Seth Klarman is one of the greatest value investors of all time. He has produced annual returns of 20% for Baupost Group since 1982; incredibly, with just one down year. Klarman makes investments with large “margins of safety” and is comfortable holding cash if opportunities are absent. His book Margin of Safety is rumoured to sit on Warren Buffett’s desk and in Karman’s words is the “intellectual successor to Intelligent Investor.”
Margin of Safety is the best and most accessible book on value investing I have read. Not long after reading it I was fortunate to ride on Klarman’s coat-tails in a multibagger investment in the PDL BioPharma spin-off Facet Biotech. I hope you have the fortune to do both.
In this rough transcript of An Interview with Seth Klarman by Charlie Rose I try to present some of Klarman’s key insights into value investing. These are rough notes, that I hope encourage you to watch the whole interview. If you do, and are not interested in Klarman’s philanthropy, skip to the 20 minute mark.
Why was Benjamin Graham’s Security Analysis so profound?
Warren Buffett’s captured the idea in his 1984 article the Superinvestors of Graham-and-Doodsville. In that article he says value investing is like an inoculation, you either get it right away or not. It’s a gene, you have it or not. [This is why it is so important to know yourself and find the right investing path for you. There are many path to investing success and there is no point travelling down the value path if it is not in your genes.]
Everyone appreciates a bargain, but when markets are going down, most people over react and get scared. “My stock is going down, what am I going to do?” People are happy to get a bargain when they go shopping, but get scared when the sharemarket puts companies on sale.
For me it is natural, for others it is fighting human nature. When you find out about value investing, it’s like being let in on a little secret. A key insight is that stocks are fractional interests in businesses, not just prices of paper or ticks on a screen. So what does it matter if the price goes down a little or gyrates?
Analysis is the easy part
Investing is the intersection of economics and psychology. Economics, the valuation is not hard. The psychology takes experience and a long time to learn, it is the harder part.
What is the right psychological make-up.
- Be patient and disciplined.
- Don’t be greedy. Greed and leverage caused financial blow-ups.
- Balance arrogance and humility. Arrogant to buy when others are selling. You’re saying I know more than everyone else, but you need the humility to understand you might be wrong.
Warren Buffett evolved through three phases (maybe even a fourth).
- Buying cigar butts and getting the last few puffs for free.
- Buying good companies at great prices.
- Buying great companies at so so prices.
- Buying weird securities from crappy businesses at better than market prices. For example Buffett’s recent purchase of Bank of America special preferred stock .
Klarman thinks he’s still in phase one, but believes that a great phase to be stuck in.
I think Buffett is a better investor than me, because he has a better eye for great businesses.
Don’t focus on daily price gyrations
I don’t have a Bloomberg on my desk. I spends my time thinking big thoughts.
Liking bad times
We are making medium to long term investments. 3-5 years or longer. We are only interested in the gyrations so we can buy things cheaper. We provide liquidity when people want to sell things in a hurry. Our rhythm is opposite most of the market rhythms.
Little guys get pulled in at exactly the wrong time, when the market is going higher and higher.
Be comfortable holding cash.
Is there any philosophy of timing?
Buying is easier, selling is hard. You can never know how bigger bargain you’ll get tomorrow. Try to leave more money to buy more. The dilemma is not figuring out what something is worth today, but finding out that the value is worth less tomorrow. All of a sudden a dollar is no longer worth a dollar; perhaps it is now worth $0.50.
Getting into bed with bad people
A lot of stocks are cheap for a reason. For example, management raping and pillaging a company; overpaying themselves, giving themselves free stock or options and hiring their brother-in-law.
A new value investor might think a stock is cheap fundamentally, but there is usually a reason why it is cheap and that’s often poor management.
Good management adds value.
Look at the management of a company. For example, perhaps the management is looking at their compensation packages, and not looking out for the shareholder.
Put the clients first. Then you’ll do great. Relative performance and short term thinking is bad for investors. If someone said, “Seth makes me money by the end of the year.” Klarman would tell them to talk to someone else.
Pressures are so short term. Impossible to know where things will trade in a few months or even one year. Look 5-10 years out.
Investment industry adds no value. It matches the market as it is the market.