By VW Staff. Originally published at ValueWalk.
After discussing how he went about finding value, and the conservative method used to arrive at an intrinsic value, Seth Klarman moved on to talk about the value mentality. Specifically:
"Barron's: There was a time, not very long ago, when everyone was a value investor.
Klarman: In the mid-to-late' Eighties, you had this explosion or proliferation of investors in what I would call private market value, which is a very dangerous term. They don't call themselves value investors. But I think there was both a self-fulfilling prophecy going on and a circularity to it. If somebody did a takeover, they said, that is private market value; it didn't matter if that person knew what they were doing or not…Company X has a private market value of $50 today, $60 next year, and $100 in three years…just ludicrous. In my view, predicting future private market value is like predicting future Dow Jones levels: It simply does not make any sense at all.
Seth Klarman continues to talk about the leveraged buy-out boom of the '80s, noting that many of the business brought out weren't worth half of the price paid. No prudent person would pay the sums asked. Deals only became possible because of the leverage artists on Wall Street.
"We could never see ourselves paying that kind of price. Owning a business is not purely a positive, not always great shakes. You are illiquid, you are locked in. Sometimes owning a few shares of stock is vastly superior."
seth klarman
Seth Klarman: What creates opportunity
The conversation then moves on to the perfect market conditions for value investors. Seth Klarman preferrs volatile markets. Indeed, volatile markets increase the number of mispriced securities.
But at the time, while he was able to find opportunities, Klarman was also trying to grapple with the fact that value investing was becoming more popular and, as a result, it was becoming harder to uncover mispriced securities.
"In 1985, as far as we can remember there was only one firm doing research in distress. That was R.D. Smith. In 1991, we check our faxes and our research reports, and we count 44 firms doing work in that area."
Baupost's flexibility helped it work around this trend. Klarman's investment universe was not limited, therefore he could search for value wherever he pleased.
And Klarman had a number of "rocks" under which he could usually find the kind of bargains he was looking for. Institutional constraints were one of these rocks. Institutional selling is a prolific creator of opportunities:
"The institutions tend to be natural sellers of the spinoffs…And they sell regardless of fundamentals, regardless of the value. So we tend to look at spinoffs as one category. That would be a type of rock that we look under."
Klarman continues:
"Another type of rock we would look under would be when securities get downgraded from investment grade to below investment grade…many funds that own these are not permitted to own other than investment-grade securities…That may create a short-term supply/demand imbalance."
Seth Klarman: How we view the market
"Barron's: We guess we have a reasonable working knowledge of how you work and reason. So why don't we switch to the way you view the economy and the market?"
Klarman's answer to this question was simple. His bottom-up approach to investing is designed to work without needed a detailed view of the global economic picture. If Klarman finds value, he is willing to buy, no matter what the rest of the world is doing.
At this point in the interview, Klarman touches on "the trend to indexing", blaming it in part for the market's sudden move upwards.
"There's no question that indexing exacerbated the market movement upward. If we had a bad year or two it is easy to envision that institutions that had money in indexing might pull it out en masse, exacerbating the decline."
Klarman believed that at the time of the interview (November 1991) the market was overvalued. His yardstick for measuring the market's condition was the fact he wouldn't buy most of the securities he studied even if they declined 25% or 30% from present levels.
Cash weighting and portfolio holdings
For the year to September 1991, Baupost returned approximately 14% – 19% for investors with a 50% cash weighting.
In the second half of the interview with Barron's, Seth Klarman moves on to discuss some of Baupost's current holdings.
"We continue to look closely in the distressed area. We have two major positions in that area I can talk about…Federated Department Stores bankruptcy, where we were fortunate to be buying senior debt shortly after it defaulted…These are the bond, the pre-merger debt, that ranked equal with the bank debt. And at one point they traded down to below 40 cents on the dollar…where $2.4 billion of such claims outstanding, one could have owned all of the senior claims, which in effect controlled the company, for approximately…$1 billion."
Federated had $500 million of cash on the balance sheet, five major store chains and was still operating in the black after excluding interest costs, with positive free cash flow.
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