Street Capitalist: Event Driven Value Investments

Today, while browsing twitter I noticed Abnormal Returns post about JNJ yielding more than 10 year treasuries. It got me thinking again about the fact that large cap stocks look pretty undervalued right now.

You don’t really get popular by being bullish on large cap stocks – most people actually look down upon it, especially as a value investor. We are supposed to find these hidden gems that nobody knows about. Everybody and their mother knows about Johnson and Johnson. Still, it and a number of other large caps are trading at valuations that are really attractive right now.

Value investing can go either two ways:

1. Buy an undervalued stock with some kind of catalyst and sell once it reaches your target price.

That approach is much more akin to Benjamin Graham and Warren Buffett from his partnership days.

2. Find a great business with excellent growth potential that is trading at an absurdly low price.

This is the approach Warren Buffett honed in his later years.

To me, either approach works. And for my own portfolio, if I can crank out an annualized return of around 15% over an extended period of time, I’ll be pretty happy. The way I look at undervalued large caps is you can sometimes find them trading at levels that are low enough to make it so your potential for capital loss is minimal. Worst case – you lose nothing. Best case – you have bought into a large cap that still has great overseas growth prospects and a healthy dividend. An investment like that can enable you to buy and hold for years.

So what are some names that have been interesting to me?

Johnson and Johnson

AR’s comment about treasury yields versus the yield on Johnson and Johnson (NYSE:JNJ) reminded me of a chart I saw over at Value Investors Club:

I have updated the original chart to compare the past data with JNJ’s current price and the price it hit during the bottom of the financial crisis. As you can see, the company looks amazingly undervalued — especially when compared to the past. Whenever its forward earnings yield and dividend hit levels like this, it is usually an amazing opportunity for investors.

JNJ is getting some heat right now about a recall from their consumer products division, but the company has a history of being around since the Great Depression. With a minuscule amount of net debt ($6B) and almost $20B in EBITDA, the company is at a really sweet spot. Margins are still healthy at above 25% and a return on equity of around 27.5%.

Yes, sales did decrease for 2009, but it was also during a crisis period described as the worst since the Great Depression. In the longer term, I think there are demographic trends that make the company appealing. With our population expected to grow older, JNJ products should be more in demand. In addition, a substantial amount of revenues come from abroad which means that there will be tailwinds for growth outside of the US.

Walmart

Another one I’ve been looking at is Walmart (NYSE:WMT). A while back after hearing Warren Buffett recommend it, I read Sam Walton’s biography Made in America which details how he started Walmart. I came away for a much higher regard for the company, particularly after learning about their humble beginnings. It is truly amazing that Walmart has been able to grow from its humble beginnings as a rural discount retailer to a global corporation. Along the way, they still have not forgotten their ethos of making sure they bring customers the lowest prices.

Some investors have been skeptical about Walmart, especially after the recent decision to let the Chinese yuan rise. Since Walmart sources most of its goods from Chinese manufacturers, a rising yuan will eat into Walmart’s bottom line as they convert from dollars. Since Walmart buys such a massive amount of goods from China, this could impact margins. I think that this is possible, but I am not too worried.

The fact is, capital is mobile and the folks at Walmart are bright enough to realize that if one country becomes too expensive, they can move elsewhere. That kind of mobility is going to pressure the Chinese to keep their currency down because if they don’t, the prices may hurt their exporters. So far, China does not quite have the kind of domestic demand that is necessary to offset a major reduction in American consumption of their goods.

Walmart has a lot going for it. It is by far, the lowest cost distributor and retailer of basic goods. Part of this comes from its amazing supply chain/distribution system. Walmart was one of the first retailers to figure out that a company-wide computerized inventory system would allow them to stock exactly what people want, when they want them. This translates into better inventory turnover numbers.

Vinod Palika has a report on Walmart (PDF) with plenty of data points that show Walmart’s strength relative to peers. In 2001 Walmart inventory was 51 days, in 2010 it decreased to 40 days. For comparison, at Target inventory was at 58 days in 2001 and is now 56 days in 2010. Walmart’s economies of scale help maintain margins. Take advertising, in 2010 Walmart’s ad budget was only 0.6% of sales, comparatively Target spends 2.15% of sales on their ad budget. The best part? Even though Walmart spends less as a percent, they are still spending more overall – $2.4B versus $1.4B. That means Walmart can outspend Target but keep its margins in tact.

