Article Reviews, Value Investing

Seth Klarman on Baupost Group’s Edge

I came across this compilation of quotes from Seth Klarman: The Collected Wisdom of Seth Klarman. Wanted to just capture some of those that speaks more to me. While writing this post, I came across this 2009 interview that Klarman did with TIFF that is pretty good, and have captured some of its points below.


Know Your Edge

  • We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What’s your edge? To succeed in today’s overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resources provide less and less of a competitive edge; they are necessary but not sufficient.
  • If you are investing and you don’t have an edge you probably shouldn’t be. And so we think about that a lot, that there are a lot of really formidable competitors, a lot of money that’s flowed into the hands of very capable value investors, long-term oriented, smart people. There are obviously also people that know a huge amount about industries, industry specialists, corporate executive, former executives, and so it’s very competitive out there most of the time. So much of the time we have drifted into less liquid or more obscure parts of the universe.
  • Investing is, in many ways, a zero-sum activity in which your returns above market indices are derived from the mistakes, overreactions, or inattention of others as much as from your own clever insights.

Know What You Are Not

  • Warren [Buffett] evolved through three stages. He went from buying cigar butts and getting the last few puffs for free to buying great businesses at really cheap prices to buying and holding great businesses at so-so prices. And maybe even this new area of buying weird securities from crappy businesses at better than market prices. Like BoA preferred or whatever. I’m still in phase one. We’re still buying cigar butts – there’s a good business there in buying them and it’s a lot of fun — November 2011.
  • I think that Buffett’s a better investor than me because he has a better eye towards what makes a great business. And when I find I great business I’m happy to buy it and hold it [but] most businesses don’t look great to me.

Stand Apart From the Crowd

  • You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work.


Baupost’s Edge

  • Truly long-term capital
  • A flexible approach
  • Strong culture
  • Deep industry knowledge
  • Strong sourcing relationships
  • Strong grounding in value investing principles
  • Knowing where to look
  • Focus on the downside

Truly Long-Term Capital

  • Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  • The first and most important thing is make sure that you choose your clients carefully.
  • Having great clients is the real key to investment success. It is probably more important than any other factor in enabling a manager to take a long-term time frame when the world is putting so much pressure on short-term results.
  • In our minds, ideal clients have two characteristics. One is that when we think we’ve had a good year, they will agree. It would be a terrible mismatch for us to think we had done well and for them to think we had done poorly. The other is that when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming. At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and — most of the time, if not all the time — add, rather than subtract, capital.
  • The truth is, some of our clients don’t understand, but we’ve worked really hard over time to explain it and to educate them to our way of thinking.
  • We believe it is important in every investment to have an edge, an advantage over the herd. This edge could be a willingness to take a long-term perspective in a short-term-oriented market…

A Flexible Approach

  • We think more value is added by being generalists and seeing opportunities from a broader perspective. If you have silos, you’re going to own things only within those silos.
  • It enables you to move opportunistically across a broad array of markets, securities, and asset classes.
  • Some of our best analysts can get up to speed in a day or two on something they’ve never heard of before.
  • We don’t have a pharmaceutical analyst, an oil and gas analyst, a financials analyst. Instead, we are organized by opportunity. We have analysts whose focus is on spinoffs or distressed debt or post-bankrupt equities.

