Seth Klarman is not only the author of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, a book on value investing, but he is also the founder and president of the Baupost Group, a Boston-based private investment partnership. Klarman attended Cornell University, where he got an economics' degree, and later attended Harvard University, where he earned an M.B.A.
Seth Klarman considers that the most important way of operating is to keep a high degree of risk aversion. He thinks that the first thing to take into account is not to lose money, and the second one is never forget about the first one. Thus, he believes that value investors have to avoid losing money this is a primary rule. Klarman's value investment strategy includes three key elements:
- A bottom-up approach, searching via fundamental analysis
- Supreme return strategy
- Be aware of the risk
Klarman also recommends keeping some cash in the side pocket to avoid forced liquidation. Besides, the investment's duration should be equal to the duration of the capital.
RISK = (AMOUNT OF LOSS) X (PROBABILITY OF LOSING)
For Klarman the risk is determined by how much the potential loss is and by what is the probability of losing.
He thinks that an investor can counteract risk by diversification, hedging (if necessary) and invest with a margin of safety.
From an individual investor's perspective, I find truly interesting to focus on stocks that are large holdings in Seth Klarman's portfolio. I analyzed them and found some reasons why Seth Klarman could have been attracted to invest. I look for companies that I can understand, with favorable long-term prospects that are operated by competent people and, importantly, are available at attractive prices.
Protein Design Labs Inc. (PDLI) is a biopharmaceutical company which main activity is the research, development and commercialization of novel therapies for inflammation and autoimmune diseases, acute cardiac conditions and cancer. PDL trades various biopharmaceutical products in the United States through its hospital sales force and wholly-owned subsidiary, ESP Pharma, Inc. As a leader in the development of humanized antibodies, PDL has licensed its patents to numerous pharmaceutical and biotechnology companies, some of which are now paying royalties on net sales of licensed products.
Mr. Klarman was attracted by the good revenues of PDLI. Total revenues in 2011 were $362 million, compared to $345 million in 2010, with royalty revenues growing two percent over full year 2010. For the fourth quarter of 2011, total revenues were $72.8 million, compared to $76.1 million in the fourth quarter of 2010.
Royalty revenues for the fourth quarter of 2011 are based on third quarter product sales by PDL's licensees. The fourth quarter 2011 revenue decline is primarily driven by reduced royalties from third quarter 2011 sales of Avastin ® and Herceptin ® , which are marketed by Genentech and Roche, partially offset by increased royalties from third quarter 2011 sales of Lucentis, which is marketed by Genentech and Novartis, and Tysabri, which is marketed by Elan and Biogen Idec. Royalty revenue for the fourth quarter and 2011 are net of payments made under our February 2011 settlement agreement with Novartis Pharma AG.
As regards operating expenses, in 2011 the number was $18.3 million, compared to $133.9 million in 2010. A $92.5 million legal settlement with MedImmune and $41.4 million in general and administrative expenses are included in operating expenses of 2010. For the fourth quarter of 2011, general and administrative expenses were $4.8 million compared to $12.1 million for the same period of 2010.
Another very good result for PDL was its net income of $199.4 million for 2011, or $1.15 per diluted share compared to its net income of $91.9 million in 2010 or $0.54 per diluted share. Net income for the fourth quarter of 2011 was $38.9 million or $0.24 per diluted share as compared with a net loss of $24.5 million or $(0.18) per diluted share for the same period of 2010.Non-GAAP net income for 2011 was $201.6 million, or $1.17 per diluted share, adjusting for effects of certain convertible note transactions throughout the year. Non-GAAP net income was $168.4 million, or $0.97 per diluted share in 2010, adjusting for the legal settlement with MedImmune and the effects of certain convertible note transactions in that year. Non-GAAP net income for the fourth quarter of 2011 was $39.6 million, or $0.24 per diluted share, compared to non-GAAP net income of $35.0 million, or $0.20 per diluted share for the fourth quarter of 2010.
Net cash provided by operating activities in 2011 was $169.8 million, compared with $184.3 million in 2010. At December 31, 2011, PDL had cash, cash equivalents and investments of $227.9 million, compared with $248.2 million at December 31, 2010.
PDL's current net profit margin is 55.07%, currently higher than its 2010 margin of 26.63%. I like companies that increased profit margins in comparison to other years. It is essential to know the reason why that happened.
In terms of income and revenue growth, PDL has a 3-year average revenue growth of 7.16 and a 3-year net income average growth of 42.86%. Its current revenue year-over-year growth is 4.95%, lower than its 2010 revenue growth of 8.42%. I do not like when current revenue growth is less than the past year. It generally shows that business is decelerating for some reason. The current net income year-over-year growth is 117.02%, higher than its 2010 net Income y/y growth of -51.56%. I like when net income growth is higher than the past.
