Value Investing

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Value Investing: 3 Lessons from Seth Klarman’s “Margin of Safety” and 1 Value Investment Recommendation

by Mark Skousen, Chairman, Investment U
Tuesday, August 8, 2006: Issue #568

When the stock market gets stuck in a trading range, funny things happen on Wall Street.

This year, Yahoo! (Nasdaq: YHOO) reported an 83% jump in revenues, and its stock promptly fell 13%. Starbucks (Nasdaq: SBUX) said new-store sales rose 4% – considered terrific at many restaurant chains – and its shares tumbled 8% on heavy volume.

In short, growth is no guarantee of higher stock prices.

That is why investors are switching to “value” plays, looking for stocks that may not have the best earnings outlook, but are selling so far below their intrinsic value that they have little downside risk and considerable upside potential.

Thus, the new hot “sector” is value investing. At the end of this issue, we’ll reveal one of today’s most successful value funds. But first, let’s look at a used book on this strategy that’s currently selling on Amazon and Bookfinders for anywhere from $1,295 to $2,003. You can even rent it on eBay for $75 a week

The World’s Most Successful “Value” Investor

The book is Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, by hedge fund manager Seth Klarman. It was written in 1991, but is long out of print, and the author and publisher have no plans to reprint it.

Why? Because Klarman has been so successful as a hedge fund manager that he doesn’t care to reveal his secrets to the general public. Since 1982, his oldest Baupost Group partnership posted a cumulative return of 6,133% after fees, four times better than the S&P 500 Index (1,517%, including dividends reinvested).

But before you run out and buy this obscure title, let me give you a summary of its contents:

Basically, Klarman is a devotee of Benjamin Graham, who first wrote about his “margin of safety” formula for picking stocks in Graham and Dodd’s classic work, Security Analysis. The idea is to buy companies at deep discounts to underlying business value.

Of course, there are thousands of value-oriented investors and fund managers, but Klarman takes Graham and Dodd to an extreme. Despite his subtitle of seeking “risk-averse” value investing, Klarman speculates in distressed securities and even bankrupt companies where the current price is close to the value of its tangible assets (excluding goodwill).

According to the latest SEC filings, Baupost Group holds mostly obscure securities whose prices have plunged, and have hopefully bottomed out, such as:

Mills Corp. (NYSE: MLS), a REIT
Alliance One (NYSE: AOI), a tobacco company
Pxre Group (NYSE: PXT), a reinsurer; and
Novelis (NYSE: NVL), an aluminum manufacturer.

His biggest position is in News Corp. (NWS). Clearly his approach is not for the faint-of-heart.

Three Highly Valued Investing Lessons From A Highly Priced Book

1. Value investors must be patient, willing to wait for months to find a truly undervalued play. Klarman has sometimes invested half his portfolio in cash waiting for opportunities to buy cheap stocks or bonds. According to Klarman, value investing “can be a very lonely undertaking, and may experience poor, even horrendous, performance.”

2. Successful investors “tend to be unemotional, allowing the greed and fear of others to play into their hands.” His statement reminds me of Joe Kennedy, a strict contrarian who had an ideal temperament for speculating: “a passion for facts, a complete lack of sentiment, a marvelous sense of timing,” as one confidante said.

3. Create a “margin of safety” by waiting for stocks of good companies to sell at a significant discount to enterprise value (or in his case, distressed companies that have valued assets and a good chance of turning around).

A Mutual Fund That Shares Klarman’s Value Investing Philosophy

Mutual Shares is one of the most successful value funds, stressing turnarounds and distressed securities. The fund’s founder was the late Max Heine of Heine Securities.

Heine died years ago, and his successor, Michael Price, has left the firm. Today, Mutual Shares is owned by Franklin Templeton Group of Funds and managed by Peter Langerman, who used to be an analyst for Heine in the 1980s.

Mutual Shares is available in A shares (TESIX) with a front-end load; or B shares (FMUBX) with a back-end load. Mutual Shares owns a big position in Tyco (NYSE: TYC), a potential turnaround. The fund is rated 4 stars by Morningstar.

By the way, don’t bother to contact the reclusive Klarman, who manages $6.2 billion of assets in nine partnerships. His firm is so successful that they are refusing new investors.

And don’t bother buying Margin of Safety. I suspect it won’t be long before a new edition comes out, or pirated copies appear in Asia.

Good trading, AEIOU,

Mark

Today’s Investment U Cribsheet

For some of the world’s most successful contrarian approaches, read Investment U’s free report: Contrarian Investor: The Top Six Contrarian Investors of Our Time. This article takes a look at winning investment styles ranging from from George Soros to Jim Rogers.