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Value investing requires a particular gene and understanding it is like being let in on a little secret, according to Seth Klarman, chief investment manager of The Baupost Group.
The hedge-fund manager’s interview resurfaced recently with people sharing it widely after the Baupost Group revealed its investment in Amazon in its 13F filing with the Securities and Exchange Commission (SEC).
In the interview, Klarman, who usually keeps a low profile, spoke about the mindset required for value investing, his attitude to the market’s gyrations and the toughest decisions to take in investing.
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He quoted Warren Buffett about value investing, saying that it is like inoculation, “you either get it right away or you don’t”.
He said, “I think it’s just true. I actually think there is a gene for this stuff, whether it is a value-investing gene or contrarian gene.”
To explain further, Klarman cited people’s attitude to a bargain sale and how it differed with their approach to investing. “Everybody appreciates a bargain. But when the markets go down, most people overreact and get scared, (wondering) ‘my stock is going down, what do I do’… for me, it’s natural (to see this drop in price as an opportunity) but for a lot of people, it’s fighting human nature.”
If a person can remember that stocks aren’t pieces that gyrate all the time but that stocks are fractional interests in business, then value investing makes sense, said Klarman. “It’s almost like you have to slow the game down…. (thinking) I can buy this thing (a stake in a business) for a fraction of what it is worth, (then) what am I worried about,” he asked listeners to consider.
It is the mindset that Klarman stresses when he speaks to business school students about investing. He tells them that investing lies in the intersection of economics and psychology, and the first part is easier to get.
“Economics (that is) the valuation of business is not that hard (to understand). The psychology — how much do you buy, do you buy at this price, do you wait for a lower price, what do you do when it looks like the world might end — those things (the questions to answer) are harder… knowing whether you stand there, buy more or something legitimately has gone wrong and that you need to sell, those (decisions) are harder (to come to than valuation). Those (harder decisions) you learn to make with experience, you learn by having the right psychological makeup,” he said.
For the right psychological makeup, value investors need patience and discipline, but more importantly, they should not be greedy, according to Klarman.
“If you are greedy and you leverage, then you blow up (your capital) almost every financial blow-up is because of leverage… then you need to balance arrogance and humility. When you buy anything, it is an arrogant act, you are saying that the markets are gyrating… (but) I know more than everybody else so I am going to stand here and buy and pay an eighth more than what the next guy is willing to pay. That is (being) arrogant. At the same time, you need to have the humility to say that you might be wrong,” he said.
On Warren Buffett
Klarman said that he believes that Buffett is a better investor than the two of them because Buffett has a great eye for what makes a great business but to Klarman “most businesses don’t look so great”.
“Warren evolved through three stages. He went from buying cigar butts and getting the last few puffs for free to getting great businesses for really cheap prices, to buying and holding great businesses for so-so prices… and maybe even this new thing of buying weird securities of crappy businesses at better-than-market prices,” he said.
“I am still in phase one, we are still buying cigar butts, there is a good business in buying them and it is a lot of fun,” he said.
The similarity between the two, said Klarman, is that they don’t care about the gyrations of the market. “I don’t have a Bloomberg on my desk,” he added.
Elaborating on that, he cited a “wonderful” story told by Chris Browne at Tweedy, Browne.
After attending an interview at the firm, a person was escorted to the elevator by Chris Browne when the person said that the atmosphere of Tweedy, Browne gave no idea about the market’s behaviour.
“He said that, in most firms, you can tell from the atmosphere in the place, whether the markets are up or down. But at Tweedy, Browne, the interviewee couldn’t even tell if the markets were open. It’s like that at our firm. We are making medium to long-term investments of three to five years or longer. The only reason we care about the gyrations (of the market) is only so that we can buy something cheaper,” said Klarman.
He added that their “rhythm is opposite to that of the market”, buying when the market is down and selling when the market is up.
Answering a question on whether Klarman likes the bad time, he responded that they (value investors) provide liquidity when someone wants to exit a holding that has gone down in value. That said, Klarman does find it frustrating when the markets keep going up and “sucks in” the small investor, causing them to enter the market at the wrong time. “That is painful to me,” he said.
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