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Seth Klarman Explains Why Investors Need an Edge in Today's Market

Seth Klarman (Trades, Portfolio) is widely considered to be one of the best value investors alive today.

Over the past few decades, as the head of the multibillion-dollar hedge fund Baupost, Klarman has achieved outstanding returns for himself and his investors by buying deeply undervalued assets at a fraction of their intrinsic value and holding for the long term.

Looking for value

Klarman is not afraid to invest whenever he sees value. For example, he has recently been reported to be buying insurance claims against the bankrupt Californian utility PG&E (NYSE:PCG).

In the past, he's also bought the debt of Irish banks, distressed real estate, distressed credit, stocks and a range of esoteric assets. All of these assets had one common feature: they were available to buy at a deep discount to intrinsic value.

I do not think it is unreasonable to say that one of the reasons why this value investor has achieved such a fantastic record over the past few decades is his ability and willingness to invest where many others cannot. Baupost has been known to hold as much as 40% of assets under management in cash, which gives the firm a huge amount of optionality.

With so much liquidity on the balance sheet, Klarman and his team can act quickly to take advantage of market opportunities when they present themselves. On top of this, the firm is not limited on where it can invest.

As I noted above, in the past, Baupost has bought real estate, insurance claims and distressed debt as well as stocks. Some of these markets are still highly efficient.

Having this edge is critical to succeeding in modern markets, according to Klarman. He once declared:

"To succeed in today's overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resources provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do you benefit from watching the competition at work."

The state of markets

I think this statement defines the current state of financial markets.

In the 1950s, when Warren Buffett (Trades, Portfolio) was starting, it was quite challenging to find securities that the rest of the market was overlooking. Investors had to do the legwork to find the stocks by reading annual reports, visiting managers and even sending out advertisements to buy shares.

Today, the whole process is much easier. In 30 seconds, I can scan the market for companies selling for less than book value, and in a few clicks, I can download the annual report. There are tens of thousands of investors all around the world doing the same thing. Meanwhile, Wall Street is in the middle of a tech and brains arms race.

How can the average investor compete against Wall Street and everyone else chasing value? The key is to focus on a specific niche, as Klarman advises. That's something Buffett advocates as well, although he calls it the circle of competence.

Whichever definition you want to use, the takeaway is the same. To get an edge in today's market, you need an advantage over everyone else. This edge can be something as simple as having a unique insight into a company as an employee, or as complex as understanding debt or insurance contracts better than others.

From there, you should stick to your circle of competence, stay with what you know and use your advantage to gain an edge over the rest of the market.

Disclosure: The author owns no stocks mentioned.

Read more here:

  • Warren Buffett: Waht to Look For in an Annual Report
  • Some Insight Into How Buffett Has Used Float to Leverage His Returns
  • Warren Buffett's Thoughts on Finding Good Managers

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This article first appeared on GuruFocus.