Strong Culture

  • Process
    • We put great emphasis on a consistent investment process that demands enormous creativity, energetic sourcing, outside-the-box thinking, intellectual honesty, and vibrant debate.
  • Assessment
    • There are huge advantages to not keeping track of each person’s individual contribution in terms of letting capital slosh back and forth so that no one person hogs the capital.
  • Compensation
    • I’m happy to pay full price [for talent], and I’ve sometimes intentionally chosen over the years to pay people more than absolutely necessary.
    • I’d rather pay up for people that I might be able to attract to make their entire careers at our firm rather than try to be cheap about it and hire bargains but ultimately pay the price for that in turnover or other things.
    • We have evolved to a system where the partners would strive for equality with each other. I’d be higher but hey’d be in a range with each other, and the younger and less experienced ones would rise up toward equality…. We have evolved… to a structure with a ratio relationship between the partners, and then we have a bucket of additional compensation that goes to exceptional performers.
  • Keep the bar high
    • We usually interview 25 to 50 people for every one we make an offer to.
    • One year we interviewed over 50 people and made no offers, so it was like waiting for a cheap stock. You’re waiting for something, and unless you have a massive hole that you have to fill, you have no urgency, so it forces you to have that long-term, craft-like perspective.
  • Characteristics of people that it looks for
    • Intelligence
      • Raw intelligence
      • Flair for getting to the heart of the matter better than just about anybody else.
      • Having plain common sense. Some people are brilliant but lack common sense.
      • Having ideational fluency. Ideational fluency measures innate curiosity and how your mind presents options in response to a question or problem. Your mind needs to come up with a lot of different options, else you are not going to be able to figure out what’s wrong with an idea or what you should be worrying about in terms of a hedge.
    • Don’t lose money
      • Have a sense of history and a vivid sense of risk.
      • Ability to imagine things that has never happened before.
      • Portfolio managers need to be able to identify risk (e.g. excessive concentration, lack of diversification, failure to hedge, etc.), while for analysts we’re asking for analysis and facts, and then secondarily, their opinion.
    • Able to make money
      • A broad curiosity blended with some contrarianism and a sense of what makes you money.
      • Understanding the value of optionality.
      • Determination to hunt for extremely mispriced risk-and-reward scenarios.
      • It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.
    • Stayer
      • Willingness to be a team player. We want people who want to be part of a team.
    • Ethics
      • People with values and ethics, someone who is not morally blind.
      • We dwell a lot on past experiences. We ask people, “What is the biggest mistake you’ve ever made?” It’s a very open-ended question because it’s not solely an investment question.

Strong Sourcing Relationships

  • There’s also something about the engine of creating opportunities that needs some cash to function.
  • You’d hate to tell a great real estate partner or a great broker, “You know, that’s a really interesting opportunity; I’m glad you have this billion dollars of assets for sale at a ridiculously low price, but I’m sorry, we’re tapped out today.” That’s not a good answer. When you’ve worked really hard to cultivate relationships, you’d like to feed them, so you in some sense always want to have some buying power.

