Investing is not rocket science… but that doesn’t mean success is easy to achieve over the long run either! To reduce our learning curve and enhance our ultimate results, we should seek to learn from the greats in the field. Join me as we discover seven essential value investing principles from Seth Klarman.
I am a huge fan of history and strong believer that we can learn a lot from those who have blazed a path before us. As such, one of my favorite types of articles that I write on Wicked Capital is my series featuring lessons and principles we can glean from the great investors of all time.
In this one, we will sift through the investing experiences and wisdom of Seth Klarman to discover some incredibly powerful and valuable principles for long-term investors to successfully build upon.
While Seth is a pure value investor, his principles can and should be applied to all the spheres of long-term investing, including dividend-growth and dividend-value (aka passive-income) investing!
Who is Seth Klarman and why should we listen to him?
If there was a Mount Rushmore of investing greats, Seth Klarman would certainly be at least an honorable mention in the running for a spot on it.
I would place him in my top five of value investors, top ten of modern-era investors, and top 20 of all-time investors.
Andrew Ross Sorkin of the New York Times has referred to him as “the most successful and influential investor you probably have never heard of.” This is due in part to his low (almost reclusive) public profile—but he is considered a giant within investment circles and mentioned in the same breath as Warren Buffett. Incidentally, he is one of the only hedge fund managers Buffett has ever publicly commended.
This billionaire investor is affectionately referred to by many as the “Sage of Boston” (a play on Buffett’s label of “Sage of Omaha”), where he manages the Baupost Group—a private investment group he founded in 1982.
At Baupost, he has managed to deliver a 16.4% annualized return since its inception (1982-2015)—that’s more than three decades and an amazing accomplishment. During that time, he quietly grew the fund from $27 million to $30 billion in assets under management.
He is probably best known for his iconic 1991 book Margin of Safety: Risk Averse Investing Strategies for the Thoughtful Investor. He was also the editor of the 6th edition of Benjamin Graham and David Dodd’s Security Analysis in 2008. The same year he was inducted into the Institutional Investors Alpha’s Hedge Fund Manager Hall of Fame.
Klarman is a pure value investor—in the mold of Benjamin Graham (whose teachings he strongly advocates) and an early Warren Buffett (who has since evolved his investing style beyond that of pure value).
While we are on polar opposite ends of the political spectrum (and that’s an understatement), his investing record is as impressive as it is impeccable—and has endured the great crucible of time.
Furthermore, while he is a pure value rather than passive-income investor, his wisdom is highly applicable to both dividend-growth and dividend-value investing—providing valuable principles that suitably apply to long-term investing in general.
As such, I think we can learn a great deal from this seclusive investing giant.
Great interview of Klarman–well worth the watch.
Much more in depth presentation by Seth Klarman if you are interested in learning more about his investing approach to value investing.
Now that we’ve introduced Seth and covered his credentials, let’s dive into the seven investing principles we can learn from Klarman…
Speculation is price focused, market driven, and predicated on relative investing. In other words, it views stocks as merely ticker symbols and is focused on price action and relative opportunities.
It is a game of musical chairs (or hot potato if you prefer)—one that depends on there being a “bigger fool” to buy at a higher price. One attempts to identify and buy at a “relatively” good price and then sell to someone else at a higher price… based on the speculation that the price will go up.
Unfortunately, this approach does not have a great long-run track record. The “good” price just keeps getting ratcheted up, based on rosier and rosier speculation regarding future growth potential.
It’s a case of: “Yes, this stock is overvalued on an absolute basis. However, boy is it relatively cheap if we factor in higher future growth.”
Who cares if that future growth will materialize so long as the rest of the market continues to believe it will!
Unfortunately, it’s a house of cards and a fool’s errand. Eventually, the rosy outlook will run face-first into the wall of reality and there will be an inevitable rush for the exits.
Yes, this approach can work very well for a time—the recent bull run (fueled by massive inflows of liquidity and corporate buybacks funded by cheap debt) demonstrates this. However, all good things must come to an end—at least for a season.
The problem is that the average retail investor gets lured (or duped) into the game in the late innings… and, when the music stops playing, finds themselves at the back of the line of the now crowded exits. They end up being the undesirable “bigger fool.”
