Tech, commercial banks, and P&C insurance so many value investors avoid them
  • Value investing can work well with inflation
  • Look for overfunded pension fund or real estate carried on books below market value
  • Technical analysis is a waste of time
  • Large caps are much more efficient with more competition
    • Charlie Munger “Don’t try to figure out Merck’s pipeline vs. Pfizer’s, it’s too hard.  Go where there is less competition, where you have an edge”
• Key Elements
  • Bottom-up – not top down
  • Absolute performance – not relative
    • Hold cash if you can’t find anything
  • Focus more on risk than return
    • Risk is the probability and the potential amount of loss
    • Risk reduction
      • Adequate diversification
      • Hedges
      • Margin of safety
• Business Valuation
  • DCF
    • Best used in a high return business with stable cash flows
    • However - Very difficult to forecast the future
    • Contradiction – To calculate present value, you must predict the future, yet the future is not predictable
    • Only answer is be conservative
  • Liquidation Value
    • Best used for unprofitable business with price below book value
    • Cash worth 100% of book value
    • Investments worth market value
    • A/R very close to book value
    • Inventory more difficult
      • Raw material or finished product?
      • Risk of technological or other obsolescence?
    • Fixed Assets also difficult to estimate
    • Short cut is Ben Graham net nets
      • Current Assets less Total Liabilities
      • No value placed on Land, buildings, equipment, growth, patents, trademarks etc.
      • Need to also consider OBS items (underfunded pension)
  • Dividend discount model is not useful because dividends are only a small fraction of corporate cash flows
• Areas to look for potential investments
  • Filtering can be helpful for net nets – but still need to look more closely
    • Databases can be out of date or inaccurate
  • Daily stocks with large % declines
  • New 52 week low list
  • Elimination of a dividend
  • Stocks below $5 (Institutions unwilling to own)
  • Small with infrequent trading
  • Year-end tax selling can depress shares
  • Spinoffs
    • Analysts normally don’t cover them – low trading volume = low commissions
    • Info not readily available for a few months
    • Holders of the parent company don’t want to mess with a small cap
    • Temporary supply/demand imbalance with initial selling
  • Insider buying
    • Insiders know the company best
    • They sell for many reasons but only buy for one – they think the stock is going higher
  • Need to determine why a stock is undervalued
    • Pending litigation?
    • Off balance sheet liabilities?
    • Competition launching superior product?
• Portfolio Management
  • Appropriate diversification
    • 10-15 holdings in different industries
    • It’s not how many different things you own, but how different the things you do own are and the risks they entail
  • Hedging
    • Diversification does not protect you from market risk
    • Short entire S&P 500 against portfolio of large cap stocks
    • Not always smart to hedge
      • Should be willing to take on more risk if available return is sufficient
  • Liquidity
    • Opportunity cost of illiquidity is high
  • Staying in touch with the market
    • Problem with buy and hold is that the market can create good opportunities each day based on short term movements
    • Does not mean watching every market tick and doing short term trading
  • Buying
    • Must resist fear and greed
    • Buy partial position to leave room to average down
      • If you are not willing to average down, you are speculating instead of investing
  • Selling
    • Wrong way to sell
      • Setting target sell price at time of purchase
      • P/E ratio target or P/B
      • % gain target
      • Using stop loss prices limits downside risk but is crazy – you should be increasing the position!
    • Right way to sell
      • Based on business value which is always changing
      • Don’t sell an undervalued company and pay tax on a gain if there is nothing better to buy
  • Leverage is neither necessary nor appropriate for most investors