Seth Klarman’s Investment Framework

Margin of safety and risk aversion is Seth Klarman's central investment tenet. And risk aversion begins with defining a margin of safety for your investments. In his book Margin of Safety, Klarman outlines three of the best ways to build a winning stock portfolio:

· Consider the risk and downside associated with the investment before focusing on potential returns.

· Perform a bottom-up approach on individual companies while ignoring the industry and its connections with the economic cycle as a whole.

· Evaluate how the company achieves its returns and research why revenues and profits have increased or decreased year by year.

The key to downside risk protection

In the current financial market environment, unprecedented things are happening with surprising regularity. This is as true for our preparations for financial disaster as for any other kind. And when the memories of disaster, along with worry and diligence, dim over time, it leads to complacency in investors. Complacent investors naturally focus more on benefits and the focus on benefits will lessen the concern over what could go wrong. It is important to prepare your investments for stormy times and one way to do this is to consider the downside protection an investment offers. Downside protection starts with understanding the risks associated with the investment. When the risks are identified, then the best course of action is developing a plan for protecting against those downsides. One of the most popular forms of downside protection is investing with a margin of safety.

As Klarman writes in Margin of Safety, "A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." Klarman, when giving a margin of safety, drives towards investments that provide adequate balance sheet cash and low-risk collateral. A margin of safety! doesn't guarantee an investment will generate high returns but it provides room for error in an investor's judgment. In particular, it provides a cushion against any miscalculations that may occur. Miscalculations, no doubt, will be inevitable because an investment's intrinsic value is subject to various interpretations by investors, which affect how large a margin of safety investors will choose to set. In general, the bigger the margin of safety set by investors, the less likely investors will suffer losses.

Why use bottom-up approach

Bottom-up investing focuses more on analyzing a specific company and less on the the financial markets and economy as a whole. With bottom-up investing, a thorough review of the company is done, paying close attention to factors like financial stability and the conduct of management. This approach is commonly used during instances where we think that individual companies can do well in an industry that is not performing well. They pose great opportunities for value investors because these types of companies are ones most likely to be overlooked by the average investor.

Most investors naturally choose top-down investing, a strategy focused on investing according to the market cycles and economic environment, which tends to be a better measure of how the stock market is performing as a whole. However, economies and industries are often too complex for investors to gain useful insight.

Bottom-up investors ignore the markets and focus on specific dynamics to get ahead of the game. They evaluate factors like competitive advantage and management reputation.

Klarman said the following to investors in his Baupost letter earlier this year: "Our disciplined risk aversion throughout 2011 enabled us to avoid dangerous temptations and remain focused on investments in our areas of strength and competitive advantage." Competitive advantage comes down to two questions. Can the company raise prices for their products while maintaini! ng sales ! in a competitive environment? Can it continue to retain customers as the business undergoes operational and technological changes? One aspect for investors to keep in mind is that of technological change, a constant threat to industries like retail stores and mobile communications. Best Buy (BBY) used to be the go-to place where customers could shop for electronic appliances but internet retail took that away. RIM (RIMM) used to be a model company that produced phones for email on-the-go but competitors like Apple (AAPL) and Google (GOOG) upped the ante and took away the value of RIM's products. These kinds of circumstances show that keeping up with trends on a regular basis is a vital part of bottom-up investing.

Management reputation explains a company's business model, a measure of how the business makes a profit while delivering value to its stakeholders. If there is one theme that continually runs through the public statements of billionaire investor Warren Buffett, it is the principle that investors should only consider investing in companies with managers of competence and integrity. Buffett explains that he likes managers who stick to doing what the company does best. He declares, "The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago." On the contrary, Buffett suggests investors to avoid companies with managers who pursue growth for growth's sake and acquisitions for the sake of owning more. Like Buffett, Klarman is a deep value investor who thinks more bottom-up than top-down.

Develop a framework for decision making

Outstanding investment returns are, indeed, hard to achieve. But once investors take care of the risks and understand a company better, it is possible to develop a strategy for generating better returns. Investors can increase their chances at bigger returns by gaining an idea on how much cash a business is generating, where it is coming from, and ! whether i! ts origin is sustainable. According to Klarman, a company's share price often fluctuates significantly in the absence of fundamental developments, such as when a sizeable seller needs cash quickly. So how can investors determine the sustainability of cash within the business? Reading through the financial statements, focusing on the line items that affect cash generation, and trying to remember key statistical numbers are just a few of the key steps.

When investors find the information they need, they need to dig deeper into those numbers by examining sub-statements and reports that say something about the numbers. These steps, taken altogether, will form the foundation of a unique investing strategy for each value investor. Over time, Klarman discovered a great strategy that produced a top-of-the-line stock portfolio.

Four of Klarman's stocks include PDLBioPharma (PDLI), Ituran Location and Control (ITRN), BP (BP), and Microsoft (MSFT). What these companies have in common are annually increasing total revenues, annually increasing cash flows, and gradually decreasing operating expenses and debt. Additionally, they show a clear value focus with P/E ratios no greater than 15. And even when stocks like these go through a troubling period brought on by a sagging economy or major scandal, they have an ability to bounce back.

The following sums up what Klarman tries to do at Baupost: "We are always long-term oriented. We never attempt to gauge near-term market movements; we have no edge there. We strive to make long-term investments that have truly compelling risk-reward characteristics. We are never afraid to stand apart from the crowd. We stick to our game plan, and focus on areas where we are skilled and experienced."

An investment framework like Klarman's is necessary to develop a winning portfolio. The framework should include principles through which ideas and decisions are filtered. A sound investment process, most of the time will lead to a good investm! ent resul! t. But ultimately, investor success in the long term is shaped by how well we can develop and utilize our skills over time to understand companies better.