Stock market investing strategy from Seth Klarman disciple David Stein - Business Insider

David Stein, former chief investment strategist and chief portfolio strategist at Fund Evaluation Group — a $70 billion investment advisory firm — homed in on his investment strategy under the influence of billionaire investor Seth Klarman. He advocates for a focus on the drivers of returns: dividend yield, earnings growth, and emotion to make the investment landscape less wishy-washy. Stein also has a new book coming out called “Money for the Rest of Us: 10 Questions to Master Successful Investing,” and is the host of a successful podcast.Click here for more BI Prime stories.Financial markets are anything but predictable. Just ask the guys at Long Term Capital Management. No one has an untarnished record. Not Benjamin Graham. Not Peter Lynch. Not even Warren Buffett.But in a world with so much ambiguity and competition — where Ph.Ds, Nobel laureates, and Ivy Leaguers gear up to go head-to-head — how can an investor effectively allocate？ That's where David Stein — former chief investment strategist and chief portfolio strategist at Fund Evaluation Group, a $70 billion investment advisory firm — comes in. And he's here to offer a helping hand.Early in his career, Stein was influenced through his exposure to Seth Klarman — the legendary, billionaire investor and author of Margin of Safety — and adopted many of his diversified, value driven strategies along the way.“I spent a lot of time with Seth Klarman of the Baupost Group, who managed money for one of my private foundation clients,” he said. “And I realized, just admiring how he invests — I mean, he's one of the best investors ever — he's an asset allocator.”By watching Klarman's every move, he was able to learn the ins and outs of value investing — and he took full advantage of the sage advice. When others were rushing for the exits, Klarman kept his head and bought downtrodden, out-of-favor shares.“My approach to investing has always been focusing on asset allocation, what's interesting, where are people being overly fearful to where they're not paying very much for cash flow and cash flow growth,” he said in an exclusive interview with Business Insider. “I spend a lot of time just teaching people the drivers of returns.”He continued: “Basic rules of thumb that people don't consider.”Stein's strategy for uncovering profitable investments is rather simple. It all comes down to dividend yield, earnings growth, and changes in valuations. Nail those three factors, and the future becomes much less nebulous. These are the factors that drive returns.But before we dive in, it's important to note that Stein isn't trying to pinpoint tops and bottoms or even specific stocks. He's just trying to narrow down his investment universe in order to get a better idea of where to allocate his money most efficiently. “The highest degree of predictability is the cash flow: What is its current income yield,” he said. “If you can lock in the dividend yield, that's the most predictable — and then it gets more challenging after that.”Throughout history, dividend yields have generally settled in a range of 3% to 4%. Stein says that if you can find stocks that are yielding more than this, that's an attractive starting point. It takes the pressure off of cash-flow growth. You've already locked in a predictable income stream and now don't have to rely heavily on growth to meet expectations.The importance of earningsNext up is earnings growth.“Earnings — typically — for stocks is a reasonable 3% to 4%,” he said. “You add that to the dividend yield, so then you're up to six percent.”Stein refers to the notion above as the “math of investing” — and uses this historical data as a measuring stick. It's a valuable gauge to juxtapose other assets against. He whittles down until potential allocations look ripe for the picking.But there's still one more variable that hasn't been factored in yet: emotion.“The emotion is what investors are paying for those cash flows, and how that changes,” he said. “That's the least predictable.” A real-time measure of emotion is the price-to-earnings ratio, which demonstrates how much investors are currently willing to pay for $1 of earnings.Today, the S&P 500's price-to-earnings ratio is just below 20. Historically, it's been around 17, which means that (theoretically) stocks are on the loftier side of valuations.When investors aren't willing to pay much for cash flow growth — that's when Stein thinks it's time to give that asset class a closer look.According to him, that time isn't now. He's in wait and see mode.“It's not like things are hugely overvalued,” he said. “I'm being conservative.”With all of that under consideration, these ideas may seem rudimentary on the surface, but many investors overlook them. They're blinded by the sexiness and story of a company without focusing on the important factors that drive returns. To Stein, this is a fools errand.