Seth Klarman addressed a Columbia MBA class back in 2010. Someone was nice enough to record it (you can find the video at Valuewalk).
His presentation covered his investing principles, which have defined his success over the years. I pulled out three of his principles below.
Absolute, Not Relative Returns
Klarman believes that a focus on relative returns – our returns compared to the market – fuels short-term thinking and poor behavior. He has point.
The world has a relative performance orientation. If you beat the market or you beat your peers, you will gather assets, even if you lose money doing it.
I really don’t understand why most people benchmark themselves against the market. It seems to me that a sort of intellectual clarity to say, ‘A client gave me money so I have cash. And to be provoked to part with the cash, I ought to have an idea that I’m going to do better than the cash.’
Now think about that. I can keep an absolute barrier from doing dumb investments. If I have a relative barrier, it basically says ‘The whole markets overvalued, I’ll buy the least overvalued crap.’ And I think that’s a sound principle.
That over a long period of time, the market will perform a certain amount. Probably a little bit higher than cash. And we want to beat that too. But I still think to keep your intellectual clarity of how you’re thinking about deploying money, you would not feel good buying stocks at 30x, when the market’s 35x – as if that was some kind of bargain – when you know in the long run, stocks will go to 12x or 15x.
People focused on relative performance end up repeating the same mistakes.
You can’t think straight with a gun to your head. If you have a relative performance gun to your head, on the way down and on the way up, you’ll do the wrong thing every time. You’ll be liking them when they’re up, and hating them when they’re down – when you should be doing the opposite.
Focus on Risk Before Return
Klarman’s primary focus is capital preservation. It’s no surprise that he chooses the logical definition of risk as a chance of loss.
Risk is not beta. Risk is not volatility. Volatility…is a wonderful thing. Because if you buy a bargain, and there’s a lot of volatility, it becomes a better bargain. You can make more money. Volatility helps you.
Volatility is not correlated to risk. Value is something that correlates to risk. In the sense that, if the price you pay is higher than its value, you have risk. If the price is lower, you don’t. We think about risk as the chance of losing.
He looks for investments that are heavily skewed in his favor, but aware he could be wrong because he knows he can’t avoid all risk.
The focus on risk as permanent loss is one reason Klarman avoids leverage.
The risk of leverage is that it’s like drowning in a pond that, on average, is one foot deep.
The average of all the worst outcomes may not seem bad but there’s still a chance to lose everything.
Opportunity, Not Market Timing
Klarman uses cash to time opportunity, not the market. By being focused on bottom up bargains, absolute returns, and capital preservation, he’s naturally inclined toward timing opportunities not timing the next market turn.
His response to people when they ask why clients pay him to hold cash:
They’re not paying us to hold cash. They’re paying us to steward their money frugally and sometimes that means you can’t buy bargains. There’s no reason to think that today’s opportunity set is the only one you’ll ever see.
To say you have to look only at today’s opportunity set, and therefore, be fully invested all the time, is sort of like saying you have to marry someone from your high school graduating class as that’s your whole opportunity set.
Of course, he needs to be comfortable sitting with a large cash allocation while he waits.