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PORTFOLIO TALK A BOTTOM FISHER REVEALS HIS CATCH(FORTUNE Magazine)By Seth Klarman Brett Duval FromsonJune 18, 1990(FORTUNE Magazine) – In these financially dicey times, many money managers talkabout buying the securities of bankrupt or distressed companies, but few put theirclients' money on the line. An exception is Seth Klarman, 33, president of BaupostGroup in Cambridge, Massachusetts. From a warren of paper-strewn rooms just offHarvard Square, Klarman tends $300 million for 25 well-to-do families. Since the first ofhis investment portfolios was formed in early 1983, his clients have had an averageannual return of 25%, beating the total return on Standard & Poor's 500-stock index bymore than seven percentage points. Klarman is already acclaimed by his peers on WallStreet as one of the young generation's best value investors. In an interview withFORTUNE's Brett Duval Fromson, he tells where he is finding bargains today.What is your investing approach? We try to buy dollars for 50 cents, and to realize thedollar before too much time passes. We look for catalysts that will promptly precipitatethe realization of the underlying value in a stock or bond.More from FortuneNo party for Citi's owners: You and meIs it time to buy American Express?GE: The global stimulus bellwetherFORTUNE 500Current IssueSubscribe to FortuneHow do you value securities in today's financial environment? Very conservatively. Adollar of value is not what a bunch of debt-financed maniacs might want to pay forsomething. The question we ask ourselves is, ''What would we be willing to pay to owna security forever?'' Then we determine whether we can buy it at a discount from thatfigure. If, for example, we would buy equity in a broadcasting company only at seventimes cash flow and the stock is already selling at that multiple, we would not find itcompelling.So what is compelling? We are 70% invested, and most of that money is in thesecurities of distressed and bankrupt companies. This is a wonderful time to scavenge,for the supply of these securities is large and growing.How do you distinguish ''good'' junk bonds from ''bad'' junk? The distinction is hair-thin.We see opportunity only in bad junk bonds trading at 20 cents to 40 cents on the dollar,which have already been clobbered. Even then the opportunities to find value are fewand far between.Give an example of good junk that fell from grace and now looks undervalued. The mostfascinating example I'm able to talk about is Harcourt Brace Jovanovich. It has two

businesses, insurance and publishing. In August 1989 the total market capitalization ofall Harcourt's securities, debt and equity, was about $4.6 billion. That included its themeparks, which have since been sold for $1.1 billion, with the proceeds used to retire bankdebt. That should have lowered the market capitalization to about $3.5 billion. Instead, itdove to $1 billion because of panic selling in the junk bond market by people whobought at par, and has recovered to only $1.4 billion.What is Harcourt's real worth? Between $1.4 billion and $1.7 billion. Studious analysts,not delirious people on Wall Street, use numbers more optimistic than ours. Thepublishing operations should earn $130 million to $140 million pretax in 1990, a toughyear for the business. The insurance company will contribute another $50 million. If youassume the company had no debt and was valued on an all-equity basis at a multiple of12 times after-tax earnings, that translates into a value of $1.4 billion.Which of the bonds are the best buy? The zero-coupon and paid-in-kind subordinateddebentures. We began buying them in the 30s. At those prices they were ludicrouslycheap. Today they trade at about 40 cents on the dollar, and we think the bonds areworth close to par value.What is the catalyst to realize that value? The pressure to pay off the debt tends to put afirecracker under management. Either the company will tender for the bonds atsomething less than par but above their unceremoniously low prices, or, if they cannot,bankruptcy will lead to the underlying values being realized through a court- orderedreorganization or liquidation.Are you finding value in any common stocks? Only in a very few small-capitalizationstocks like United Foods, a vegetable-processing company. On a per-share basis, bookvalue is about $4, and the company earned 63 cents in its last fiscal year, but the recentstock price is only $2.50. United Foods is ignored because small stocks haven't beenperforming well lately, and Wall Street, with its rearview mirror approach to investing,stays away from them. How often can you buy a stock at four times earnings and two-thirds of book value?Any other stocks? One of the cheaper situations is Safeguard Scientifics. I view it as a( closed-end mutual fund. The company owns stock in a host of companies, includingNovell, a software network company; CompuCom, a computer retailer; Rabbit Software;QVC Network, a cable home shopping company; and CenterCore, an office furniturecompany. Safeguard Scientifics also has controlling positions in about ten privatecompanies. The market capitalization is only $70 million, yet the company's holdings ofNovell alone are worth that much based on its recent price. So you effectively geteverything else for free. Conservatively, the net asset value of the company is north of$25 a share. But the stock languishes at $13.75.What catalyst will unlock this value? We can't see one. But even if the company alwaystrades for 50% of its true value, as long as management continues to build thebusiness, the price will go up.