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ANDREW CARNEGIE USED to say that competitors were welcome to tour his factory, to see his production line up close. Why? Because of Carnegie Steel’s massive scale and complex operations, he was confident no one would ever be able to replicate what he’d built.
Hedge fund manager Seth Klarman is a modern-day Carnegie. Klarman founded the Boston-based Baupost Group in 1982, and while performance numbers aren’t publicly available, the firm’s track record is believed to be among the best in the industry. By some accounts, returns have averaged 20% per year, roughly double the overall market’s returns.
Like Carnegie, Klarman’s approach is so specialized and so unique that he’s happy to tell people how he does it. He regularly gives interviews and even wrote a book detailing the different ways Baupost makes money.
While this approach isn’t appropriate for everyday investors, these strategies—known as deep-value—are so different from what’s popular on Wall Street that they’re worth understanding.
Klarman’s philosophy rests on several key pillars, the first of which is that he avoids making forecasts. He jokes that he’d “predict ten of the next two recessions,” and as a result, doesn’t find that a useful basis for making investments. This is a particularly important point because active management often involves forecasting. Klarman’s view, though, is that it’s too unreliable and thus the wrong approach.
Other successful investors share this view. Peter Lynch, the retired manager of Fidelity’s Magellan Fund, called forecasting “futile” and argued that “crystal ball stuff doesn’t work.” Lynch was especially wary of economic forecasts. “If you spend 13 minutes a year on economics, you’ve wasted 10 minutes,” he once commented. Instead, Lynch would go company by company, looking for stocks that, in his estimation, were selling for less than they were worth.
Warren Buffett has expressed largely the same view. “What you really want to do in investments is figure out what is important and knowable,” he’s said. And while the future direction of the economy is important, it isn’t knowable. For that reason, Buffett says, investors should avoid making forecasts and should avoid listening to others’ predictions.
If forecasting isn’t part of the value investors’ toolkit, then how do they choose investments? In short, they search for things selling at such steep discounts that a crystal ball isn’t necessary. But because these sorts of opportunities are rare, they’re often looking far off the beaten path. Obvious investments—even if they look like good investments—don’t appeal to value investors. Baupost doesn’t own Apple, Amazon or Microsoft. This approach, in other words, is the opposite of what Wall Street tends to promote.
To illustrate how Baupost operates, Klarman describes an early investment. When he was a teenager, he worked out an arrangement with a local bus driver to secure rare coins. At the end of each day, the driver would go through the bus’s coin box, and when he found an out-of-circulation coin like a Mercury dime, the driver would give it to Klarman in exchange for a regular coin. In other words, Klarman would pay 10 cents for something worth far more than 10 cents somewhere else. In finance, this is known as arbitrage, and it’s among the strategies that hedge funds like Baupost use.
In his book, Margin of Safety, Klarman describes some of the other unusual investments favored by value managers. These include corporate spinoffs, bankruptcies, thrift bank conversions, rights offerings and other complex securities.
If these sound complicated, that’s the idea. These investments tend to be profitable because they’re so arcane. Consider spinoffs. Why do they present opportunity? Margin of Safety explains that individual shareholders receiving spun-off shares will often sell reflexively because “they may know little or nothing about the business,” and institutional investors “may deem the newly created entity too small to bother with.” For these reasons, newly spun off shares tend to trade at depressed prices, providing opportunity for value investors willing to go against the grain.
In one sense, the types of investments Klarman pursues are straightforward. Value investors like to say that they’re simply looking to buy a dollar for 50 cents. It’s really no more complicated than that.
Hedge fund manager Joel Greenblatt ran a firm called Gotham Capital that pursued many of the same strategies as Baupost, and with similar results. Over one 10-year period, Gotham averaged 50% annual returns, a remarkable feat. And just like Klarman, Greenblatt wrote a book detailing exactly how he did it. It’s called You Can Be a Stock Market Genius. What’s telling, however, is how few people choose to follow their lead. That’s because deep-value investing like this requires more than just a playbook; it requires a commitment of time and patience, it involves significant legwork, and perhaps most important, it requires the mental fortitude to intentionally go against the crowd.
What can individual investors learn from these strategies? Just as with Carnegie’s steel mill, funds like Baupost and Gotham are a marvel. Their complexity, though, tells us something important: It illustrates just how difficult it is to beat the market. This type of investing entails significant effort and enormous cost. To run his fund, Klarman employs 250 analysts. To reliably beat the market, that’s what’s required. And even then, it doesn’t always work. According to the data, the majority of actively-managed funds underperform each year. Recent reports indicate that even Baupost has been struggling of late.
That’s why, at the risk of sounding like a broken record, I always recommend index funds. To be sure, they aren’t designed to beat the market. But by avoiding counterproductive strategies like forecasting and tactical trading, index funds are designed to do something else critically important: They’re designed to help investors avoid underperforming.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Adam, interesting and insightful article. The one advantage that Peter Lynch and Warren Buffet had was that their investing acumen was accessible to many investors through Magellan and Berkshire Hathaway. As such, their performance was tracked, scrutinized, audited and celebrated for their outstanding returns. Others may follow, although Klarman hasn’t joined the mainstream of investment guru/ household name over his almost 50 years of investment success. I wonder why not?
Yep at $2500 that’s a hard pass on the book maybe I’ll find it cheap at a used bookstore haha.
Adam,
Three issues with your issue:
Excellent article, thanks Adam. The last two paragraphs are the real message, and certainly what resonates for me. Unfortunately I think for many (not the HD community) the part they hear is “returns have averaged 20% per year, roughly double the overall market’s returns”. The allure of “beating the market” will remain strong.