Monthly Archives: June 2010

Investing Lessons from Sam Zell

Don’t Just Look At The Financials

Zell says investors should always study a company’s key assets, not just its financial statements. As a private equity investor, Zell has the opportunity to take a hands-on role in a company’s management and operations. But every shareholder should dig deeper into a company before investing. It’s not enough to know sales and profit margins. Always ask: Who are the managers, and what is their motivation? Who are the competitors? Who are the customers? What are the regulatory and/or political hurdles facing the industry?

Invest In Companies With Staying Power

Zell requires that companies he invests in have “staying power”–in other words, that there will be continuous future demand for their product. He particularly likes situations where he does not have to spend any money on marketing because consumers already have a need for what is being offered. “The demand for my product should be facilitated by other people’s consumption.”

Management Should Always Be Aligned With Shareholders

Zell demands that management be aligned with shareholder interest. At its most basic, this means that management should own large positions in the company’s stock. Still, Zell cautions, “Management that is obsessed with stock price is worrisome. I want them to obsess about the business,” he says. Zell also recommends avoiding companies that have anti-takeover devices. “As someone responsible for a public company, I’m responsible for the public’s capital. If someone comes along and wants to buy it at the right price, why not?”

Think Long Term

If you are going to invest in a company, you should always be in it for the long haul. “When you own a company and the company is doing well, then keep going. You don’t make exponential profits by going short.”

Newsletter Issues To Be Released Thursday

The July issues of ValueFocus and ValueEdge will be sent his Thursday July 1st. For information regarding subscriptions see HERE. For questions contact us at


I am excited to announce that ValueHuntr readers have been offered an exclusive 50% discount for the 6th Annual Value Investing Congress, taking place October 12 & 13, 2010 in New York City.

The Value Investing Congress is the place for value investors from around the world to network with other serious, sophisticated value investors and benefit from the sharing of investment wisdom. The world-renowned presenters of successful investors present timely investment ideas, examine key concepts of value investing, and reflect on past misjudgments to help you become a more successful investor. This year’s presenters include:

  • David Einhorn, Greenlight Capital Management
  • Lee Ainslie, Maverick Capital
  • John Burbank, Passport Capital
  • J Kyle Bass, Hayman Capital
  • Mohnish Pabrai, Pabrai Investment Funds
  • Amitabh Singhi, Surefin Investments
  • J. Carlo Cannell, Cannell Capital
  • Zeke Ashton, Centaur Capital Partners
  • Whitney Tilson & Glenn Tongue, T2 Partners

…with many more to come!

Please note that the PRICE WILL INCREASE SUBSTANTIALLY SOON, so we encourage everyone to BUY TODAY. To get the exclusive discount, use code N10VH1.

A Spinoff to Watch: Motorola Mobility

According to a WSJ article, Motorola will pump the bulk of its remaining cash into its handset and set-top box business when it spins off the unit in the first quarter of 2011. This could be an opportunity to invest in a debt-free business with plenty of cash to operate and grow.

The story, which cited unnamed sources, mentions that the company would buy back most of its debt, which stands at about $3.9 billion, and provide the mobile phone unit $3 billion to $4 billion of its cash.

It will also leave the cellphone company, to be called Motorola Mobility, without pension liabilities and most other debts, according to the story.

This would leave the rest of Motorola, which caters to enterprise customers and sells network equipment to operators, with the remainder of its cash, its pension obligations and all its other liabilities, the Wall Street Journal said. That business would be called Motorola Solutions.

The company’s cellphone unit has been struggling to compete with new smartphones and has not had a blockbuster phone since 2004. Its set-top box business suffered due to a weak economy and the wireless network equipment business was hit by a consolidation among telecom operators.

Analysts said it makes sense for its cellphone business, headed by Co-CEO Sanjay Jha, to get the bulk of the company’s cash and to be free from debt to help it in its turnaround.

The idea behind buying back most of Motorola’s debt is to leave the separated entities with clean balance sheets that could make acquisitions or be bought, the paper said.

But both Pompeii and another analyst, Gerry Granovsky of Moody’s, raised doubts about whether Motorola would indeed buy back the bulk of its debt, which is expected to total around $3 billion by the end of this year.

Granovsky sees Motorola allocating the long-term debt to Motorola Solutions, which will be run by Co-CEO Greg Brown. Unless the company has a big cash requirement, such as a share buyback or dividend payment, Granovsky said Brown’s unit may get its desired investment grade rating.

Motorola, which had $8.5 billion cash at the end of the first quarter, has said publicly that it expects to end 2010 with roughly $3 billion in debt after paying back debt due this year and finishing a $500 million buyback.

Yale Lecture By David Swensen

David Swensen, Chief Investment Officer for Yale University Endowment, gives a guest lecture for Yale students.

