Sunday, May 25, 2008

Seth Klarman...the only OTHER guy to beat the market?

When I was doing my MBA, my finance professor was extolling the virtues of Efficient Market Hypothesis (EMH) when a student asked, "But what about Warren Buffett? Doesn't he serve as evidence that markets are not efficient?". My professor stated something to the effect that Buffett's pretty much the only guy that can beat the market. Fortunately for us, that's not the case. Fortunately for this prof, the professor market is not efficient either and therefore he still has a job.

Seth Klarman is an example of another value investor who has consistently beaten the market. Since the inception of The Baupost Group in the early 1980s, Klarman has been generating returns of nearly 20% per year. What may be most amazing, is that he has done this with his first priority being risk, not returns! In this regard, he follows the oft-referenced first rule of investing: "Never lose money", and pays equal attention to Rule #2: "Don't forget about Rule #1."

In order to find value, Klarman likes to look for motivated sellers. Such sellers may be present for a variety of reasons. The stock may be:
  • Dropped from the index. Many fund charters preclude them from owning shares.

  • A spin-off. Large funds will pull the trigger on a sale of these often smaller IPOs.

  • Involved in a bankruptcy proceeding. Again, certain charters my restrict ownership of these shares.

  • In the wrong hands. For example, banks owning foreclosed real estate.
By taking advantage of sellers who are selling for non-economic reasons, one can buy at a discount and thus generate excess returns.

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