Sell Up and Sleep Well

"Ultimately, nothing should be more important to investors than the ability to sleep soundly at night."

That's how Seth Klarman concluded a recent speech he gave at MIT. He is the portfolio manager of the investment partnership The Baupost Group. Founded in 1983, The Baupost Group now manages $7 billion and has averaged returns of nearly 20% annually since its inception.

That's some investing record, so when Klarman talks, it pays to listen. If you can't sleep at night because you're worried about your portfolio, follow his lead ... and sell.

Value investing for the risk averse
Value investing as popularized by Warren Buffett emphasizes a buy-to-hold strategy: Buying great companies at reasonable prices and holding them for the long term will result in strong returns. Buffett has used the strategy to great effect with his holdings in companies such as Coca-Cola (NYSE: KO  ) , Washington Post (NYSE: WPO  ) , and American Express (NYSE: AXP  ) .

Despite being a value investor, Klarman is no stranger to selling, as the quarterly filings of the Baupost Group demonstrate. For example, for the quarter ending December 2007, Klarman took 22 new positions, added to 10 of his existing positions, completely sold 7 positions, and partially sold a further 9 positions.

Klarman also believes in buying strong companies. At the end of December, his biggest holding by far was student loan company Sallie Mae (NYSE: SLM  ) . Other large positions included Rupert Murdoch's media group News Corp. (NYSE: NWS  ) , mid-sized oil and gas producer Linn Energy (Nasdaq: LINE  ) , and container shipping and integrated logistics company Horizon Lines (NYSE: HRZ  ) . But he also believes that there may be good reasons to sell strong companies.

In his out-of-print book, Margin of Safety, Klarman argues that investors should minimize their risk -- and thus their sleeplessness -- by incorporating a margin of safety into their portfolio. BusinessWeek  summarizes his position:

How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles. ... By replacing current holdings as better bargains come along. By selling when the market price of an investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.

For Klarman, value investing means buying bargains, which confers on the investor a margin of safety: room for imprecision, error, or bad luck. His firm's preferred approach is to seek situations where there is urgent, panicked, or mindless selling. In the current environment, he must feel like a pig in mud.

Selling cheap to buy even cheaper
Klarman can clearly be an active seller of stocks. He sells when a stock reaches fair value, but he also replaces current holdings with better opportunities as they come along. It's not rocket science, but it isn't a strategy most investors follow.

For many reasons, the simple option is to sit on your existing holdings, particularly if they are already cheap. I don't know about you, but I am loathe to sell cheap stocks since, if they're well-researched, those cheap stocks are likely to bring me a sizeable return. In this market, though, many stocks are cheap. By selling one cheap stock, you may be able to buy one with even greater prospects.

Sell the weakest links, buy the strongest
Ranking your existing portfolio positions from strongest to weakest is an important investing discipline. The team at our Motley Fool Hidden Gems investing service is disciplined enough to do it every six months. The financial writers rank each and every stock they've ever recommended based on both the company's business prospects and the stock's price.

As Klarman would likely advise, the stocks at the very bottom of the list are generally sold off, and the stocks at the very top of the list are re-recommended as buys. It's a strategy that has proven very sound for Klarman and for Hidden Gems. Since inception in 2003, Hidden Gems recommendations have returned 36% on average, compared to 11% for a like amount invested in the S&P 500.

To check out the team's latest six-month review and get access to its very best investment ideas today, click to take a free 30-day trial. There is no obligation to subscribe.

The shares in Fool contributor Bruce Jackson's portfolio don't stop him sleeping well at night. The kids are a different issue. He doesn't own any shares mentioned in this article. Coca-Cola is a Motley Fool Inside Value selection. The Motley Fool's disclosure policy is not cheap.


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