Long-term out-performance from a risk-averse strategy.
Seth Klarman has an enviable record, outperforming the market considerably and consistently over a long period, without using leverage or short selling.
Background and early career
Klarman was born in New York in 1957 and grew up in Baltimore, the son of a health economist. With economics in his blood, he studied the subject at Cornell University, graduating with distinction in 1979.
For the next year and a half he worked at Mutual Shares, a company taken over by Franklin Templeton in 1996, where he learned the art of value investing from Max Heine and Michael Price -- to this day he credits them with shaping his philosophy.
His learning progressed further at Harvard Business School, from which he graduated with an MBA in 1982. Like John Paulson two years previously, he graduated in the top 5% of the the class, earning himself the honour of Baker Scholar.
On leaving Harvard, two of his professors and another couple of wealthy families gave him $27m to manage on their behalf, and with that his Baupost wealth management business was founded.
Track record
Data for the group is a little hard to come by, but according to an article two years ago in the New York Times, total returns averaged 19.55% annually since the group was established, and there were only 11 negative quarters out of 97 during this time. Other sources show only one negative year over this period, and performance beating the S&P 500 by an annualised 6.5%.
Investment style
While it might seem reasonable to compare his performance to the S&P 500, Klarman is careful to target absolute return rather than relative return; he even considers it one of the three pillars of his business.
To some extent this is a logical extension of the fund's extremely wide remit, making it hard to decide what it should be benchmarked against. Choosing a benchmark would provide "ensured mediocrity" and lead to closed tracking, and that would defeat the purpose active management.
That management is very much bottom-up rather than top-down -- the second pillar of his philosophy. "I don't know anybody with a really good, long-term, demonstrated record of success with macro forecasting."
While he can't ignore macro-economic trends, he regards it as immensely difficult to get these forecasts correct, and then to determine what sectors will benefit under those conditions, and finally to pick the winners in those sectors. So he doesn't try. Instead, he focuses on the fundamentals of each business and tests those under all scenarios, ranging from benign to Armageddon.
Testing the various outcomes in this way is central to his perception of risk, and this distinguishes him from the academics who equate risk with volatility -- beta is not risk. "Focus on risk before you focus on return" is his third pillar. "Ultimately, nothing should be more important to investors than the ability to sleep soundly at night."
This risk aversion results in some interesting positions. Despite being a hedge fund, with a mandate to do whatever he wants, Baupost almost always has significant holdings of cash, and never borrows. He entered the latest crisis with nearly half the fund in cash, and even at the depths of the market still had about 20% ready to spend.
His short positions are never more than 1% of assets, partly because shorting requires a short-term frame of mind that conflicts with his long-term ethos, something he regards as a particular strength of Baupost.
Value is clearly the core of his approach, but he is critical of the 'value pretenders' who simply buy the dips. "We're looking for egregious mis-pricings … triggered by urgent, panicked, or mindless selling."
A good example of this is in the area of distressed debt, especially bankruptcies, where many bond funds are forced to dump their holdings immediately and en masse due to their mandates. In these situations, the bankruptcy process itself can be the catalyst to unlocking the value. Klarman is good at messy situations like this that others would avoid.
Rather than riding momentum, his policy is to sell an investment before it reaches fair value, even though there is always the chance that it might overshoot. "Don't fall in love with companies or their managements."
Margin of safety
His ideas were summed up in his famous 1991 book, Margin of Safety - Risk Averse Investing Strategies for the Thoughtful Investor. The title is a tribute to the ideas of Ben Graham, and although the book is in huge demand, Klarman, who owns the copyright, has never revised or reprinted it. Copies change hands on the internet for large sums.
Philanthropy
Klarman is a keen philanthropist, and although Baupost has been mostly closed to new money since 2000 -- it has something of the order of $19bn under management -- he has accepted funds from some educational foundations.
Realising that he and his family have more wealth than they will ever need, his motivation is now to run the fund for the benefit of these investors. But as ever, his interests are aligned with theirs; in common with the late Ian Rushbrook, he believes that he and his team should have the bulk of their personal wealth invested in the fund that they manage.
Books by Seth Klarman:
- Margin of Safety (1991) -- good luck finding a copy!
More investing greats:
John Bogle | George Soros | Ben Graham | Jim Rogers | Warren Buffett | Anthony Bolton | Jesse Livermore | Jim Slater | Charlie Munger | Peter Lynch | Carl Icahn | Philip Fisher | Ken Fisher | John Neff | John Templeton | Mark Mobius | Neil Woodford | T. Rowe Price | Bill Miller | Robin Geffen | David Dreman | Ian Rushbrook | James Montier | John Paulson
