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Analyzing Seth Klarman's Investing Style

In "The Little Book That Beats the Market," Seth Klarman of Baupost posits his value investment style. He wants stocks in the top half of each of 1) returns on capital (NYSE:ROC), or underlying profitability, and 2) the earnings yield, which is the inverse of the P/E ratio. (A high earnings yield means a low P/E ratio or a cheap stock.) The sum of the two (relative) scores are added, and stocks are selected on this metric.

These simple screens select stocks in the top fourth of desirability. As a practical matter, it is more like top fifth, or quintile, since the system doesn't cater to stocks that "just make" the screens, falling in the 5% sliver between the 75th and 80th percentile.

Almost by definition, stocks with high ROC's are likely to generate earnings momentum, either now, or in the future. But the high earnings yields (low P/E's) almost "guarantee" that the earnings momentum will be in the future, rather than "now." (If it were now, the P/E probably wouldn't be in the cheap half. So the idea is to get tomorrow's performer (and probable bargain) at today's price.

The result is when the system outperforms, it will be based on yesterday's, rather than today's picks. As a result, a certain amount of patience is needed. The system doesn't beat the market every year, but tends to outperform over three year periods. That's a short enough time frame for most value investors.