Seth Klarman (Trades, Portfolio) is a value investor through and through. He's willing to invest wherever he sees value in the market, even if that means buying into bankrupt companies such as Enron or PG&E (PCG, Financial).
The key to Klarman's long-term success has been risk analysis. He believes that every investor should start their research process with a review of the risks involved in taking a position. Once you've figured that out, you can start looking at the potential profit if everything goes to plan.
No shortcuts
Unfortunately, there is no shortcut investors can use to analyze a company and its riskiness. There is no substitute for time and effort. However, Klarman has issued some advice for investors who want to streamline the process.
Writing in his now out of print book, "The Margin of Safety," Klarman said:
"Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat. The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market."
What Klarman is describing here is pretty similar to the Pareto Principle. The Pareto Principle states that 80% of the effects come from 20% of the causes, or in this case, 80% of the results come from 20% of the research.
For example, if you look at a company's balance sheet, there are potentially hundreds of data points to consider, but how many of these will have a direct impact on the investment outcome? In my opinion, metrics like debt and gearing have much more influence on the long-term outcome of an investment than accounts receivable.
Getting hold of and analyzing this 20% of the data is the hard part. It all comes down to knowing what you're looking for. On this topic, we can look to Charlie Munger (Trades, Portfolio) for advice.
Building mental models
Charlie Munger (Trades, Portfolio)'s thoughts on mental models can help us construct a loose framework for finding that 20% of information that's most important to the investment outcome.
Munger explained this principle at a speech in 1999:
"Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head."
Mental models can help break down large chunks of information about businesses into manageable bites. These bites of information can then hang off the latticework of analysis to help you form a suitable conclusion.
No matter how you approach it, good, detailed investment research is always going to take time and effort. Using mental models to help break down the volume of work and analyze specific parts of businesses can help you through the process.
Concentrating on the most important factors can also help you reach a suitable conclusion in as little time as possible to help prevent psychological biases creeping into the analysis.
These are my thoughts on how Klarman and Munger can help us streamline our research process and reach a suitable conclusion on an investment straightforwardly and reliably.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman Explains why Investors Need an Edge in Today's Market
- Warren Buffett: Waht to Look For in an Annual Report
- Some Insight Into How Buffett Has Used Float to Leverage His Returns
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