Walmart initially had some hurdles breaking into overseas markets, but so far they have corrected that and if you look you can see some impressive growth there. I think for a business as huge as Walmart, which generates large benefits from its size (bargaining power with suppliers) the company should at least get a forward P/E multiple that is greater than 11x. A 15x multiple on 2011′s EPS would result in a share price of about $66 compared to $49 today.

Kraft

If you study Warren Buffett, you’ll see that some of his best investments occur at a time before a business is about to embark on an upward trend in margin expansion. Basically, what he does is find great businesses that are down in the dumps.

When Roberto Goizueta came to Coca-Cola, the business lagged behind Pepsi. Goizueta applied his background as a chemical engineer to the company, in order to standardize certain processes and add efficiency to the Coca-Cola’s operations. These actions reduced expenses. Then, he he culled low return on invested capital operating units from the business to boost overall profitability. These actions dramatically increased margins and magnified shareholder value: Coca-Cola’s market capitalization increased from $4.3B in 1981 to $152B in 1997. To learn more about how Goizueta did it, be sure to read I’d Like the World to Buy a Coke, his biography.

You might be wondering why I am mentioning Coca-Cola when I’m supposed to be talking about Kraft (NYSE:KFT). Back when Irene Rosenfeld announced the merger with Cadbury, Pershing Square’s Bill Ackman released a report which detailed the potential for margin expansion at Kraft:

Ackman’s thesis appears sound. A merger between Kraft and Cadbury, means there is less competition in the marketplace and the combined company may have the ability to raise prices. That might help increase EBIT margins in 2011 to Ackman’s projected 15%. Plus, I think you really cannot ignore the gains in Kraft’s supply chains that will come from this deal. Most people underestimate just how difficult it is to get consumer goods to shops in developing nations where there might be no paved roads. It’s the kind of investment that takes years to refine, but will pay dividends in the future as we increasingly rely on the developing world for growth.

With leading consumer brands from chocolates to macaroni and cheese, combined with 25% of revenues from developing markets (more than any other North American peer) Ackman’s 15x 2012 EPS ($2.70) multiple appears possible. Ackman provides an upper range of 17x 2012 EPS ($2.90). That gives us a share valuation of $41 to $49 versus today’s $28.30. Plus, you get a 4% dividend.

Kraft is obviously not going to have the same kind of dramatic growth that you saw from Coca-Cola during Goizueta’s time as CEO, but it is an illustrative example of how changes in the business can increase its valuation.

Anheuser-Busch InBev

Another interesting large cap that looks undervalued is Anheuser-Busch InBev (NYSE:BUD). The company, formed by the merger of Anheuser-Busch and Brazil’s InBev looks like another case where through a merger there is a potential for substantial cost savings. Anheuser-Busch is a powerhouse in the beer market. The merger effectively created the largest brewer by market cap, at $77.4B. The company boasts 200 different brands, 13 of which have over $1B in sales. Moreover, BUD occupies the #1 or #2 rank in 25 of its top 31 markets.

BUD trades at basically a 9.6% FCF yield which is great given its side. Free cash flow is expected to increase over the next two years, as Anheuser-Busch InBev is able to reduce costs as the two companies integrate. In contrast, Diageo, a market leader in the beer and spirits area has a FCF yield of 6.2% — even though it is less than half ABInBev’s size. I could see BUD trading at about a 6% yield which would be about $77 per share, 60% higher than today’s prices.

So far BUD seems to be making the right inroads in trying to break into the Chinese market. I think that beer and spirits companies are increasingly going to look at Asia for growth. It wont be an overnight process and so if there is some lag between that Asia growth and US sales growth, you might see some pessimism. One thing I particularly like about BUD is because of its size, it should be able to have better margins because of its size. As in the Walmart case, BUD looks poised to spend more on advertising than its peers at a lower percent of sales. This company should be a bargain as long as the management at BUD are willing to take FCF and use it intelligently by paying down debt and pursuing buybacks.

For anyone interested in learning more about the industry, I suggest checking out Beer Wars, a documentary about the beer business. It contrasts small craft breweries with the majors like Budweiser and Molson Coors. You get to learn a lot about how the major breweries have been able to take advantage of our fragmented legal structure to erect huge barriers to entry in the beer business.