And this is the best-case scenario—when the speculation actually works for a time!
Again, this is a price focused, market driven strategy—one fueled by ever-shrinking attention spans and time horizons.
It’s akin to playing the lottery—and not a good approach to long-run investing success.
As we point out repeatedly, this is a major driver of why the average retail investor only managed to produce an anemic annualized return of 1.9% (less than the rate of inflation) over a twenty-year period (1999-2018)—most retail “investors” are actually engaged in the speculation game.
The other type of market participant is the investor.
This individual doesn’t view a stock as simply a ticker symbol and piece of paper (like a lottery ticket), who’s price oscillates up and down over the short run. Rather, they understand that stocks represent fractional ownership in real businesses. They are a stake in the company’s future earnings.
They are not looking to “flip” a ticker… they are looking to invest in a business over the long run.
As Peter Lynch reminds us, “Behind every stock is a company. Find out how it’s doing.”
Investors mirror the approach of Warren Buffett, who asserts, “Buy into a company because you want to own it, not because you want the stock to go up.”
Simply put, investing is about (1) analyzing the fundamentals of the business to determine what those future earnings will be, (2) identifying the present value of those future earnings, and (3) buying them at a discount.
As Benjamin Graham, the godfather of value investing, asserted, “Buy not on optimism [speculation], but arithmetic.”
This approach (aka absolute value investing) will provide you with a critical margin of safety (MOS). Speculation, on the other hand, provides zero margin of safety! That’s how retail folks get burned when the fire alarm sounds, and everyone rushes in vain to squeeze through one tiny emergency exit door!
Obviously, a MOS is not perfect and won’t always save you. However, it works quite well and provides a relatively secure backstop to minimize your downside risk—unlike with speculating.
As such, price is always the final step—not the first one. “Relatively” cheap does not equal value. Value can only be established by understanding the underlying business and performing steps one and two!
As Buffett always notes, “Price is what you pay. Value is what you get.”
Phillip Fisher shrewdly stated, “The stock market is filled with individuals [speculators] that know the price of everything, but the value of nothing.” We would be wise to take the advice of Buffett, Fisher, and Klarman to heart—don’t be a speculator.
It is important to always remember that, to paraphrase Klarman, it’s not so much about figuring out what a business is worth today—that’s easy. Rather, it is about determining if it will be worth the same or more tomorrow!
That’s the dilemma for investors—avoiding value traps (aka when a bargain turns out not be a bargain).
Klarman defines this as a bottom-up or risk-averse approach. When evaluating a company, he always assesses the risk first (aka what can go wrong) and establishes a solid margin of safety. Only then does he analyze the upside potential.
This is the complete opposite of Wall Street, which typically employs a top-down approach. They play the speculative growth game and look at the upside first—the classic “bigger fool” mentality.
Unfortunately, they (and the average investor) get crushed when things go wrong—as they inevitably will at some point.
This is why Klarman asserts, “We [referring to his fund] refuse to enter Wall Street’s ubiquitous short-term performance derby.”
Thus, Seth Klarman’s first principle is always be an investor—not a speculator.
The second investing principle that we can glean from Klarman is that long-run success requires being patient and logical.
The great investors share one trait in common… an unbelievable ability to stay patient and disciplined.
They never chase the market—they wait for it to come to them!
As the Oracle of Omaha has wisely noted, “The stock market is a device for transferring money from the impatient to the patient.”
Once you’ve performed steps one and two above, you will have developed a price that you would be willing to buy an ownership stake in a business. It’s your price.
Always buy at the best price—your price!
There is no rush. Let the market come to you. Over time, it frequently will, and your patience will be rewarded.
Opportunity will come. You just have to have the patience to wait for it. If you have a list of businesses you’re interested in, the odds of one of them being on sale (i.e., selling at your price) at some point are quite high.
Steady on the trigger! Wait… wait… wait… for the right moment.
This also requires you to be logical rather than emotional.
You’ve done your homework… trust in the process. Don’t succumb to emotion and fall prey to the fear of missing out (FOMO) or herding. Emotion is the fuel of speculation—avoid it at all cost!
