- Billionaire Seth Klarman’s investing philosophy has been in something of a rut for years.
- But comparing his recent writings to investors to his nearly 30-year-old book show that he hasn’t changed the way he does things — and value might be making a return as the markets tumble due to coronavirus fears.
- Klarman has doubled down on his belief that the market does not reflect the true value of an investment because it’s based on the actions of others, not the underlying fundamentals.
- In his letter to investors at the beginning of this year, he said that “short-term market gyrations matter little unless one wishes to – or is forced to – transact.”
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Value investing appears to be slowly returning to favor for hedge fund managers, as Seth Klarman has predicted all along.
One of the world’s most famous value investors has stuck with his strategy, despite the markets’ years-long upward march and momentum managers making big returns thanks to bets on high-flying tech names like Apple and Amazon.
As the sell-off related to the novel coronavirus pandemic began, Morgan Stanley’s prime brokerage desk found that hedge funds were selling out of growth stocks and buying value companies, according to Bloomberg. A recent report from industry data-tracker Hedge Fund Research has found that value funds have so far vastly outperformed growth fund competitors during the sell-off.
Klarman, the billionaire founder of Baupost Group, is not pushed to buy or sell based on market moves though, as outlined in his nearly 30-year-old book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investors” and, more recently, in his annual letter sent to clients in January.
Trying to time people and markets is irrational, value investors believe, and nearly impossible, according to Craig Bergstrom, the chief investment officer of fund-of-funds Corbin Capital.
“Timing factors is incredibly difficult,” Bergstrom said.
Klarman’s recent letter to his investors re-ups some of the tenets he laid out in the book — and doesn’t budge on his original processes or beliefs. Put simply, the value investing approach means picking stocks that most of the market is undervaluing, with the belief that their price will rise once everyone catches on to their real value.
“Sometimes, the market tells you one story, even as the performance of the underlying businesses tells you another. This is the case with many ‘value equities’ today, which have been significantly underperforming the market even as operating cash flows are strong,” he wrote to investors.
Nearly 30 years ago, he wrote in his book that value investors need to have “unusually strict discipline” when “speculators” that trade on the market instead of fundamentals make money.
“High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before,” he wrote in the book.
Baupost declined to comment further.
That sort of discipline has faced a huge test since the financial crisis more than 10 years ago — after stocks bottomed out, the broad market rise made it hard to find unloved names. Growth investors, as the name might suggest, look for companies poised to grow rapidly, and that’s been rewarded by meteoric gains like those seen in the FAANG stocks.
Cliff Asness, the billionaire founder of AQR and legendary momentum trader, even posted a trolling blog on the hedge fund’s site on Feb. 27, styled off of Abraham Lincoln’s Gettysburg Address.
“The world will little note, nor long remember what we say here, but it can never forget the Tesla [value investors] shorted here,” reads Asness’ post, titled “The Valuesberg Address.”
Baupost returned roughly the same amount as the average hedge fund in 2019 and barely broke even in 2018, while other value investors have fared worse.
Mangrove Partners meanwhile dropped 9.4% in 2019, according to the firm’s annual letter to investors, which blamed the firm’s “near complete lack of exposure to growth stocks.”
“We have always been more comfortable owning value stocks because they are typically less exposed to rapid technological change and obsolescence and also have greater valuation support based on near-term cash flows. While this strategy has delivered good returns for investors over long periods, it has also gone through extended periods of underperformance, including the last ten years,” the Mangrove Partners letter said.
Klarman’s own letter reflecting on 2019 performance noted that the Russell Value Index has returned half of what the Russell Growth Index has annually since 2007. And Stephen Mandel’s Lone Pine wrote last year that some companies that once looked like value investments may actually just be outdated and never recover.
In comparing value investing to other styles, Klarman’s book makes three distinctions: value investors don’t believe the market reflects the value of a company; market changes don’t really matter in the short term; and sticking to your guns is key to making the value strategy work.
“Fortunately for Baupost, investing is not a sprint but a marathon. Over the long run, major mispricings are eventually corrected – the share price and value of a business tend to converge – because short-term illusions are pierced and enduring characteristics become more apparent,” the letter from earlier this year stated.
To be sure, some see cracks of light appearing at the end of the tunnel for Klarman and his disciples who have stuck with it through the stubborn bull market.
The billionaire founder of Maverick Capital, Lee Ainslie, told investors in his letter to start the year that he believes the value “drawdown” reached rock bottom last year, and will come back in fashion as the economy turns. Ainslie has since told investors that, in light of the market drop related to the COVID-19 pandemic, he is trying to “take advantage of the panic” and buy stocks at a discount.
Though if there is a huge pullback on momentum trades and a surge in value stocks, which happened for a quick week-long period last September before reverting back, Klarman won’t be buying based on “short-term market gyrations” — a view he has stuck by since 1991 and reiterated in 2020.
“Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked,” he wrote toward the end of his book.