Wisdom from Seth Klarman - Part 2

Last week, we posted some quotes and commentary on the Baupost 2004 Letter to Investors penned by Seth Klarman. We continue our wisdom / quotes from the Baupost 2005 letter.

First of all, they posted a return of 11.22% for the year, with 3.32% of the gain coming from "non-performing debt." Further this position represented ~15% of the NAV at year end. When the odds are in your favor, you bet big. Most people in the distressed debt can guess what this position is...My personal guess is Enron. There was a video floating around on the interweb, where Seth Klarman gave a speech to Columbia business school students, where he mentions Enron. From Gurufocus (via Alex Bossert's Value Investing Blog):

"Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18 billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were low balling what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents."

My old fund had a large position in Enron, in which I was the analyst, and the time frame pretty much matches with the movements of the bonds. We owned the Class 4's with S (if you do not know what that means, don't worry about it). I do not know the exact vehicle Baupost would of invested, but it looked like they made a nice chunk of change (as many distressed funds did).

Back to the Baupost letter now.

"For most investments, much can go wrong, including numerous factors beyond an investor's control: the economy, the markets, interest rates, the dollar, war, politics, tax rates, new technology, labor problems, competition, litigation, natural disasters, fraud, dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these risks can be hedged, often only imprecisely and always at some cost. Other factors are under an investor's control, but are not always controlled: discipline; consistency; remaining within your circle of competence; matched duration of client capital with underlying investments; prudent diversification; reacting rationally to news or market developments; and of course, not overpaying"

One of the characteristics that has impressed from reading Klarman is how consistent he seems. He does not seem to waver from his strategy. I know he has used options and very tight CDS (specifically sovereigns) to hedge his portfolio. Those factors where he commented that are under our control...well we should spend 90% of our time thinking about them and not worrying if the market will finish higher a month from now. For our next quote, Klarman discusses Baupost's investment returns:

"Is or past success the result of skill or luck? Is it replicable, or merely a lengthy run of good fortune? We are confident that our success has not been the result of a favorable spin of a roulette wheel or a timely roll of the dice. It has been truncated, not heightened, risk. Our gains over the years have been earned, banked, redeployed into the next advantageous investment, and thereby compounded, again and again. With sound investment principles, a committed and dedicated investment organization, a healthy and vigilant awareness of what can go wrong, and a strong sell discipline, investing is more akin to a high-yielding, periodically volatile, and non-guaranteed bank account than a game of chance. Can gains be lost? Of course they can, through laziness, sloppiness or hubris. Buck such a reversal is hardly inevitable, especially when one is aware of these risks. We work assiduously to maintain our gains, emphasizing as always the preservation of capital and, only when attractive opportunities become available, its enhancement."

One of the reasons I like this quote is because it pretty much puts to rest the buy and hold argument. Klarman buys, and when the offered return vs downside risk is against him, he banks the gain and waits for another attractive opportunity. Too many times, hedge fund managers get sucked into a story of a never ending bullish sentiment on a particular stock. Yes, intrinsic value changes throughout the life of an investment. But when a stock is trading at 125% of your IV target, it's hard not to bank some of those gains. And in the final sentence, Klarman again differentiates the return of capital vs return on capital, something that I talk about way too much on this medium.

A few other sets of quotes I really liked:

"While you know that our investments often stand apart from those of the crowd, you may not be aware of how deeply this contrarianism permeates our activities. Our investments can be remarkably contrary; we regularly search the "new low" list for investment ideas, while shunning names on the "new high" list. We purchase what the crowd is dumping. We typically buy stocks in the face of Wall Street "sell" recommendations, and reduce positions in their "buys" We eagerly assess financially distressed companies for opportunity while the world experiences revulsion. For us, analytically complex, litigious, stigmatized, and shunned situations bought at the right price form the backbone of a limited risk portfolio of opportunity."

Contrarian for the win. Some more nuggets:

"Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity, accepting a minor diminution in expected return where, and only where, the historic returns have been particularly out sized for the risk. There was never any logic, for example, behind the consensus industry annual return targets of 20% or more on bankrupt bonds or private investments. At times, an expected 15-18% return is ample, given the qualify of the underlying assets, the conservative nature of the assumptions made, and the limited spectrum of things that can go wrong. Other times, even a projected 25-30% return might be inadequate, where the quality of the assets is suspect, the return is earned in a risky and unhedged currency, and the downside risk is larger than usual. The quality of management must be factored in. The expected duration of an investment may also play a role; a short-dated investment earning inadequate return is over soon, and one can move on to better opportunity. Long duration mistakes are the gifts that keep on taking, locking you in to low returns, or significant capital losses if you exit early."

And finally:

"We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What's your edge? To succeed in today's overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resource provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work."
This 2005 Letter may need a second post. Seth Klarman offers many more nuggets of wisdom. Stay tuned.


Anonymous,  8/05/2009  

While I have tremendous respect for Klarman and concur with you that his letters are a must read for any serious student of the markets, I think the Enron example you cite is not the best example of his wisdom. A 15% position in a single name is a tremendous risk. While the Kelly Rule has its place, I don't think any investor can ever get enough of an edge in a situation like Enron to make an outsized bets. Judges make mistakes and inconsistent decisions too often; not frequently, but too often for oversize bets, which makes big bets on litigation outcomes risky. The returns cited are hardly extraordinary for distressed. If the one position was the entire 15% of non performing and contributed 3.3% to NAV, then it generated just a 22% return; middling by distressed standards and not appropriate for what would have begun as a greater than 10% position.
I don't mean to take anything away from Seth Klarman, his letters or his returns, but simply make the point that this particular investment isn't the examplar of why he is (rightly) held in such high regard.
Thanks again for taking the time to post and discuss Klarman's letters; its a good service to the investment community.

Lawrence D. Loeb 8/05/2009  

For those who are unfamiliar, the Kelly criterion is a strategy relating to how much of your portfolio to allocate to any particular investment. The Wikipedia article has links to the original paper, which was - interestingly - focused on improving communications for Bell Labs.

The story is well told in the book Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.

Anonymous,  8/13/2009  
This comment has been removed by a blog administrator.
luciyahelan 6/04/2010  

Really, Hat’s off. Well done, as we know that “hard work always pays off”, after a long struggle with sincere effort it’s done. This action proof to be a win, win situation. This is a true art
work, which will be a success story.
The Finance Firm


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.