It’s Only Castles Burning

The following is a guest post from Six Figure Investor. If you’d like to guest post on the Dividend Ninja, be sure to check out our Guest Posting Guidelines.

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 [2011], 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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19 Responses to “It’s Only Castles Burning”

  1. FrankP

    Feb 02. 2012

    Thanks for sharing. This was a great guest post.

  2. spbrunner

    Feb 02. 2012

    Interesting article. There is an YouTube interview of Seth Klarman by Charlie Rose

    • The Dividend Ninja

      Feb 02. 2012

      Susan thanx for passing on the link. I’m going to go watch that now 😉

    • The Dividend Ninja

      Feb 05. 2012

      Susan that was a great video, I really enjoyed it!

  3. My Own Advisor

    Feb 03. 2012

    Nice guest post indeed.

    I will need to watch that link – thanks Susan!

    As for MSFT, I don’t do tech. They pay dividends now, which is great, but I won’t go there. I’ve read too much that says not to buy tech stocks. Stay with banks, pipelines, utilities, energy and consumer companies.

    I’m too conservative really when it comes to investing.

    BP, a great stock.


    • The Dividend Ninja

      Feb 03. 2012

      MOA ironically I feel MSFT is a much safer bet than BP 🙂 I really view Microsoft more as a utility than a tech company – it pretty well is an infastructure for the PC market, doesn’t really have substantial growth, and pays a good dividend. If there was going to be any change in the PC market after all these years, I do believe we would have seen it by now. There may be some surprising growth in MSFT for 2012.


    • Six Figure Investor

      Feb 05. 2012

      Tech is troublesome for value investors. Most tech companies are one trick ponies that have a difficult time reinventing themselves when technology changes. IBM/Apple are notable exceptions, but they did hit the bottom along the way!

      MSFT/INTC have largely missed the mobile revolution, but they are both working on it. The error that you can make with MSFT is to conclude that it’s a dying software company. This is far from the truth they have an embedded corporate base of customers that isn’t going anywhere. There is a huge investment by customers in their products that can’t easily be replaced.

      • The Dividend Ninja

        Feb 05. 2012

        SFI thanx for posting. Yes this is a real problem for tech companies to reinvent themselves, and yes Apple is a stellar example of a success story. Cisco tried but decided to go back to its core business (servers and networks) which was a good move. RIM unfortunately seems unable to make the shift 😉

        There is also an assumption with investors that a tech company has to be in the mobile game to be successful. But this really isn’t the case, and I think MSFT is an excellent example – they virutally dominate the OS for PC’s and for a large portion of the business market – which as you suggest isn’t going anywhere.

        Thanks for the great article! 🙂

  4. Dividend Monk

    Feb 04. 2012

    A few months ago I published a freelance article on Guru Focus about Seth Klarman’s top five holdings. Microsoft, of course, was among them.

    He’s a great investor, and I currently view MSFT as a solid holding (although I’m a bit disappoitned that the stock has jumped so much recently). It’s currently the only tech company I hold in my portfolio, although I do have an eye on IBM as well.

    I don’t consider Microsoft damaged. The company has produced over 14% annualized EPS growth over the last decade, and is one of only four non-financial companies to have an AAA credit rating. By virtually every company metric, Microsoft has been outstanding. The poor stock price performance over the last decade was due to overvaluation at the beginning of the decade.

    Going forward, Microsoft’s damage is theoretical rather than actual. There are questions regarding how well it will transition to the cloud, and whether it can finally acquire decent mobile computing market share or not.

    • Six Figure Investor

      Feb 05. 2012

      Exactly DM. Investor opinion has to change to view the company for its real value as opposed to what the large investors currently see it as.

    • The Dividend Ninja

      Feb 05. 2012

      Dividend Monk Can you post the link here so we can read your article? Thanx 🙂

  5. Alex

    Feb 06. 2012

    Having just spoken with a fund manager at Dynamic, I am now in the camp that Microsoft is a utility. There are few products that are so widely used as Xbox, Windows, and the Office suite. Most people who use a computer for work inevitably use some form of Microsoft product.

    I think the Skype acquisition will end up surprising many who thought Microsoft overpaid. MSFT has solid earnings growth, a low PE, no debt, and a good amount of cash. Sounds good to me.

    As for Margin of Safety, a quick look will reveal that PDF copies of it are in fact around. If you can track one down, I’m sure it would be worth the time.

    • The Dividend Ninja

      Feb 06. 2012

      Alex thanx for the interesting comment 😉 Yes I do agree with you on the utility viewpoint for MSFT. I’m going to look around for a PDF copy of Margin of Safety – thanx for letting us know!



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