Seth Klarman is not a name very well known in our part of the world but he manages the Baupost Group, which is one of the top 10 hedge funds by net gains since inception, which was in 1983 (29 years).
Most of the top hedge funds that we see are usually quantitative, momentum based managers, so for a value manager to have such a great record in the long run he must be doing something right.
Seth wrote a famous book Margin of Safety which was written in 1991 and now out of print. The hard cover book is so coveted that people bid up to $1000 to get their hands on it.
Ronald Redfield though, provided here a great summary of what is written in the book.
This summary is great and touches on the psyche that money managers require, what he thinks is the best way to interpret fundamental figures, valuation as a whole. But above all the theme of his book was that the future is unpredictable and as a money manager you should look at your downside, risks and safety more than the upside.
Understand why things work. Memorizing formulas give the appearance of competence. Klarman describes the book as one about “thinking about investing.”
“Investors in a stock expect to profit in at least one of three possible ways:
a. From free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.
b. From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.
c. Or by narrowing of the gap between share price and underlying business value.”
Don’t confuse the company’s performance in the stock market with the real performance of the underlying business.
“Think for yourself and don’t let the market direct you.” “Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.” This could be helpful in my research of the 1973 – 1974 period. As I study that era, it looks as though price earnings ratios contracted for no real apparent reason. Many think that the price of oil and interest rates sky rocketed, but according to my research,that was not until later in the decade
He discusses choosing a discount rate. He states, “A discount rate is, in effect, the rate of interest that would make man investor indifferent between present and future dollars.” He mentions that there is no single correct discount rate and there is no precise way to choose one. He explains that some investors use a generic round number, like 10%. He claims it is an easy round number, but not necessarily the best choice. He emphasizes to be conservative when choosing the discount rate. The less the risk of the investment, the less the time frame, the less the discount rate should be. He explains, “Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.” Of course discount rates are changed by changing interest rates. He discusses how investing when interest rates are unusually low, could cause inflated share prices, and that one must be careful in making long term investments.
If you see a company selling for what you consider to be a very inexpensive price, ask yourself, “What is wrong with this company?” This reminds me of Charles Munger, who advises investors to “invert, always invert.”Klarman mentions, “A bargain should be inspected and re-inspected for possible flaws.” He indicates possible flaws might be the existence of contingent liabilities or maybe the introduction of a superior product by a competitor. Interestingly enough, in the late 90’s, we noticed that Lucent products were being replaced by those of the competition. We can’t blame the entire loss of wealth on Lucent inferiority at the time, as the entire sector followed Lucent’s wipeout at a later date. There were both industry and company specific issues that were haunting Lucent at the time.
Let me know what you think.