Strong Grounding in Value Investing Principles

  • Premise
    • Value investing is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value.
    • We make money when we buy things. We count the profits later, but we know we have captured them when we buy the bargain.
    • In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.
    • We worry top-down, but we invest bottom-up.
  • Analysis
    • When we look at value, we tend to look at it on a very conservative basis — not making optimistic forecasts many years into the future, not assuming growth, not assuming favorable cost savings, not assuming anything like that. Rather looking at what is there right now, looking backwards and saying, is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year, and is it unlikely to be repeated? We tend to look at hard assets as much as possible.
    • Investors should pay attention not only to whether but also to why current holdings are undervalued.
    • ‘Value traps’ are cheap for a reason – perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline.
    • Look for investments with catalysts that may assist directly in the realisation of underlying value. Give preference to companies having good managements with a personal financial stake in the business.
    • A catalyst for the realization of underlying value is something we seek, but we will also make investments without a catalyst when the price is sufficiently compelling.
  • How profit is realised
    • Undervalued stocks are of interest when several or all of the following criteria are met: if the undervaluation is substantial; if there is a catalyst to assist in the realization of that value; if the business value is stable and growing, not eroding; and if the company’s management is able and properly incentivized.
    • The arbitrage profit from purchasing the undervalued stock of an ongoing business can be more difficult to realise. 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.
  • Understand our weaknesses
    • Understanding how our brains work – our limitations, endless mental shortcuts, and deeply ingrained biases – is one of the keys to successful investing. At Baupost, we believe that it is sometimes easier to predict how investors will behave in certain situations than it is to predict a company’s bottom line. At times of market extremes, by avoiding emotional overreaction and remaining aware of our biases, it may be possible to know market participants better than they can know themselves.
  • Spread the buying on the way down
    • You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
    • In my view, investors should usually refrain from purchasing a ‘full position’ (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to ‘average down’, lowering their average cost per share, if prices decline.
    • While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.
  • Invest only when there are opportunities
    • Being fully invested at all times will at best generate mediocre returns; at worst they entail both a high opportunity cost — foregoing the next good opportunity to invest – and the risk of appreciable loss.
    • Should we accept a lower return than we used to in order to buy a bankrupt bond, corporate spinoff or half-empty office building? If we don’t, we may be forced to sit on a growing pile of cash, perhaps for a very long time, betting that the markets will revert to historical levels of valuation. If we do, we will be betting that times have changed, that investing to earn a barely adequate return is better than not investing at all. Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity, accepting a minor diminution in expected return where, and only where, the historic returns have been particularly outsized for the risk.
  • Margin of safety
    • Risk is not the same as volatility; risk results from overpaying or overestimating a company’s prospects. Prices fluctuate more than value; price volatility can drive opportunity.
    • The actual risk of a particular investment cannot be determined from historical data. It depends on the price paid.
    • Margin of safety, by always buying at a significant discount to underlying business value and always giving preference to tangible assets over intangibles. By replacing current holdings as better bargains come along. By selling when the market value comes to reflect it’s underlying value and by holding cash, if necessary until other attractive investments become available.
    • Real value, of bricks and mortar, finished goods inventories, accounts receivable, operating factories and businesses, and even brand names, is hard, although far from impossible, to destroy. If you don’t overpay for it, your downside is protected. If you purchase it at a discount, you have a real margin of safety.
    • We have a mental hurdle rate that says we ought to get paid for the risk of that investment, and if it’s low-risk we ought to get a good return, and if it’s medium-risk we should get a really good return, if it’s high-risk we should get a great return.
  • When to sell
    • It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies.
    • When the underlying value changes. When management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value, a disciplined investor can re-evaluate the situation and, if appropriate, sell the investment. Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change you mind. It is only wrong to change your mind and do nothing about it.
    • Liquidity considerations are also important in the decision to sell. For many securities the depth of the market as well as the quoted price is an important consideration. You cannot sell, after all in the absence of a willing buyer; the likely presence of a buyer must therefore be a factor in the decision to sell.
    • We always sell when a security’s price begins to reflect full value, because we are never sure that our thesis will be precisely correct.

Knowing Where to Look

  • Rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers.
  • When buyers are numerous and sellers scarce, opportunity is bound to be limited. But when sellers are plentiful and highly motivated while potential buyers are reticent, great investment opportunities tend to surface.
  • We’d rather not try to outsmart somebody, we’re not sure we could, but we’d rather try to hunt where they’re not looking.
  • Buy from urgent, forced, distressed, or emotional sellers
    • Desperate sellers on margin calls
    • Institutional selling of a low-priced small-capitalization spinoff.
    • If a company fails to declare an expected dividend, institutions restricted to owning dividend-paying stocks may unload shares.
    • When a company eliminates it’s dividend, it’s shares often fall to unduly depressed levels.
    • Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies.
    • Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index.
    • Year-end tax selling also creates market inefficiencies. The internal revenue code makes it attractive for investors to realise capital losses before the end of each year. Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further.
  • Go to places where competition is scarce
    • The debris of financial wreckage
    • Out-of-favor securities and asset classes
    • Highly complex securities and situations
    • Illiquid situations, situations with uncertain timing
    • Unexciting stories
    • Situations with stigma of financial distress, taint of litigation, scandal, fraud, unexpected losses, management turmoil.

Focus on the Downside

  • We continuously worry about what can go wrong with each investment and the portfolio as a whole; avoiding and managing risk is a 24/7/265 obsession for us.
  • We diversify.
  • The prospective return must always be generous relative to the risk incurred. For riskier investments, the upside potential must be many multiples of any potential loss.
  • Be sure that you are well compensated for illiquidity — especially illiquidity without control — because it can create particularly high opportunity costs.



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