In the offices of an unmarked high-rise building in Boston sits Seth Klarman, surrounded by stacks of papers and books, which, by his own admission, are at risk of toppling over and crushing him at any instant.
Klarman is the founder and president of the phenomenally successful Baupost Group, a $29 billion "deep value" hedge fund. It has produced 19 per cent annual returns, and every $10,000 given to Klarman at inception in 1982 is worth about $1.85 million today - and this was achieved while carrying extremely high levels of cash (more than 50 per cent at times) and using minimal leverage.
So how did he do it?
Know your seller
The financial markets are fiercely competitive, with millions of investors, traders and speculators around the world trying to outwit one another. Klarman concluded that since prices are set by the forces of supply and demand, rather than buy something and wait for someone to demand it at a higher price, why not wait for an irrational supplier to sell it to you for any price? Hence, Klarman looks for assets that people are being forced to sell or avoid, often as a result of fear or institutional constraints.
You can apply this principle by looking at heavily sold or avoided opportunities closer to home.
For example, stocks at the bottom of the S&P/ASX 200 are kicked out and replaced on a regular basis and, since index funds can hold stocks only over a certain size, newly removed stocks from the
S&P/ASX 200 are sometimes driven down in price because of the selling pressure from such funds.
To make matters better, owing to regulation many super funds often cannot invest in smaller companies and such stocks are rarely followed by analysts. Servcorp resides on Intelligent Investor's buy list and falls into this category.
Some institutions are also forced to ignore debt instruments unless they achieve a certain credit rating, even though they might offer an attractive risk-reward profile. You can take advantage of this by investing in income securities in a downturn, when large price falls create great opportunities such as those in 2009, for example, the Goodman PLUS, Dexus RENTS and Southern Cross SKIES hybrid securities.
Tax-loss selling (in Australia, this tends to occur in June, at the end of the financial year) can cause irrational mispricing in already beaten-down stocks. Cheap blue chips that could be this group next week include Computershare, QBE Insurance and Macquarie Group.
The difference between great investors and mediocre ones is only a few percentage points in terms of judging things correctly. Klarman realised he would have to bring something different to the game to win: a "competitive advantage".
"I will buy what other people are selling," Klarman says. "What is out of favour, what is loathed and despised, where there is financial distress, litigation - basically, where there is trouble."
An inexperienced individual will have little success using such a tactic. After all, how many of us have four years to spend analysing Enron's accounts? Instead, look for inefficiencies you can exploit.
Most market participants have a narrow, short-term view and are driven by fear and greed. So your edge is having a longer-term perspective and controlling your emotions. These two advantages will help you pile on the performance points over the professionals. Both have been invaluable to Klarman.
Cash is a weapon
Holding cash is perhaps Klarman's most famed characteristic.
However, contrary to what you might expect, Klarman holds cash so it can be used in a concentrated manner when the right opportunity arises. This is because while value investing outperforms in the long run, Klarman quips that "you have to be around for the long run ... [you have to make sure] you don't get out and you are a buyer".
Despite the complexity of some of his investments, Klarman's underlying approach is not complicated, although that is far from saying it is easy.
He says Baupost has outperformed "by always buying at a significant discount to underlying business value, by replacing current holdings as better bargains come along, by selling when the market value comes to reflect its underlying value, and by holding cash ... until other attractive investments become available".
Nathan Bell is the research director at Intelligent Investor, intelligent investor.com.au. This article contains general investment advice only (under AFSL 282288).