In 1991, investor Seth Klarman, founder of the hedge fund Baupost Group, wrote a book on value investing, called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. There was one hard cover edition published, followed up by a paperback edition. Klarman quietly has been running his hedge fund since and he keeps a very low profile, even for clients who want to invest in his fund. Every few years a story will pop up about him. I first learned about his story in a recent article from DynamicDividend, which talked about his recent investing bets. In this article, I talk about his book and his recent investment picks.
What happened to the book? It has largely vanished from booksellers, not printed or released again. Since that book was written, Klarman hasn’t published any more books. The latest way to find Klarman’s published words is his contribution for the leather bound hard cover edition of Sixth Edition of Security Analysis, by Benjamin Graham (2008). Klarman also publishes an investor letter which is available to his investors, excerpts have been released by third parties.
Even though the book has vanished it is far from irrelevant having achieved iconic status among value investors. It’s the book recent MBAs and fund managers read along with their copies of Security Analysis, Intelligent Investor, and Buffet’s investor letters. Since the supply of the book is essentially fixed, and demand has grown over the years, getting a copy is difficult unless you are willing to pay $800-$2000 on reseller sites, or try to find a library that has a copy available to lend.
I haven’t read the book, but have cobbled together some excerpts and opinions from others. Here is a short summary of the book, linked from BusinessWeek:
The term “margin of safety” refers to the cushioning, or wiggle room, that investors should build into what they pay for a security. He doesn’t claim to have invented the term, which comes from Graham & Dodd. “How can investors be certain of achieving a margin of safety?” writes Klarman. “By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles….By replacing current holdings as better bargains come along. By selling when the market price of an investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.”
Although definitions of “underlying value” abound, Klarman’s interpretation opts for a more no-nonsense view that’s shorn of intangible assets such as goodwill. “Since investors cannot predict when values will rise or fall,” he writes, “valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”
Is There Anything New Here?
The summaries and excerpts I’ve read from the book demonstrate that Klarman has a good investor methodology a la Graham that he has put to work to make money in the real world for his clients. Even if you never read the book, he is confirmation through his writing and hedge fund that value investing is a good strategy that you can make money with. According to BusinessWeek, Klarman’s fund has returned about 20% per year since it inception, over almost 30 year period.
But, there doesn’t seem to be anything totally new here from a methodology view that you couldn’t get just from reading Security Analysis or Intelligent Investor. The major difference between the books is that books like Security Analysis are more academic, while Margin Of Safety is more practical and approachable. The book devotes many chapters (nearly 1/3 of the book) to investing in specific real world situations, such as bankruptcies, thrift conversions, and market inefficiencies. The examples provided in the book (such as his opportunistic bond buying of bankrupt Texaco in 1987) were timely for 1991 but aren’t necessarily relevant for investing today. Security Analysis, which was first released in 1936, hasn’t gotten stale because it mostly covers methodology versus specific situations.
Value investing isn’t a magic formula, it’s a methodology that I’ve found requires practice and confidence since in its full form you want to make concentrated bets to get outsized returns that are not diversified away. I wouldn’t want to mimic any one elses picks unless I first did my own research. But, I do find it interesting to watch what Pros like Klarman are buying. Klarman’s portfolio has been published on Stockpickr.
Klarman’s Recent Huge Bets
His book may be unavailable but his recent stock picks are public knowledge. In the recent article by DynamicDividend, they mentioned two stocks that Klarman has made huge bets on, making up about 23% of his portfolio at the time of the article’s release.
The Baupost Group initiated a huge position in Microsoft during the second quarter [2011 ], purchasing 12 million shares. That quickly made it the firm’s third-largest stock investment at the halfway point of the year, representing 12.9% of the firm’s equity portfolio.
Klarman purchased 5.5 million shares of BP during the second quarter , making it Baupost’s fifth-largest equity position (10.1% of the entire stock portfolio) at the end of June. BP’s American Depository Shares are currently trading at $40.17, where the reduced dividend produces a very attractive 4.18% yield. That’s more than the yields carried by rivals Chevron (CVX), ExxonMobil (XOM), and ConocoPhillips (COP), which currently pay 3.25%, 2.61%, and 4.00%, respectively. In addition to having a fatter yield, the stock also trades at a discount to its peers according to common valuation metrics. Its forward earnings multiple (analysts expect the company to earn $7.44 per share in 2012) is a paltry 5.4, while its price/book ratio is just 1.18.
My Take On These Picks
Both of these companies are damaged goods and the market has priced them appropriately (update: looks like investors have rediscovered MSFT in 2012 so far). I would make the case that MSFT is more damaged because BP has assets of great value that will one way or another will be realized after the issues that plagued the company have been fixed or have passed.
BP doesn’t really require that much explanation, we all know what happened. This is a classic distressed asset play.
I’ve looked at MSFT. Other Dividend investors in the blogosphere have written about MSFT. It’s one of those companies that could be a great investment if changes are made. The main problem with MSFT is that big investors, institutional investors are being sold a different set of “goods” from the management than what it actually being delivered. Neither growth nor value investors can really get behind this company. I strongly considered investing in MSFT previously, but they didn’t increase the dividend during the Great Recession (they were plenty able and would have made it more attractive as a value play). However, MSFT does have a larger moat then they get credit for particularly in the corporate space. Maybe he believes that this investor conflict will eventually get resolved?
It’s interesting to read about what Pro value investors are investing in and how they go about it. There are plenty of good books on value investing and they don’t cost $1,000! I’ve mentioned a few in this article. 😉
The following was a guest post from the Six Figure Investor. If you enjoyed reading this article you should visit his website. SFI is a dedicated dividend and value investor, who has indeed amassed a six-figure portfolio. There’s a lot of wisdom, sage advice, and good investment ideas on this website. Check it out!
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