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The new Warren Buffett

Philip Ryland profiles star US hedge fund manager Seth Klarman, and explains how private investors can replicate his value investing approach
The new Warren Buffett

Margin of Safety - now there's an ironic title for an out-of-print book that is so sought after that rare second-hand copies sell for £1,330 on Amazon. Ironic because there is clearly no margin of safety for anyone who pays that price. After all, it's not the secrets of the text that generates the value. That can't be, since a PDF of the book is available as a free download. And it's doubly ironic because Margin of Safety, the book, is an investment text with the core message that much of the time investors forget all about margin of safety, the concept, when they buy and sell stocks and bonds.

The book in question is written by Seth Klarman, a 56-year-old US fund manager, who is often dubbed "the new Warren Buffett". That's partly because of his investment principles and partly because of his success. More about his principles in a moment. As to his success, Mr Klarman runs Baupost, a fund management company that he launched in 1982 with a pool of $30m (£18.6m) mostly provided by staff at Harvard Business School, where he had just finished an MBA. Today, Baupost manages $29bn and, along the way, has added $16bn in value, making it the fourth most successful hedge fund ever, according to LCH Investments, which monitors these things.

Now, how can we conflate Warren Buffett with a guy who apparently runs a hedge fund, vehicles that are the antithesis of Mr Buffett's 'value-investing' approach? First, because real hedge funds stick to Mr Buffett's - and Mr Klarman's - prime rules of investing: the first rule is not to lose money and the second rule is not to forget the first. And that’s consistent with the idea that a proper hedge fund is also an absolute-return vehicle, which much prefers the strong likelihood of a small return to the slim possibility of a fat return. The preference for such caution owes much to the fact that both Mr Buffett and Mr Klarman started out looking after the wealth of families who valued the preservation of capital above all else.

Second, because they seem alike in manner and style. Mr Buffett, who works out of Omaha, Nebraska, because it's his home town and it keeps him well away from the distracting hurly-burly of Wall Street, is famous for his avuncular style and folksy aphorisms. Ditto Mr Klarman - well, almost. He was born and raised in Baltimore, where, as a boy - and like Mr Buffett - he developed a keen interest in horse racing. Now he is based in Boston, where he lives in its most affluent suburb (close to John W Henry, the owner of Liverpool football club) and has an office that sounds much like Mr Buffett's: "I don't have a Bloomberg terminal on my desk and I don't care. There's just giant piles of paper that are in danger of falling on me; oh, and several bottles of water, always well hidden." (With Mr Buffett, it's cherry-flavoured Coke.)

 

 

Third - and more serious - even before either started managing money, both had a great grounding in the principles of value investing. Mr Buffett cut his teeth in the early 1950s at Graham-Newman, the fund management firm run by Benjamin Graham, the British-born New Yorker who is caricatured as 'the founding father of investment analysis'. Mr Klarman could not start at such rarefied levels (Graham died in 1976), but before Harvard he worked for two years at Mutual Shares, a value-orientated unit trust run by Max Heine, who had been much influenced by Graham. Mr Klarman says that what he learnt at Mutual Shares (code: TESIX), which, incidentally, is now owned by Franklin Templeton Investments and has a continuous record since 1949, eclipsed what he learnt at Harvard.

Small wonder then that he chose 'margin of safety' as the title of his book. It's borrowed from the title of the final chapter of probably the best known – and arguably the best - investment text of all time: The Intelligent Investor, Graham's accessible work on investing, which in its most recent - and still available - 1973 edition was updated by Mr Buffett. In it, Graham said: "When confronted with a challenge to distil the secret of sound investment into three words, we would venture the motto, margin of safety."

It's the principle that lies behind all of Mr Klarman's investment plans and proof of its application is in Baupost's returns. In 30 years, these have included just two down years - 1998 and 2008 - during which time annual returns - depending on which source you take - have averaged 18 to 19 per cent.

That's not quite Buffettesque, and Mr Klarman acknowledges that "Buffett is the better investor because he has the better ideas". Even so, it's stellar stuff. So how does he do it? First, by sticking to those two prime rules of investing. If that means taking no chances at all, then so be it. Earlier this year, Mr Klarman had 30 per cent of Baupost’s assets in cash or something very much like it; and he has taken the proportion to 50 per cent.

Next - and unlike so many hedge funds - he uses no leverage. This is where a fund 'levers up' its returns to its investors by using a tranche of fixed-cost capital, or the equivalent. If - a big if - the manager really has hedged his market exposure, then leverage can turn tiny returns - say, an arbitrage between exchange rates - into something massive. But, as Mr Klarman points out, that requires making two correct calls rather than one, and that's twice as difficult. Which takes us neatly to the Klarman plans that all investors can follow.

 

 

A bottom-up approach

Like almost all value investors, Mr Klarman thinks it's easier to be right about one call than many calls. Therefore, he will focus on one opportunity at a time. The opposite is the so-called 'top down' approach, where an investor starts with the macro-economic outlook and works down. The trouble with that is it requires lots of sequential forecasts to be right. Worse, it's competitive. Many other analysts are doing much the same. So, for success, it's not just necessary to be right, but it requires making the right calls before the other guys in order to get into the appropriate securities first. It's all too demanding. Much better, in Mr Klarman's words, to "buy a bargain and wait".