In terms of Valuation Ratios, PDL is trading at a Price/Book of -4.3 x, a Price/Sales of 3.1 x and a Price/Cash Flow of 6.6 x in comparison to its Industry Averages of 5.0x Book, 5.5 x Sales and 27.2 x Cash Flow. It is essential to analyze the current valuation of PDL and check how it is trading in relation to its peer group.
Ituran Location and Control
Ituran (ITRN) provides location-based services, which consist mostly of stolen vehicle recovery and tracking services and wireless communications products used in connection with its location-based services and several other applications as well. Ituran grants mobile asset location, Stolen Vehicle Recovery, management & control services for vehicles, cargo and personal security, and radio frequency identification products for a number of purposes, including automatic meter reading, electronic toll collection and homeland security applications.
ITRN's current net profit margin is 5.89%, currently lower than its 2010 margin of 14.99% I do not like when companies have lower profit margins than the past. That could be a reason to analyze why that happened. Current return in equity for ITRN is 7.22 lower than the +20% standard I look for in companies I invest in, but also lower than its average ROE of 15.18%.
In terms of income and revenue growth, ITRN has a 3-year average revenue growth of 5.80% and a 3-year net income average growth of -44.71%. Its current revenue year-over-year growth is 21.79%, higher than its 2010 revenue growth of -8.47%. The fact that revenue increased from last year shows me that the business is performing well.
The current net income year over year growth is -52.17%, lower than its 2010 net income y/y growth of 22.24%. I do not like when current net income growth is less than the past year. I look for companies that increase both profits and revenues.
In terms of Valuation Ratios, ITRN is trading at a Price/Book of 3.1 x, a Price/Sales of 1.7 x and a Price/Cash Flow of 6.6 x in comparison to its Industry Averages of 1.6x Book, 0.3 x Sales and 15.9 x Cash Flow. It is essential to analyze the current valuation of ITRN and check how it is trading in relation to its peer group.
London, England-based BP plc (BP) is one of the largest energy companies worldwide, which provides its clients with fuel for transportation, energy for heat and light, retail services and petrochemical products. It operates in three areas: Exploration and Production, Refining and Marketing, and Other Businesses and Corporate. Of the total 2010 revenue of the company, Refining and Marketing, Exploration and Production, and Other Businesses and Corporate segments accounted for 89%, 10% and 1%, respectively.
A very positive aspect which led Klarman to invest on BP is that it is not offloading its non-core upstream properties but also it is creating a portfolio with potentially powerfull growth from a smaller base. Besides, BP is divesting the Carson, California and Texas City, Texas refineries, which hold half of its U.S. capacity. The sale is supposed to take place by the first half of next year. It has kept three refineries with the best competitive advantage, which is expected to raise returns.
BP keeps centered in a string of upstream activities. We consider that its new strategy of active portfolio management, higher exploration activity with further precautionary actions and refining and marketing repositioning as well will generate value for shareholders. From the beginning of this year through 2014, the firm expects to bring 17 additional material upstream projects online. The cash margins per barrel on these projects are thought to be double the average of BP s existing portfolio, and in turn boost cash flow.
The company also highlighted that half of the increment in cash flow would be spent on growth capex, while the balance would be allocated toward shareholder returns (dividends and/or share buybacks) and reducing debt to the lower half of its 10 20% target range.
BP's current net profit margin is 6.65%, currently higher than its 2010 margin of -1.23%. I like companies that increased profit margins in comparison to other years. It is essential to know the reason why that happened. Current return in equity for BP is 24.90% higher than the +20% standard I look for in companies I invest in, and also higher than its average ROE of -3.78%.
In terms of income and revenue growth, BP has a 3-year average revenue growth of 1.73% and a 3-year net income average growth of 6.7%. Its current revenue year-over-year growth is 25.10%, lower than its 2010 revenue growth of 26.63%. I do not like when current revenue growth is less than the past year. It generally shows that business is decelerating for some reason. The current net income year-over-year growth is 0.00%.
In terms of Valuation Ratios, BP is trading at a Price/Book of 1.3 x, a Price/Sales of 0.4 x and a Price/Cash Flow of 6.6 x in comparison to its Industry Averages of 1.7x Book, 0.7 x Sales and 5.8 x Cash Flow. It is essential to analyze the current valuation of BP and check how it is trading in relation to its peer group.
When talking about valuation we think that the gradual economic recovery which took place after the GoM tragedy and the company's focus on upstream activity are favorable factors. On the company's growth profile, management remains positive and looks forward to recovery, as well as consolidation to reduce operational risk or oil spill related tasks. We think the company's new strategy of active portfolio management, higher exploration activity, and refining and marketing repositioning will generate value for shareholders.
