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.

Seth Klarman is worth listening to, especially when markets go mad

Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.

To measure Mr. Klarman's importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman's book, "Margin of Safety": Published that year at a cover price of $25, hard copies now fetch up to $2,400.

But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.

Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. "There is no nutritional value," he said. "There is nothing natural in the markets. Everything is being manipulated by the government." He added, "I'm skeptical that the European bailout will work."

Some members of the audience gasped audibly when Mr. Klarman said, "The government is now in the business of giving bad advice." Later, he got more specific: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

"We didn't get the value out of this crisis that we should have," Mr. Klarman told the audience. "For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions." He added: "All we got out of this crisis was a Really Bad Couple of Weeks mentality."

You could have heard a pin drop as Mr. Klarman proclaimed, "I am more worried about the world, more broadly, than I ever have been in my career." That's because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

"Will money be worth anything," asked Mr. Klarman, "if governments keep intervening anytime there's a crisis to prop things up?"

To protect against that "tail risk," said Mr. Klarman, Baupost is buying "way out-of-the-money puts on bonds"—options that have no value unless Treasury bonds plummet. "It's cheap disaster insurance for five years out," he said.

Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries. "All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive," he warned. Especially gold. "Near its all-time high, it's a very hard moment to recommend gold," said Mr. Klarman.

Mr. Klarman pointed out that his own ideas "on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what's going to happen in the world at large." In other words, while you might want to insure against a disaster scenario, you shouldn't bet the ranch on it.

And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is "out of favor, loathed and despised." So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors' stomachs. Then you can pounce.

As Mr. Klarman put it, "Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."

Seth Klarman: Investing is like Chess

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?

Direct Link

Paul Sonkin on Value Investing, Small Caps and the Information Advantage

Bruce Greenwald on Shorting and Current Opportunities

Seth Klarman's Lessons and False Lessons of 2008

Extracted from Baupost Group's 2009 Letter to Shareholders, written by Seth Klarman:

Twenty Investment Lessons of 2008:

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

18. When a government official says a problem has been “contained,” pay no attention.

19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons:

1. There are no long-term lessons – ever.

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

Read my article about this here.