This is a guest article for Capital Allocators’ China Chapter, written by LIONS ASSOCIATES
Many well-known investors have been hailed as the “next Buffett,” and among them is a low-profile veteran who has achieved a 20% annualized return over a career spanning more than 40 years – Seth Klarman, the CEO and fund manager of Baupost Group.
Let’s go back to April 23, 2015, at the “Value Investing with Legends” class at Columbia Business School. Professor Bruce Greenwald opened with, “Today, we are fortunate to have a very special guest, the connecting tissue in the world of value investing. His boss, Max Heine, the founder of Mutual Shares, was Benjamin Graham’s stockbroker, and many of his students have become outstanding value investors of our generation, including one that you all should know, Seth Klarman. Ladies and gentlemen, please welcome Michael Price!”
Over the next 20 minutes, Mr. Price opened that day’s Wall Street Journal, vividly demonstrating how he reads the newspaper: from filtering the headlines (which ones to read now and which to save for later or the weekend) to focusing on useful news for analysis and making quick judgments on their impact on the investment portfolio, and finally arranging the next steps. The topics covered that day’s earnings release, acquisition events, the healthcare and energy industries, and the presidential election, among others. It was as if we were there with him, attending a morning meeting, experiencing firsthand Price’s breadth and depth of knowledge, judgment, and decisiveness. Throughout the process, the underlying theme was to focus on extracting actionable insights. This lesson, eight years later, remains profoundly insightful for how we can stay focused, filter out noise, and effectively absorb information in today’s era of information overload. Additionally, during this class, through his mentor, we gained a glimpse into Seth Klarman’s early experiences, which he rarely shares in interviews.
(The late Michael Price, sadly Mr. Price passed away in 2022, but that 20-min lesson will stay with us at LIONS)
This interview with Capital Allocators provides a rare opportunity to directly listen to Seth Klarman’s personal story and investment philosophy. Here are some interpretations and reflections on this interview:
1. Investment Philosophy and Strategy – Catalysts for Growth, a Great Mentor
Although Seth Klarman is often compared to Buffett, his investment style and strategy were heavily influenced by his mentor Michael Price (with a focus on arbitrage and special situations). In Klarman’s own words, he learned a version of value investing from Mutual Shares in his early years. As a result, Baupost not only looks at company stocks but also discovers value and price discrepancies in special events across different asset categories, such as M&A, spin-offs, inclusion & exclusion from indexes, bankruptcies, private assets, distressed debt, real estate, and emerging market stocks. This requires a strong ability to rapidly analyze and research companies bottom-up, across asset categories, and within complex transaction structures. This broad capability of finding and analyzing market inefficiencies and specific asset supply vs. demand imbalances can be understood as Baupost’s circle of competence.
The impact of this first job on Klarman was also evident in the interview. For instance, he gave an example of how Michael Price would often hand him a prospectus or a task and say, “Go figure this out.” Klarman also mentioned that he hopes brokers or investment banks will call him when they discover interesting special events. Michael Price was to Seth Klarman what Graham was to Buffett. In contrast, Buffett nowadays mostly adheres to buying high-quality companies at reasonable prices and holding them for the long term, although he occasionally engages in arbitrage-like trades, such as the Microsoft acquisition of Activision Blizzard and buying Japanese trading companies.
Therefore, different value investors have different strategies and capabilities due to their past experiences. However, the philosophies and principles they follow are similar: 1) At the core of the market is human nature, which has irrational moments and inefficient corners; 2) Avoid following the crowd and investing in the most popular companies; 3) Insist on having a reasonable margin of safety; 4) Have the courage to be concentrated in holdings and not overly diversified. These principles can also be glimpsed from Baupost’s holdings disclosed by the SEC 13F filings (does not include private assets, foreign-listed stocks, real estate deals, and debt).
