Wisdom from Seth Klarman - Part 4

If you are new to the blog, here is part 1-3 from our "Wisdom from Seth Klarman" series.

Wisdom from Seth Klarman - Part 1

In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it, thank you to Andy for his donation (for those so inclined, a donation link is on the right rail, lower in the page). More donations = the better.

In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in comparison to the S&P which was up 15.8% that year. Gains were made from a number of categories with approximately 7% of absolute gain coming from performing and non performing debt - with the largest gain coming from "unnamed non-performing debt" which I speculated in last post was a position in Enron. These results are even more impressive given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over 40% during the year.

After discussing the party that was 2006, Klarman writes:
"We maintained our discipline throughout the year: disciplined buying when bargains emerged, and disciplined selling when prices approached full value. Despite fairly expensive markets, robust competition, and a near complete dearth of distressed debt opportunity, our tireless, highly capable, and experience team was able to fairly regularly uncover new opportunities. Considerable fundamental progress in many of our holdings, along with our strong selling discipline, triggered realizations during the year that were approximately equal to new purchases, resulting in relatively flat cash balances that masked substantial underlying activity.

One adverse in evidence during the year is that the markets proffered fewer extreme mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of the correction of these mispricings accelerated. In other words, fewer investments become really inexpensive, more become somewhat inexpensive, and the correction of these smaller mispricings happened faster than usual, enabling a particularly favorable overall result for us and for many value-oriented investors. It is impossible to know if this paradigm will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and increasingly private equity pool suggest that it could.

The old saw reminds us never to confuse genius with a bull market. Anyone can become "expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is lifting all boats often proves irresistible."
This guy must have a crystal ball. Remember he wrote this in January 2007. He is also somewhat pointing the finger (I am sure unintentionally) to many of the value investors that kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an interview with a prominent value investor saying that Freddie Mac was one of the cheapest stocks he had ever seen - and he just kept buying and buying it.

After talking about the sheer magnitude of capital flowing into alternative investments (hedge funds, venture capital, and private equity), fueled by demand from institutions and pensions:
"Many of today's institutional asset allocators are not evidently worried about the enormous amounts of capital surging into alternative investments. They are now asking the relevant bottoms-up question: Where are today's bargains? They are not following that thread to build, investment by investment, or one carefully chosen fund at a time, a diversified portfolio of undervalued investments. Instead, they are typically focused on the answer to three questions, each of which demonstrates a reluctance to think for themselves:
  1. What has worked lately?
  2. How can I diversify my way to investment success?
  3. How can I invest like the institutional thought leader of this era; in other words, like Yale?
Here's why these questions range from remarkably foolish to largely irrelevant.

Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the sky. Sustained out performance in any particular sector of the markets is eventually borrowed from the future, to be given back either slowly through sustained under performance or quickly through price declines. What has worked lately is popular, widely owned, and bid up in price, and therefore generally anathema to good future results. But human nature makes it extremely difficult for people to embrace what has recently fared poorly."
And further down the letter...
"The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, what at least avoiding under performance. This is the best that you can hope to do in an efficient market.

For any fundamental-based investor, this is complete hogwash. Investment come in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either."
I love it. Too many times, each of us get caught up trying to look at some many things that our heads spin. A number of value investors suffer from a problem I fondly dub "Everything is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at everything, and lots of the things you look at you think are cheap. Any investor can rationalize a price target for any asset. The goal is to be patient and swing at those once in a lifetime opportunities, and then not dilute those returns with mediocre value traps.

"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not too distant future."
The first rule of investing is to not lose money. And the second rule is to not forget the first rule. When approaching situations, always look to the possibility and magnitude of permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an event a year or so ago and she mentioned that Warren Buffett will not invest in a situation where there is even a remote chance of permanent capital loss.

Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006 Baupost Annual Letter.


Anonymous,  10/06/2009  

Hi - good post and good blog. Where could one find the more recent (after ~2001) Baupost letters? Thanks.


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.