PORTFOLIO TALK A BOTTOM FISHER REVEALS HIS CATCH (FORTUNE Magazine) By Seth Klarman Brett Duval Fromson June

18, 1990 (FORTUNE Magazine) – In these financially dicey times, many money managers talk about buying the securities of bankrupt or distressed companies, but few put their clients' money on the line. An exception is Seth Klarman, 33, president of Baupost Group in Cambridge, Massachusetts. From a warren of paper-strewn rooms just off Harvard Square, Klarman tends $300 million for 25 well-to-do families. Since the first of his investment portfolios was formed in early 1983, his clients have had an average annual return of 25%, beating the total return on Standard & Poor's 500-stock index by more than seven percentage points. Klarman is already acclaimed by his peers on Wall Street as one of the young generation's best value investors. In an interview with FORTUNE'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 the dollar before too much time passes. We look for catalysts that will promptly precipitate the realization of the underlying value in a stock or bond. More from Fortune No party for Citi's owners: You and me Is it time to buy American Express? GE: The global stimulus bellwether FORTUNE 500 Current Issue Subscribe to Fortune How do you value securities in today's financial environment? Very conservatively. A dollar of value is not what a bunch of debt-financed maniacs might want to pay for something. The question we ask ourselves is, ''What would we be willing to pay to own a security forever?'' Then we determine whether we can buy it at a discount from that figure. If, for example, we would buy equity in a broadcasting company only at seven times cash flow and the stock is already selling at that multiple, we would not find it compelling. So what is compelling? We are 70% invested, and most of that money is in the securities 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 few and far between. Give an example of good junk that fell from grace and now looks undervalued. The most fascinating 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 of all Harcourt's securities, debt and equity, was about $4.6 billion. That included its theme parks, which have since been sold for $1.1 billion, with the proceeds used to retire bank debt. That should have lowered the market capitalization to about $3.5 billion. Instead, it dove to $1 billion because of panic selling in the junk bond market by people who bought 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. The publishing operations should earn $130 million to $140 million pretax in 1990, a tough year for the business. The insurance company will contribute another $50 million. If you assume the company had no debt and was valued on an all-equity basis at a multiple of 12 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 subordinated debentures. We began buying them in the 30s. At those prices they were ludicrously cheap. Today they trade at about 40 cents on the dollar, and we think the bonds are worth close to par value. What is the catalyst to realize that value? The pressure to pay off the debt tends to put a firecracker under management. Either the company will tender for the bonds at something 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- ordered reorganization or liquidation. Are you finding value in any common stocks? Only in a very few small-capitalization stocks like United Foods, a vegetable-processing company. On a per-share basis, book value is about $4, and the company earned 63 cents in its last fiscal year, but the recent stock price is only $2.50. United Foods is ignored because small stocks haven't been performing 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 twothirds 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, including Novell, a software network company; CompuCom, a computer retailer; Rabbit Software; QVC Network, a cable home shopping company; and CenterCore, an office furniture company. Safeguard Scientifics also has controlling positions in about ten private companies. The market capitalization is only $70 million, yet the company's holdings of Novell alone are worth that much based on its recent price. So you effectively get everything 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 always trades for 50% of its true value, as long as management continues to build the business, the price will go up.

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