You may not be familiar with Seth Klarman, but for serious value investors his name is up there with Warren Buffett and Charlie Munger. His investing success and his ethos, which he outlined in his book “Margin of Safety,” (itself inspired by a concept originating in Benjamin Graham’s “The Intelligent Investor”) has helped make him one of the most successful value investors of all time.
His Boston-based hedge fund, Baupost Group, is one of the largest in the world with $30 billion in assets under management (AUM) and has generated market-beating performance since inception in 1982.
And, like the other successful investors named above, Seth Klarman has refined a handful of investing rules over the years that have allowed him to outperform both his peers and the market averages.
So, here are Seth Klarman’s five rules for beating the markets …
- Be Lonely
Seth Klarman was an expert in investing where no one else would. Whether due to geographics, industry, special situations, or unpopular companies, Klarman always invested where no one else wanted to be. This is the “easy” and most effective way to outperform.
Having a broad circle of competence helps with such opportunities. The advantage of unpopular investments is that you don’t need the most detailed understanding. Such investments are undervalued due to behavioral reasons. Rationality is key to profit from them.
- Be Ready. All Bull Markets Come to an End.
This doesn’t seem as controversial as it would have last year. After all, we are currently in a bear market. For Klarman, this is excellent news. He knows that exceptional returns have their roots in bear markets.
In bull markets, Klarman only aims to match the returns of the indexes. His outperformance comes from investing when the mood changes and stocks get cheaper. Once again, he benefits from a less crowded market and thus less competition.
- Hold Cash
When the market is melting down and opportunities are everyone you need cash. That’s why Klarman, contrary to most investors, advocates holding cash. This results in slight underperformance when the markets are going up, but he makes up for that when opportunities arise.
- Look for Catalysts
A general rule of thumb is that the market realizes its mistakes in a span of two years. Seth Klarman prefers having catalysts for his investments. A catalyst is an event that should cause the investment to reach fair value.
I wholeheartedly agree with this approach. My favorite situation is when a stock is cheap on an absolute and relative basis and has positive fundamentals.
A perfect example (my favorite current idea) is NexPoint Diversified REIT (NXDT).
It’s cheap (NAV of $26 vs. stock price of $16) and has an imminent catalyst: it is transitioning from a closed end fund to a REIT which will allow many more investors to own the stock (including index funds).
- Special Situations
There’s a specific style of investing that combines the above-mentioned characteristics. Special situations are almost inherently overlooked, inefficiently priced, and come with catalysts. That’s why Klarman likes investing in them.
In his book “Margin of Safety” he devoted a whole chapter to Spinoffs, Risk Arbitrage, Liquidations, etc. The reason why special situations are still so profitable, despite not being a secret any more, is their size. Most companies are just too small for institutional investors.
They are not only under-analyzed, but the competition in that space is primarily other retail investors or small funds. This ensures the inefficiency of the space. Putting in the work to analyze upcoming situations can therefore prove very profitable.
Were you familiar with Seth Klarman prior to reading this post? Have you read “Margin of Safety” before? If so, tell us about how influential he’s been on your investing.