1. In 2023, among the “Magnificent Seven” tech stocks, Baupost only has Google and not many other popular companies.
2. The top five holdings account for over 50% of the total portfolio, and the top ten holdings account for over 80%.
3. Baupost does not invest in China, but they bought Chinese education company New Oriental in Q2 2022.
2. The Impact of AI on Value Investing – Abundant Identical Samples vs. Abundant Samples of One
With the rise of the next-gen AI technologies represented by ChatGPT, knowledge-intensive investment practitioners naturally contemplate the impact of AI on their profession. As a large language model that predicts the next correct word in a sentence, ChatGPT does not know the information it processes and lacks an understanding of complex causal relationships in the real world. From this perspective, our judgment is that while generative AI may improve the efficiency of investment research in certain specific problems or scenarios (such as the impact of each 25bps interest rate hike by the Fed on the stock market in history), it cannot replace human judgment in investment decision making. Seth Klarman also shared his thoughts based on his investment style. Because Baupost leans towards special situations, they deal with abundant non-standard and complex one-time samples rather than abundant identical samples (where there may be similar patterns but no uniform rules). For example, understanding the returns of distressed debt investors during the liquidation of a company (especially private ones) requires not only quantitative skills but also an understanding of the seniority among different asset owners, relevant legal procedures, judicial event probabilities, and the impact of unpredictable human factors. As Klarman admonishes, “Teaching humans to do these analyses is difficult enough, and I don’t know how to make machines do so many complex and collaborative tasks.”
Investing is an art, not pure science. The foundation of long-term effectiveness in value investing is that the market is driven by humans, and human irrationality will not change with the advent of AI. The complexity and openness of the real world are current barriers to entry that the investment community has in the face of advancing AI. As far as the eye can see, there is no path to complete replacement.
3. Team Management – Optimizing Processes and Managing Teams around Investment Strategy
Individual investors can be like “artists,” but an investment institution is primarily a business and then a company, which needs to operate as a company based on the fundamental nature of the investment business.
As a newly established value investing firm, LIONS is continuously refining and optimizing its investment process and culture around its value investing approach. The LIONS team has years of frontline experience in investment management and company building, which gives our team’s investment thinking a dual perspective of “investing + industry”. As a result, we approach investment analysis from three dimensions: Social Value, Business Value, and Investment Value.
We cannot control the market’s ups and downs tomorrow; the only controllable aspect is our own process and mindset in the face of market fluctuations.
As a fund primarily focused on arbitrage/special situations, how does Baupost manage its investment research process and team? Unlike some institutions (like us at LIONS), Baupost does not have a fixed coverage of “200 stocks” or industry analysts. Klarman refers to their investment process as “Opportunistic,” starting one mile wide and then going one mile deep. This is consistent with Baupost’s circle of competence and investing style. For Klarman personally, this approach helps focus on the core element of mispricing. Once an opportunity is identified, the team divides into small groups (one partner, one senior analyst, and one junior analyst) to conduct research, which may take a few months or up to a year, depending on the specific opportunity. When the team is ready, they meet with Klarman and the president of Baupost to discuss; here, Klarman retains the ultimate decision-making power. This may seem like an “autocracy,” but it actually clearly defines the accountability and responsibility of portfolio decisions and research, maximizing the efficiency of decision-making based on business needs (many special situations are time-sensitive).
Although retaining the ultimate decision-making power, Baupost’s culture seems to be in accordance with Klarman’s character as displayed in the interview (calm, humble, and thoughtful), with much people-oriented consideration given that the team is highly performant. The character of the leader has a profound impact on the culture of any company. For example, Klarman mentioned that if a partner wants to study some investment targets he is uncertain about, he will give the team enough space to do what they want, if the past performance is solid. This preserves the team’s drive while providing the maximum room for growth and a sense of professional accomplishment (given they do not have the ultimate decision-making power). Meanwhile, Baupost’s compensation not only considers individual performance but also the overall performance of the company, minimizing conflicts of interest among team members competing for investment allocation. If there are no good opportunities in stocks, but good opportunities in bonds, why not increase the allocation to the latter? The sole objective of an investment firm is to fulfill fiduciary duties and achieve the best risks/returns for clients. The business structure and decision-making mechanisms also have an impact on team stability. For example, another outstanding investment firm, Pershing Square, founded by Bill Ackman, saw its number two person, Paul Hilal, leave in 2016 and start his own fund. Although we don’t know the details, as a one-product fund, when a company reaches a certain stage, Pershing Square’s business structure may not provide senior partners with enough autonomy. Just as a capable CFO/COO has acquired the ability and willingness to become CEO, the current CEO is still young and won’t step down in a short period of time.
On top of that, Seth Klarman intentionally avoids certain meetings to create a sense of security and space for young members to communicate with each other, minimizing the influence of “autocracy” on junior members. We believe these are characteristics of a demanding but humane leader. It is not difficult to imagine that most of the Baupost team has stayed with the company for a long time, which lays a solid foundation for the team’s stability, trust, and long-term performance.
