Seth Klarman holds an MBA from Harvard University and was one of the founders of the Boston based Baupost Group. He has developed somewhat of a cult following amongst value investors because of his track record (he has achieved similar returns to those of Warren Buffett’s Berkshire Hathaway).
The Baupost Group remained heavily invested in cash during 2007 and into 2008. From all accounts the Group is now actively investing that cash in the market.
Klarman can legitimately be called a “great” investor and I thought I would provide some extracts from his book Margin of Safety (Harper Collins, 1991). Unfortunately this book is long out of print but I thought I would share some excerpts from it with you.
While Klarman is very cynical with respect to all encompassing stock valuation formulas, he does in fact use a Net Present Value methodology (discussed below) which is the same as the discounted cash flow (DCF) methodology.
Klarman on valuation formulas and forecasting
Many investors greedily persist in the investment world's version of a search for the holy-grail: the attempt to find a successful investment formula. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success.
Regardless of the market environment, many investors seek a formula for success. The unfortunate reality is that investment success cannot be captured in a mathematical equation or a computer program.
Like most eighth grade algebra students, some investors memorize a few formulas or rules and superficially appear competent but do not really understand what they are doing. To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don't when they don't.
Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. You cannot
appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?
Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.
The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts. Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.
Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game.
Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.
Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond.
Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one's estimate of future share prices.
Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future.
The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew.
Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities.
Klarman on methods of valuing a business
While a great many methods of business valuation exist, there are only three that I find useful.
Net Present Value
The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate.
When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation.
Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present value analysis an imprecise and difficult task.
A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. Real businesses, even the best ones, are unfortunately not annuities.
Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right. Responding to business uncertainty is the job of corporate management. However, controlling or preventing uncertainty is generally beyond management's ability and should not be expected by investors.
A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries.
Will Coca-Cola sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less clear; factors such as pricing, the sensitivity of demand to changes in price, competitors' actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.
There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business's present value. Yet several difficulties confront growth-oriented investors.
First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted.
Second, for fast-growing businesses even small differences in one's estimate of annual growth rates can have a tremendous impact on valuation. Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. Since entry to the "Business Hall of Fame" is frequently through a revolving door, investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses.
When growth is anticipated and therefore already discounted in securities prices, shortfalls will disappoint investors and result in share price declines. As Warren Buffett has said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
Another difficulty with investing based on growth is that while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases.
Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of non-alcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits.
Some of these sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. The reaction of customers to price increases is always uncertain. On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits.
How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.
Liquidation Value
The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.
Stock Scribe Note: This method has been used to great effect by multi-millionaire investor Sir Ron Brierley. However, it often requires gaining control of a company (or at least board seats) to achieve a successful outcome.
Stock Market Value (for unlisted companies)
The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.