Killing a Large Cap

I’ve outlined short reasons why I would be bullish on these companies. The question you have to ask is why these great companies are trading at such low prices. I think there are a few factors. More broadly, into and during the financial crisis, money poured into these stocks as they were seen as safe havens. Some held up and others only had slight price declines relative to the market. When things started to turn, money exited and went into the stocks that got clobbered. So there might be less money in some of these large cap blue chip stocks than others.

Secondly, when you start hearing worries about global growth some of these stocks get affected. Many of them are large enough to provide the liquidity necessary to allow large macro funds to exit in and out. So they might be more susceptible to day-to-day volatility than smaller, less noticed stocks.

Then there is sell side pessimism. Large cap stocks are particularly vulnerable to sell side pessimism. They tend to attract the masses who sell whenever they hear an analyst downgrade a company. Most sell side calls are for the medium term, so whenever there there is some temporary panic the sell side erupts. Such reports tend to discount the longer term potential earnings power behind some of these businesses.

During the financial crisis some analysts claimed people would stop drinking Coca-Cola because of the deteriorating economic situation. Or with Kraft, some analysts feared that private labels made by supermarkets would undercut Kraft’s products. But, the fact is, you can make a bear case for almost any investment. Most people I know kept chugging cans of Coke, even during the March 2009 bottom. People still ate Kraft Mac ‘n Cheese. But none of these companies are a perfect hedge, they almost all hit 52 week lows during the crisis. At the same time, their longer term prospects were much better than the broader market. If you are willing to wait years I’d expect these companies to do quite well. They should at least be able to preserve your capital — especially at the P/Es we see today. That is a critical factor you need to look for in equities given the concerns about inflation.

More Depth

Now, I’ve outlined reasons for why some of the above companies look undervalued and have sustainable competitive advantages. That’s not enough to warrant an investment though — more research needs to be done. Over the next coming weeks I plan to look at a few of them in more depth in terms of analyzing financials and putting together models. If I get some indication of what company readers would be interested in (either by comments or e-mail) I’ll start there first. They can even be large caps not explored in this post. I’ve also started looking at: MasterCard (NYSE:MA) – at 17x EPS for basically an oligopoly, it looks really appealing, Monsanto (NYSE:MON) – their seeds and pesticides are going to be needed by the rest of the world’s farmers, and even some foreign telecoms.

For those of you happy to do your own reading, one of the neat things I noticed is certain big companies have very generous annual report policies. I was able to get 5 years worth of 10Ks mailed to me within a couple days from JNJ and McDonalds.

Some people fret about whether or not they can get an edge when looking at companies that are so large. I think with these blue chip companies, you’re edge is going to come from your discipline. Being willing to ignore downgrade calls and buy when most people are selling. If you can do that, you might be able to own part of a growing business at a price that is low enough to provide you with a satisfactory margin of safety.

Yesterday, at the CFA Institute conference, Seth Klarman gave a talk on how he sees things today. Reuters was there to report and I thought I’d excerpt the article:

Star hedge fund manager Seth Klarman sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.

“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.

Current market conditions remind Klarman of a Hostess Twinkie snack cake because “everything is being manipulated by the government” and appears “artificial.”

“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.

Klarman has 30 percent of assets at his $22 billion Baupost Group in cash, he said. He started the firm in 1982 with $27 million and has averaged 20 percent annual gains ever since. In 2007, amid the depths of the credit crash, Baupost had its best year, gaining 52 percent.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

One of the key traits you will see Klarman exhibit, year in year out, is his willingness to put a substantial portion of his assets into cash. In Margin of Safety, Klarman sees shorting as flawed because of the potential for unlimited losses. Studying his career, you will see that he also tends to use out-of-the-money options to hedge against risk. He did this in the late 80′s/early 90′s with Nikkei puts and later with gold. In Michael Lewis’ The Big Short, you can read about hedge fund Cornwall Capital’s use of a similar strategy (they did remarkably well).

Here is what Klarman had to say about options:

Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.

