By GERALDINE FABRIKANT
Published: May 13, 2007
EARNING 22 percent on your investments while holding half of your portfolio in cash is no easy trick, but last year Seth A. Klarman pulled it off, and it was not the first time.
Mr. Klarman, a 49-year-old hedge fund manager, has turned in market-beating performances since 1983, while perpetually warning that the markets were dangerous and that investors should minimize risk.
What is his investment approach? He will not spell it out, although lots of people would like to know. On the Web, the price for his out-of-print 1991 book — “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” — has gone for $1,200 on Amazon and $2,000 on eBay.
At a time when hedge fund managers seem to be grabbing headlines with stories about their homes, hobbies, philanthropy and outsize compensation, Mr. Klarman keeps a low profile, and is reticent about the investments of his $7 billion Baupost Group of hedge funds, which has been closed to new money for the last seven years.
But his book, his letters to investors and other fund documents provide some clues about his thinking, and he added to the picture in a telephone interview. Mr. Klarman clearly sees himself as a deep value investor, in the mold of Warren E. Buffett or Benjamin Graham, the Columbia professor who pioneered value investing.
He is also a world-class worrier. In one letter, Mr. Klarman said, “At Baupost, we are big fans of fear, and in investing, it is clearly better to be scared than sorry.” In an earlier note, he wrote, “Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity.”
Last year, the cash holdings of his hedge funds amounted to 49.8 percent of assets, an enormous proportion for actively managed investments, but not an anomaly at Baupost: a year earlier, the cash holdings amounted to 45.8 percent. To add safety to his portfolios, he said that he usually eschews leverage, or debt, in his funds, using it only in some real estate investments. Instead, he has profited handsomely from investing in the debt of other companies, particularly those in financial distress.
Mr. Klarman, who is based in Boston and works with a team of 24 people, does not make bets on the overall market. Instead, his funds look for specific opportunities that he deems worthy. But he warns that Wall Street often tries to sell customers overvalued assets. For example, he said that he is wary of new issues because in the pursuit of large fees, banks may underwrite overpriced or highly risky securities.
Mr. Klarman’s record has generated intense loyalty from investors. Since he began Baupost in 1983, it has posted an average annual total return of 19.55 percent, according to data provided by the hedge fund group. Declines have been posted in only 11 of the total 97 quarters since Baupost’s debut.
In 2006, Baupost’s portfolio held an array of assets, including United States, European, Asian and Canadian equities, which accounted for 17.1 percent of the portfolio; debt and real estate, which each made up 10 percent; and 4.7 percent in private equity funds. And there was that big dollop of cash.
“Seth has a remarkable record, and even more so when you realize that he has achieved it by holding significant amounts of cash,” said Jack R. Meyer, who until 2005 ran Harvard’s endowment, which has been a longtime investor in Baupost.
“In other words, his risk-adjusted numbers are spectacular. What is unusual is the high return and the high cash levels,” added Mr. Meyer, who now runs the investment fund Convexity Capital.
Mr. Klarman grew up in Baltimore, where his father was a health economist. After graduating from Cornell with a degree in economics in 1979, he worked for Max Heine and Michael Price at Mutual Shares for a year and a half, then went on to Harvard Business School, where he graduated with an M.B.A. in 1982. Immediately afterward, four wealthy families, including those of two Harvard professors, put up $27 million for Mr. Klarman to manage.
While his actual compensation has not been disclosed, years of high returns have made him wealthy. Baupost charges a 1 percent management fee on investments in its funds, as well as 20 percent of annual profit. It was managing roughly $6 billion at the end of 2005 — which would mean a $60 million management fee for Baupost. In addition, its 22 percent return on investments last year would suggest profit of about $1.3 billion — generating a 20 percent share for Baupost of about $260 million. The only leverage Mr. Klarman said he used was on the 10 percent of holdings in real estate, where the leverage was one to one.
Despite more than two decades of smart choices, Mr. Klarman seems to obsess continually about potential crises. In his most recent letter, he said that while investors had been upbeat because of relatively low market volatility and inexpensive credit, he was worried about trade imbalances and high levels of consumer debt, which he said could set off market declines. Writing about the stock market rally in 2006, he said: “There was nothing about this party that would have made you want to leave early, unless you were a value investor. The only adverse trend was the scarcity of mispricing opportunities.”
One place in which he said he had found some mispricing was in the shares of News Corporation stock, which rose 37 percent in 2006. While Baupost sold 1.8 million shares last year, at the end of December, it still owned 4.19 million shares, according to company filings. Last week, Mr. Klarman said he believed the stock was still undervalued. He added that he was not concerned about Rupert Murdoch’s bid for Dow Jones & Company, at a price many have described as extremely generous, because it would be a relatively small transaction for a company the size of News Corporation.
Other Baupost equity holdings include Home Depot and Posco, a Korean steel manufacturer, two stocks that happen to be held by Berkshire Hathaway, Mr. Buffett’s company.
Figuring out which distressed bonds Baupost owns is more difficult. For competitive reasons, Baupost does not name the companies, but last year Mr. Klarman told investors that its second-largest single annual gain came from an holding in NationsRent, a company that rents equipment to builders. NationsRent filed for bankruptcy in 2001. The next year Baupost invested about $100 million in the defaulted bank debt.
A year later, NationsRent reorganized. Baupost put in about $50 million in fresh capital in exchange for stock and ended up with a total of more than two-thirds of the stock. Last year, Sunbelt Rentals bought the company for $1 billion in cash and the assumption of debt. Mr. Klarman said that Baupost more than doubled its investment.
In the interview, Mr. Klarman said that he found bankruptcy investing appealing because the process of bankruptcy itself can help unlock the value of an investment.
“There is a catalyst,” he said, “because the way you make money is dependent on specific situations; the bankruptcy process itself will deliver you securities in the reorganized company.”
DESPITE Baupost’s stellar returns, Mr. Klarman’s team continues to take out what he calls “disaster insurance.” Last year it emphasized gold, which would appreciate if the dollar and other currencies declined in value. Although Baupost did not indicate the size of its wager, it did tell investors in one of its funds that 2.87 percentage points of about 20 percent in total fund profit came from a bet that the precious metal would rise. He wrote that gold was underpriced because investors in this “goldilocks” era have not worried enough about currency devaluation.
Baupost has had its setbacks. In 2006 it lost money on an investment in TRM, which operates automated teller machines. “It seemed cheap on cash flow, but its business deteriorated after Hurricane Katrina,” Mr. Klarman said. “It did not turn out to be as stable a business as we thought.”
Baupost has done better with real estate. Last year, Coastal Management Resources, a company in which Baupost has an equity stake, bought the neighboring Cojo and Jalama Ranches north of Santa Barbara, Calif. Although neither the size of Baupost’s investment in Coastal Management nor the purchase price of the ranches is known, the asking price was $155 million.
The ranch purchases may reflect Mr. Klarman’s passion for horses. He has owned racehorses, and even at the track his penchant for details is manifest. One of his horses, now retired, is named Read the Footnotes.
[4/8/08] Klarman can clearly be an active seller of stocks. He sells when a stock reaches fair value, but he also replaces current holdings with better opportunities as they come along. It's not rocket science, but it isn't a strategy most investors follow.
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