Whenever there is something written about Seth Klarman, or even more importantly, when the man speaks himself, I stop whatever I am doing to read or listen. Mr. Klarman is the founder of Baupost Group which is one of the best performing hedge funds of all time. What I like about Mr. Klarman is his strict adherence to investing disciplines. He is a value investor and often has cash balances in his funds that exceed 30%. Last week I saw a few excerpts from Mr. Klarman’s letter to his investors in 2015. Evidently, his performance last year was pretty bad which is not surprising given the market volatility that characterized most of 2015. One excerpt from that letter looks pretty wise given the dramatic stock market reversals in the first 6 weeks of 2016:
“Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.” — Seth Klarman year-end 2015 letter to investors.”
I am a devotee of Mr. Klarman. Like him, I believe there is something called fundamental value. Mr. Klarman does not disclose his secret sauce. His book “Margin of Safety” is available on Amazon for $2000!!! That is not his price because he published the book in 1991 for a cover price of $25. The book was a flop and he only sold 5000 copies. Today’s price reflects the market’s view of his value as an investment legend.
I wrote in my 2016 predictions blog “Investment Thoughts For 2016“ that we had seen a slowdown in growth from our industrial companies. While that slowdown has stabilized in early 2016 it may portend an adjustment of values in the stock market. The trading prices of private businesses in the M&A markets are consistently exceeding 7x multiples and as much as 10x for larger companies. Those private company valuation multiples are near the peak we saw in 1999 and 2007. By comparison the average EBITDA multiples of the S&P500 through the middle of 2015 hover around 12x according to the ValueWalk website that tracks Enterprise Value to EBITDA multiples for the S&P500 from 1990 to mid ’15.
Luckily, when you are focused on one asset class like private equity you can develop Seth Klarman’s notion of a North Star for valuation. In general terms most of the companies we see in the lower middle market trade in a range of 6x-7.5x the most recent twelve months EBITDA. They also trade in a broad range of 9-13x the free cash flow of the target company. Unlike earnings, cash flow is much harder to fake or manipulate for any length of time. As a consequence, we always look at the free cash flow generation of our target when searching for our polestar.
When you are wondering why the stock market may be heading south, it may have something to do with outlooks for growth? Seth Klarman would tell you that there are a few head fakes in the numbers, especially the comparative valuations between private and public companies. Here are a few data points as of February 11, 2016 from Yahoo Finance on a variety of companies some of which are always in the news:
|Mkt Cap/ Levered Free Cash|
Someone is clearly wrong. If you can buy Apple for the same price range (EBITDA and Cash Flow) we are paying for $35 million sales companies with 10% EBITDA margins, one of the markets is wrong. Similarly, if you can buy Parker Hannifin for 9x EBITDA and 10x Free cash flow, why would you buy any private company in motion and control technologies that is a fraction of Parker’s size for the same M&A valuation multiples? Maybe Mr. Klarman would say Apple and Parker are cheap? Maybe the private company has higher growth expectations than Parker and you should pay up? A great value investor like Seth Klarman might also say that the private market is giving you a head fake and the public stock is telling the truth. The M&A market has become quite event driven (buying and selling), complacent about exit liquidity and forgetful about bank credit. Price and value are certainly disconnecting in the public markets when you can buy shares of market leaders in many industries at a discount to the M&A value of lesser private peers. Maybe the public market is signaling concerns about deflation of certain classes of financial assets. Why else can you buy Apple for the price of a bus ticket to Buffalo unless investors think Apple is on a path to becoming Buffalo?
You might also look for confirmation of the right trend in places like the commodities market where businessmen, without having to negotiate at all, are paying less every day for a bucket of raw materials than they paid last week. Maybe the Patriots aren’t the only group with a deflate gate issue?
My opinion does not matter. Whether I am right or wrong is not the point. A value investor like Benjamin Graham, Warren Buffet, or Seth Klarman would say that I am speculating. For them that is not investing. Until the entry point for each market is certain, there is not margin of safety and no reason to invest. Seth Klarman might say it is time to sit on your wallet and go fishing until the positive trend, the sure thing, has established itself?
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