Seth Klarman: The Secret to Outperforming the Market

You need not to be greedy. If you're greedy and you leverage, you blow up. Almost every financial blow-up is because of leverage. And then you need to balance arrogance and humility, and I'll explain what I mean.

When you buy anything, it's an arrogant act. You're saying the markets are gyrating, and somebody wants to sell this to me, and I know more than everybody else, so I'm going to stand here and buy it. I'm going to pay an eighth more than the next guy wants to pay and buy it. That's arrogant, and you need the humility to say, "But I might be wrong." You have to do that on everything.

You know his own Ben Graham experience and coming to Columbia and what it meant to him to help you understand why this has been such a profound series of principles that have made you in investments who you are today. First of all, I wish I'd met Ben Graham. I never was fortunate enough to do that. I think Warren captured the idea himself in his 1964 article "The Super Investors at Graham and Doddsville." In it, he talks about value investing being like an inoculation—you either get it right away or you never get it. I think that's just true.

I actually think there's a gene for this stuff, whether it's a value investing gene or contrarian gene. I think that everybody appreciates a bargain, but when the market's going down, most people overreact and get scared. "My stock is going down! What am I going to do?" So if you're buying a sweater and it goes on sale from $400 to $150, you get excited when you get to the store. But if you have a stock, or you bought the sweater at $400, maybe you're not so happy.

So I think it's, for me, it's natural, but for a lot of people, it's fighting human nature. But it is true what Warren Buffett said—when you find out about it, it's like being let in on this little secret. So if you can remember that stocks aren't pieces of paper that gyrate all the time, that stocks are fractional interests in businesses, it all makes sense. It's almost like you have to slow the game down, like they talk about baseball speeding up on you. You need to slow it down. I can buy this thing for a huge fraction of what it's worth; what am I worried about? If it goes down, okay, so what's the gift here?

Knowing what it's worth, I think that the analysis is actually the easy part. When I speak to business school students, I tell them investing is the intersection of economics and psychology. The economics—the valuation of a business—is not that hard. The psychology, how much do you buy? Do you buy it at this price, do you wait for a lower price, what do you do when it looks like the world might end? Those things are harder, and knowing whether you stand there, buy more, or something legitimately has gone wrong, 80% to sell, those are harder things. You learn those over time with experience; you learn by having the right psychological makeup in the first place.

What's the right psychological makeup that you have? So, patience would be one; cash would be another. Value investors have to be patient and disciplined. But what I really think is you need not to be greedy. If you're greedy and you leverage, you blow up. Almost every financial blow-up is because of leverage. And then you need to balance arrogance and humility, and I'll explain what I mean.

When you buy anything, it's an arrogant act. You're saying the markets are gyrating, and somebody wants to sell this to me, and I know more than everybody else, so I'm going to stand here and buy it. I'm going to pay an eighth more than the next guy wants to pay and buy it. That's arrogant, and you need the humility to say, "But I might be wrong," and you have to do that on everything.

But one, I mean, are you different than Warren in terms of how Warren has evolved and how you have evolved? You know, I mean, obviously, I think Charlie Munger had some influence on Warren in understanding to, to not just to look for the classic example of the cigarette butts, you know, but to look at things that were reasonably priced with the belief that this still was a margin of safety.

First of all, a lot of my Charlie Mungers are out here in the audience, so a lot of people here that I bounce ideas off of, and we share thoughts. I mean, how have you involved? Warren evolved from different one. Warren evolved through three stages. He went from buying cigar butts and getting the last few puffs for free to buying great businesses at really cheap prices to buying and holding great businesses at so-so prices and maybe even this new area of buying weird securities from crappy businesses at better than market prices, like B of A preferred or whatever.

I'm still in phase one. We're still buying; we're still buying cigar butts. There's a good business there, and buying them, and it's a lot of fun, and that's what you're proud of. No, I feel like I have stunted growth, Charlie. You know, what I think that it's hard? I think Buffett's a better investor than me because he has a better eye towards what makes a great business, and when I find a great business, I'm happy to buy it and hold it.

Most businesses don't look so great to me, but he also doesn't—I mean, he's not really focused on the gyration of the stock every day. Me neither. You're not eating—I don't have a Bloomberg on my desk. I don't care. You don't have a Bloomberg on your desk? No, because Mike makes enough. What song you can find out? But what's on your desk then? A phone, a giant pile of paper that are at risk of falling on me at any moment, and I have a computer and a phone.

Yeah, so tell us about your death-filled water bottles. I mean, you sit at a trading desk. I mean, when you're not meeting either clients or people that are going to give you some information that might be relevant to what decisions you have to make, you're sitting at a trading desk thinking big thoughts. Are you really, are you? It's not so much because you are reacting to the volatility of every market that you're invested in because if you're a value investor, my assumption would be that you're not looking to trade every moment—we're not traders.

There's a wonderful story Chris Brown at Tweedy Brown tells about how they were interviewing somebody to come and, you know, to join their firm. After the interview, he's walking the fellow to the elevator, and the fellow says, "You know, it's amazing here at Tweedy Brown. At most firms, you can tell from the atmosphere in the place whether the market's up or the market's down. At Tweedy Brown, you can't even tell if the market's open." And I think it's like that in our firm. We're making medium to long-term investments, you know, three to five years or longer, and so we're not really that in.

The only reason we care about the gyrations is so we can buy something even cheaper. Do you like bad times then? You know, we benefit from volatility and distressed data and everything else. We provide liquidity when people want to sell things in a hurry, presumably. You know, it's a transaction between consenting adults. When somebody owns a bond that was triple A and now is triple C, they want to sell; they want liquidity.

We sort of, our rhythm is opposite most of the market's rhythm. We buy things when the market's down; we sell things when the market's up. Do I root for bad times? Of course not; I love our country. I didn't mean it that way. Bad times? But is it frustrating when the market goes straight up and up and up, as it did from '82 to '87? It was frustrating, and I worry because just at those times, it's when the little guy gets sucked in.

The little guy finds it irresistible when the market's going higher and higher. The little guy gets pulled in by stories from their neighbors, stories from the cocktail party, and they hear about how much money people are making in the market. Charlie, you probably know this, but the return from all mutual funds in the 1990s was 600 basis points higher than the average return from the investors in those funds during the same period. And that's because they get in at the wrong time and out at the wrong time, so that's painful to me.

So what is your lesson? That's why I wrote the book, to try to educate the average person. But only a few hundred of them read the books. I hope I'm going to get a copy of this book. But can you talk to us about your philosophy of timing? If there is, there no philosophy of timing because you know you're looking at value and that you understand value. Essentially, the big decision for you is the buy decision more than the sell decision. Buying's easier; selling's hard. Hard to know when to get out.

There's no timing element. You can never tell how big a bargain you might get offered tomorrow. If somebody comes along and wants to sell you a dollar for 50 cents, you can never know if they'll want to sell to you at 40 cents tomorrow. So you need to buy it and leave a little room to buy more and maybe someday spend your last dollar and buy the bargain. Maybe it goes down before it goes up, so you always are checking and rechecking your work.

The critical thing—the thing that would cause you to lose your confidence when you're doing that—would be if you realize the dollar wasn't a dollar. You thought it was worth a dollar, but Greece failed or the euro fell or collapsed, and all of a sudden, your dollar is only 30 cents, and now what you thought was a bargain is overvalued. So that's the dilemma. It's not so much figuring out what it's worth today; it's making sure it'll still be worth that same thing, or approximately that same amount tomorrow.

So a lot of stocks are cheap for a reason, and often a value investor will figure out the reason, because everybody else has gotten sick of a management raping and pillaging a company—overpaying themselves, deploying capital poorly, taking advantage of the shareholders with free stock or huge options awards or hiring their brother-in-law. So, there are stocks that have been perennially undervalued because they're run by somebody who fits that profile.

A novice value investor will come along and say, "Well, that looks awfully cheap." And Graham and Dodd didn't really place the quality of management as high as they might have, and so good managements add value. Good managements have lots of levers they can pull. They can buy back stock when it's undervalued; they can use the stock as currency when it's overvalued. Bad managements will think only about themselves first.

And so, those are early lessons, but profound lessons that I learned to learn them well.