There are many books on investing but only a few have stood the test of time and are considered essential reading by investors. One of which is the “Margin of Safety,” a book written by the renowned value investor, Seth Klarman, who has managed the Baupost Group hedge fund for over 30 years. In “Margin of Safety,” Klarman laid out his investment philosophy based on the idea of buying stocks that are trading for significantly less than their intrinsic value. In today’s FA Alpha Daily, let’s look at Baupost’s fund through Uniform Accounting and see how his approach has helped the fund generate consistently strong returns, even during periods of market volatility.
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Step into the historic New York Public Library and you’ll be surrounded by a treasure trove of knowledge.
Amongst the rarest finds are centuries-old copies of Shakespeare’s First Folio and the legendary Gutenberg Bible.
However, there’s one book that you won’t find leaving the premises, even though it looks like an ordinary modern hardcover on investing.
Published in 1991, “Margin of Safety” by Seth Klarman didn’t initially garner much attention. In fact, only about 5,000 copies were printed, and its first two editors even left the publisher before it went into print.
Little did anyone know that Klarman’s hedge fund, Baupost Group, would go on to achieve one of the most remarkable investment performances in the industry, averaging around 20% annual returns since the 1980s.
The book’s scarcity and Klarman’s refusal to reissue it have turned it into a cult classic and a highly sought-after collectors’ item. Signed copies can fetch several thousand dollars each, while unsigned ones, originally priced at $25, now go for around $2,000.
It is so valuable that libraries with a copy take special precautions to safeguard them due to the risk of theft.
Even the legendary investor Warren Buffett is said to have kept a copy of Klarman’s book on his desk.
Part of the reason the “Margin of Safety” framework used at Baupost Group became so successful is that Klarman has as much skepticism about as-reported metrics as we do here at Valens.
Klarman has regularly railed against the issues with as-reported 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 metrics.
To show how this framework lines up with Valens’ Uniform Accounting, we’ve done a high-level portfolio audit of Baupost’s top holdings based on their most recent 13-F.
Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.
These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.
It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.
See for yourself below.
Looking at as-reported accounting numbers, investors would think that the “Margin of Safety” author is not successful at all.
On an as-reported basis, many of the companies in the fund are poor performers. The average as-reported ROA for the top 15 holdings of the fund is 3%, which is significantly below the U.S. corporate average.
However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return in Baupost Group’s top 15 holdings is actually 51%.
As the distortions from as-reported accounting are removed, we can see that Liberty SiriusXM Group (LSXM.K) isn’t a 4% return business. Its Uniform ROA is a whopping 245%.
Meanwhile, Fidelity National Information Services (FIS) looks almost like an unprofitable company with only a 1% return, but this massive payments company actually powers a 61% Uniform ROA.
That being said, to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent 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.
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 average Uniform ROA among Baupost Group’s top 15 holdings is actually 51% which is much better than the corporate average in the United States.
- 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 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 are 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, the average Uniform P/E across the investing universe is roughly 20x.
Embedded Expectations Analysis of Baupost Group paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to remain at current levels with a slight decline in profitability. However, the market thinks these companies will be destroyed and their returns will almost halve.
Analysts forecast the portfolio holdings on average to see Uniform ROA slightly decrease to 46% over the next two years. At current valuations, the market’s expectations are way lower than analysts and it expects a 26% Uniform ROA for the companies in the portfolio.
For instance, Liberty Global (LBTY.A) returned 26% this year. Analysts think its returns will be around the same levels with a 24% return. At a 1.9x Uniform P/E, the market expects profitability to fall significantly lower and is pricing Uniform ROA to be as low as 3%.
Similarly, Fiserv’s (FISV) Uniform ROA is 82%. Analysts expect its returns will decline to 75%, but the market is highly pessimistic about the company’s future and pricing its returns to be almost halved around 46%.
Overall, it’s highly clear what made Klarman and his “Margin of Safety” framework so successful. He does not focus on the noise and misleading nature of as-reported metrics and understands the true profitability of the companies.
Additionally, he understands that much of the value is created by finding high-quality, high-return names that the market has low expectations of.
This is exactly what we are focusing on at Valens, evaluating the current valuations of companies by utilizing the market’s expectations, and their true profitability is a crucial part of success in investing. Investors should be highly careful about it and shouldn’t jump on an investment opportunity before considering these factors.
This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and 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 has 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 Baupost Group’s largest holdings.
SUMMARY and Liberty Global plc Tearsheet
As one of Baupost Group’s largest individual stock holdings, we’re highlighting Liberty Global plc (LBTY.A:USA) tearsheet today.
As the Uniform Accounting tearsheet for Liberty Global plc highlights, its Uniform P/E trades at 1.7x, which is below the global corporate average of 18.4x, and its historical average of 10.5x.
Low P/Es require low EPS growth to sustain them. In the case of Liberty Global plc, the company has recently shown 591% Uniform EPS shrinkage.
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, Liberty Global plc’s Wall Street analyst-driven forecast is for EPS to shrink by 41% in 2023 and grow by 55% in 2024.
Furthermore, the company’s return on assets was 26% in 2022, which is 4x the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 80bps above the risk-free rate. Together, these signal low operating risks and low credit risks.
Lastly, Liberty Global plc’s Uniform earnings growth is above peer averages, and below peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.