The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

Many long-only value managers try to stay fully invested in the market because they are afraid to miss out on upswings in the market. With that kind of attitude, they are almost always crushed more than others with a downturn (concentration juices returns in both directions). But if you study Klarman and Warren Buffett, you will see that there are periods when they put a lot of their assets into cash. Cash allows them to opportunistically invest after the fallout of a market downturn while leaving out the guess-work of picking the right shorts.

So where is Klarman finding opportunities right now? Commercial Real Estate:

One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

Now the trick for us small investors is to see if there are any indirect ways to play distressed CRE markets. As Klarman says, REITs have mostly rallied. That means we would have to look at some more creative, less direct investments.

The new Bloomberg Businessweek has so far really impressed me with their new content. Today, they ran a great article from David Winters on finding value in companies that will probably be around for 100 years:

A dramatic global change was accelerated by the economic crisis. A couple of billion people in the Far East, India, and parts of Latin America have joined the economic party. They see everything we have and are willing to work hard to get it, too. They want to look good, eat better, be entertained: basic human desires. So we like consumer names, and oil. You’ve got an incremental couple of billion people who want cars and motorcycles. To play on higher oil prices, we try to find oil resources in countries that have good legal systems and also good management. The management of Canadian Natural Resources (CNQ) owns about 4% of the company. CNQ is worth a lot more than 76, which is what it trades for now…

We look for repeat human behavior. People are going to eat chocolate bars 100 years from now. We owned and bought more of Nestlé during this period. It is earning an increasing amount in the Far East. One thing we’ve thought a lot about during this global crisis is pricing power and currency diversification. One of the beauties of Nestlé is that it can generate streams of increasing free cash flow. This helps to protect you as an investor.

Wintergreen’s direct exposure to the U.S. is at the lowest it has been in my 25-year career, 70% outside the U.S. today. The U.S. and European multinational companies we invest in are ones with major global exposure. Coke is listed in the U.S., but roughly 80% of its earnings are abroad. Our largest investment is Jardine Matheson, a 178-year-old conglomerate with activities in China and Southeast Asia. Jardine dominates Indonesian auto manufacturing and will capitalize on increasing car ownership there. The stock trades at a discount of about 35% to net asset value.

Jardine has a controlling interest in Dairy Farm, a supermarket chain that owns other retailers and has 5,000 stores in Southeast Asia, with modest operations in China and India. Dairy Farm’s margins are equal to Wal-Mart’s, but it is a company that almost no one has heard of. Jardine really is a Western company. You get transparency, and the family and management own about 16% of the company, so their bacon is frying along with the other shareholders’.

Target Basic Human Needs. On the Cheap (Bloomberg Businessweek)

A lot of value investors are looking for value globally, as they are finding US equities to be more or less fairly valued. I think that one of the benefits of a global value approach is the fact that you will be able to find great companies in less efficient markets. I imagine there are plenty of Buffett-like companies abroad with great growth prospects at appropriate prices. Given the tailwinds behind these improving economies, these types of companies should be poised for continued growth.

More importantly, I believe that these companies can often generate returns on equity that will help them survive and possible thrive during inflationary periods. Winters makes note of that when he claims that Nestlé can generate ever increasing amounts of free cash flow. Why is that? Because they have a moat around their products because of their brands. People are usually willing to pay more for Nestlé products than generics. That means that if the value of the dollar declines, they can raise prices to compensate.

For me, these are just the types of companies that I have been looking at as possible inflation hedges. Especially when the companies are backed by currencies from natural resource rich countries (Canada, Brazil). I’m not really a gold guy, so I fall more into the Buffett and Bill Ackman approach which involves looking at high quality companies. You can even find some US companies that generate a tremendous amount of revenues from abroad. If you look at Buffett’s stock portfolio, he has a number of consumer companies like Kraft (NYSE:KFT) and Coca-Cola (NYSE:KO) that seem to have pricing power. Ackman is also an investor in Kraft but has a stake in Yum! Brands (NYSE:YUM) too. I think Yum! is probably part of his bet on consumers abroad and pricing power. A company like Yum! must benefit from certain economies of scale that allow it to price better than smaller restaurants in these emerging market nations.

