We have all heard about the “Oracle from Omaha”,
but what about the “Oracle from Boston”?
According to famed professor Bruce Greenwald at Columbia Business School,
Warren Buffett once said that
he would only invest with three outside managers
if he ever decided to retire and stop managing money
on behalf of Berkshire Hathaway.
One of them was Seth Klarman from the Baupost Group.
In this video, you will learn the key components of Seth Klarman's investing,
which has allowed him to turn $30 million from 1983 into $30 billion today.
You will also learn what his current portfolio looks like, and about his biggest holding.
Here’s a hint:
It’s an online marketplace.
This is the Swedish Investor,
bringing you the best tips and tools for reaching financial freedom,
through stock market investing!
The “Oracle from Boston”, president of The Baupost Group,
is pretty much unknown for most people
but Klarman's overall track record speaks for itself.
He's become a billionaire through investing in a Warren Buffett-way,
and his firm, the Baupost Group has grown to manage
more than $30 billion in assets after starting with less than $30 million.
The 63-year-old investor,
with a reported net worth of 1.5 billion dollars,
and an alumni of Harvard Business School,
also has a stake in the Boston Red Sox
and owns various racing horses!
After graduating, Klarman worked for Mutual Shares Corporation,
which was run by value investing guru, Max Heine.
Later in his career,
Klarman was recruited by Adjunct Professor Bill Poorvu
to help him manage a pool of capital just south of $30 million.
The company was named Baupost.
As you know now,
this turned out to be the ride of a lifetime.
Headquartered away from the noise of Wall Street, in Boston,
his firm has averaged an annual return of nearly 20% since launching in 1983,
despite holding a large portion of its assets in cash.
So how do we put that track-record in perspective?
Well, the rule of 72 says that 20% means that assets double every 3,6 years.
(72/20)
And since that is 37 years ago,
that means about 10 doublings (37/3,6).
10 000 dollars invested in 1983 would become around 8.5 million dollars today.
That`s what compounding looks like,
and more importantly,
that is the importance of not losing money,
the mantra of Warren Buffett.
You may see glimpses sometimes of Seth Klarman’s sought after letters to investors,
but if they ever appear online,
Klarman and his lawyers at Baupost have them taken down in a matter of minutes.
The only public material out there is a book he wrote in 1991, called
"Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor,"
which is out-of-print
and reads more like an academic text
than a New York Times bestseller.
It has been circulated online in pdf form for some time
and has also been reported to sell for thousands of dollars on various platforms.
There are essentially 5 underlying pillars to Klarman`s investment approach:
1. The margin of safety
The title for his now out-of-print book was not chosen randomly.
It also happens to be the mantra of Warren Buffett,
his would-be client if he ever retired from managing money on behalf of Berkshire.
Warren Buffett said,
“The three most important words in investing are margin of safety.”
That means to buy stuff on sale.
That means paying less than what it’s worth.
That means buying 10 dollar bills for 5 dollars.
That’s the whole secret to great investing.
Buffett, as we all know,
found his mentor in Benjamin Graham and in his book,
The intelligent investor.
In chapter 20 “Margin of Safety”
Graham wrote:
“The function of the margin of safety is, in essence,
that of rendering unnecessary an accurate estimate of the future.
If the margin is a large one,
then it is enough to assume that
future earnings will not fall far below
those of the past
for an investor to feel sufficiently protected against the vicissitudes of time.”
Buffett once used an analogy including a bridge to describe what he means:
“If you understood a business perfectly and the future of the business,
you would need very little in the way of a margin of safety.
So, the more vulnerable the business is,
assuming you still want to invest in it,
the larger margin of safety you’d need.”
“If you’re driving a truck across a bridge that says it holds 10,000 pounds
and you’ve got a 9,800-pound vehicle,
if the bridge is 6 inches above the crevice it covers,
you may feel okay;
but if it’s over the Grand Canyon,
you may feel you want a little larger margin of safety…”
Klarman defined it as:
“A margin of safety is achieved
when securities are purchased at prices sufficiently
below underlying value
to allow for human error,
bad luck, or extreme volatility
in a complex, unpredictable and rapidly changing world.”
He goes on telling that it can also be achieved by:
“… always buying at a significant discount to underlying business value,
and giving preference to tangible assets over intangibles.”
Moreover:
“Since investors cannot predict when values will rise or fall,
valuation should always be performed conservatively,
giving considerable weight to worst-case liquidation value as well as to other methods.”
2. Flexibility
What makes Klarman special is that he has essentially applied value investing principles
across the entire capital structure of both public and private businesses.
He once said that
“It doesn’t matter if an investment is a public or private, fractional or full ownership, or in debt,
preferred shares, or common equity.”
In other words, favor substance over form.
The mantra of Baupost and Klarman
has always been to go where there is inefficiency
and where there is less competition.
That`s why Baupost spends most of its time in complex securities
which doesn’t receive much attention from other market participants.
In a lecture held at Columbia Business School in 2006
he summarized their approach by saying:
“if you had to use one word for our approach,
it would be either mispricingss or perhaps overreactions.
Situations when the market gets something wrong.”
It`s fair to say that Baupost prefers MESSY/ICKY situations
which are too complex for most people to get involved in,
and thus leads to favorable prices and a margin of safety.
Here is an example from the financial crises:
Klarman once said that
“Whatever investment success we achieve will take place against a troubled backdrop”.
