In 1991, Seth Klarman was about 9 years into his investment career with Baupost and had a pristine track record. He produced 20% to 25% annual returns after fees for his limited partners with no down year during that span.
He sat down for a Barron’s interview in November of that year and was asked about his investment strategy.
Our investment strategy is to invest bottom up, one stock at a time, based on price compared to value. And while we may have a macro view that things aren’t very good right now – which in fact we feel very strongly – we will put money to work regardless of that macro view if we find bargains. So tomorrow, if we found half a dozen bargains, we would invest all our cash.
Klarman expanded on his process when he was asked to define value investing:
We define value investing as buying dollars for 50 cents, somewhat like Mike Price’s definition.
That is a favorable phrase. We certainly don’t stick to it rigidly. We will buy dollars for 40 cents, or dollars for 60 cents when they are attractive dollars to buy. I think we implement it a fair bit differently than many value investors or so-called value investors who frankly I’m not sure are buying good value at all. Value to some extent is in the eye of the beholder. It is very hard to pin down what the value of a future set of cash flows from a business, be it cable TV or biotechnology, is going to be. Some are easier to predict than others. But it is very hard to predict what those future cash flows are going to be. And it is very hard to ascertain the correct discout rate to bring them back to the present with.
When we look at value, we tend to look at it on a very conservative basis – not making optimistic forecasts many years into the future, not assuming growth, not assuming favorable cost savings, not assuming anything like that. Rather looking at what is there right now, looking backwards and saying, Is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year, and is it unlikely to be repeated? We tend to look at hard assets as much as possible.
For instance, cash is something we understand. When a company has cash on the books, or marketable securities on the books we think we understand that. And the more you get into businesses that depend on things going right in the future, the harder we find it to understand it. So we tend to buy asset-rich businesses. But perhaps most important, we are not just focused on equities. We focus on any security of a company that is mispriced.
There is always some level of prediction with investing. For instance, long-term index investors are predicting their index of choice will perform at a reasonable rate over time.
Active investors tend to make more predictions. But more predictions bring more chances of being wrong.
Predicting things like future cash flows, growth rates, potential cost savings, and picking the right discount rate are all opportunities to be wrong. Howard Marks said it another way and I’m paraphrasing – a lot of things need to go right to consistently pick winners.
Klarman knows that trying to predict the future is beyond difficult so he focuses on those things he knows and understands. Part of that is knowing the limits to his strategy.
There are dis-economies of scale in terms of ther returns that can be earned on managed money…But over the realm of all possible sizes, you just don’t want to get beyond a certain level, particularly when you have a eclectic strategy like ours. There is only so much that you can buy that fits our kind of criteria.
Staying small has its advantages.
The Value Hunter – Barron’s Nov. 4, 1991