Aventine Asset Management Inc.

Published by Jim Pottow

You Don’t Become a Value Investor for the Group Hugs

…And other sage investing advice from Seth Klarman, founder of The Baupost Group.
August 2016

If you aren’t yet familiar with Seth Klarman, the value investing legend who heads Boston-based Baupost Group and who is frequently lauded as the current generation’s Warren Buffet, you should look him up – and if possible try to get your hands on his out-of print book Margin of Safety (presently selling for $2,100 on Amazon.ca – used).

Here at Aventine we share Baupost’s concentrated, value-oriented investment approach and focus on managing risk, particularly with respect to the ACE Fund. Notoriously media-shy, Klarman rarely grants interviews or makes public statements on investing but when he does they are frequently bursting with wisdom. Below we share a few sound bites from some of Klarman’s more notable letters:

On Value Investing:   You don’t become a value investor for the group hugs.

“Did we ever mention that investing is hard work — painstaking, relentless, and at times confounding? Separating relevant signal from noise can be especially difficult. Endless patience, great discipline, and steely resolve are required. Nothing you do will guarantee success, though you can tilt the odds significantly in your favor by having the right philosophy, mindset, process, team, clients, and culture. Getting those six things right is just about everything.

 

Complicating matters further, a successful investor must possess a number of seemingly contradictory qualities. These include the arrogance to act, and act decisively, and the humility to know that you could be wrong. The acuity, flexibility, and willingness to change your mind when you realize you are wrong, and the stubbornness to refuse to do so when you remain justifiably confident in your thesis. The conviction to concentrate your portfolio in your very best ideas, and the common sense to nevertheless diversify your holdings. A healthy skepticism, but not blind contrarianism. A deep respect for the lessons of history balanced by the knowledge that things regularly happen that have never before occurred. And, finally, the integrity to admit mistakes, the fortitude to risk making more of them, and the intellectual honesty not to confuse luck with skill.

 

Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight.”

On Concentration:   I see no sense in having the same size position with your best idea and your 100th best idea.

“It seems to me that, as we know, you diversify most of the diversifiable risk away from a portfolio by owning 20 or 25 positions, and that if one is able to tell a good investment from a bad, one should be able to tell a great investment from a good. So I see no sense in having the same size position with your best idea and your hundredth best idea to round out a 1% idea type of portfolio.

 

When we take a concentrated position, I’d say a dozen times over 26 years, we have had a 10% or so position. It also depends on the definition: Is a position in a type of investment a position or is it only a particular issuer? So a little definitional clarity might also be needed. But in general, in one particular company’s securities, every 2 years or so we have a 10% position. Most of the time, we have 3, and 5, and 6 percent positions as our most favorite ideas. We will take them higher when a cheap position becomes much, much better a bargain or when there’s a catalyst for the realization of underlying value. We favor catalysts because it gives you a much shorter duration on the investment and greater predictability that you will in fact make money on that investment and aren’t subject to the vagaries of the marketand the economy and business over a longer period of time.

 

So we would not own a 10% position in a common stock that was just plain cheap unless we had a seat on the board and control, because too many bad things can happen. But we’d own a 10% position in a senior, distressed debt investment where there was a plan in place, where the assets were very safe – either cash or receivables or something where we could count on getting our money back, and where we saw almost no chance of principal loss over a couple of years and a chance of a very high, meaning 20% plus, type of return.

 

That’s how we think about it. I think when people make mistakes, it often is on both sides of diversification. Occasionally, new managers especially, that aren’t that experienced in the business, will have a 20% position or perhaps even two in one portfolio. And those two might even be correlated – [i.e.] same industry, or the same exact kind of bet in two different names. That’s absurdly concentrated; maybe not if you have enormous confidence and it’s your own money, but if you have clients, that’s just not a good idea. But 1% positions also are too small to take advantage of what are usually the relatively few great mispricings that you can find. When you find them, you do need to step in and take advantage.”