Seth Klarman—A Framework for Investment Success --

GuruFocus.com
http://w w w .gurufocus.com/new s.php?id=127275 April 4, 2011

Seth Klarman had a section in his annual letter to investors on creating a framework for investment
success.

I think Klarman's writings may be even more valuable to investors as a learning tool than the
Berkshire annual letters. Although obviously brilliant, both Klarman and Buffett can explain in very
simple terms how to create an investment approach that will outperform.

Here is Klarman this year:

Two elements are vital in designing an investment approach for long-term success. First, answer
the question, ''What's your edge?" In highly competitive financial markets, with thousands of very
smart, hardworking participants, what will enable you to reliably outperform the field? Your toolkit is
critically important: truly long-term capital; a flexible approach that enables you to move
opportunistically across a broad array of markets, securities, and asset classes; deep industry
knowledge; strong sourcing relationships; and a solid grounding in value investing principles.

But because investing is, in many ways, a zero-sum activity in which your returns above the market
indices are derived from the mistakes, overreactions or inattention of others as much as from your
own clever insights, there is a second element in designing a sound investment approach: You must
consider the competitive landscape and the behavior of other market participants. As in football,
you are well-advised to take advantage of what your opponents give you: If they are defending the
run, passing is probably your best option, even if you have a star running back. If scores of other
investors are rigidly committed to fast-growing technology stocks, your brilliant tech analyst may not
be able to help you outperform. If your competitors are not paying attention to, or indeed are
dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention,
regardless of the currently poor fundamentals that are driving others' decisions. Where to best apply
your focus and skills depends partially on where others are applying theirs.

When observing your competitors, your focus should be on their approach and process, not their
results. Short-term performance envy causes many of the shortcomings that lock most investors into
a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but
out of respect, and focus your efforts not on replicating others' portfolios, but on looking for
opportunities where they are not.

Much of the investment business is centered around asset-gathering activities. In a field dominated
by a short-term, relative performance orientation, significant underperformance is disastrous for
retention of assets, while mediocre performance is not. Thus, because protracted periods of
underperformance can threaten one's business, most investment firms aim for assured, trend-
following mediocrity while shunning the potential achievement of strong outperformance. The only
way for investors to significantly outperform is to periodically stand far apart from the crowd,
something few are willing or able to do.

In addition, most traditional investors are limited by a variety of constraints: narrow skill-sets, legal
restrictions contained in investment prospectuses or partnership agreements, or psychological
inhibitions. High-grade bond funds can only purchase investment-grade bonds; when a bond falls
below BBB, they are typically forced to sell (or think that they should), regardless of price. When a
mortgage security is downgraded because it will not return par to its holders, a large swath of
potential purchasers will not even consider buying it, and many must purge it. When a company
omits a cash dividend, some equity funds are obliged to sell that stock. And, of course, when a
stock is deleted from an index, it must immediately be dumped by many.
Sometimes, a drop in a stock's price is reason enough for some holders to sell. Such behavior
often creates supply-demand imbalances where bargains can be found. The dimly lit comers and
crevasses existing outside of mainstream mandates may contain opportunity. Given that time is
often an investor's scarcest resource, filling one’s in-box with the most compelling potential
opportunities that others are forced to or choose to sell (or are constrained from buying) makes
great sense.

Price is perhaps the single most important criterion in sound investment decision making. Every
security or asset is a "buy" at one price, a “hold” at a higher price, and a "sell" at some still higher
price. Yet most investors in all asset classes love simplicity, rosy outlooks and the prospect of
smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of
price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even
though empty or unloved buildings may be the far more compelling, and even safer, investments.
Because investors are not usually penalized for adhering to conventional practices, doing so is the
less professionally risky strategy, even though it virtually guarantees against superior performance.

Finally, most investors feel compelled to be fully invested at all times—principally because
evaluation of their performance is both frequent and relative. For them, it is almost as if investing
were merely a game and no client's hard-earned money was at risk. To require full investment all the
time is to remove an important tool from investors' toolkits: the ability to wait patiently for compelling
opportunities that may arise in the future. Moreover, an investor who is too worried about missing
out on the upside of a potential investment may be exposing himself to substantial downside risk
precisely when valuation is extended. A thoughtful investment approach focuses at least as much on
risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on
generating returns, risk be damned.

What drives long-term investment success? In the Internet era, everyone has a voluminous amount
of information, but not everyone knows how to use it. A well-considered investment process—
thoughtful, intellectually honest, teamoriented, and single-mindedly focused on making good
investment decisions at every turn—can make all of the difference. Investors with short-time
horizons are oblivious to kernels of information that may influence investment outcomes years from
now. Everyone can ask questions, but not everyone can identify the right questions to ask. Everyone
searches for opportunity, but most look only where the searching is straightforward even if
undeniably highly competitive.

In the markets of late 2008, everything was for sale as investors were caught in a contagion of
selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative
scenarios, many securities could have been purchased at extremely attractive prices—if one had
capital with which to buy them and the stamina to hold them in the face of falling prices. By late
2010, froth had returned to the markets, as investors with short-term relative performance
orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as
investors purchased securities offering limited returns even on far rosier economic assumptions.

Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor
panic. But these conventional reactions are inverted. When all feels calm and prices surge, the
markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk.
When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-
taking becomes considerably less risky, because risk is often priced into an asset's lower market
valuation. Investment success requires standing apart from the frenzy—the short-term, relative
performance game played by most investors.

Investment success also requires remembering that securities prices are not blips on a Bloomberg
terminal but are fractional interests in—or claims on—companies. Business fundamentals, not price
quotations, convey useful information. With so many market participants fixated on short-term
investment performance, successful investing requires a focus not on how one is doing, but on
corporate balance sheets and income and cash flow statements.
About the author:
http://valueinvestorcanada.blogspot.com/

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User Comments:

1.Ttch009 says on Mar 29, 2011 at 11:17 AM:

Good and informative article about one of the doyens of value investement.

Really enjoyed the excerpt. Klarman maintains and executes one of the most fundamentally sound
investment approaches anywhere.

Do you have access to the full letter?

3.Junk says on Mar 30, 2011 at 4:03 PM:

great article. would love to read the full letter as well - any chance you could post it?