Seth Klarman’s 3 Principle’s of Investing 

Few people in the world are as successful as Seth Klarman when it comes to investing. He has a long history of making profitable investments, and his skills have earned him a great deal of respect within the investment community. So what can can we learn from him?

That is the purpose of this post.

Who Is Seth Klarman?

Seth Klarman is the founder and president of the immensely successful Baupost Group, a $29b ‘deep value’ hedge fund. His hedge fund is based upon a modern-day version of methods employed by Graham and Dodd.

Klarman is not one to boast about his legend. In fact, despite being one of the most successful long-term investors, he maintains a low profile. It is rare to see Klarman giving interviews and his book, Margin of Safety, no longer in print, can only be bought used (if we can find a copy, it will cost more than $1,200 to buy it). I’ve heard that Warren Buffett has a deep admiration for Klarman and that he keeps a copy of his book always within reach.

Baupost Group’s success is of a magnitude we rarely see.  Over its 30 year history, with the exception of only one down year, Baupost has generated approximately 19% a year in returns. When Klarman began in 1982, every $10,000 he was given is now worth about $1.85m today. Amazingly, he achieved this while holding immense amounts of cash, at times more than 50%, and using minimal leverage.

The Secret To Seth Klarman’s Investing Success

What was his secret to success? Did he jump on the bandwagon of the latest success stories with Apple, Google or Microsoft? While that would have been my guess, the answer is a resounding no. Klarman’s highest position was in the late 2000’s at Enron. You know, that bankrupt company embroiled in litigation for accounting fraud?

In 2008, Klarman immersed himself in unknown mortgage-backed securities. These securities were floundering following the bursting American real-estate bubble. If that wasn’t enough, he most recently invested in Canadian potato farms. Why? Because he saw the opportunity to expose limestone that was hidden beneath the soil.

I know that most of us would have a difficult time finding and managing the types of opportunities Klarman took advantage of, but I think we can all learn from his three principles of investing.

Seth Klarman’s 3 Principles Of Investing

Principle #1: Arm yourself with cash

Klarman’s signature weapon is holding cash. He learned to use it by waiting for the right investing opportunity and then under controlled conditions, pounced on it. We can see why when we consider the fact that while, over the long-term, value investing outperforms, but as Klarman says, ‘you have to be around for the long run … [you have to make sure] you don’t get out and you are a buyer’.

If we can be patient enough to wait out the times when there is a drought of opportunities and then take advantage of the right opportunity when it presents itself, our portfolios will be more successful.

If we think about it, while Klarman’s investments have been quite complex, the approach is not. Of course, I wouldn’t go as far as saying that it is easy.

Klarman explains that Baupost has outperformed  ‘by always buying at a significant discount to underlying business value, by replacing current holdings as better bargains come along, by selling when the market value comes to reflect its underlying value, and by holding cash … until other attractive investments become available’.

Principle #2: Get familiar with your seller

When it comes to the financial markets, we know that competition is the name of the game. Traders, speculators and investors from all parts of the globe try to outsmart one another, yet the performance of at least half of these individuals will prove to be less than average. Klarman suggests that we seek out assets that investors are either trying to avoid or, are being forced to sell because they are fearful or because of institutional limitations. His reasoning behind this is because supply and demand is what sets prices. Therefore, he asks why we would buy something and bide our time until an investor demands it at a higher price. Instead, Klarman advises us to go straight to the supplier who is irrational and wait for them to sell it to us at any price.

We can use this principle by taking a look at stocks that are repeatedly sold or opportunities that are avoided. For instance, stocks that wind up at the bottom of the barrel of the S&P500 are booted out and regularly replaced. Plus, because index funds have a limit on stocks above a specific size, the stocks that have been taken out of the S&P500 occasionally see their price driven down because of the pressure to sell.

Even better, super funds, which are some of the largest participants in the market can’t put their money into smaller businesses and are largely not on the radar of analysts. This is thanks to regulations.

Unless they earn a particular credit rating, even if they have an alluring risk-reward profile, some institutions are forced into ignoring debt instruments. We can capitalise on this by investing in income securities that are on the downturn. When prices fall, we can see some terrific opportunities, similar to those seen during the GFC.

Irrational mispricing in already lower-priced stocks can be due to tax-loss selling. We often see this at the end of December in the United States and in June, the end of the tax year, in Australia.

Of course, while this doesn’t always create opportunities, the most likely time to see mispricings is when an investor is selling irrationally or is forced to sell and has no buyers.

Principle #3: Stay with your competitive advantage

Fortunately, the stock market does not require us to be exactly right. What makes someone a mediocre investor and a great investor is a difference in just a few percentage points in terms of how close to correct the investor got. According to Klarman, the more successful investor brings a ‘competitive advantage’ to the table when investing. He dedicated a lot of time to thinking this idea through.

Klarman’s ability to enter into situations that were under-priced in relation to the involved risk and those that were passed up because of their complex nature was thanks to the expert ability of this team to analyse complicated financial assets and instruments. This and the forced selling I mentioned earlier, was key to his success. We can now understand how Klarman was able to invest in Enron and still profit. He had a dedicated analyst at Baupost who spent over four years studying Enron’s accounts after bankruptcy.

Now, I doubt that most of us have four years to dedicate to analysing accounts such as Enron. If we are less experienced investors, the likelihood is that we are not going to be very successful employing Klarman’s strategy. However, what we can do is look at our own skills and what others around us are doing, thereby developing our competitive advantages.

What You Can Do As An Investor If Even You’re Not Seth Klarman

We should be looking for inefficiencies that we can use to our advantage. Understanding that most investors in the market are fueled by greed and fear, and view things in the short-term, we can provide ourselves with an edge over them.

By looking at things in the longer-term and maintaining a grip on our emotions, we can perform better. That’s exactly what Klarman did.

So, when investing, remember the words of Klarman who said,  ‘I will buy what other people are selling’, what is out of favour, what is loathed and despised, where there is financial distress, litigation – basically, where there is trouble’.

Now… if you’re relatively new to investing and trading, what I’ve just said might make sense to you, but you’re still a little unclear on what it actually means to “look for inefficiencies to use to your advantage.”

If that’s you, I’d like to invite you to attend my FREE online masterclass.

I’ll be breaking down into very simple, black-and-white terms, how you can read the markets like a pro in less than 20 seconds using my “Traffic-Light” process. You’ll also be learning the 4 key stock criteria that will help you filter out 98% of the rubbish, so you can focus only on the best stocks.

It’s a highly interactive class (I’ll actually get you to practice what we go through together with me), complete with your own downloadable workbook, and I guarantee you’ll walk out of the Masterclass with a completely different filter of the trading and investing world.

If you’d like to join me, book your spot here, and I’ll see you on the other side.

Terry

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