The trick to me, is figuring out the optimal time to buy these companies. You need one that not only has pricing power, but is also cheap. For example, had you bought Coca-Cola in 1998, you would likely be down on your investment. If you had bought 1 share for $80 at that time, you would be down on your investment. Shares currently trade around $54 and you would have collected about $12 in dividends. If you buy into Ackman’s thesis on Kraft being able to increase their gross margins and realize synergies from their merger with Cadbury, you would be looking at a 24% annualized return for the base case. Not bad for a best in class company with pricing power.

I haven’t had the opportunity to get into global value investing myself because of some of the limitations of my brokerage firm. However, my Fairfax Financial shares are poised to benefit from the improving economies abroad. Fairfax is based in Canada but has operations as far as India and Brazil. These are typically countries characterized by having under-banked citizens. As they improve their status, financial services should be made more available to them, providing new sources of growth for Fairfax.

Howard Marks of Oaktree Capital has a new memo that is great as usual. I particularly liked his point about inflation:

When Paul Volcker left the Fed in 1987, he was asked at his first public appearance, “Will interest rates go up or down?” He answered presciently: “Yes.” Of course, his answer is still the right one. But from today’s levels, I think rates are more likely to go up than down (there’s so little room for the latter).

Reduced faith in the dollar means it would take higher interest rates to attract non-U.S. buyers to dollar investments. And, even domestically, (a) one of these days the government will stop holding rates down and (b) higher inflation would require rates to rise to compensate for the fact that the dollars with which debts are repaid will buy less. For all these reasons, I think investors must consider the prospect of higher inflation, dollar weakness and higher interest rates.

What to do about them? The list of possibilities is long:

· Buy TIPS.
· Buy floating rate debt.
· Buy gold (but only at the “right” price, and what’s that?)
· Buy real assets, such as commodities, oil and real estate (ditto).
· Buy foreign currencies.
· Make investments denominated in foreign currencies.
· Buy the securities of companies that will be able to pass on increased costs.
· Buy the securities of companies that own commodities, or that own assets denominated in foreign currencies.
· Buy the securities of companies that earn their profits outside the U.S.
· Hold cash (to invest once interest rates have risen).
· Sell long-term bonds (and possibly go short).

These are the actions that can profit from – or that provide the flexibility to adjust to – increased inflation, a decline in the dollar and increased interest rates, all of which are interconnected. The most important one is the last one: long-term bonds could suffer worst in an inflationary, higher-rate environment, especially given today’s low starting yields.

One final point: When I provide this answer to the frequent question about inflation, I ask people whether they agree. Usually they do. Then I ask how much of their portfolio they’re willing to devote to protecting against these macro forces. If their answer is 5%, 10% or 15%, I point out that that’s pretty close to doing nothing. The question is whether you’re willing to devote at least 30-40%. Few people are.

But that’s the thing: It’s easy to say, “I’m worried about inflation.” It’s something very different to say, “I’m worried enough about inflation to do something meaningful about it.” Let me know when you decide how much you’re willing to devote.

Howard Marks: Tell Me I’m Wrong (Oaktree Capital)

Marks makes an excellent point about whether managers are taking on superficial hedges — only investing a small, meaningless amount in their hedges. These positions make great talking points in quarterly letters but offer nothing by way of actual protection for their partners.

The best hedging opportunities usually come in the form of missed priced insurance. Nassim Taleb’s option trading seems to fit this description. The most recent example is the CDS trade that worked beautifully during the crisis. Credit default swaps were so mispriced that even a small position offered massive returns.

When things look dangerous, great investors are always ready to significantly protect themselves. Warren Buffett’s hoarding of cash provided Berkshire with great opportunities to invest in companies that were temporarily weakened by the crisis. Investors like Seth Klarman sometimes move 50% into cash if opportunities dry up. That is a meaningful move that protects investors from potential losses versus those who complain about overheated markets while keeping their partners hopelessly fully invested.

I’ve been thinking about hedging a lot these days and plan on having a comprehensive post up soon.

The folks over at Dealbook have Paulson’s 3Q investor letter up. The letter is peppered with his insights from stocks to defaulted bonds.

What I wanted to do though, was highlight a few parts of the letter where I thought we could take a look at his methodology for looking at stocks. The idea here isn’t to find potential buys, but to see how he looks at companies.