This was clearly shown during the financial crises back in 2008-2009
when Klarman and his team deployed around 10% of their portfolio
into auto finance companies like Ford Motor, Chrysler Finance, and GMAC.
They invested around $1.8 billion and made around $1.2 billion in profits.
Ford Motor credit bonds were bought at 40 cents on the dollar
when, in a depression, they estimated getting 60 cents on the dollar.
Here is that margin of safety again.
Klarman and his team at Baupost modeled that
they would make money even if their worst-case assumptions happened.
They were able to make this investment because
a) they were ready with cash when other people HAD to sell
b) they were the first people to receive a call
when Goldman Sachs had clients needing to sell in a hurry,
and c) they were able to assess the odds of not losing money in a relatively short time.
3. Long-term orientation
A key pillar of Bauposts strategy is a long-term orientation.
All else equal, if you own a stock of a company producing high returns on capital
which is also able to reinvest that capital at high returns,
you want to own that company for as long as possible.
Let`s say a business generates free cash flow of 1 million dollars every year,
to keep it simple.
It`s return on capital is 20%
and the business has the opportunity to reinvest annualy at the same rate of return.
After 10 years, the combined cash generation and reinvestment
amounts to over a six-fold increase in free cash flow.
Being able to structure one's investment approach
in a way to fully reap the rewards just described, is incredibly important.
However, many funds have constraints in some shape or form.
This also holds true when it comes to clients.
There are many investment managers out there who own businesses for the long-term,
but unfortunately have clients with a short-term horizon.
This mismatch creates subpar performance.
Bauposts clients are mainly comprised of endowments and foundations
which are long-term entities in nature.
After generating world-class returns to their investors for long periods,
they get goodwill from clients
but, more importantly,
Baupost can choose which investors they let in the door!
This can be a key competitive advantage
and partly explains why Baupost has been able to produce
fantastic returns for their clients for such a long period.
4. Focus on business risk
Risk, according to Klarman, is not measured as “Beta”
like many people in academia and Wall Street wants you to believe.
Risk according to Klarman,
is described by both the probability and the potential amount of loss.
This mindset is the same applied in assessing credit risk
and how a bank man would calculate expected loss on a given exposure.
It`s common to overemphasize on the probability of loss
but the amount you lose is also important.
That’s why a credit mindset applied to investing
is much better than thinking in terms of Beta and volatility.
This also goes back to how a value investor looks at a stock.
As a value investor, you are buying a piece of a business
and you are trying to pay a price
which is less than the sum of the cash flow the business produces,
adjusted for alternatives.
If the volatility of returns of the stock relative to the market increases,
the beta increases,
and hence the riskiness, also increases.
But does this mean that the risk for you as a shareholder has increased?
According to Klarman`s way of thinking,
increased volatility creates more opportunities
for a long-term investor whose focus is on the fundamentals of the business.
Did the cash flow and value of the business change
and are the price changes justified as a result?
As we know, this may not always be the case.
It`s all a matter of looking at the business for yourself.
5. Absolute orientation
Most mutual funds are primarily focused on accumulating assets under management.
The reason for this is that investment funds earn management fees
as a percentage of the assets they manage.
The bigger the pie, the larger the fees!
Most funds also charge additional fees based on the performance of the fund
relative to a benchmark.
Underperforming your benchmark means clients leaving out the door.
Clients leaving means fewer assets and hence fewer fees.
This is the reason why many funds chase relative performance,
and investment managers are afraid of investing in anything
that might have a different return than their benchmark indices,
even in a single quarter!
Trick question:
How can “active” managers overperform for their clients, meaning after fees,
if they invest very similar to an index?
Less tricky answer:
They can’t.
Baupost takes the opposite approach.
Klarman and his team only focus on absolute returns,
which means that they don`t care if they might be
underperforming a benchmark in the short term.
What`s important for Klarman is that they can make good investments,
even if the big payoff may lie many years into the future.
Again, this approach is only possible
because clients trust Baupost to do a good job,
it`s all about the track record!
Seth Klarman and his team at Baupost are always extremely secretive
when it comes to what they are buying and selling
but they are required by law
to report quarterly to the Securities and Exchange commission
what they own in the US in terms of public equities.
This means that few people know what their actual portfolio looks like
when it comes to debt instruments,
real estate, and all other non-US or nonpublic holdings.
What we do know is that disclosed equity holdings in listed companies
were around 8 billion dollars as of June 2020,
which is the latest reporting date to the SEC.
Having assets under management of around 30 billion dollars
results in a portfolio of 27% listed equity
if we only account for the US public holdings.
The top equity positions as of June 2020 were
eBay, Liberty Global, Fox, and Viasat.
An interesting pattern looking at the US listed holdings,
is the notable exposure within telecommunication
and media including Liberty Global (controlled by John Malone, the legendary outsider investor),
Fox, Viasat and Viacom.
Benjamin Graham was the inventor of the margin of safety concept,
and as such,
he has had a major influence on Seth Klarman's investment style.
If you want to hear more about this mentor of Klarman,
who is often referred to as
“The Father of Value Investing”,
head over to my summary of his magnum opus
“Security Analysis”.
Incidentally, Seth Klarman wrote the foreword to the 6th edition of this book,
so I think it is fair to say that it gets his recommendation.
Cheers guys!