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Seth Klarman's Investing Strategy
Seth Klarman, also called the "Oracle of Boston," managed to return ~20% CAGR over three decades. His Book Margin of Safety is the only book that Buffett reads daily (Rumor spread by: Warren Buffett).
Seth Klarman’s Investing Strategies
Seth Klarman is the founder of the hedge fund Baupost Group, which he initially started with two of his Harvard professors. Klarman is, like many other billionaire investors, a value investing advocate.
His track record is highly impressive. He achieved a ~20% CAGR over a 30-year period, turning his Hedge Fund into one of the biggest in the world.
In contrast to some of his colleagues, Klarman doesn’t give a lot of interviews or speeches. The information in the following article mainly comes from his book Margin of Safety.
However, some of the information comes from those rare speeches to find of him on the internet.
The Relative Performance Gun
Margin of Safety
Holding Cash: The Ultimate Contrarian Action
The 80/20 Rule: Incomplete Information
Avoiding Loss Should Be The Primary Goal of Every Investor!
Similar to Buffett’s two rules of investing...
Don’t Lose Money
Never Forget Rule Number 1
Klarman believes that not losing money should be the primary concern of every investor.
But why is it better to focus on the downside rather than the upside potential? Shouldn’t this be a zero game?
There are two answers to that.
1. A Key Factor in this equation is Compound Interest.
Neither Klarman nor Buffett aim for stocks that double in one month and crash the next. Trying to time the market and benefit from such manias is mostly luck.
Investors, better said speculators, who focus on such stocks might win big on one stock and lose big on another. Returns that diminish in a matter of weeks cannot compound.
Good businesses that return more modest but regular gains will compound over time.
A business that might offer big returns in the future but offers equally great losses when not growing as planned is too big of a risk.
That’s why value investors primarily invest in businesses with a longer market history than younger growth companies. It’s not that growth companies, in general, don’t fit the profile. Growth is part of every great business; it’s just that the risk/reward relationship is out of balance more often.
2. Losses weigh a lot more than most investors initially expect.
“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% a year for nine years and then loses 15 percent the tenth year.”
This is counterintuitive, and our minds struggle to comprehend this. Most of us, and that’s totally normal, would think that the 4% outperformance for 9(!) straight years in a 10-year period can’t be erased by one 15% drawdown.
The reason is that the last year of compounding, in this example, year ten, adds so much to the existing number that the outperformance of the investor scoring 20% over all those years isn’t enough to match this.
There is this beautiful, non-investing-related example of a water lily and a pond. The water lily doubles every night. So, on day one, there’s only this one water lily. On day two, there are two, on day three, there are four. You get the idea.
If the pond has a maximum capacity of 128 water lilies, what day is the maximum reached halfway?
Day 1: 1
Day 2: 2
Day 3: 4
Day 5: 8
Day 6: 16
Day 7: 32
Day 8: 64
Day 9: 128
It’s always the day before. The more days we add, the bigger the importance of the last day. Same in investing. You can have a tremendous performance for decades, but one big loss weighs extremely heavy on that performance because every year that adds to the performance gets more and more important.
Take a look at the net worth expansion of Warren Buffett by age:
The Future is Unpredictable
Seth Klarman’s investment strategy is based upon the assumption, or rather the fact, that the future is unknowable.
Macroeconomic forecasts don’t matter when he’s considering a possible investment.
“No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall.”
Even the most likely outcomes fail to happen all the time. That’s why worst-case scenarios should be the primary focus when evaluating an investment decision.
“Be prepared for the worst possible outcome and welcome the best possible outcome.”
A good investor is not a pessimist nor an optimist; he’s simply aware of the range of possible outcomes and his lack of influence on them.
The Relative Performance Gun
Klarman criticizes investment goals that aim to “beat the market.”
A focus on relative returns, returns compared to the market, fuels short-term thinking and poor behavior.
Pressured to outperform the market, investors act against their investment maxims, lose patience, and participate in manias and trading activities.
“You can’t think straight with a gun to your head. If you have a relative performance gun to your head, on the way down and on the way up, you’ll do the wrong thing every time. You’ll be liking them when they’re up, and hating them when they’re down – when you should be doing the opposite.”
