- Billionaire Baupost founder Seth Klarman has been one of the most-followed voices in investing for years.
- His 1991 book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” is considered by many to be the seminal text on value investing. It is out of print, and first editions of the book sell online for thousands of dollars.
- In the book, Klarman makes several predictions, some of which now seem prescient while others are clear misses.
- For example, Klarman calls indexing — and index funds — a fad.
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Seth Klarman has built a career and massive fortune on being right when it comes to picking investments.
The billionaire founder of Baupost Group is one of the world’s most-followed investors, and has grown his hedge fund to more than $30 billion in assets since it was founded in 1982.
But even Klarman cannot see into the future, as several remarks from his out-of-print book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” show. The book, which resells online for thousands of dollars, is considered one of the most important investing books out there, and details Klarman’s approach to value investing.
Despite the massive size of his fund, Klarman keeps a relatively low profile and rarely gives interviews. That combined with the scarcity of the book has helped contribute to its lasting allure.
The ability of value investors to consistently outperform has also become a hot topic in recent years as a surging market has pushed up nearly every stock, not just the companies seen as the best deal.
Other hedge funds, like Steve Mandel’s Lone Pine, are questioning if companies viewed as value bets should still be considered a bargain, or if they are simply unable to keep up with massive, tech-driven structural shifts. Baupost has had muted returns the past couple years, and returned roughly the same as the average hedge fund last year.
The decades-old descriptions of Klarman’s thought process and portfolio management techniques contained several comments on what he thought the future would hold, as well as strong stances that were uncommon at the time, but popular now.
Several of the predictions now look prescient, nearly 30 years since the book’s publication. Others did not materialize, in part because they did not capture just how much technology would transform the investment industry.
The firm declined to comment. The book notes that investing is an art as much as it is a science, and that no investment can be 100% sure and safe.
Klarman’s focus, the book explained, has been on making decisions, projections, and predictions with as much research as he can, while also being flexible to change his prognosis if new information emerges.
And to be sure, Klarman has changed up his outlook in areas outside of investing. The one-time largest donor to the Republican party in Massachusetts has become a leading Democratic donor, and he laid out his issues with the Trump administration to The New York Times ahead of the 2018 midterm elections.
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SEE ALSO: Billionaire Seth Klarman blames low rates and ‘capitalist excess’ for his fund’s languishing returns — and says we’ve seen only the ‘tip of the overvaluation iceberg’
Missed: Index funds are just ‘a fad’
It’s no surprise that an active investor like Klarman is not a fan of index funds.
Even in 1991, he called it “mindless investing,” saying the strategies gave investors “assured mediocrity.”
“To value investors the concept of indexing is at best silly and at worst quite hazardous,” he wrote in his book.
But what actually transpired was explosive growth in index funds, and the influence of fans of low-cost investing like Vanguard founder Jack Bogle who helped spread them across millions of retirement accounts.
“I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded,” he wrote.
Klarman’s book included estimates that $170 billion was invested in index strategies at the end of 1990.
At the beginning of 2020, Vanguard’s Total Stock Market Index fund alone had more than $820 billion in assets.
Index funds and ETFs now have more money under management than actively managed competitors, with more than $4.3 trillion.
Klarman’s thinking on indexing has not shifted much in the decades since the book. In his letter to investors two years ago, he wrote that indexes “lock in” the values of companies in the index without taking into consideration their actual valuations.
“Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings,” he wrote in the investor letter.
Nailed: No-load mutual funds
There has been a fee revolution in retail asset management, prompted by low-cost index funds and ETFs.
And salespeople at large asset managers have seen their pay squeezed thanks to a switch from mutual fund share classes with commissions to those without.
In 2008, more than a third of mutual fund assets were held in share classes that required investors to pay an upfront commission, according to data from Morningstar Direct. A decade later, less than 20% of mutual fund assets were in those share classes, shifting instead to commission-free share classes.
But way before regulations forced asset managers to examine their share classes and fees, Klarman was advising investors to avoid paying commissions, which were common for investors back then.
“Investors should certainly prefer no-load over load funds; the latter charge a sizable up-front fee, which is used to pay commissions to salespeople,” he wrote.
Missed: Computer-driven investing
It’s easy to imagine how in 1991, the year the first website was made, investors would be skeptical of a computer’s ability to run a portfolio.
In talking about investors trying to time the market – a practice Klarman is a critic of — he writes that “their goal was to find a clear signal that would indicate whether stocks or bonds were the better buy. Although the search for this answer has preoccupied investors over the years, it is unlikely that a computer could ever be programmed to make what is clearly a judgment call.”
Later on in the book, when describing how to find good investment ideas, Klarman wrote “investors cannot assume that good ideas will come effortlessly from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or from punching up computers, no matter how cleverly programmed.”
Quant investing has come a long way since 1991, and the world’s biggest hedge funds owe their success to computers quickly making decisions. Renaissance Technologies, D.E. Shaw, Two Sigma, AQR, Bridgewater, and more have proven that computer-driven investing can work extremely well.
Nailed: Be wary of Wall Street’s greed
Klarman wrote the book following a junk-bond crisis in the late 1980s that fueled criticism of Wall Street.
Of course, a decade and a half later, a different product — mortgage-backed securities — would bring Wall Street’s practices into the public’s purview again, as the economy crashed alongside the housing market.
Klarman warned investors who were dealing with Wall Street for the first time that as “the recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of activity than its economic utility.”
“Wall Street … is in many ways a gigantic casino.”
Investors that are relying on Wall Street to help them personally invest need to realize that the banks’ loyalties lie with their institutions, not their clients, Klarman warned.
“The standard behavior of Wall Streeters is to pursue maximization of self-interest.”
Missed: Trying to predict where the market is going is useless
The big difference in value investors and momentum investors is that value investors do not care what the market is going to do next.
The theory Klarman and others subscribe to is that the market is unpredictable and irrational, and trying to make investments based off of where it’s heading next is foolish.
“In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking,” he wrote.
To be a momentum investor, in other words, “is based, not on fundamentals, but on a prediction of the behavior of others,” Klarman wrote.
But many investors, most notably billionaire Cliff Asness of AQR, have made a lot of money investing based on the behavior of others. Bets on momentum stocks, mostly well-known tech names, have more recently driven the returns of many hedge funds over a long bull market.
The returns of iShares Edge MSCI Momentum Factor ETF have been more than 50% better than those of its value counterpart since the inception of the two funds in 2013; filings show the momentum ETF has returned 16% after fees, while the value ETF has returned 10.76%.
Nailed: Venture capital investors find it hard to ‘cash in’
The soaring valuations of private companies, and the flood of investors keeping those valuations sky-high, took a hit last year when unprofitable unicorns Uber and Lyft went public and quickly saw their stocks drop while WeWork’s IPO ambitions imploded entirely.
Commentators have sounding the alarms for years about the risks of high-flying unicorns, especially for investors who are pumping in money in late-stage rounds.
For many of these companies, because they are so highly regarded in the venture capital community, it can be tough to get into the round, much less get any assurances to make up for the lack of liquidity that comes with a venture investment.
Klarman warns in his book that “when investors do not demand compensation for bearing illiquidity, they almost always come to regret it.”
“Investors making venture-capital investments, for example, must be exceptionally well compensated to offset the high probability of loss,” he wrote.
“The cost of illiquidity is very high in such situations, rendering venture capitalists virtually unable to change their minds and making it difficult for them to cash in even when the businesses they invested in are successful.”