Thus, Klarman’s second investing principle is always remain patient and logical.
The third investing principle we can learn from Klarman is we need to leverage our time-arbitrage edge.
You will hear a lot of discussion about the efficiency of the markets. It is one of the driving arguments behind advocates of index investing. However, I would argue that the best supporting argument for index investing is behavioral—not market efficiency. But that’s a story for another day.
The important thing to understand is that, while the market is fairly efficient in the short run, it is not nearly as efficient in the long run. And that is the source of our greatest edge as long-term investors—the time-arbitrage edge!
Do to short-run catalysts and the emotional (behavioral) component of the market, their will be aggregate overreactions to the upside and downside.
As Klarman aptly asserts, “The stock market is the story of cycles and of human behavior that is responsible for overreactions in both directions.”
Our goal as long-term investors is to capitalize on those short-run overreactions.
This requires maintaining a long-term orientation and the patience and discipline to stick to it.
If you’re interested in learning more about market efficiency and our time-arbitrage edge, I encourage you to read my article Here’s Why an Efficient Market Is Irrelevant to Long-Term Investors.
While many of our readers are pure dividend-growth investors, we would all be wise to integrate a value component into our overarching passive-income strategy.
It can be dangerous to add to positions with blatant disregard (intentional or otherwise) for the value of our companies. We don’t want to unknowingly metamorphosize into speculators—under the guise or misguided pretense of being disciplined, conservative investors.
Know the value of your companies and add to your position (or initiate one) when it makes sense. Meaning, add when you can improve your cost basis and have a reasonable margin of safety. Don’t chase the market—even great companies can be purchased at a bad price. And doing so can negatively impact your long-term returns in a material way!
As Klarman aptly asserts, “The single greatest edge an investor can have is a long-term orientation.”
Thus, Klarman’s third investing principle is to always leverage our edge by capitalizing on time-arbitrage value opportunities.
The fourth investing principle we can takeaway from Klarman is to always maintain liquidity.
Let’s be honest, it doesn’t do a whole hell of a lot of good to be patient… if we’re unable to act when opportunity finally strikes!
Buffett is fond of saying, “Opportunities come infrequently. When it rains gold, put out the bucket—not the thimble!”
We never know when the market will serve up a great opportunity. The worst feeling (and trust me, I know firsthand) is to finally get the price you’ve been waiting for on that stock you’ve had at the top of your list for years… only to not have the liquidity (cash or cash equivalents) to capitalize on it!
Klarman asserts that we should always have a cash cushion!
How much cushion? Well that’s up to you. That’s something only you can determine.
We don’t want too much—it’s capital that’s not working for us. However, we want enough dry powder that we can make a sizable move if the right opportunity or opportunities presented themselves.
Seth has maintained an average of 33% in cash and cash equivalents with his Baupost Fund over the past 30 years. This is similar in style to the stockpile of cash that Buffett has amassed at Berkshire Hathaway.
The important thing—what really matters—is that you have some liquidity.
I would add that one of the contributing factors to harmful churn is a lack of liquidity. Folks find “better” opportunities but don’t have sufficient liquidity to grab them… so they exit other positions to buy them. They jump from one ship to another and it becomes a graveyard spiral—repeating over and over again as their long-run performance continually deteriorates. (Does a 1.9% annualized return over twenty years sound familiar?)
How do the greats drive consistently high returns over the long run? They always maintain a strong degree of liquidity so they can maximize their ability to take advantage of great deals when they occur.
They don’t pull the trigger often but, when they do, they put out the buckets (thanks to their liquidity) and capture some serious gold!
Again, this requires patience… but it will pay huge dividends to you over the long run! It may seem inefficient in the short run, but trust me (and Buffett and Klarman), you will more than make up for it over the long term.
The fifth investing lesson we can learn from Klarman is not to fear averaging down.
Averaging down has become synonymous with the devil! The mere mention of the idea is likely to cause anyone to be the recipient of an emotional and impassioned tongue-lashing these days!
However, while it’s true that this is extremely dangerous when speculating… it’s hogwash when it comes to long-term investing!