So That’s Why Investors Can’t Think for Themselves

by Jason Zweig (WSJ)

From February through May, the Dow Jones Industrial Average gained more than 1000 points in an almost uninterrupted daily march upward. Then came the “flash crash” of May 6 and day after day of losses through May. Now, in mid-June, the market has been up six of the past seven days.

What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish, all changing direction together?

Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear.

In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn’t just give investors a sense of “safety in numbers.” It also gives them pleasure.

That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the “consensus view” on Wall Street.

In the experiment, researchers from University College London and Aarhus University in Denmark asked 28 people to submit a list of songs they wanted to buy online and then to decide which they would most like to own. Then the participants viewed the ratings of the same songs by two professional music experts. Meanwhile, a magnetic resonance imaging machine recorded the patterns of activity in their brains. Finally, as a way to measure the influence of the experts’ views, the participants had the chance to change their minds about which songs they wanted the most.

The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum—a reward center wired with dopamine neurons that respond to pleasures like sugar and sex—fired intensely.

“If someone agrees with your choice, it’s intrinsically rewarding in the same way food or money is rewarding,” says one of the experimenters, Chris Frith of University College London.

Why might other people’s estimates of what something is worth lead you to change your own? Their appraisal could make you unsure that yours is correct. You might become more popular once you agree with others, or joining the experts may make you feel like one yourself. “We are very social creatures,” says Prof. Frith, “and we are desperately keen to be part of the group.”

“When someone influences you, it happens very quickly, in under a second,” says the lead researcher, Daniel Campbell-Meiklejohn of Aarhus University. “That mechanism can travel quite quickly through a population.”

The experiment also showed that learning that the experts agree with one another—regardless of whether you agree with them—triggers activity in the insula, a brain region associated with pain and heightened body awareness. This suggests that the agreement of others may have a special ability to grab our mental attention. No wonder a consensus opinion is almost impossible for many investors to ignore.

Benjamin Graham, the founder of value investing, wrote that “the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities.” Rather, he added, “the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.” Herding, Graham understood, is part of the human condition.

Thus, if you buy individual stocks, you should note which way the herd is moving—and go the other way. You should get interested in a stock when its price gets trampled flat by investors stampeding out of it. The list of new 52-week lows is a rough guide to what the voting machine has been trashing lately. Then run your own weighing machine, studying the company’s financial statements, products and competitors to determine the value of its business—while ignoring the current price of its stock. And make a permanent record that thoroughly details your rationale for making the investment. That way, you set in stone exactly where you stood before the herd began trying to sweep you away.

Buffett’s Scout Says Chances Rising for European Deal

By Tommaso Ebhardt and Andrew Frye (Bloomberg)

Warren Buffett’s chances of making an acquisition in Europe have improved since his tour of Germany Italy, Spain and Switzerland in 2008, the billionaire’s scout on the Continent said.

“I believe that Warren Buffett is now on the radar screen for European entrepreneurs,” Angelo Moratti, the Italian energy executive who helped arrange Buffett’s tour two years ago, said in an interview today at his office in Milan. “Ten years ago they didn’t know who he was, three years ago they knew but didn’t understand. Now they know.”

Buffett is turning his attention to Europe and Asia after his Berkshire Hathaway Inc. bought a U.S. railroad this year for $27 billion. Over the last two years, Moratti said, Buffett has rejected proposals from European companies because prospective sellers weren’t big enough or had too much debt. Buffett probably won’t be deterred by the fiscal crisis in Greece and the slide in the euro, said Moratti, vice chairman of Saras SpA, which owns the largest oil refinery in the Mediterranean.

“He’s not interested in the macroeconomic scenario, we hardly would talk about what the euro will be doing,” said Moratti. “He’s looking for a business that is of considerable size, that has long-term prospects, good management and comes out for a fair price.”

The euro fell to its lowest level in four years against the dollar this week amid concern that Europe’s weakest economies will struggle to finance their budget deficits. Greece’s credit rating was cut to junk by Standard & Poor’s on April 27, and Nouriel Roubini, a professor at New York University, has said that aid from the strongest European countries may not be enough to support all 16 nations in the common currency.

Profit Rebound

Buffett is seeking new investments as Berkshire’s earnings improve during the U.S. economic recovery. Berkshire swung to a $3.63 billion profit in the first quarter from a $1.53 billion loss in the same period a year earlier on a rebound in sales of diamonds, luxury flights and recreational vehicles.

Buffett has transformed Omaha, Nebraska-based Berkshire over four decades from a failing textile maker to a $190 billion seller of insurance, electrical power and consumer goods. Berkshire doesn’t pay a dividend or buy back stock, leaving Buffett with the task of investing the firm’s earnings in stocks, bonds and takeovers.

