FA Alpha Daily

The Baupost Group just had its best year in nearly a decade… Here’s how the fund is set up for 2022

Last year, The Baupost Group has produced its best returns in nearly a decade. Today’s FA Alpha Daily will dissect the fund’s top holdings to see if they can continue this streak.

FA Alpha Daily:
Friday Portfolio Analysis
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After The Baupost Group’s best performance in nearly a decade, we felt it was time to revisit our analysis of Baupost’s portfolio.

Seth Klarman is one of the few managers who actually managed to call his shot. Before becoming one of the best fund managers of the generation, Klarman wrote his book Margin of Safety, outlining how he planned on running his fund for sustained outperformance.

Then, he actually did it.

Below you will find our original report on what makes The Baupost Group so special, along with an updated portfolio overview and analysis of how Klarman applied his strategy during the pandemic.

It’s game 3 of the 1932 World Series, and the score is tied 4-4 in the 5th inning.

October baseball is always special, but an at bat in a tied game in the World Series is a true pressure cooker.

Babe Ruth strode to the plate for the Yankees, facing the Chicago Cubs in Wrigley Field.

As he takes strike one, the Cubs bench players are jeering at him and the Wrigleyville faithful are screaming any insult they can think of.

Ruth doesn’t tune them out. Instead, he steps one foot out of the batter’s box and points the head of his bat to the deepest part of center field. He steps back into the box.

He takes strike two.

The fans, the players, the atmosphere only gets louder. They smell blood.

Ruth steps out and, again, uses his bat to point to the Exact. Same. Place. He’s calling his shot!

He steps back into the batter’s box…and Charlie Root throws a curveball that never makes it to the catchers mitt.

Instead it ends up over 440 feet away into the center field stands. Exactly where he said he would.

The Yankees went on to win the game 7-5, and to win the series also. Baseball fans have loved telling that story every day since.

That story has such staying power because of the improbability of it. It’s easy for a pitcher to say after a no-hitter that he felt like something special was going to happen as he warmed up that afternoon.

It’s easy to look back and call David Ortiz one of the most clutch players of all time after he helped the Red Sox win 3 world series. But to be able to call your shot, not just that you were going to get a hit, but that you were going to hit a home run, over right center field, is near impossible.

Which is why it’s so impressive that sixty years later, Seth Klarman did the exact same thing—it’s why he’s a legend in investing, almost to the scale Babe Ruth is in baseball.

Seth Klarman has been a wildly successful investor. His fund Baupost has produced 20% returns a year since 1983. He’s outperformed the market by almost 4x since he started the strategy.

But what’s impressive isn’t just that he has had such phenomenal returns. It’s that he told everyone how he was going to get those returns before he did.

Long before Klarman became a billionaire he wrote a book called Margin of Safety. The name is an homage to Ben Graham’s Security Analysis.

In the book, Klarman laid out his value investing philosophy and how he would pick stocks. He laid out his exact strategy that would eventually lead to Baupost’s phenomenal performance. He called his shot and then he delivered 4x the market’s performance.

Klarman and Baupost are still picking stocks today, and doing an amazing job.

Part of the reason they remain so successful is because Klarman has as much skepticism about as-reported accounting metrics as we do here at Valens.

Klarman has regularly railed against the issues with as-reported accounting metrics. Mocking investors who use metrics like EBIT and EBITDA to value companies, because of how distorted they are.

At Baupost, they are focused on the real operating profitability of companies, not the inaccurate noise of as-reported accounting metrics.

To show how Baupost’s analysis unsurprisingly lines up with Valens Uniform Accounting, we’ve done a high level portfolio audit of Baupost’s current portfolio, based on their most recent 13-F. This is a light version of what we do for our institutional clients when we analyze their portfolios for torpedos and companies they may want to “lean in” on.

See for yourself below.

Using as-reported accounting, investors would think Baupost was not focusing on companies that provided them much margin of safety, given the companies in the portfolio have very weak return on assets (ROA).

On an as-reported basis, many of these companies are poor performers with an average as-reported ROA of around 6%.

However, once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see that the returns of the companies in The Baupost Group’s portfolio are much more robust.

The average company in the portfolio displays an impressive average Uniform ROA of 43%. This is well above corporate average returns.

Once the distortions from as-reported accounting are removed, we can realize that SS&C Technologies (SSNC) doesn’t have an ROA of 5%, but returns of 60%. SS&C isn’t a low-return business as shown by wrong data.

Similarly, Fiserv’s (FISV) ROA is really 71%, not 1%. The Baupost Group’s focus on better accounting recognizes a high return business with robust cash flows.

Liberty Global (LBTY.K), Baupost’s largest holding, is another great example of as-reported metrics mis-representing the company’s profitability.

The company’s ROA isn’t 2%, it’s actually 102%. Uniform Accounting shows what The Baupost Group saw in Liberty Global.

The list goes on from there, for names ranging from Alphabet (GOOGL) and Meta (FB), to Nexstar Media Group (NXST).

If Baupost’s investment strategy was powered by as-reported metrics, it would never pick most of these companies, because they look like bad companies and poor investments.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics mis-represent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

The Baupost Group is also investing in companies that the market has low expectations for, low expectations the companies can exceed.

Once we account for Uniform Accounting adjustments, we can see that many of these companies are strong stocks that have unfairly been beaten down by occluded accounting standards.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The Uniform ROA FY0 represents the company’s current return on assets, which is a crucial benchmark for contextualizing expectations.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here is 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, average Uniform P/E across the investing universe is roughly 24x.

Embedded Expectations Analysis of The Baupost Group paints a clear picture of the fund. The stocks it tracks are strong, and while the markets are pricing them in for a significant drop in profitability, analysts are projecting returns to remain consistent.

While the fund is forecasted by analysts to see Uniform ROA drop to 27% over the next two years, the market is pricing in the fund to see returns fall to 13%, which may lead to upside.

In particular, there are a couple of companies that are being priced in by the market as excessively bearish.

While Fiserv (FISV) has achieved strong profitability in recent years, the markets are pricing in declines in returns. Meanwhile, analysts are projecting the company to not just maintain their returns, but improve to 75%.

SS&C (SSNC) may similarly provide upside as the market is projecting their returns to plummet to 21% Uniform ROA, while analysts expect them to nearly maintain their returns with a 58% Uniform ROA.

This just goes to show the importance of valuation in the investing process. Finding a company with strong growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which have not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of The Baupost Group’s largest holdings.

SUMMARY and Intel Corporation Tearsheet

As one of The Baupost Group’s largest individual stock holdings, we’re highlighting Intel Corporation’s (INTC:USA) tearsheet today.

As the Uniform Accounting tearsheet for Intel highlights, its Uniform P/E trades at 19.8x, which is below the global corporate average of 24.0x, but above its historical average of 17.2x.

Low P/Es require low, and even negative, EPS growth to sustain them. In the case of Intel, the company has recently shown a Uniform EPS shrinkage of 3%.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Intel’s Wall Street analyst-driven forecast is for EPS to compress by 39% and 2% in 2022 and 2023, respectively.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Intel’s $44 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to contract by 9% annually over the next three years. What Wall Street analysts expect for Intel’s earnings growth is below what the current stock market valuation requires in 2022, but above that requirement in 2023.

Meanwhile, the company’s earning power is 2x long-run corporate averages. Also, cash flows and cash on hand are around 2x the total obligations—including debt maturities and capex maintenance. Moreover, intrinsic credit risk is 30 bps. Together, these signal low dividend and credit risks.

Lastly, Intel’s Uniform earnings growth is below peer averages, but is trading above its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we use to power our FA Alpha product. To find out more visit our website.

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