Why? Because, as we’ve noted, when you are engaged in speculation, you have no margin of safety—no floor to provide support. You’ve entered a position based on the relative upside—typically late in a broader move.
If it goes wrong (i.e., the music stops), you have no way to know just how far the stock can fall or where the floor may be. That’s the danger of relative versus absolute investing. As such, you should NEVER average down as a speculator or trader.
However, as an investor, averaging down is actually a good thing!
When a company hits our price, based on our fundamental analysis and valuation, we should buy it.
However, we can never call a bottom—for a stock or the broader market. We must be able and willing to give our investment some room to breathe. And, thanks to our long-term orientation, we have plenty of time (and, hopefully, patience) to do just that.
If the price falls lower—and it almost always will (we can’t call bottoms and selling begets selling in an emotional market), we absolutely should average down. This lowers our cost basis and—if it’s a passive-income position (i.e., dividend payer)—increases our capital efficiency… meaning we are buying more cash flow for less capital.
And that’s great for passive-income investor because that cash flow will continue indefinitely regardless of price volatility.
There is one HUGE caveat to this! We should only average down so long as our underlying investing thesis, the company’s fundamental story, and our macro outlook remains intact!
This is precisely why we want to invest with a margin of safety. It provides us with a built-in downside cushion. We need to trust our MOS and process over the long-term. The short-run overreaction will only boost our long-term return.
If we believe a company is worth X at $10 dollars… it should still be worth X at eight dollars (ceteris paribus)—given that our analysis and math is correct! That’s just an additional time-arbitrage gain thanks to the emotionally-driven behavior and short-run orientation of the so-called rational and efficient market!
Again, this is why liquidity (principle #4) is so critical to long-term investing success. We need to have enough dry powder to not only initiate a position… but to add to it when it presents a beneficial opportunity.
Finally, just because we shouldn’t fear averaging down doesn’t mean we should just automatically or always do it. It’s a judgement call based on a vast number of variables. However, the point is that is can be a very beneficial tool in our toolbox—one we should embrace when it makes sense.
In the words of Klarman, “Sometimes buying early on the way down looks like being wrong, but it isn’t.”
Thus, Seth Klarman’s fifth investing principle is to never fear averaging down.
The sixth investing principle Klarman provides us with that we to know what we’re doing.
We must approach investing like any other profession—it requires a certain set of knowledge, skills, and abilities.
For example, we need to know how to perform fundamental analysis and calculate valuations.
We need to understand the sectors and industries we are investing in—all the way down to our individual companies.
As Buffett is found of saying “Never invest in a business you can’t understand.”
How would you feel about a business owner that didn’t understand his or her business? Well, we are business owners and, as such, it is paramount that we fully understand them!
But investing also requires understanding the macro picture—what’s going on in the broad market and economy… domestically and internationally.
As such, investing requires research and learning… it requires consistent effort. We are not just investing our money but our time as well.
We must be willing to learn and develop our craft. Ten minutes a week simply won’t cut it. We must be willing to invest ourselves in the profession and process.
If you’re not able, interested, and willing to put the work in, then I highly recommend you employ a more passive strategy, such as index investing.
There’s absolutely nothing wrong with that. In the spirit of the Greek philosophers, it’s critical that you “know thyself.” It doesn’t matter if stock investing resonates with you on an emotional level or you find yourself being influenced and drawn to it by the experiences of others—if it doesn’t fit you, it doesn’t fit you. It’s that simple. Save yourself the trouble (and money) and find a more passive strategy that does!
Furthermore, we need to be able to do our own research. There is nothing more dangerous than relying on stock picks from others.
I have seen so many good folks get hurt investing in things simply because of someone else’s advice—without (1) any knowledge or understanding of the company, industry, sector, macro outlook, (2) how that recommendation fit within the stock pickers investing plan, strategy, and portfolio, or (3) how that pick fit their unique financial situation, financial goals, or risk profile/tolerance.
For more on the danger of using stock picks, I encourage you to read my article Dividend-Growth Investing—Why You Should Never Buy a Fish.
Finally, there are lots of opportunities out there. We need to be selective in the ones we chose. We need to always stay within our circle of competence. After all, as Buffett points out, “Risk comes from not knowing what you’re doing.”