Berkshire is prepared to spend as much as $10 billion on its next deal, Buffett said at the company’s shareholders meeting this month. “We’re as interested as ever,” Buffett said. “We are ready to act.” Buffett didn’t respond today to a request for comment left with an assistant.

‘Bigger and Bigger’

“The possibility that something’s coming up gets bigger and bigger in Europe,” said Moratti, commenting on prospects for an acquisition.

Buffett, who is Berkshire’s chairman and chief executive officer, amassed the biggest stake in Germany’s Munich Re in the first quarter. Next year the 79-year-old billionaire will travel to Japan in search of opportunities, Buffett said at a press conference on May 2.

Buffett’s tour of Europe two years ago was orchestrated by Moratti to drum up acquisition candidates. Buffett met privately with the owners of family-run businesses and touted Berkshire as an appealing buyer at press conferences in Frankfurt and Milan.

Moratti, who fields proposals from interested sellers and filters them for Buffett, said he was “very confident” that a purchase would be made, without specifying a time period.

‘Difficult to Predict’

“It’s very difficult to predict,” Moratti said. It “may happen tomorrow, may happen in five years.” Milan-based Saras isn’t for sale, Moratti said.

Moratti’s holdings in the U.S. include investments in reduced-fat ice cream maker Lovin’ Scoopful and Wat-ahh!, a seller of bottled water for children.

Berkshire’s largest acquisition of a non-U.S. firm was Iscar Metalworking Cos., an Israeli company with operations in China and Japan. Buffett paid $4 billion for an 80 percent stake in Iscar in 2006. Buffett bought a 9.9 percent stake in Chinese carmaker BYD Co. in 2008, and last year he injected 3 billion Swiss francs ($2.6 billion) into Swiss Reinsurance Co., which is second only to Munich Re in the sale of backstop coverage for insurers.

The acquisition of Burlington Northern Santa Fe, Buffett’s biggest, was an “all-in wager” on the U.S. economy, he said when the deal was announced. The railroad’s 35,000 employees and about 6,700 locomotives help haul coal, grain and consumer goods across the Western U.S.

“Warren Buffett’s overall philosophy is America is the strongest,” said Michael Yoshikami, chief investment strategist at Berkshire shareholder YCMNet Advisors. “But that doesn’t mean that you don’t tactically adjust your investment strategy.”

The Market Valuation Parity

Yesterday I heard a Wall Street guru on CNBC say “The S&P500 P/E is now 20, so the market is overvalued by historical standards”. I think this argument is misguided as market valuation, in my opinion, is not an absolute. Rather, equities valuation should be a relative exercise which may or may not make sense based on the opportunity cost of an investment in the S&P500 at any given level.

My hypothesis is that one cannot say for certainty whether a P/E of 15, 20, or 25 indicates an overvaluation in the market without considering what the expected return on alternative investment options are. For example, a P/E of 20, which implies an earnings yield of 5%, may be attractive if all other investment alternatives yield less than 5%. Therefore, there must be a historical convergence between the prices investors are willing to pay for equities and other alternative investments such that the ratio between the equity yield of the S&P500 and the alternative investment of choice is 1. This I call the “Market Valuation Parity”.

Consider, for instance, the historical yield of the 10Y treasuries, which is near 7%. This is exactly what the earnings yield of the S&P500 historical P/E of 15 would imply. Therefore, it may not be a coincidence that the average P/E ratio for equities seems to be around 15. Whether by coincidence or not, the historical average of the ratio between S&P500 earnings yield and the yield offered by 10Y treasuries is 1. Therefore, it seems to me that this ratio could be a better indication of whether equities are an attractive asset class. Although we have chosen the 10Y treasuries, it would make sense to perform the exercise with other asset classes with similar liquidity. But for now, the chart of the ratio between S&P500 earning yield and the 10 year treasuries is shown below:


When the parity is less than 1, it is said that equities is the better option, or has an “attractive valuation”. As the chart shows, March of 2009 was the most attractive time for equities since 1974. Additionally, the parity indicates that although the market is trading at a P/E of 20, it is still attractive based on what other investment options (in this case the 10Y treasury) offer at the moment. The chart also shows the excess that characterized the late 90s, when the parity reached 2.5 just before the collapse of the internet bubble.

A clear flaw is that the chart does not indicate any over-valuation before the 2008 crash, although it may also be indicative of artificially high earnings in the P/E ratio. Furthermore, the relationship that as long as the Federal Reserve keep rates low, the market earnings yield will be above the historical mean of 15. However, that does not automatically mean that the market is overvalued, as it may still offer a more attractive return than other investment alternatives.

The same exercise could be done using the average 10-year earnings yield (courtesy of Matt DeLano), as shown below:

Warren Buffett Worries About Muni Defaults. The Raters? Not So Much

By Michael Corkery (WSJ Deal Journal)

Warren Buffett is warning of a “terrible problem” in municipal debt and has trimmed his investments. The cost of insuring municipal debt – through credit default spreads — has increased as some communities, such as Central Falls, R.I., have inched closer to insolvency.