Entering its 41st year, Baupost has grown from a small team to an enterprise with 250 employees managing $27 billion in assets. Building a long-lasting company, selecting and nurturing talent, and managing smooth transitions are issues that every CEO must consider. Klarman has not considered managing Baupost until he is 90 years old like Buffett, but he has prepared to hand over leadership to the next generation in 10-15 years. After the handover, Klarman still hopes to continue participating in the company’s operations in other forms, providing wisdom and guidance to the next generation. When a company emphasizes talent cultivation and has a sufficient number of long-tenured employees, smooth transitions are not a source of anxiety but a matter of serious planning.
This high-performance and people-oriented culture is also what LIONS hopes to cultivate step by step.
4. Risk Management – Combining Multiple Means to Control Drawdowns
“When the market is more expensive than historic averages, you can lose a lot to simple mean reversion”
— Seth Klarman
The above quote speaks to the perennial risk of multiple compression destroying long-term returns. The reverse is Charlie Munger’s insightful observation, it is acceptable to pay a higher multiple for high-quality companies, as the compounding nature of earnings growth provides some hedges against the linear nature of multiple compressions, over the long term.
For value investors, volatility does not equal risk; real risk is permanent capital loss, followed by the opportunity cost of time. This is also the fundamental attitude of LIONS towards risk. Like investment strategies, specific risk management strategies and methods vary among value investors.
From day one, Baupost’s mission has been to protect the founding family’s capital over the long term. The risk management posture and means are primarily bottom-up and sometimes with macro overlays:
1. Any individual investment must have a sufficient margin of safety.
2. There should be some non-correlation or hedging effect among individual investments, jointly constituting the investment portfolio (rather than relying on top-down mathematical algorithms for allocation).
3. Do not rely on hopes but on catalysts that drive prices closer to value.
4. Do not only rely on equity investments; control the portfolio’s duration and distribute risk through various asset categories (equity vs. bonds, etc.).
5. Use multiple means to guard against market risks or valuation multiple contraction risks, such as position diversification, portfolio hedges, interest rate hedges, and commodity hedges.
6. When there are no good investment opportunities, perfectly comfortable with holding cash.
The combination of these risk management methods has brought Baupost solid protection against drawdowns during its 41-year history, with only 5 years of losses during this period (two of which had single-digit drawdowns).
As an investment company focused on China and global markets, LIONS’ fund has significantly outperformed the MSCI China All-Shares Index (A+H) in a year filled with macro challenges and volatility. Like Baupost, we believe that a sufficient margin of safety is core to risk control. However, how to protect hard-earned returns through a combination of hedging methods and continuously develop the ability to safeguard client assets in the face of business and market changes is a capability that we need to continue building.
5. The Business Model of an Investment Management Firm – Prudent Expansion, the Importance of Long-Term Capital
In the interview, Seth Klarman mentioned, “Perhaps only Buffett can underperform for a long time (5-10 years) and remain unaffected.” On the one hand, this reflects the scarcity of Berkshire Hathaway’s insurance float + long-term capital from cash generated by its businesses and investments. On the other hand, it reflects Klarman’s emphasis on sticky client relationships. Indeed, Baupost’s initial capital came from the $27 million of Klarman’s real estate professor at Harvard and other partners, in the form of a family office. They only accept one or two family offices or individual clients each year through internal referrals. Only 20 years after its establishment did they first accept external institutional clients – university endowment funds. To this day, founding family members and employees remain the largest shareholders of the Baupost fund. Seth Klarman’s approach to business and client selection is also influenced by his other mentor, David Swensen, the late CIO of Yale University’s endowment fund. When facing potential clients, he asks them to read at least five years of shareholder letters to ensure a high degree of understanding between Baupost and clients. This approach to expansion, not solely pursuing asset gathering, demonstrates Klarman’s patience and prudence, which has provided a solid foundation for Baupost’s excellent performance over 40 years. Although unable to replicate Buffett’s business structure and advantages, Seth Klarman created a long-term capital-based business in his own way, which requires great restraint and patience, seemingly common sense but not common enough in reality.
As for LIONS, our primary goal is to create absolute returns for clients. Therefore, fund performance always takes precedence over AUM and fundraising needs. LIONS also hopes that through this persistence, we can meet like-minded partners who share the long-term perspective and achieve win-win through market cycles. Working with outstanding people and having fun with happy people, growing rich patiently – these are the principles of the LIONS team.
After completing this article, I checked the price of “Margin of Safety,” the book published in 1991 and no longer in print, which has risen from $1,400 in 2015 to ~$2,500. As for Seth Klarman’s plans for his next book and his thoughts on the current market environment, it may be worthwhile to pour a cup of tea and listen carefully to his wisdom.
LIONS ASSOCIATES 