Wednesday, September 29, 2010

Wisdom of Seth Klarman

Seth Klarman, of the Baupost Group, is one the greatest investors of all time. Here are some gems from his numerous letters to Baupost investors over the years.

One must understand the importance of an endless drive to get information and seek value.

Literally draw a detailed map—like an organization chart—of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull threads is the lesson that I learned from Mike Price.

Value investing works over a long period of time, outperforming the market by 1 or 2 percent a year, on average—a slender margin in a year, but not slender over the course of time, given the power of compounding.

The inability to hold cash and the pressure to be fully invested at all times meant that when the plug was pulled out of the tub, all boats dropped as the water rushed down the drain.

At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and—most of the time, if not all the time—add, rather than subtract, capital.

When managers are afraid of redemptions, they get liquid. We all saw how many managers went from leveraged long in 2007 to huge net cash in 2008, when the right thing to do in terms of value would have been to do the opposite.

We spend a lot of our time focusing on where the misguided selling is, where the redemptions are happening, where the over leverage is being liquidated—and so we are able to see a flow of instruments and securities that are more likely to be mispriced, and that lets us be nimble.

Benjamin Graham wrote, “Those with enterprise haven’t the money, and those with money haven’t the enterprise, to buy stocks when they are cheap.”

Graham’s wonderful sentence as, an investor needs only two things: cash and courage. Having only one of them is not enough.

The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters.

It’s awful to have a depression, but it’s a great thing to have a depression mentality because it means that we are not speculating, we are not living beyond our means, we don’t quit our job to take a big risk because we know we might not get another job. There is something stable about a country, a society built on those values.

A tipping point is invisible, as we just saw in Greece. In most situations, everything appears fine until it’s not fine, until, for example, no one shows up at a Treasury auction.

There is an old saying, “How did you go bankrupt?” And the answer is, “Gradually, and then suddenly.” The impending fiscal crisis in the United States will make its appearance in the same way.

A commodity doesn’t have the same characteristics as a security, characteristics that allow for analysis. Other than a recent sale or appreciation due to inflation, analyzing the current or future worth of a commodity is nearly impossible.

If an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.

Investors need to pick their poison: Either make more money when times are good and have a really ugly year every so often, or protect on the downside and don’t be at the party so long when things are good.

My experience is that short sellers do far better analysis than long buyers because they have to. The market is biased upward over time—as the saying goes, stocks are for the long run.

Typically, we make money when we buy things. We count the profits later, but we know we have captured them when we buy the bargain.

Never stop reading. History doesn’t repeat, but it does rhyme.

Jim Grant has a wonderful expression: In science, progress is cumulative, and in finance, progress is cyclical. Fads will come and go, and people will think we are on to a new thing in finance or investing; but the reality is that it is probably not really new, and if we have seen the movie or read the book, maybe we know how it turns out.