So it seems like an curious time for Fitch Ratings to be “recalibrating” its municipal debt ratings, which has had the effect of lifting the ratings of thousands of municipalities.

Amy Laskey, who is a managing director at Fitch, tells Deal Journal that the recent recalibration took into consideration the fact that many municipalities are under intense stress, but “historically, the level of [muni] default was very minute as compared to other sectors.” Defaults account for a miniscule .002% of the $2.8 trillion muni-debt market in the past year, according to this Wall Street Journal article.

Fitch downgraded only 8% of the “tax-support” muni-debt, meaning the debt services is supported by tax revenue, in 2009 and is running at a comparable rate so far this year, Laskey said. (Fitch declined to provide Deal Journal the percentage of debt that it had downgraded so far this year).

“These are very long term obligations and we expect governments to meet those obligations,’’ says Laskey.

Does that make communities like Central Falls outliers or warnings of future problems? Central Falls, a small city with a large, impoverished immigrant population, was about to be taken over by a receiver largely because it can’t afford to pay the pensions of its city workers. (The state legislature just passed a law to prevent Central Falls and other municipalities from going into receivership)

It is one of only two communities in Rhode Island that has had its muni-debt downgraded by Fitch. (The other is Woonsocket.) With one of the nation’s highest unemployment rates, declining tax revenue, shrinking population, and large unfunded pension liabilities, Rhode Island could prove to be an outlier. And the problems in the muni-debt market may be contained to the weakest links.

But haven’t we seen this prologue before? In early 2007, investors were making similar predictions about how subprime mortgages would be contained to the riskiest, least credit worthy sector of the mortgage market. They also relied on history in formulating their opinions that the mortgage problems could be contained.

As investment advisers often warn: the past is no guarantee for the future performance.

The Value of Seth Klarman

By Stephen Taub (Absolute Return+Alpha)

Seth Klarman, president and portfolio manager of 28-year-old Baupost Group, is considered the dean of value investing among hedge fund pros, and such a devotee of Benjamin Graham and David Dodd that he was the lead editor to the reissue of their classic, “Security Analysis,” in 2008. With his wire-rimmed glasses, graying beard and kindly smile, the 53-year-old Klarman has a gentle, professorial air about him—and a reputation as a cautious investor who is more likely to be found sitting on a mound of cash than taking big risks in frothy markets.

That being the case, it might be surprising to learn that Klarman’s Baupost bested Carl Icahn in the tussle over CIT Group last year and helped wage a successful activist campaign in a merger battle for a small biotech company. But if Baupost has been able to throw its weight around recently, it’s not just because beaten down markets provided tremendous opportunities for value investors. It’s also because Klarman has been on such an asset building binge that Baupost has become the sixth-largest hedge fund firm in the United

States, with $21 billion under management—three times the $7.4 billion Klarman managed just three years ago. After raising more than $4 billion in early 2008—the first time in eight years that he had opened his fund to new investors—the founder of once-obscure Baupost has become a hedge fund titan.

To hear Klarman talk about these matters, the success and the deals all flow from the value-investing philosophy he first popularized in his book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” now out of print. The CIT deal became one of last year’s highest-profile hedge fund trades, but Klarman was way ahead of the crowd. He began to buy distressed credits, especially in the reeling financial sector, during spring 2008, and thought the senior debt of the shaky middlemarket lender, looked especially attractive. After all, he remembered that he’d made a successful investment 10 years earlier in another diversified loan company, Finova Group. So Klarman’s team scooped up CIT’s bonds, which were yielding 12% to 14%, for 65 cents to 75 cents on the dollar.

“It had some loan problems, decent quality assets and an equity cushion that would need to be burned through before the bondholders would be impaired, which made for an attractive risk-return,” says Klarman, recalling his initial thinking on the CIT trade on a recent morning in early April at his office on St. James Ave., just a few blocks from Boston Common. During 2008 the bonds fell to the low 40s, and Baupost bought more all the way down. But by July 2009, CIT was in such poor shape that Baupost and five other hedge funds ended up lending it an additional $3 billion. To help buy some time, the facility was expanded by an additional $4.5 billion.

Klarman says he was confident the deal would offer him a comfortable margin of safety. A first-lien loan, the debt was collateralized by assets worth four times more than the face amount of the debt, and in exchange Baupost got a fat 12% yield. “We don’t usually lend money at par,” concedes Klarman, who for a short period agreed to sit on an unofficial steering committee of CIT’s creditors before it went into bankruptcy. “But how often do you make a loan that is exceptionally safe and you get to make 12%?” Nor did the prospect of bankruptcy worry him. If it were to occur, Baupost calculated that the assets would recover at least 80 cents on the dollar to the unsecured bondholders.

