There are three central elements to a value-investment philosophy (Part 2) – Seth Klarman

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Seth Klarman is a value investor and Portfolio Manager of the investment partnership, The Baupost Group. Founded in 1983, The Baupost Group now has $27 billion in Assets Under Management.

Klarman is also the author of the best selling book “Margin of Safety” which sells for around $1000 on Amazon.

One of the best chapters in this book is Chapter 7, At the Root of a Value-Investment Philosophy.

Chapter 7 covers his three central elements to a value-investment philosophy.

According to Klarman, these are:

First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities.

Second, value investing is absolute-performance, not relative-performance oriented.

Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

A few weeks ago I covered the first of these principles from Klarman’s book, which is The Merits of Bottom-Up Investing.

This week we’re going to take a look at the second principle which is, value investing is absolute-performance, not relative performance oriented.

Let’s take a look…

Klarman writes:

Adopt an Absolute-Performance Orientation

Most institutional and many individual investors have adopted a relative-performance orientation (as discussed in chapter 3).

They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss.

Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do.

Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring.

Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.

Absolute-performance-oriented investors usually take a longer term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of under-performance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results.

Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term under-performance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

One significant difference between an absolute and relative-performance orientation is evident in the different strategies for investing available cash. Relative-performance-oriented investors will typically choose to be fully invested at all times, since cash balances would likely cause them to lag behind a rising market.

Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index. Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available.

Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs.

Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.

Next week, we’ll take a look at Klarman’s third principle, developing a risk-averse approach.

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