On Seth Klarman & His Margin of Safety

January 23, 2017

On Seth Klarman & His Margin of Safety

  • Understanding value is just the beginning of profitable investing.
  • Would you be able to hold, on average, 33% of your portfolio in cash with peaks above 50%?
  • Studying human behavior through history is what the best hedge fund managers do.

Introduction

Seth Klarman’s book Margin of Safety – Risk-Averse Value Investing Strategies for the Thoughtful Investor sells on Amazon (NASDAQ: AMZN) for $1,992.92 new, and $792.33 used. It’s priced that high because it is a collector’s item that was printed in a small run.

I believe Klarman would agree that it’s better to invest in stocks than to pay that much for a book. I agree and didn’t want to wait for the book turn up at the library, but I finally managed to get a copy.

I’ll analyze the book, see what is still relevant today as the book was published in 1991, and share Klarman’s insights with you in a series of articles. Before we start with the book, I’ll start with some insight on Seth Klarman, his investing technique, performance, and general view on investing.

Seth Klarman

After graduating from Harvard Business School,, he founded Baupost Group with a few colleagues in 1983. Several wealthy families entrusted the company with $27 million. Klarman managed to deliver an average yearly return of 17% on the fund and the group is now managing more than $30 billion.

Klarman managed to achieve such an astonishing return by combining economics and psychology. He is considered one of the greatest value investors, but he clearly states that value is just the beginning of profitable investing.

It’s easy to calculate the value of something, what’s difficult is to have the courage to act upon that calculation. Realizing that a stock might go down much more often defers people from investing at all.

Apart from courage, a significant trait of his personality is not to follow the crowd. A look at his track record in the 1990s demonstrates what I mean.


Figure 1: Klarman underperformed the S&P 500 for 5 years in a row in the late 1990s. Source: Baupost Group Letters.

It takes guts to stick to your own ideas and to value investing while underperforming the S&P 500 by 50% in 6 years, while the whole world is getting richer on dotcom stocks. In the end, Klarman was right and didn’t lose much when internet stocks imploded because he didn’t own them and because he held a lot of cash, which is another interesting characteristic of his.

Holding Lots Of Cash

Klarman prefers to wait in cash than to invest in companies with low safety margins. As the dotcom bubble started to unravel, Klarman was sitting on 48.6% cash waiting for better investing opportunities.


Figure 2: Baupost’s portfolio in April 2001. Source: Baupost Group Letters.

Also, from 2001 onward, Baupost’s average cash balances were 33%, often reaching as high as 50%. Having 50% in cash is something few of us manage to keep.

Firstly, if you are an asset manager, your customers pay you to manage assets, not to keep cash. Personally, I have solved that issue by eliminating fixed fees and charging fees only on the profits I make in the long term. Such a structure allows me to keep large portions of cash and seize market opportunities, which constantly arise thanks to the fear and greed patterns and myopic short term perspectives, both from investors and corporations, that focus on the next 90 days and not on the highest long term return.

Secondly, keeping cash leads to opportunity costs in the form of lost capital gains, dividends or coupons. Therefore, another characteristic that you must have is optimism. Optimism that the markets will be volatile and offer amazing opportunities.

Fortunately for us, the market consistently gives extreme bargains even at these historical highs. In January 2016, buying commodities was a great play. In June, banks were cheap while REITs were overpriced. In October, fertilizer stocks were extremely cheap, and currently the pharma sector—especially generics—is looking extremely cheap. Having cash allows you to seize such opportunities and gain better returns with less risk as you buy on the cheap.

History As A Teacher

Apart from being a value investor and keeping lots of firepower in the form of cash, a characteristic that Klarman shares with another extremely successful hedge fund manager, Ray Dalio, is the constant study of human nature and behavior throughout history (more about Ray Dalio here and here).

Dalio is one of the few investors who talks about 75 year-long credit megacycles, while Klaman goes even further and analyzes historical behavior patterns going back to ancient Greece. Baupost’s 2012 letter to investors starts with the following quote from 18th century historians:

“In the end, more than freedom, they wanted security. They wanted a comfortable life, and they lost it all–security, comfort and freedom. When the Athenians finally wanted not to give to society but for society to give to them, when the freedom they wished for most was freedom from responsibility, then Athens ceased to be free and was never free again.”

 – Edward Gibbon (1737-1794), British historian and MP.

When I was a university professor, I used to see immense differences in behavior among students. With the risk of being prejudicial and discriminatory, I must say that students coming from emerging countries are on average much hungrier while the ones from the developed world seem complacent. To see who is hungrier, it’s enough to look at PISA scores, a global assessment of the high school education levels.


Figure 3: Pisa results. Source: OECD.

In the long term, the civilizations that are hungrier and better educated will see faster economic growth, which gives us a good indication of where to be invested. Developed countries have capital on their side, but that will slowly change as monetary and fiscal policies are very relaxed. The second quote on Klarman’s letter is related to debt cycles.

“A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world’s greatest civilizations has been 200 years.” 

 – Attributed to Alexander Fraser Tytler (1747-1813)

In a world where deficits are the norm and loose monetary policy is the icing on the cake, nobody wants to go back in history and see how such situations affected other civilizations. However, knowing how risks are formed and where they come from is an incredible advantage.

Looking back so far into history might seem like you’re overdoing it, but if the best hedge fund managers in the world do that, there must be a good reason for it.

Keep reading Investiv Daily to learn more about how the best investors consistently beat the market. In future articles we will dissect Klarman’s book and give you more tools to help you learn how to reach amazing returns too without spending $2,000 on a book.