In late October, as CIT seemed headed for a prepackaged bankruptcy, the deal looked so good to Icahn, who claimed to own $2 billion in CIT bonds, that he opposed it. Icahn called it a sweetheart deal for the large bondholders like Baupost and the other five hedge funds and countered with a $6 billion loan for CIT. But a week later Icahn backed down, paving the way for CIT to enter into a prepackaged bankruptcy from which it emerged in just 38 days. And Klarman’s analysis turned out to be spot-on: Baupost wound up receiving a package of securities with a market value of about 80 cents on the dollar for its CIT debt.

Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

Klarman’s high-profile roles last year in both the CIT and Facet Biotech deals helped him generate average returns in 2009 of nearly 27% in the 11 partnerships of Baupost, with the oldest recording a 19% annualized return since inception in 1983. Klarman has succeeded by deftly exploiting undervalued markets, whether they are equities, junk bonds, bankruptcies, foreign bonds or real estate. His long-term performance is especially impressive since he is not afraid to place as much as 50% of his assets into riskless cash if he can’t spot a good deal, preferably one with a catalyst.

“Seth is a student of the doctrine of Benjamin Graham, but he is not wedded to it,” says James Grant, editor of Grant’s Interest Rate Observer, who has known Klarman for nearly three decades. “He has a very good understanding of not only what makes an attractive valuation but also what makes an attractive opportunity. Seth looks for value in a 360-degree circle of markets and geographic regions. He is one of the all-time leading opportunists.”

In his characteristically understated manner, Klarman simply smiles and says, “I’m not the best, but I am on the all-star team.” After the debt and equity markets rallied sharply over the past 14 months, Klarman is seeing many fewer good values—and that’s despite the market’s huge sell-off that began in mid-May. He thinks junk bonds are no longer attractive now that spreads have narrowed sharply, and he has selectively sold down his corporate debt holdings over the past year. As a result, Baupost was only up about 3.25% to 6.4% in the partnerships net of fees through April; Baupost now has 30% of its assets in cash, and Klarman expects that number to drift higher. Baupost’s returns this year have been hurt by the huge cash position, but that doesn’t deter him. Says Klarman: “We are concerned by the high degree of optimism over the past few months.”

Baupost’s recent growth spurt has come at the same time that more recognizable names—such as Louis Bacon’s Moore Capital Management, Kenneth Griffin’s Citadel Investment Group and Paul Tudor Jones II’s Tudor Investment—have seen assets shrinking from losses or investor withdrawals of capital. By contrast, investors have been clamoring to get into Baupost. “I felt Baupost could handle more money than ever, given the magnitude of opportunities that we were anticipating,” Klarman recalls.

Like John Paulson—whose Paulson & Co. also very quickly became one of the biggest hedge funds—Klarman smelled trouble in the global markets as early as 2006. He thought stock prices were too expensive and that excesses in the credit markets, resulting from heavy borrowing by countries, companies and individuals as lending standards were relaxed, were ominous. “Some things made little sense,” he remembers thinking.

As credit conditions tightened in 2007 and holders of securitized mortgage debt and collateralized debt obligations were forced to take huge write-offs, he noticed that credit spreads had started to widen. At the same time, he realized the housing market was deteriorating and figured trillions of dollars in mortgage-backed securities were not worth par value.

Klarman’s view was prescient. Paulson and Klarman, however, responded to the impending credit crisis in distinctly different ways. In 2006 Paulson shorted risky pools of CDOs and bought credit-default swaps on mortgage assets on the cheap. His aggressive bets were life changing, as he personally made $3.7 billion in 2007. The risk-averse Klarman, on the other hand, placed nearly half his assets into cash. Then, as the financial world was imploding, he started scouring the markets for distressed debt. In late 2007 he started putting cash to work, reducing his cache to 25% to 30% by the beginning of 2008. “We were patient,” he recalls.

Klarman reckoned the game changed at the end of February 2008, when London hedge fund firm Peloton Partners was forced to liquidate its $1.8 billion asset-backed fund. “That was like a bell going off for us,” he says. “That was when we made our decision to raise capital. We realized there were a lot of weak holders out there,” he adds, referring to struggling funds that needed to raise cash.

He scooped up some of Peloton’s senior mortgage bonds for about 65 cents to 70 cents on the dollar. Shortly thereafter, their value fell further as the market worsened. But Baupost’s team saw other large sellers and developed relationships with Wall Street, letting various firms know that if anyone was looking to sell, Baupost was interested in loan portfolios, nonperforming debt, toxic assets of any sort, private investments or so-called tier-three assets.

Sensing so much opportunity, Klarman also decided to open up his funds to new investors for the first time in eight years, raising about $4 billion. He raised the money only from foundations and educational institutions—including the Ivy League—as well as existing investors, all of whom he deemed more likely to stick with Baupost for the long haul regardless of short-term performance swings. Baupost is noted for eschewing fund-of-fund investors, who tend to redeem at the first sign of trouble.

Throughout 2008 Klarman was on the lookout for bargains. And after Lehman filed for bankruptcy and AIG was rescued in September, Baupost made new investments virtually every day, often shelling out $100 million on a single day. Klarman bought the beaten-down securities from others who were reeling from the markets, including many hedge fund managers who were forced to raise cash to meet a surge in redemptions. He didn’t escape unscathed from the carnage: his funds lost between 7% and the low teens during 2008. But the comeback was worth it. For example, Klarman bought covered bonds of Washington Mutual at an average price of 74 cents on the dollar. He made money on them after JPMorgan assumed the bonds as part of its takeover of WaMu. By early 2009, yields on some of the depressed paper surged to as high as 25%. His firm also bought distressed corporate debt, including nonbank financials such as CIT and Sallie Mae and mortgage securities, mostly the senior bonds, which were yielding about 12% to 16%. He was able to make double-digit returns on some of this nonequity paper in 2009. As in the case of Peloton, Klarman continued to buy up the heavily marked-down senior mortgage securities from collapsing fixed-income funds. Baupost picked up pieces of nonperforming debt and private investments from large sellers. Klarman also bought credit default swaps, but unlike Paulson, he used them sparingly and solely as a hedge against calamity. At the same time, he was lightening his equity load, reducing his stock portfolio from $2 billion in June 2008 to $1.2 billion by year-end.

By October 2008, he drew down the rest of the newly committed money. “As the world blew up in the fall of 2008, it was business as usual for us,” he says with more than a small degree of pride. “It was a fortuitous time because we were conservatively positioned.”  Klarman admits he may have begun buying a little too early, as the returns of 2008 would suggest. However, since March 2008, when he began to take in the new money, he is up more than 30% through April. “Seth has an extraordinary sense of patience and discipline, which not many people have,” says Ray Jacobson, chief investment officer at Davidson College, who made his initial investment in Baupost in January 2009. “He is flexible and opportunistic.”

The elder of two boys, Klarman was born in New York City. His family moved to the Mt. Washington section of Baltimore when he was six, but his parents divorced shortly afterward. His father was a professor of health economics at Johns Hopkins University, and his mother taught English in a Baltimore high school before returning to graduate school to earn her master’s degree in social work.

Growing up in the shadows of Pimlico Race Course, he frequently spent his teen years there and developed an interest that would lead to him to buy race horses when he became wealthy enough to do so. And he was always into numbers. Klarman says he loved tracking baseball statistics, and by the age of eight had become fascinated with the stock tables in the back of newspapers. Like so many hedge fund managers, he started investing at an early age. Klarman bought his first stock—Johnson & Johnson—with money he had saved when he was 10. His analysis was simple. Given that he was a big user of the company’s Band-Aids, he figured he would stick to something he knew well. Shortly afterward, the stock split three for one.

When Klarman headed off for college at Cornell University, in Ithaca, N.Y., he initially planned to major in math, the subject in which he had received the best grades. However,after taking a number of economics and history classes, he earned a BA in economics in 1979, graduating magna cum laude.

In the summer of his junior year, Klarman had a fateful experience when his uncle helped get him an internship at New York’s Mutual Shares, the legendary value-driven mutual fund firm founded in 1949 by Max Heine, and also headed by Michael Price, who in his 20s had become a Heine protégé. During a summer working at Mutual Shares, Klarman learned the value philosophy that today is the bedrock of Baupost’s investment principles. “I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom,” he says.

Klarman likes to describe the connection he made to value investing as an inoculation. Either it takes or it doesn’t. “Ultimately, it needs to fit your character,” he explains. “If you are predisposed to be patient, disciplined and psychologically appreciate the idea of buying bargains, then you’re likely to be good at it. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor, and you shouldn’t be one.”

Upon graduation, Klarman returned to Mutual Shares. Price, who now runs his own family office, MFP Investors of New York City, recalls one of the first stocks Klarman bought was a Baltimore meatpacking company called Schluderberg-Kurdle, subsequently renamed Esskay, before it was acquired by Smithfield Foods. Mutual Shares wound up holding the position for several years and made a pretty good profit, Price recalls. “Seth left us a true believer,” says Price.

After 18 months Klarman left the firm for Harvard Business School, where he earned his MBA and was named a Baker Scholar, an honor given to the top 5% of the graduating MBA class. There he took a real estate course with professor William Poorvu, who says Klarman was the smartest person in his class. “I realized he was a special guy,” Poorvu recalls.

