Seth Klarman – The Price You Pay Protects Your Downside – Here’s How

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One of our favorite investors here at The Acquirer’s Multiple – Stock Screener is Seth Klarman.

Klarman is a value investing legend who runs The Baupost Group, one of the largest hedge funds in the U.S. He also wrote one of the best books ever written on investing called Margin of Safety. Such is the popularity of Margin of Safety that at the time of writing there are 15 used copies selling for $940 and 6 new copies selling for $1500.

I was recently re-reading Klarman’s 1999 Baupost Shareholder Letter in which he discusses the importance of not overpaying in order to protect your downside.

Here’s an excerpt from that letter:

A recent Wall Street Journal article was headlined: For Some Stocks, Price Doesn’t Matter.

Within the article, the co-manager of the billion dollar Stein Roe Young Investor Fund described how he had revised his investment strategy to cope with today’s environment: “To own a company like AOL (America Online), you had to throw out traditional measures of valuing companies. We had to say we have to own what we think is the dominant franchise in the Internet. It was a space that as a money manager you simply have to be in.” Another manager similarly said, “It’s almost like you have to own it.” AOL recently sold for 388 times 1998 earnings and 238 times projected 1999 earnings.

This bubble is spilling over into the rest of the stock market, again at an increasing rate. Internet valuations make those on real companies, however overextended, seem reasonable, propelling those stocks even further into uncharted valuation territory. We believe there has been an extraordinary (and unknowing and probably temporary) increase in the risk tolerance of average investors.

Specifically, what may happen in the future is today valued with unprecedented enthusiasm while what has already come into being (buildings, stores, traditional businesses) trades at subdued, even depressed prices.

Many of today’s leading technology and telecommunications companies trade at 50 to 100 times earnings, or higher. While most of these companies are growing rapidly and possess extraordinary technology, these businesses remain highly competitive. Very low costs of capital and high returns attract enormous competition, and companies have to innovate faster and faster to stay ahead of the pack. Product life cycles are shorter and shorter, and unit prices continue to decline. We understand that the technology content of these companies is fabulous. Whether they are good businesses, deserving of astronomical multiples of current earnings, is an entirely different matter.

Students of financial history can point to historic levels of valuation to suggest that we are in a bubble. But students of psychology may be needed to complete the picture. For one thing, the financial markets have been so strong for so long that fear of market risk has mostly evaporated. People who used to hold bank certificates of deposit now maintain a portfolio of growth stocks. It is not really within human nature to comprehend that you may not know everything you think you know, and, further, that what you believe in could change on a dime. When your investments are backstopped by reasonably-priced tangible assets, the prospect of a change in sentiment is not very costly.

If a building is no longer needed as a furniture retailer, maybe it would make a good warehouse. If you can’t make money as a distributor, you can recover most of your capital by reselling your inventory. Not so for dreams. With more and more of the market value of U.S. equities represented by lofty (in some cases infinite) multiples of current results, a change in sentiment could wipe out a large percentage of investor net worth. Sentiment, existing only in the minds of investors, is subject to change quickly and without notice. Perhaps today’s dreams will become realities for some of the current Internet and technology favorites; and perhaps not. For many, the dream will be replaced by a nightmare. Then, the escalating bill for betting on dreams rather than on realities will have to be paid up.

Real value, of bricks and mortar, finished goods inventories, accounts receivable, operating factories and businesses, and even brand names, is hard, although far from impossible, to destroy. If you don’t overpay for it, your downside is protected. If you purchase it at a discount, you have a real margin of safety.

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