Out of Print Investment Ideas

By Christopher Mayer

Seth Klarman is a value investor who has seemingly mastered
the craft. Not only are his results strong – his Baupost
partnerships have averaged returns of nearly 20% annually
since their inception in 1983 – but he is also a graceful
writer whose brilliance shines through in his annual
letters to shareholders. Klarman stays out of the limelight
and most investors have probably never heard of him. His
annual letters are not widely distributed a la Berkshire
Hathaway’s, and though he wrote a terrific book called
Margin of Safety in 1991, it has long been out of print and
is exceedingly rare (commanding prices north of $300).

I was able to read his book for this issue, thanks to the
kindness of a friend who loaned me a copy, and I also have
his 2004 letter to shareholders. I would like to share with
you some of Klarman’s insights.

Klarman’s own investment activities are shrouded in secrecy
and his positions are not disclosed even in his letter.
Categorically, he discloses the amounts he has invested in
various asset classes. And one can see right away that
Baupost is no run-of-the-mill value outfit. Baupost’s
partnerships hold a wide array of investments. Their
positions range from fairly traditional value stocks to
more esoteric investments like distressed debt,
liquidations, and foreign equities or bonds. Cash balances
averaged 50% in 2004, reflecting Klarman’s inability to
find what he considers reasonable values. "We are not
seeking perfection in our investments," he explains, "just
acceptable return prospects for the risk incurred."

Klarman doesn’t mind "doing nothing" on occasion. He is
completely unperturbed by the idea of sitting on the
sidelines holding cash whenever investment opportunities
are scarce, though he recognizes that by doing so, his
clients may be forced to accept lower returns. But Klarman
is unrepentant about his recent inactivity. "Investors," he
observes, "confuse decisions with diligence, activity with
insight, and a fully invested posture with a worthwhile

Investing, he cautions, is more than just producing
absolute returns. Too often investors focus on that one
easy number – return – and ignore the risks incurred to
generate that number. Certainly, a 20% annual gain in a
conservative value stock is a much better result than the
same return generated by "naked" options trading. In the
latter instance, the risks incurred would be much greater.

Part of the reason why investors focus so simplistically on
return, Klarman thinks, is that risks are so hard to
quantify. Some investors buy gold, for example, as a means
of avoiding risk. But during some periods of time, owning
gold can FEEL far riskier than owning tech stocks.

Also, Klarman feels that few investors are able to maintain
a truly long-term focus and that the psychological pressure
to generate near-term returns is great. We’ve all fallen
victim to this, watching over our stocks, checking in on
them several times a day. Klarman reminds us: "What matters
is not who performs best during sequential short-term
intervals, but the attainment of a successful long-term,
risk-adjusted, cumulative result."

Returns are deceptive too, because some portion of it may
be due to luck or short-term factors. Remember when
Internet funds posted triple-digit annual returns? Many of
them are no longer around. They were products of a crazy
time and were not sustainable investment operations.

The underlying methodology is a more important indicator of
long-term success than the returns themselves. As Klarman
writes, short-term results often belie the "absence of an
investment philosophy that would suggest any replicability
of results." In other words, lacking a sound investment
philosophy, these short-term star performers are not likely
to reliably reproduce good results in the future.

What’s it take to succeed as an investor? According to
Klarman, "analytical rigor, intellectual honesty, resolve,
humility, sound judgment and a contrarian instinct."

Klarman also shares our preference for tangible assets. He
writes in his book, "The problem with intangible assets, I
believe, is that they hold little or no margin of
safety…Tangible assets, by contrast, are more precisely
valued and therefore provide investors with greater
protection from loss."

Tangible assets, like land and mountain resorts, and a
generous margin of safety provided by a cheap valuation.
It’s comforting to know we share a similar philosophy with
such an accomplished investor.

Did You Notice…?
By Carl Swenlin

At DecisionPoint.com we have recently added a chart of S&P
600 Small-Cap 52-week new highs and new lows (NHNL). (We
also have NHNL charts of the S&P 500, S&P 400 Mid-Cap,
NYSE, and Nasdaq). This allows us to examine and determine
the condition of each sector.

As with other indicators, we look for divergences between
the indicator and prices. New lows are particularly good
for identifying long-term bottoms. Note the sharp
contraction of new lows in March 2003 compared to October
2002 associated with price lows that were about the same.
This positive divergence was a good sign that the bear
market decline was ending.

From March 2003 new highs began to expand until they peaked
in September 2003. From there they began to contract and
continued to do so for almost a year. So why didn’t this
negative divergence signal a major price top? Primarily
because in a bull market negative divergences are very

One way we can determine if a contraction of new highs is
probably meaningless is by observing what is going on with
new lows. Note how between September 2003 and August 2004
there was virtually no expansion of new lows until the end
of the period when the bull market correction climaxed.

Next we can see how new highs peaked in December 2004, and
they have been contracting ever since. This time we can see
that the angle of contraction is much steeper than the
previous one, and, more important, there is a visible and
persistent expansion of new lows. The negative divergence
of new highs along with the expansion of new lows is one
sign that the bull market may be over.

And the Markets…



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