We don’t have to swing at every opportunity—stick to the ones that fall in your wheelhouse of competence.
The surest path to long-term investing failure is to get in over your head—to invest in things you don’t understand. Ignore the Siren’s song and focus on what you know, slowly expanding that circle of knowledge through learning and experience.
Thus, Klarman’s sixth investing principle is always know what you are doing.
The last and greatest investing principle we can take from Klarman is that long-term success is all about the mindset.
Of all Klarman’s principles, I find this one to be the most important—thus, I saved the best for last!
The process side of investing is the easy part. All the skills needed can be learned.
It is the mental or psychological side of investing that is so difficult. It inescapably requires a rare combination of patience, discipline, and balance between arrogance and humility.
Klarman, in paraphrasing Buffett, has quipped, “Value investing is like an inoculation. You either get it right away or you never get it.”
It’s easy to say you’re a calm, cool, and collected investor… but it’s an entirely different matter actually putting it into practice.
As Klarman notes, “Everyone appreciates a bargain but, when the market is going down, most people overreact and get scared.” Being a long-term value investor is either natural for you or you’ll be fighting your human nature at every turn.
Klarman has intuitively noted that investing is the intersection of economics and psychology.
We couldn’t agree more and that is why we constantly stress the pivotal combination of process and mindset in everything we do on Wicked Capital. As I eluded to, the process component is the easy part—one I’m confident anyone can master if they are willing to put in the time and effort.
Unfortunately, the mental side is not so easy—and most will fail at it. It just doesn’t mesh well with our engrained hunter-gatherer spirit. We are wired to think short-term and find safety in the herd.
Ultimate success in investing, however, requires a long-term orientation—one that views short-term price gyrations as merely buying opportunities to seized.
With most investors, you can quickly ascertain if the market (and/or their portfolio) is up or down on any given day with the smallest amount of interaction. However, with great investors, you could spend hours with them and not even be able to surmise if the markets were open or closed. That’s the place we need to be to find success.
As I noted, it also requires finding a healthy balance between arrogance and humility—something in short supply in our world. As Klarman so eloquently states:
Success requires a contrarian mindset—we must zig when everyone else is zagging. This will often look and feel wrong for a season. We need the confidence in ourselves and in our process to persevere in the face of apparent adversity—to stand our ground and say the market is wrong and it will eventually agree with me.
Unfortunately, you either have that “inoculation” or you don’t. We can attempt to train and condition ourselves to behave appropriately—but that only takes us so far. If you don’t have it, you will ultimately stress yourself out and develop ulcers. You can’t fake it to make it with value investing!
If you don’t have it, it’s better to admit and accept that quickly. But it’s not the end of the world! I recommend saving yourself the stress and investing in index funds—where you can put portfolio and funding on autopilot and just set it and forget it.
But if you do have that contrarian gene—there is a land of opportunity out there if you can master the process and marry the two!
We’ll finish with one of my favorite quotes from Klarman—one that succinctly captures what it is to be a value investor:
We can learn a great deal from the greats of investing that have blazed a path before us. No need to reinvent the wheel—we can simply learn vicariously from their ups and downs, successes and failures.
In this article, we examined seven investing principles that can be gleaned from legendary value investor Seth Klarman—nuggets of wisdom that we can apply to our own long-term investing to construct a solid foundation:
I hope you enjoyed this article and gained some valuable insights that you can apply to your own investing journey. If you’d like to read more articles like this, check out these great reads:
Finally, if you’re interested in dividend-growth investing predicated on a value framework—you’re in the right place! We focus exclusively on helping others be as successful as possible with this passive-income approach to investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!
We also encourage you to follow along with our public Wicked Capital Passive-Income Portfolio (PIP) through our monthly updates on the website and by viewing the portfolio on M1 Finance at https://m1.finance/1zUclN2JL
It’s a great way to learn from a real-world example of building and managing a dividend-growth portfolio predicated on a value investing framework!
If you’re interested in starting your own portfolio using the M1 Finance platform (which we highly recommend), please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash to invest!
That’s just one more reason to start your dividend-growth investing today! It’s never too soon to start working towards your financial freedom!
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