Bank of America (NYSE:BAC)

-Paulson believes that by 2011, banks will have passed the write down cycle and return to growth in 2012.
-They are using a 10x normalized earnings multiple for large banks and the team estimates BAC to be worth $29.81 per share in 2011. Current shares trade at $16.35, so you are looked at almost 40% annualized.
-They expect provision for credit losses to come down quite a bit from 2008 levels, to 1.75%. That figure, $16,357 is about 61% of 2008′s numbers.

Then, there is Paulson’s gold position. If you looked at the latest 13F-HR filings, there are a lot of ways that investors have been playing gold. Some are going after miners, others are gaining exposure via ETFs, and then there are some that are trying to get their hands on the physical asset.

Paulson mentions two gold miners in his portfolio. This is how he looks at them:

-Five gold mining stocks comprise 14% of their portfolio.
-All five stocks would have upside in a flat environment, but an even higher upside in a rising price environment.
-AngloGold Ashanti (NYSE:AU) is the third largest gold producer in the world but trades at a lower Price/NAV than peers. So this is a value play based on comps.
-The company has a number of figures, which could contribute to its peer undervaluation:
1. Exposure to South Africa
2. Declining production profile
3. Large hedge book
4. Poor safety record.
-Paulson & Co. believe that the new CEO, Mark Cutifani would be a catalyst for change in the company and indeed: the company diversified out of South Africa, reduced their hedge book, increased their production profile, and improved their safety record.

So what we can take away here is that Paulson and his team were looking for a gold miner undervalued, relative to peers and viewed Cutifani, a great mining operator, as a catalyst.

Then, there is Gabriel Resources (TSE:GBU)

-Gabriel is another miner with an event catalyst
-The company is the largest potential goldmine in Europe and Paulson & Co. own 19.9% of it.
-NGOs have stymied the process for the mine to get their permit due to environmental concerns
-Newmont Mining and Electrum Strategic are other large owners of the company with 16% and 19% stakes
-Though the company trades at only $2 per share, the upside can go to $6-8 and $8-12 if they receive their permit and start production.

Gabriel appears to be a low risk high uncertainty situation with a binary outcome. Without their permit, the company is likely to trade flat while having a number of potential catalysts in place to unlock value.

Be sure to read the rest of the letter at the NYTimes Dealbook.

I mentioned Seth Klarman and inflation hedging previously in my post about his talk at the CIMA conference. Here is another quote, this time from a recent article on MarketWatch:

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be “vicious and protracted.”
“The financial market collapse and bailout makes us sick,” he wrote. “There is likely more carnage to come.”

The U.S. dollar will likely weaken and its reign as the world’s reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.

The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.

I still haven’t figured out what his inflation hedge might be, but it’s something worth thinking about. Here’s a line from his book Margin of Safety, which hints a bit at inflation hedges:

…value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar.

What might he be looking at? Timberland? Oil and gas properties? Or maybe land itself, domestically or abroad.

Note: these notes come from BenGrahamMan at the Motley Fool Boards, the original thread is here.

Seth Klarman runs the Baupost Group, a prominent value investing fund that has had stellar performance since inception. What’s really amazing about Klarman is how risk averse he is, I’ve heard that sometimes he will convert nearly 50% of his portfolio into cash while still still posting strong returns. In my previous post, I mentioned the Buffett quote where he says that they look for people with risk aversion programmed into their DNA, I think Klarman fits the bill.

He’s the author of Margin of Safety, the expensive and out of print value investing book, and has recently contributed an entry to the new edition of Security Analysis.

1. The biggest fear was buying too soon and on way down, from up in over-valued levels. We knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.

Q&A

1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman – Unusual amount of forced sellers, via margin calls. This could breed opportunity. We see a lot of money managers staying on the sideline. We finds this to be an opportunity to buy. Buy when others react to news or false news. Our experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald – Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant – Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman – We think this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don’t own gold as a commodity. We won’t disclose our inflation hedge, yet with enough work, you can find true inflation hedges.

I have to wonder what Klarman’s inflation hedge is. I know that Warren Buffett believes that one of the better ways to navigate through inflationary times is to own companies that can increase prices (think See’s Candies) with little worry for losing market share. On the other hand, some investors choose to look towards commodities. David Swensen of Yale’s Endowment fund is pretty famous for investing in timber and Prem Watsa of Fairfax Financial (NYSE:FFH) made a recent investment in that area as well. Anyone out there have an idea?