09 Seth Klarman & Baupost Group

Seth Klarman was born in New York City and grew up in Baltimore.

His mother started her career as an English teacher and then became a psychiatric social worker, while his father, a health economist, taught at Johns Hopkins and NYU.

Seth Klarman's interest in business reportedly began at the age of four, when he redecorated his room to match a retail store by putting price tags on his possessions. At ten, he bought his first stock, Johnson & Johnson.

The reason why he picked the healthcare giant was pretty simple: he used a lot of Band-Aids as a kid. Though the choice was based more on instinct than analysis, the stock soon tripled in value.

Seth Klarman studied economics at Cornell University. When he was an intern at Mutual Shares Fund, he was mentored by Max Heine and Michael Price, both of whom were disciples of Benjamin Graham.

Three years later, he left the company and pursued his studies at Harvard Business School. He co-founded Baupost Group with his professor and three other investors upon graduation.

Following Graham's footsteps, Klarman sticks to the principles of value investing.

He focuses on long-term performance instead of quick returns. He says, "Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized."

There are three pillars at the heart of Seth Klarman's overall strategy: focus on risk before return, absolute over relative performance, and investing bottom up rather than top down.

Seth Klarman outlines three critical approaches for investors to reduce risk in his book "Margin of Safety": diversify adequately, hedge when appropriate, and invest with a margin of safety.

In Klarman's view, diversification does not refer to the number of stocks in your portfolio but the sort of risks you take on. He explained: "Diversification is not how many different things you own, but how different the things you do own are in the risks they entail." For example, a diversified portfolio of junk bonds still carries very high risk.

Klarman also stresses that investors should always have a "margin of safety" because it can "allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world."

According to Klarman, there are only three ways to value a stock: going-concern value, liquidation value, and the market value of equities.

Businesses that consistently generate cash are most suited for going-concern values. The category can be further divided into discounted cash flow and private market value. However, there is an unsolvable paradox: to perform present value analysis, you must make predictions, which can be wrong.

Liquidation value is more conservative as it only considers a business's tangible assets. However an asset becomes an attractive investment when priced at its liquidation value.

The market value approach also works because securities of the same type are generally traded at similar prices. So investors can use multiples, or financial metrics, to compare companies within the same industry.