However, the British oil giant faces considerable risk from a decline in natural gas processing margins and a drop in domestic oil and gas drilling and end market demand, which could lower the growth rate.
BP should generate sufficient operating cash flows to cover its capital investment and dividends, minus a large and prolonged decline in oil and gas prices. Free cash flow and the company's recent asset divestments should sufficiently allow BP to fulfill its Macondo duties and either pay off or refinance near-term debt maturities.
Nowadays, Microsoft Corporation (MSFT) is one of the biggest broad-based technology producers worldwide. Despite the fact that software is the most significant revenue source, the company's offerings also include hardware and online services. Furthermore, Microsoft grants support services in the form of consultation, training and certification of system integrators and developers. The firm reports revenue in five separate areas, each of which targets a particular user group: Microsoft Business Division (30%), Server and Tools (24%), Entertainment and Devices Division (13%), Online Services Division (4%) and Windows & Windows Live (30%).
One important reason for Klarman investing in Microsoft is that the company is now taking steps to build a position in the mobile space. Late last year, the firm announced that it would begin to build an OS to support the ARM architecture, what was an important decision strategically, as most of the weakness in Intel's x86architecture is related to the power it consumes. This is the reason why it has failed to get traction in the mobile space, where battery life is of great significance.
As Microsoft's new Windows 8 OS supports ARM architecture, the company will be better placed in the mobile computing space (a sector where it keeps on lagging the iOS and Android significantly). What is more, Windows is a much better-known and familiar OS with backward compatibility, so there should be some stickiness in demand. The new OS is expected to launch next year (we think the second half), so there should be important traction in Windows demand thereafter.
Microsoft's Bing search engine is taking market share. Even though most of the recent achievements have been thanks to Yahoo, there is reason to think that the firm is also chipping away at Google in specific verticals, such as travel. Furthermore, share gains are not just limited to the U.S.; some powerful Google markets, such as the U.K. are also showing a slight movement in preferences. Strategic actions, such as the agreement with HP to put Bing as the default search engine on most of its PCs have undoubtedly contributed. Apple is becoming a bigger Google competitor, which could prove to be of strategic significance to Microsoft. For instance, Apple renamed the search tab on its devices, changing from Google Search to Search, possibly showing that it could offer choices here. We are also encouraged to see that while the fledgling search business keeps generating losses, these losses are on a gradual decline. More improvements could therefore be around the corner.
MSFT's current net profit margin is 33.1%, currently higher than its 2010 margin of 30.02%. I like companies that increased profit margins in comparison to other years. It is essential to know the reason why that happened. Current return in equity for MSFT is 44.84% higher than the +20% standard I look for in companies I invest in, and also higher than its average ROE of 43.76%.
In terms of income and revenue growth, MSFT has a 3-year average revenue growth of 5.00% and a 3-year net income average growth of 9.40%. Its current revenue year-over-year growth is 11.94%, higher than its 2010 revenue growth of 6.93%. The fact that revenue increased from last year show me that the business is performing well. The current net income year over year growth is 23.40% lower than its 2010 net income y/y growth of 28.77%. I do not like when current net income growth is less than the past year. I look for companies that increases both profits and revenues.
In terms of Valuation Ratios, MSFT is trading at a Price/Book of 4.2 x, a Price/Sales of 3.8 x and a Price/Cash Flow of 9.4 x in comparison to its Industry Averages of 4.1x Book, 4.0 x Sales and 10.8 x Cash Flow. It is essential to analyze the current valuation of MSFT and check how it is trading in relation to its peer group.
In terms of valuation, Microsoft shares are now trading at 10.8X its trailing twelve months earnings compared to 43.6X for the peer group and 13.9X for the S&P 500. The important discount to the peer group is a consequence of the investor concerns regarding Microsoft s share losses in mobile computing platforms. Nonetheless, while this is a near-term negative, we expect Windows 8 to gain traction next year.
During the last five years, the shares have traded in the range of 8.6X to 23.2X trailing twelve months earnings. Thus, it is currently trading at the low end of the historical range. The company is also trading at an important discount based on forward estimates for fiscal 2012 and 2013. The current 75% discount to the peer group based on the 2012 estimate is somewhat better than the historical average of 66%. Consequently, the shares are likely to trade up.
In conclusion, we can say that Microsoft has a solid balance sheet, with nearly $52 billion in cash and cash equivalents, and about $12 billion in debt. We wait the firm to generate more than $20 billion in free cash flow annually, allowing it to comfortably service the debt while keeping on investing in expanding the business.