The decision to go to Harvard—and to take a real estate course—was also fortuitous. One day Poorvu invited his student to lunch with some of the professor’s friends. At lunch Poorvu told Klarman how he had just made a lot of money selling his interest in a local television station to then-media giant Metromedia. Poorvu added that he and several friends wanted Klarman to help them invest their considerable sums of money earned from that and other interests, including a computer consulting firm.

In 1982 they created Baupost, an acronym of the names of the four founders of the firm—Poorvu, Howard Stevenson, Jordan Baruch and Isaac Auerbach—with initial capital of $27 million. Klarman, who came in later and got left out of the acronym, was initially paid just $35,000 per year, not exactly Wall Street compensation. The initial plan was for Klarman to serve as portfolio manager, while Stevenson, who taught an entrepreneurial management course, served as part-time president. He is now cochairman of the advisory board. They also planned to farm out the money to other money managers, creating an expanded family office. However, after meeting with several, they had a change of heart. 

The Baupost founders were turned off by what they deemed to be a big disconnect between how the prospective money management firms were investing their clients’ money and how they were dealing with their own money. They also frowned on the herd behavior they saw, as most of the managers generally invested in the same stocks. Meanwhile, Poorvu and his friends were impressed with the kinds of questions Klarman was asking. So they decided he was the best person to manage their money. “They were taking a big risk on a relatively inexperienced person,” Klarman says.

Poorvu and his friends didn’t think so. Poorvu recalls how he was drawn to Klarman’s curiosity and desire to explore things in depth. Klarman, he saw, was not afraid to challenge anyone. “He was fearless,” Poorvu adds. “He had strong opinions. There were discussions more than arguments. It was an enthusiasm for what he was doing. We realized he was on a different level than they were.”

Those attributes have not disappeared. Grant describes Klarman as ferociously smart, notoriously prickly and not one to engage in a lot of soft preliminaries in a business context. “His intellect can be hugely intimidating,” he elaborates, stressing that Klarman has earned a great deal of respect in the investment community. “He comes out and says what is on his mind and expects you to be blunt and direct as well.” Grant recalls how, years ago, Klarman would aggressively press Goldman Sachs salesmen on their investment ideas with a flurry of detailed questions. He was so fierce, Grant muses, that the Goldman guys were afraid to answer the phone if they saw it was someone from Baupost calling.

When Baupost was created, Klarman determined that one of the best ways to make money is to avoid buying stocks that are widely covered on Wall Street and owned by many managers. In general, he tries to buy everything at a big discount. “What you are buying is a margin of safety,” he explains, invoking the name of his book written in 1991, which laid out his value philosophy. The book has found its own secondary market, and currently can be purchased for $1,700 new or $775 used on Amazon.

Managing risk and determining the margin of safety are the backbone of Klarman’s investment process. He and his team look at what could go wrong in a company, the economy, how some event or issue could affect the company or the security. “You can like a company but not find opportunity in its securities, or not like a company but find opportunity in the securities,” he says.

Ultimately, he says, money managers must pick their poison. They are going to be wrong sometimes. The question is, what are they going to be wrong about? They can take a risk and then possibly lose their client’s money, or the client could see their money remain intact but wind up not liking you because you missed a great opportunity. “Our bias is to buywhen we have a high degree of conviction and wait patiently when we don’t,” he stresses. “That’s the core of our approach, which has kept us out of trouble.”

In other words, he prefers being wrong by missing opportunities rather than losing money chasing them. This is why Baupost, on average, has 30% of its assets in cash, and it is not unusual for Klarman to sit on 40% or 50% cash, as was the case in 2006 and 2007. This makes the fact that he outperformed the S&P 500 virtually every year in the past decade even more remarkable. In 2006 Baupost was up 22%, compared with 15.8% for the benchmark, despite holding a huge amount of cash. The following year it had an explosive 54% return, compared with just 5.49% for the S&P, again with nearly half its portfolio in cash.

But Klarman has never felt pressure to put money to work, especially during the late 1990s, when Internet and tech stocks were surging out of control and critics were asserting that Warren Buffett was a relic unable to adapt to new markets. Klarman’s willingness to underperform over short periods of time when he does not see value also explains why he refuses to take money from funds of funds. He prefers educational and philanthropic groups. “If making money right away is important to you, please take your money out,” he says.

“When he doesn’t see things he likes, he doesn’t buy,” says Price admiringly. “He sits on cash. He is very disciplined.” When mulling a specific investment, Klarman says, he looks at an anticipated return, although he won’t cite a specific level because Baupost’s required return depends on the perceived risk. Klarman tries to figure out what something is worth, drawing in part on the usual metrics treasured by traditional value managers: price-to-book-value, price-to-cash-flow, price-to-earnings, dividend yield and replacement cost. Unlike most value investors, however, he does not put heavy weight on these measures. For example, if a stock is trading at a deep discount to book value or some other standard, he does not automatically buy it, since there is no guarantee the stock will go back to that level and no way of knowing how long it would take to reach that level. It could go to a deeper discount before it narrows again, or the value itself could change. “Book value is not a good proxy if the inventory is subject to obsolescence,” he adds. And unlike many value managers, he does not look at what a private buyer might pay for something because that deal might never materialize.

