How to think like value investing idol Seth Klarman

Published Tue, Aug 30 20163:43 PM EDT

Editor's note: This is PRO Strategy, a column on how the smartest minds on Wall Street invest. Perhaps other than Warren Buffett, there is no other value investor more respected than Seth Klarman among his hedge fund industry peers. He has generated tens of billions in gains for his clients across decades. Here's how investors can learn from his success and apply his investment philosophy. Klarman started his investing career at Mutual Shares working with Michael Price, before going to Harvard Business School. He then became the first portfolio manager at Baupost, a firm founded by Harvard Business School professors to manage their assets. Eventually he would take a controlling position in Baupost and turn it into one of the most successful hedge funds in the world. Across his 33 years of investing at Baupost, Klarman reportedly generated annual returns of 16.4 percent and $22.6 billion in net profit for his clients as of the end of 2015. In total, Baupost had $29.2 billion of assets under management at the end of June, according to the firm. Here are three key elements of Klarman's philosophy: "Buying at a discount creates a margin of safety for the investor — room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies." — Klarman in a 2007 speech at MIT Klarman is a classic old-school value investor, who tries to buy securities at a large discount to underlying value and by focusing on potential downside risk before looking at the upside. He discussed the three main ways to value companies in his book "Margin of Safety." The first is "net present value" analysis, where one discounts the value of all future cash flows. Second is estimating "liquidation value" or how much money a company will bring in if sold. And last is "stock market value," which is predicting what a company and/or its subsidiaries would trade for individually on the public markets. "We are what we are: value investors who seek to buy bargains and sell what is fully valued," Klarman said in the Baupost 2015 annual investor letter. He is risk averse in his exit strategy as well as his entry strategy. The manager told the Ben Graham Centre for Value Investing in 2009 that he never holds for the last nickel and sells near fair value. For example, if he bought a stock worth $20 at $10, he would sell when it got to $18 or $18.50, he said. One of his favorite kinds of value investment is buying spinoff securities. Often investors sell spun-out companies without any in-depth analysis just to get it off their books. In a 1999 investor letter, he wrote about buying shares of Pactiv, the maker of Hefty trash bags, from Tenneco. "Due to indiscriminate post-spinoff selling pressure" the hedge fund manager was able to acquire the shares for only 10 times depressed earnings, "a compelling valuation" for a branded consumer products company at the time, he said. "Holding significant, low or even zero-yielding cash can seem ridiculous until you are one of the few with buying power amidst a sudden downdraft. Avoiding leverage may seem overly conservative until it become the only sane course." — Klarman in an April 2013 investor letter. The hedge fund manager said in a 2010 Value Investor Insight article that having cash on hand is critical to be able take advantage of crisis and forced selling opportunities. Moreover, he added how important it was to avoid leverage as "capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over." He told MIT students that "nothing should be more important to investors than the ability to sleep soundly at night." In fact, holding large cash positions is not out of the ordinary for his fund. In 2015, Baupost averaged a cash position of 43 percent of assets under management, according to an investor letter. "We have great clients. Having great clients is the real key to investment success. It is probably more important than any other factor in enabling a manager to take a long-term time frame when the world is putting so much pressure on short-term results." — Klarman at the 2010 CFA Institute annual conference. The investor repeatedly says his biggest advantage is having long-term-oriented clients. He remarked that it is impossible to invest for a three- to five-year holding period, if you're worried clients may redeem in six months. As a result his fund only allows wealthy families and institutional clients, instead of the more mercurial pension funds, sovereign wealth funds and fund of funds.

Seth Klarman, founder of the Baupost Group.

Daniel Acker | Bloomberg | Getty Images

Editor's note: This is PRO Strategy, a column on how the smartest minds on Wall Street invest.

Perhaps other than Warren Buffett, there is no other value investor more respected than Seth Klarman among his hedge fund industry peers. He has generated tens of billions in gains for his clients across decades. Here's how investors can learn from his success and apply his investment philosophy.

Klarman started his investing career at Mutual Shares working with Michael Price, before going to Harvard Business School. He then became the first portfolio manager at Baupost, a firm founded by Harvard Business School professors to manage their assets. Eventually he would take a controlling position in Baupost and turn it into one of the most successful hedge funds in the world.

Across his 33 years of investing at Baupost, Klarman reportedly generated annual returns of 16.4 percent and $22.6 billion in net profit for his clients as of the end of 2015.

In total, Baupost had $29.2 billion of assets under management at the end of June, according to the firm.

Here are three key elements of Klarman's philosophy: