The Conservative Genius of Psychological Value Investing: Seth Klarman’s Principles for Long-Term Success

Investing has no room for emotions. It’s a field that, value investors argue, demands a clear, logical approach that is free of speculation. This is among the core tenets of Seth Klarman, a name synonymous with value investing. According to Klarman, even the most seasoned investors are regularly influenced by emotions and make mistakes that are dangerous for building wealth.

Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return.
— Seth Klarman in his book Margin of Safety

Klarman is a founder of the hedge fund Baupost Group, ranked 8th in net gains by Bloomberg. Renowned as the “second Warren Buffett” and “The Sage of Boston,” Klarman showed his entrepreneurial spirit from a young age. At just four, he decorated his bedroom like a retail store, and in fifth grade, he gave a presentation on the basics of buying stocks to his classmates.

Klarman studied economics at Cornell University and later attended Harvard Business School, where he met Professor William J. Poorvu, then a leading expert in real estate investment analysis. The professor was already involved in the Baupost Group project before Klarman graduated from business school; upon his graduation, Klarman was asked to help manage the fund, which had an initial capital of USD 27 million. According to Forbes, the Baupost Group has achieved a 20% annual investment return since its inception.

Leading Baupost Group to become one of the most successful hedge funds worldwide, however, would have been unlikely without Klarman’s determination, as well as the investment principles he developed to facilitate better decision-making and higher returns.

Seth Klarman’s Principles of Investing

1. Investing in Value Is What Defines a Successful Investor

The concept of value investing, while not novel, is central to Klarman’s philosophy as outlined in his book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. At the heart of his interpretation of value investing is the concept of intrinsic value — the true worth of a business is based on its fundamentals, rather than its fluctuating market price.

Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities rarely are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price based on optimistic expectations and are unlikely to represent good value that has been overlooked.
— Seth Klarman in his book Margin of Safety

Inspired by Benjamin Graham, often regarded as the “father of value investing,” Klarman advocates for investing in solid, undervalued assets while keeping a margin of safety in place to guard against potential risks. In an interview with Harvard Business School, Klarman explained why he thinks value investing works better than other approaches:

First, value investing is intellectually elegant. You’re basically buying bargains. [Second] It also appeals because all the studies demonstrate that it works. People who chase growth, who chase highfliers, inevitably lose because they paid a premium price [...] Third […] you see situations that are just plain mispriced, where an ignored, neglected, or abhorred company may be just as attractive as others in the same industry. In time, the discount will be corrected.
— Seth Klarman in an interview with Harvard Business School

Reflecting on the philosophy of Warren Buffett and David Dodd, Seth Klarman emphasizes the importance of patience and a thoughtful approach to investing. Buffett never sought to make money quickly; instead, he aimed to grow wealth slowly and steadily – i.e., aiming for long-term success. This philosophy, which shuns hot, trendy investments, aligns closely with Klarman’s approach.

Value has to be determined for every company [...] not that there are growth stocks and value stocks, but rather, that all stocks may hold value, but that all stocks also could potentially be overvalued. So you have to have a mechanism, a rubric for figuring out the value of different kinds of assets, and different kinds of businesses, and figure out which ones are trading particularly mispriced.
— Seth Klarman during the interview with CNBC

Seth Klarman talks about investing challenges
Source: CNBC Television

2. The Margin of Safety and Quality of Assets

Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands.
— Seth Klarman in his book Margin of Safety

Klarman’s margin of safety essentially means the difference between the estimation of a company’s intrinsic value and its current stock price. The safety margin is a critical buffer, safeguarding against potential miscalculations and unforeseen market shifts.

This principle applies to investing in shares, but not to index funds, which, in Klarman’s opinion, are “silly and at worst quite hazardous.” The premise of index investing relies on the Efficient Market Hypothesis, which posits that all available information is reflected in stock prices. Where index investing assumes the market is always right, value investing dares to challenge that assumption, seeking profit from the market's occasional mistakes.

To value investors like Seth Klarman, index investment is akin to speculation. This behavior, based on what we call FOMO (fear of missing out), relies on the volatility of the market and therefore cannot guarantee the safety of the cash flow and investment principal.

The argument for index funds is that you’re going to have low transaction costs near zero, and you’re going to have exposure to the market. You’re not going to underperform the market, neither will you outperform the market.
— Seth Klarman during the interview with CNBC

Seth Klarman talks about index funds
Source: CNBC Television

Further, Klarman favors a focused portfolio over broad diversification, believing in quality over quantity. He argues that understanding a few high-quality companies is easier and more effective than managing a sprawling mix of mediocre stocks. Recognizing the challenge of finding exceptional companies, Klarman looks for opportunities where others see risk, buying undervalued assets and holding them until the market recognizes their true value.

Seth Klarman’s portfolio allocation as of the end of June 2024
Source: Yahoo Finance

Applying Value Investment to Your Portfolio

Seth Klarman’s value approach provides a powerful example of how patience, discipline, and psychological insight can lead to exceptional long-term returns. In an interview with Harvard Business School Professor Das Narayandas, Klarman emphasizes the critical role of psychology in investing. He points out that markets are often influenced by others’ emotional reactions, such as panic and greed.

Klarman suggests maintaining a balanced approach and avoiding these emotional extremes to invest successfully. At Moonshot, we hold with Klarman’s value investing principles. We regularly conduct rigorous due diligence to select the most promising of more than 1 million private companies, and to them, we give our community access during the key investment window before they go public.

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