How to Invest Like Seth Klarman


Shutterstock photo

To paraphrase an oldWall Street advertisement, when Seth Klarman speaks, people listen. He tends to shy away from mostinvestment conferences, but when he does hold court, it's standing room only. And for good reason. His book, "Margin of Safety : Risk-Averse ValueInvesting Strategies for the Thoughtful Investor," is considered to be a classic of the modern era, fetching more than $1,000 on, now that it is out of print. 

And he backs up his words with numbers. Thehedge fund manager has racked up 20% annualizedgains for nearly three decades. Outside of the Oracle of Omaha, Warren Buffett , such sustained greatness is hard to find.

What is Klarman's secret? Identifying valueinvestments that have a built in margin of safety. Hewill only make an investment if he is extremely confident that the investment won't lose much value, even if his initial investment thesis eventually proves to be wrong. After all, not losingmoney is just as important as making money.

Seth Klarman's Biography
Klarman launched his investment firm, Boston-based Baupost Group, back in 1982 at the ripe old age of 25. By then, he had already developed a strong track record under the tutelage ofmutual fund legend Michael Price and started off with $27 million infunds to invest. Klarman now manages more than $25 billion, making Baupost one of the 10 largesthedge funds in the world, thanks to a 30-year track record that includes just two losing years. Harvard, Yale and Stanford are all clients, and more are hopping on board everyyear . The amount of money he's tasked with managing has tripled since just 2007.

Klarman is the first to admit he's never going to have phenomenal gains in any given year, as John Paulson did during the U.S. housing crisis or George Soros did when the British pound collapsed. He never swings for the fences with high-riskstocks , nor does he useleverage to juice his returns. Instead, his steady performance is the result of a succession of small victories -- singles and walks, to extend the baseball analogy.

And he's perhaps the most patient hedge fund manager on the planet. Most fund managers, even Warren Buffett, get itchy and buy and sellshares (or whole companies) almost every quarter. In contrast, Klarman is perfectly content to wait for the right opportunities toopen up. That's why at any given time, as much as 30% to 50% of his portfolio may be parked incash . Think about that. Thisfund manager racks up robust annual gains, even when a decent chunk of his portfolio earns almost nothing. That means his risk-adjusted returns are simply off the charts.

Unfortunately, most of us will never be lucky enough to be Klarman's client. His Baupost Group only accepts funds from a select group of university endowments, non-profit foundations and highnet worth families. Yet we can take a look at his public communications and learn to mimic his style. 

Klarman will only make an investment if he is extremely confident that the investment won't lose much value, even if his initial investment thesis eventually proves to be wrong.

Seth Klarman's Investment Strategy And Big Wins
Wall Street firms aren't on closeterms with Klarman. If they areunderwriting a hot newstock in a covetedIPO , he will simply say "no thanks." He understands that much of the action on Wall Street simply exists to generate fees for the big firms. Hisbuy-and-hold approach means that he won't churn up alot of trading fees, as his rivals do.

Frankly, the currentbull market holds little appeal to an investor like Klarman. He prefers chaos and distress, putting his idle cash into play only when themarket , or an individual stock, has fallen well below any perceivedintrinsic value . For example, he generated decent, though unspectacular returns in the late 1990s, when many investors were making a killing in the dot-com bubble. But when the bubble burst in 2001, Klarman went to work. 

That year, for example, he made a $150 million investment in bankrupt rental equipment firm NationsRent when itsbonds were selling for pennies on the dollar. Five years later, he unloaded his investment for a cool $1 billion. Fast-forward to 2008, and Klarman racked up further huge gains by buying distressedhigh-yield bonds . 

Seth Klarman's Portfolio: What's He Holding Now? 
Though Klarman's approach isn't best suited to the current bull market, and he's holding a considerable amount of cash, he's still able to pounce on major opportunities as they arise. For example, after the massive oil spill in the Gulf Coast in 2010, he began building a huge stake in beleaguered energy firm BP ( BP ) in 2011.

In a similar vein, Klarman began a series of share purchases of troubled insurance firm American International Group ( AIG ) . Notably, he waited until the fourth quarter of 2012 to start buying, several years after the financial crisis had passed, just to be sure that AIG was truly on the road to recovery. Still, even with a late start, his investments in AIG have risen more than 35% over the past fewquarters .

If history is any guide, Klarman will become a very active buyer when the market hits a rough patch. Until then, he's likely to proceed with caution, ensuring that his firm's portfolio racks up another year in the win column as his existing holdings rise in tandem with the market. 

Action to Take -->  If you'd like to follow Klarman's approach, you'll need to keep an eye out for large, established companies that have been beset by short-term problems. In any given year, you'll find a few dozen companies in the S&P 500 that have fallen far from their52-week high , and often times, these companies are in need of an operational overhaul. Klarman likes to assess the depth of these company's woes, making sure that the problems are indeed fixable. But as he found with BP and AIG, most investors simply shun broken companies, even when a fix is in place. Indeed that notion of "buying when a company is out of favor," is also the secret of Warren Buffett, the late Sir John Templeton, and many other top-performing managers. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing Basics
Referenced Stocks: AIG , BP

More from StreetAuthority




Investing Ideas
Follow on:

Find a Credit Card

Select a credit card product by:
Select an offer:
Data Provided by