Rather, Klarman tries to figure out what he would be willing to pay for the business today if it had to be liquidated or if the various parts of the business were sold. He says this does not mean the future is not important. “A dirt parcel in the middle of Boston is worth more than a dirt parcel in the middle of a desert,” Klarman says. But it is difficult to navigate between the present—for example, valuing current cash flow—and the future, such as projecting future subscribers for a cell phone company. “We would have a hard time making optimistic bets about the future,” he says. “You have to worry about your margin of safety, which value investors always want.”

In general, Klarman runs a sensitivity analysis. He likes to determine the best possible scenario, the worst case, and the base to find that margin of safety. How far does he take it? Pretty far, or so it seems. Grant muses that shortly after he launched his newsletter in the 1980s, Klarman requested a meeting to determine whether to commit $200 for an annual subscription. “He grilled me to see if it was a good investment for his fund,” Grant says, laughing, stressing that Klarman has been a subscriber ever since. Baupost’s investment team consists of about 40 people—including six other partners—who investigate different asset classes, geographies and securities types. They are all generalists, except for the commercial real estate specialists. Although Klarman does not make every investment decision, he does make a point of saying he approves the concept of what they are doing.

Klarman, who spends most of the time sitting on the trading desk or in conference room meetings with his other investment professionals rather than in his office, must approve every trade, although he does not personally execute them. “If I am hard to reach on vacation, they can take a position,” adds Klarman, stressing that most of his key people have been with the firm for a number of years. Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management. These days Klarman is not very bullish. One of his concerns is the record dollar amount of junk bonds that were sold in March and April—$69.8 billion during that eight-week period. And that comes right after a record year for junk bond issuance in 2009, when $185.9 billion was sold.

 Klarman is also concerned that the leverage that has weakened the consumer and corporations in recent years has now been added to the government, whose debt has been skyrocketing over the past decade. Meanwhile, interest rates are close to zero percent. “I don’t know how we wean ourselves off that,” he warns. “It is time for caution.” As spreads on the debt have narrowed, he has been selling. Over the past year, Baupost has sold corporate debt at or near par after buying it for 40 cents or 50 cents on the dollar. He’s still selling, stressing that he’s waiting to buy when he can be adequately paid to take risk.

The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses. Baupost is 30% in cash now, its long-time average. Klarman stresses that the cash position is residual—the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”

And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.

For Klarman, the overriding concern is valuation in individual investments, not the macro state of the market. And given today’s turmoil and financial distress, one might have expected more opportunities. “But, the opportunity set has been diminished by all of the government intervention,” he adds, referring to the current 0% interest rates, TARP and TALF. If financial institutions started selling these assets, opportunities would open up, he says.

Another high-profile investment he has made in the past year was in the Boston Red Sox, buying the minority stake of advertising mogul Ed Eskandarian for an undisclosed sum. “It’s a tiny little sliver,” insists Klarman. “It’s been fun. The other owners have been incredibly gracious in welcoming me.” His biggest perk: better access to extra seats at hometown ball games.

Living next to Pimlico as a child may have been the impetus for a great career in finance, but ironically it seems Klarman’s worst investment has been in race horses. He bought his first one in the early 1990s, and in 1993 he started Klaravich Stables with longtime friend Jess Ravich, a West coast investment banker. Klarman’s crowning achievement came in 2004, when Read the Footnotes, his horse, ran in the Kentucky Derby. One of the worst moments was when he finished seventh. Horse ownership, he acknowledges, is “almost certainly a negative present value situation.”

In 2008, estimates Klaravich Stables earned less than $34,000. That’s a far cry from the roughly $275 million to $300 million Klarman probably earned last year as a hedge fund manager, a topic he won’t comment on.

Klarman will say that he gives away most of his money to the Klarman Family Foundation, which his wife Beth runs, or to individual charities, except for an undisclosed sum squirreled away for his three children. His foundation gives out considerably more than the standard 5% each year, focusing on alleviating poverty and improving education in the inner city. Healso gives money to health care and science causes; he has created an eating disorders center and a funding program for scientific grants in the field of eating disorders. Klarman, who is Jewish, gives money to causes such as Boston’s Combined Jewish Philanthropies.

“It’s easy to write checks,” he says. “It’s hard to be thoughtful philanthropists. My wife Beth and I try to make our money go a long way.” What else would you expect from the dean of value investing?