Find the right sellers

Putting it bluntly, Mr Klarman says: "We like to buy from people who don't know what they're doing." Expressing it more politely, he adds that investors sell assets for all sorts of reasons and quite often their motives are what he labels "non-economic". That’s when they are the best sellers to buy from because they don't pay enough attention to the right price.

A simple way to play this notion is to consider index-relegation candidates. In London, every quarter the constituents of the FTSE 100 index are reviewed and those whose market value has slipped lower than 110th are automatically relegated to the FTSE 250 index. So, for example, in September money broker ICAP and fund manager Ashmore dropped down. When that happens, funds that track the 100 index have to sell their holdings in the relegated constituents. They have no choice. So they sell for non-economic reasons. Companies and their prospective cash flows have not got better or worse but their shares are sold because they have moved from one 'box' to another. As a result, their share prices may fall more than they would have done otherwise and that may create bargains.

Another way of playing it is via distressed debt, an asset class that currently grips hedge-fund managers. You can see why. Banks the developed world over hold loans they don't want either because they are going bad or because they want to shrink their balance sheets in order to contrive an improvement in their capital ratios. As a result, they sell packages of loans at deep discounts to their book value - quite possibly, too deep. Mr Klarman has been an expert in this field since the 198os. He spotted then profited from the flaws in the US junk-bond market in the late 198os and much more recently - 2011 - opened an office in London to capitalise on opportunities in European debt and real estate markets, which, he reckons, are trading at bargain levels. This is a more obscure market for UK private investors, but they could play the theme through shares in Investors Chronicle favourite Real Estate Credit Investments (RECI), which runs a portfolio of mortgage-backed securities.

 

 

Much rarer - though often lucrative - are opportunities in corporate spin-offs, when companies split themselves into two, distributing shares in the new companies pro-rata to shareholders. Often, what's created is a glamorous side that investors want and a hum-drum side that they regard as peripheral. Chances are, it will be too much bother for institutional investors to assess the value of the peripheral side, so they will dump their shares, few questions asked. That's where the possibility of value arises.

For example, chemicals engineer Cookson is just about to split itself into two - Alent, a performance materials side that supplies smartphone makers, and Vesuvius, the humdrum side that makes pipes and valves. True, Vesuvius makes far more sales and profits than Alent, but it may be labelled low-growth and boring. In which case, when shares in the two groups start trading separately next week, Alent's look more likely to rise and Vesuvius's to sink. And if so, there is every chance that Mr Klarman - or his London office - will be sniffing around to see if Vesuvius shares sink to bargain levels.

Don't depend on the market

Mr Klarman knows full well how capricious the market can be. It's the manic depressive that Benjamin Graham caricatured so brilliantly as 'Mr Market'. That means it can be foolish to depend on the market for investment returns. Do that and an investor risks becoming the 'greater fool' that he hopes to exploit. Conversely, it's sensible to seek, as far as possible, returns that will come through regardless of what the market does.

That's why dividends are so nice. Buy the right fixed-income security and nowadays an annual return of 7 per cent is assured from the income alone (take Investors Chronicle's much-favoured NatWest 9 per cent prefs). That's not to be scoffed at, especially if - although this does not apply to the NatWest stock - the security has a specified date and price for redemption. In that circumstance, returns are wholly independent of the market and the risks depend solely on the borrower's ability to meet interest and principal payments. Successfully calculating those uncertainties has to be more likely than working out where the market will be in, say, five years' time.

Plenty of good-quality equities offer attractive dividend yields, too (among FTSE 100 stocks, Aviva, BT, Marks & Spencer, Vodafone, the list goes on). The payouts are not guaranteed, but over the long haul they are much more likely to trend upwards than down. In which case, locking in, say, a 5 per cent yield is a good starting point. It leaves an investor needing maybe just 3 per cent on average in annual capital gains from the market to produce very acceptable performance.

Obscure opportunities also offer returns independent of the market. One particular class is liquidations, where a company turns its assets into cash and distributes the proceeds to shareholders. True, these are rare and usually associated with investment trusts, but they pop up from time to time.

For example, Trading Emissions, which invested in carbon-emissions reduction projects, is in the middle of liquidating itself. Sure, the value of carbon credits has plummeted. Even so, there may be value in the company's shares. They trade at just 27p yet are backed by claimed net assets of 63p per share, of which 18p is unrestricted cash. Don't take this as a recommendation to buy. Take it as an opportunity to do what Mr Klarman would do - explore the detail of Trading Emissions' portfolio and decide on the chances that, over time, Trading Emissions will return more cash to shareholders than the value of its share price.

This is what authentic value investors call 'cigar-butt investing' and it's Mr Klarman's favourite sport. As he told US chat-show host Charlie Rich: "We are still buying cigar butts. There is a good business in it and it's a lot of fun." But he also cautions that, to be a successful investor "you need to balance arrogance and humility. When you buy anything you are saying 'I know more than anyone else, so I'm going pay a quarter more'. And that's arrogant. But you also need the humility to say, 'but I might be wrong'. And you have to do that on everything."

Okay, so what do you have to do to invest like Seth Klarman? Remember investment rules one and two; take a bottom-up approach; find stupid sellers; seek returns away from the market; look for cigar butts; and be both humble and arrogant. Oh, and make sure you have lots of ink in your printer - you'll need it when you download Margin of Safety.

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