Seth Klarman & Monish Pabrai’s Portfolio Rebalancing Master Class

February 19, 2018

Seth Klarman & Monish Pabrai’s Portfolio Rebalancing Master Class

  • Both Pabrai and Klarman have huge cash positions, but what’s interesting is that they both rebalance their positions in relation to the risk.



Introduction

Monish Pabrai and Seth Klarman are among the top value investors managing significant sums of money.

Pabrai is a Buffett devotee. You can read more about him in our article here, or read his book The Dhando Investor: The Low Risk Method to High Returns.

Klarman is the manager of the Baupost Group, a $30+ billion hedge fund. He’s also famous for his book The Margin of Safety. The book is a bit pricey, but you can read my series of articles about the book here.

Both can be called value investors and therefore it’s always interesting to learn from their transactions. Today, we’re going to discuss their Q4 2017 U.S. portfolios and transactions in order to shed more light on portfolio rebalancing, a tool often overlooked by many investors.

Pabrai’s Holdings

Parbai’s U.S. holdings make up less than 30% of his portfolio at the moment. He used to keep more than 75% in the U.S.

The reason behind such a low exposure is rebalancing according to valuation. More than six months ago, Pabrai was talking about how the market was overvalued in the U.S. and that he was finding it very difficult to find something to buy.

Currently, Pabrai’s U.S. portfolio consists of only 5 stocks and 3 of those stocks  make up more than 80% of his total U.S. holdings – Fiat Chrysler (NYSE: FCAU), Alphabet (NASDAQ: GOOG), and Aercap (NYSE: AER). The other two positions are Ferrari (NYSE: RACE) which was spun off from FCAU, and Southwest Airlines (NYSE: LUV), a position that has already been rebalanced in response to the stock price increasing over the last two years.

Pabrai started buying GOOG at prices below $500 and sold more than 30% of his position in Q4 2017. He also sold more than 20% of AER. So FCAU has quickly become his largest U.S. portfolio position by far.

I remember a few years ago I listened to him talking about FCAU, how the company would probably achieve earnings of $4 per share somewhere in 2018 and how it was extremely undervalued at $7 – the level he started buying at prior to the Ferrari spin-off.

Figure 1: FCAU in the last 5 years. Source: Google.



He definitely got this one right. He hasn’t yet rebalanced, or if he has, we don’t know it yet because the data only goes to Q4 2017.

In listening to Pabrai’s interviews, he often focuses on individual stocks just as he did with FCAU, but he also expresses his general concern about how stocks will perform in the future and how interest rates will evolve in the next 5 to 10 years.

This is exactly what most retail investors completely forget. It’s about how interest rates will move in the next 5+ years, not about the current spreads compared to stocks. As the 10-year yield is approaching 3%, I’ll dedicate my next article to it as it is of the utmost importance.

Pabrai’s fair value estimation for FCAU was $25, or $30 in the case of a takeover. As $25 was almost reached last month, he may have already sold part of his position. Further, what’s interesting—and something that many fail to grasp—is that with earnings of $4 and a price of $24, FCAU’s price to earnings ratio would only be 6 which many would see as cheap, but the reason behind the cheapness is the cyclical nature of the business which inevitably loses money in an economic downturn.

Back to the rebalancing, why did Pabrai sell just part of GOOG and AER and not all of it? Well, apart from being largely in cash just as Buffett and Klarman are, selling part of a position when the margin of safety is lower allows you to take advantage of the volatility, book some returns, and even buy more if the stock price drops later on. The key to rebalancing here is to limit risk while catching those small positive returns from selling part of a position.

Klarman – Merger Arbitrage 

In extremely overvalued markets, Klarman—just as Buffett is doing with Monsanto being acquired by Bayer—is engaging in merger arbitrage. He has opened a position in Time Warner (NYSE: TWX) when the price of the stock fell to $88 in Q4 2017, implying a 20% return if the deal goes through, i.e. if AT&T (NYSE: T) acquires TWX for $107.

A stock that Klarman rebalances often is Allergan (NYSE: AGN). The position was significantly increased last quarter as the stock kept falling, while the stock will probably be sold as soon as if crosses $200 again just as was in Q1 2017 when Klarman sold part of the position he bought at lower levels.

Conclusion On Portfolio Rebalancing

The key to portfolio rebalancing is cash which all of the above mentioned investors have in abundance at the moment.

The second interesting rebalancing attitude shown above is that when a stock drops, these investors are ready to buy more while they sell when the stock returns to a previous level.



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