Seth Klarman (Trades, Portfolio) is one of the best value investors of all time so when he speaks about the topic, it always pays to listen. Even if you don't agree with some of his views, his experience in the field of value investing is virtually second to none and there is always something you can learn from him.
In his year-end 2017 letter to investors, Klarman covered topics that captured the attention of financial commentators throughout the year, including the issue of a rise in populism. He also spoke about how value investing has changed.
Specifically, the manager of Boston-based hedge fund Baupost spoke about how value investing has changed over the past 10 years and why, even though the method of company analysis has changed, the core principles of Benjamin Graham remain the same.
Value investing has changed, but it's still the same
I think this is a fascinating argument. There's no denying that the world has changed significantly since Benjamin Graham came to Wall Street in the early part of the 1920s. Many have argued that his principles are out-of-date today, especially when it comes to analyzing companies based on their balance sheets alone.
Also, as growth stocks have taken over the market and value as a style has struggled, investors have started to abandon value. However, Klarman believes that this is a mistake on investors' part as they do not understand what the mentality of being a value investor entails.
Indeed, Klarman writes in his year-end letter that value is not a rigidly formulated process, it is not acceptable to judge each company in the same industry by the same standards. Every business has its unique traits and attractive qualities so each must be evaluated separately on its own merits.
And this is where the core of Benjamin Graham's teachings remain relevant even today. At the heart of Graham's valuation methodology is the desire to preserve capital and have a long-term orientation grounded in investment fundamentals. Graham's books also try to make it clear that the investors worst enemy is themselves and investors should seek to prevent themselves from making silly mistakes. These core principles of Graham's strategy, Klarman writes, are still highly relevant even today. No matter what investments style you follow or how your value strategy has evolved over the years, every investor should, at all times, seek to minimize the risk of permanent capital impairment. They should also try to prevent themselves from making silly mistakes that cost money and have a long-term orientation based on a business's underlying fundamentals.
Changing with the times
These underlying principles remain the same but value investing has changed in other ways.
When Benjamin Graham first started investing, he looked to company balance sheets to try and compute the underlying value of every business based on its assets and liabilities, hard assets that had a real, tangible value in the market.
One of the most significant problems investors face today, however, is the fact that reported company results are frequently misleading. For this reason, Klarman believes that a qualitative judgment on each opportunity as well as a quantitative analysis is always required.
Another significant change in investing world is the requirement to be able to forecast forward earnings. Graham never relied on forecast earnings because he believed that they were misleading and he could not accurately compute them himself. Today, it is vital to be able to predict a company's future growth potential, especially when net-nets are virtually nonexistent. Once again, this is a reason why qualitative, as well as quantitative analysis, is required for every opportunity.
And the final significant change between value investing today and value investing in Benjamin Graham's time is the requirement today to keep an eye on management incentives and avoid companies with managements that are in enriching themselves at the expense of shareholders. This problem existed in Graham's time too, but as noted above, back then it was the balance sheet where the real value was always found. It is a lot easier to calculate the value on the balance sheet rather than access management competence. For a net-net, even if management is being irresponsible with executive compensation, unlocking value from the balance sheet is still possible.
The bottom line
So overall, Seth Klaman believes that today, the core principles of Benjamin Graham's teachings remain relevant. But when it comes to forecasting growth, trusting management and analyzing businesses, a more up-to-date version of Graham's investment style is required.
Disclosure: The author owns no stock mentioned.
