Monday, June 7, 2010

The Value of Seth Klarman

Absolute Return had and interesting interview with Seth Klarman:

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Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. "We liked the discount and pipeline of products," Klarman recalls. "We knew that when small caps are spun off, they are frequently ignored and become cheap."

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

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Says Klarman: "We are concerned by the high degree of optimism over the past few months."

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In 1982 they created Baupost, an acronym of the names of the four founders of the firm—Poorvu, Howard Stevenson, Jordan Baruch and Isaac Auerbach—with initial capital of $27 million. Klarman, who came in later and got left out of the acronym, was initially paid just $35,000 per year, not exactly Wall Street compensation.

The initial plan was for Klarman to serve as portfolio manager, while Stevenson, who taught an entrepreneurial management course, served as part-time president. He is now co-chairman of the advisory board. They also planned to farm out the money to other money managers, creating an expanded family office. However, after meeting with several, they had a change of heart.

The Baupost founders were turned off by what they deemed to be a big disconnect between how the prospective money management firms were investing their clients' money and how they were dealing with their own money. They also frowned on the herd behavior they saw, as most of the managers generally invested in the same stocks. Meanwhile, Poorvu and his friends were impressed with the kinds of questions Klarman was asking. So they decided he was the best person to manage their money. "They were taking a big risk on a relatively inexperienced person," Klarman says.

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When Baupost was created, Klarman determined that one of the best ways to make money is to avoid buying stocks that are widely covered on Wall Street and owned by many managers. In general, he tries to buy everything at a big discount. "What you are buying is a margin of safety," he explains, invoking the name of his book written in 1991, which laid out his value philosophy. The book has found its own secondary market, and currently can be purchased for $1,700 new or $775 used on Amazon.

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Ultimately, he says, money managers must pick their poison. They are going to be wrong sometimes. The question is, what are they going to be wrong about? They can take a risk and then possibly lose their client's money, or the client could see their money remain intact but wind up not liking you because you missed a great opportunity. "Our bias is to buy when we have a high degree of conviction and wait patiently when we don't," he stresses. "That's the core of our approach, which has kept us out of trouble."

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Klarman tries to figure out what something is worth, drawing in part on the usual metrics treasured by traditional value managers: price-to-book-value, price-to-cash-flow, price-to-earnings, dividend yield and replacement cost. Unlike most value investors, however, he does not put heavy weight on these measures. For example, if a stock is trading at a deep discount to book value or some other standard, he does not automatically buy it, since there is no guarantee the stock will go back to that level and no way of knowing how long it would take to reach that level. It could go to a deeper discount before it narrows again, or the value itself could change. "Book value is not a good proxy if the inventory is subject to obsolescence," he adds.

And unlike many value managers, he does not look at what a private buyer might pay for something because that deal might never materialize.

Rather, Klarman tries to figure out what he would be willing to pay for the business today if it had to be liquidated or if the various parts of the business were sold. He says this does not mean the future is not important. "A dirt parcel in the middle of Boston is worth more than a dirt parcel in the middle of a desert," Klarman says. But it is difficult to navigate between the present—for example, valuing current cash flow—and the future, such as projecting future subscribers for a cell phone company. "We would have a hard time making optimistic bets about the future," he says. "You have to worry about your margin of safety, which value investors always want."

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Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn't make that timely payment, an investor can take action. "Catalysts can reduce your dependence on the level of the market or action of the market," he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

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These days Klarman is not very bullish. One of his concerns is the record dollar amount of junk bonds that were sold in March and April—$69.8 billion during that eight-week period. And that comes right after a record year for junk bond issuance in 2009, when $185.9 billion was sold.

Klarman is also concerned that the leverage that has weakened the consumer and corporations in recent years has now been added to the government, whose debt has been skyrocketing over the past decade. Meanwhile, interest rates are close to zero percent. "I don't know how we wean ourselves off that," he warns. "It is time for caution."