Investing, says Seth Klarman, used to be like checkers. Now it's like chess–a lot more complicated.
Mr. Klarman runs Baupost Group, a Boston-based investment firm with about $22 billion under management. For the uninitiated, he's a conservative value investor and one of the most highly regarded in the market. He doesn't share his market insights that often, so when he does it's worth listening. Tuesday morning he spoke at a conference for financial industry professionals at the CFA Institute in Boston, in a session hosted by my colleague Jason Zweig.
On the issue of checkers or chess, Mr. Klarman said he was trying to illustrate the way successful investing today involves complicating new factors and dimensions.
In particular, he is looking at the deluge of government interventions to prop up the financial system in the past couple of years and what those may mean down the road. And he is talking about the danger–not a certainty, merely a danger–that governments around the world will trash their currencies in a continuous free-for-all of "handouts and no taxes." The near-$1 trillion bailout in Europe is just the latest worry.
Where does this leave the ordinary investor?
Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash.
On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit [i.e. bond] side it's been overblown. Things are now being priced for almost perfection." (In other words, the prices are already assuming rosy future scenarios. If things get worse investors will be in trouble.)
Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again.
On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example. Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies."
He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to."
Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value.
Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.
Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits.
These things are far too abstruse for most ordinary investors, though perhaps not for the sophisticated. It's a shame that very few mutual funds open to the ordinary public are able to take these kinds of sensible steps.
So where does Mr. Klarman see opportunities for investors now? Very few, it seems. He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value.
Investors always want to know what a sage like Seth Klarman thinks about assets today, but his most valuable advice is perennial. "We are highly opportunistic," he says. "I will be buying what other people are selling. I will be buying what is loathed and despised."
Hmmm. Europe, anyone?