As an investor, more work doesn’t necessarily result in more return. While looking into more companies boosts your chances of finding bargains and/or great businesses, if there are no good opportunities out there (the cheapest security in an overvalued market may still be overvalued), working more won’t create them out of thin air.
Instead of comparing your returns to the market, Klarman says, investors should focus on absolute returns to make smarter investment decisions.
When an investment offers a sound absolute return, what that hurdle rate is is up to you. Invest in that opportunity without wasting brain power to what the market could return.
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Margin of Safety
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility [...].”
Since the book is called Margin of Safety, this principle probably didn’t surprise anybody.
It’s also a fundamental principle of value investing and, therefore, not exclusively part of Klarman’s investing strategy.
Why a margin of safety matters is already explained above: uncertainty and loss avoidance. How considerable your margin of safety should be depends on several factors.
How much bad luck are you ready to take? How much volatility can you withstand? And what are the probabilities for that investment?
If you have a valid reason to believe that your expected outcome will occur (high probability), you might be okay with a smaller margin of safety regarding the asset’s price. If the outcome is more uncertain, you should demand a higher margin of safety and thus have more room for error.
Generally, the more assumptions you have to make about the future, the higher your margin of safety should be.
Cash Positions: The Ultimate Contrarian Action
Seth Klarman is known for his unique take on cash positions. He is a harsh critic of the “invested at all times” approach and advocates large cash positions if no attractive investment case is in sight. This thinking is right in line with his absolute return principle.
The advantages of larger cash positions include...
More flexibility (through more liquidity)
No opportunity costs that arise from being trapped in other investments (trapped because of illiquidity, short-term market drops, or tax losses on sales)
No sharp declines in value because of market declines/pullbacks
Especially as a value investor, the ability to take advantage of bargains that suddenly appear in the markets is necessary. And you never know how long those bargains exist. Some will vanish in a matter of days. Being prevented from acting is to avoid.
Holding your cash in assets that might return a small percentage can get expensive (opportunity costs) when you are not able to sell that asset due to a decline that might have happened at that time.
What’s interesting about this take, and relevant for today, is the inflation rate when Klarman wrote this.
Margin of Safety was released in 1991, a year in which the inflation rate in the US was about 4.2%. In the years prior, it ranged from 4% to 5%.
So inflation back then was pretty high, and thus, we can imagine that Klarman’s take possibly didn’t change to today even though we have a lot of uncertainty about inflation rates in the future.
The inflation rate might be one of the reasons why Klarman already labeled his opinion on cash positions “the ultimate contrarian action” back in 1991.
The 80/20 Rule: Incomplete Information
“Investors have to learn to live with less than complete information.”
Most value investors are known for their concentrated portfolios. When investing a considerable amount of one’s net worth into a handful of positions, a precise and thorough analysis is necessary.
Yet, if you have already valued a company yourself, you probably realized that the information about the company that you can get is limited. You’ll never get all the information you need to know your assessment is correct. That’s simply impossible since much of the valuation is based on unknowable future developments.
Assessing management is another part dominated by uncertainty. You can look for past performances, speeches or letters, and other sources of public appearances, but in most cases, a closer look is not possible for the average investor.
It’s the same with the numbers that are reported.
You must trust the company that publishes the number to release accurate data. Most investors don’t even consider this risk when investing in US or European stocks. Yet, one of the most recent fraud cases was the Wirecard scandal, which once again showed that fraud is still possible and happening even in strictly regulated markets and big companies.
“The first 80 percent of the available information is gathered in 20 percent of the time spent.”
Deep research is necessary, yet the success of the last 20 percent of research is limited. You might find some interesting stuff occasionally, but for most companies, the first 80% of available information will influence your investment decision in the end.
And you got to get comfortable with not knowing 100 percent.
Otherwise, your research will take so long that you will miss out on great opportunities because you never had the time to look at them.
Despite that, if the opportunity isn’t convincing enough after gathering the first 80% of the information, it might not be that great in the first place…
Nevertheless, I was a little surprised when I read this section. Not because I disagree with him but because of who wrote it.
Seth Klarman is known for finding bargains because of superior research and a deep understanding of complex situations.
Thus, hearing from him that he’s okay with investing on “only” 80% of the information was unexpected.
That’s it for today! I hope you enjoyed this article!
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Have a great rest of the week!
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