If you're a serious value investor, you're probably very familiar with the name Seth Klarman. But in case you haven't run across his name, let's briefly take a look at why it's worth tuning in and listening closely to what he has to say.
Klarman runs the Baupost Group, a private investment partnership that ranks among the largest hedge funds in the world. He's an uncompromising value investor who will often keep huge chunks of his fund in cash until he finds compelling-enough opportunities; it's a strategy that has helped him produce an average annual return of 19% over the two-plus decades that he's captained Baupost. Klarman is also the author of one of the most sought-after books on value investing: Margin of Safety.
Thanks to hedge-fund-tracking blog market folly, I was able to sift through some of Klarman's investing letters, including his most recent, to find some great -- and, in most cases, timeless -- investing wisdom. Eat your heart out Warren Buffett!
1. Of course, any contrarian knows that just as a grim present is usually precursor to a better future, a rosy present may be precursor to a bleaker tomorrow.
This sentiment has been expressed in a lot of different ways, but, if you ask me, it's impossible to hear it enough. At the heights of the dot-com and housing bubbles, few thought that anything could go wrong. In the wreckage of those bubbles, few thought that anything could go right. When was the best time to buy? That's a gimme.
The same often holds true for individual stocks. Back in 2000, it seemed Cisco (Nasdaq: CSCO ) could do no wrong and investors were willing to pay triple-digit price-to-earnings multiples for the stock. Today, most investors are very skeptical of Cisco and this tech titan's stock trades at just 10 times forward earnings. Which will likely prove the better buy point?
2. Today, virtually everyone "knows" that over the long run, stocks will outperform other investment alternatives.
This comes from a Baupost letter from 1995. Since then, it seems the drumbeat for relying on stocks has only grown. Sure, it has been shaken a bit by the recent financial crisis, but I don't think I'm going out on much of a limb to say that many investors still have a religious faith in stocks as an investment.
It is, of course, rubbish. Stocks can be great investments, but price matters. There's no magic here. Buy stocks at attractive prices and you'll be happy with the results, but pay too much and you'll likely be disappointed. Lately, a few fellow Fools and I have noted that the market as a whole isn't terribly attractive and so it's more important to seek out individual bargains. Fool analyst Alex Dumortier highlighted Cisco as one of those bargains, while Fool analyst Morgan Housel pointed to the recently bedraggled Johnson & Johnson (NYSE: JNJ ) and the inflation-fighting power of Altria (NYSE: MO ) .
3. We firmly believe that one of Baupost's biggest risks, and, needless to say, that of other investors, is that we will buy too soon on the way down. Sometimes cheap stocks become a whole lot cheaper ...
This is something that always has to be on value investors' radars since the market often doesn't pay much mind to what a stock is actually worth and overshoots to either the upside or the downside. During the financial crisis, I bought more than a few stocks prior to their ultimate bottom, and I'm sure that plenty of other investors could tell similar stories.
The trick, of course, is to stay focused on your fundamental analysis and valuation work rather than the wacky swings of the market and, if anything, use further downdrafts as an opportunity to add to the position at a better price.
4. ... you must consider the competitive landscape and the behavior of other market participants. As in football, you are well-advised to take advantage of what your opponents give you: if they are defending the run, passing is probably your best option, even if you have a star running back.
For Sun Tzu fans, The Art of War is replete with similar thoughts. For instance, "He who knows when he can fight and when he cannot will be victorious."
A good current example of this is small-cap stocks versus large-cap stocks. As I've pointed out on a few occasions, Mr. Market has bid up smaller companies while letting the stocks of larger companies fall to much more compelling valuations. Ford (NYSE: F ) and Intel (Nasdaq: INTC ) are perfect examples of this; both of these big caps are trading at a forward price-to-earnings multiple below 10.
5. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging -- always an important tool for investors -- takes on heightened significance in today's unprecedentedly challenging environment.
This certainly is a tough pill for many bottom-up investors to swallow, but when it comes from Seth Klarman it'd be silly to dismiss it out-of-hand. Klarman has been known to use gold as a disaster hedge, and retail investors can do the same through vehicles like Sprott Physical Gold Trust (NYSE: PHYS ) . And while Klarman has suggested that downside protection through options has become expensive, that's another potential disaster defense.
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