Wisdom from Seth Klarman - Part 5

We continue today discussing Baupost's 2006 Annual Letter to Investors. As discussed previously on this blog, Seth Klarman is arguably our favorite investor and we hope to enlighten readers with some of his wisdom and "Klarman quotes."

"When people ask us about Baupost's risk controls, we have no glib answer. We have no risk control group we can trot out with a PowerPoint presentation. Risk control to us is a careful aligning of interests, a proper balance in our investing between greed and fear, experienced and collaborative senior management and investment teams that have worked together for quite some time, a consistent and disciplined investment approach where every opportunity is individually and meticulously evaluated on its fundamentals, a strict sell discipline, a willingness to hold cash when opportunity is scarce, a complete avoidance of recourse leverage, and a healthy level of fear."
Read that last sentence one more time. If that is not the way to run an investment partnership, then I don't know what is.

On discussing Baupost's edge (see some of our previous posts on this):
"...in today's competitive world, these edges do not ensure long term success. Our best ideas sometimes look a lot like other firms' best ideas and, at times, may even be identical. Yet our approach, if successfully executed, may enable us to outperform the crowd even if we have the exact same idea flow as everyone else. How might this be possible?

The answer is that we have worked hard to create an environment that lends itself to good decision-making. Simply put, we strive to make the most of each opportunity we have at hand. One way to do this, as mentioned earlier, is to avoid over-diversifying. Talking full advantage of our best ideas is a real no-brainer. The search for new opportunity is often times quite challenging; buying more of what we already know and like requires minimal additional effort. The teach approach that we have adopted at Baupost maximizes the probability that our best ideas will be effectively identified as such, and that a healthy overallocation of capital will be made to them. A firm that exploits its best ideas has superior returns, happier clients, better rewarded employees, and greater profitability."
Many people in the distressed debt world know circles exist among funds. Many people know which fund will put on positions just because another fund has the same position on. The problem is that only a few funds have the discipline to put a large portion of its capital in Enron or in 2007 sub-prime RMBS shorts. Those are the winners in my opinion.

A quick point on selling:

"Selling, in particular can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it."

On hedging the portfolio - and remember this was in early 2007 (read: GO GO GO market)
"In today's fully valued financial markets, one area remains quite inexpensive: disaster insurance. In general, disaster insurance is intended to offset portfolio losses from positions that are expected to suffer during or in the aftermath of extreme adversity or dislocation. Like any insurance, it usually expires worthless when the disaster fails to occur - but that doesn't mean it's not worth having. Financial disaster insurance can take many forms, including out-of-the money put options on individual stocks, baskets of stocks, or market indices. Call options on gold (a hard metal that has served as a store of value for centuries) or inexpensive out of the money options on interest rates or currencies, where a dramatic fluctuation could adversely affect our situation, are other forms of disaster insurance."
I remember watching an interview with Seth Klarman where he said he was buying credit protection on sovereign nations. It cost him approx 5-10bps a year. This was an incredible opportunity at the time as sovereigns blew out 100-300 bps depending on the country. And sub prime RMBS (whether the ABX or single-name) were a similar sort of trade...no real downside (cheap carry) and MASSIVE upside.

Speaking of Subprime:
The sub prime market is the canary in the coalmine of housing; a minor downward tremors in home prices could be felt with seismic force here, especially in the priced-almost-to perfection lower investment grade debt tranches. These tranches offer far too miserly a yield given the rather significant risk of principal impairment. Holders expect the real estate markets of tomorrow to closely resemble those of yesterday, and for Joe Sub prime to behave just like the average Joe. Should conditions worse, as they lately have been doing, and should the yield on these narrow slices of marginal credit risk to reflect this risks, as it currently happening, the financial Cuisinart that churns out sub prime tranches could become incapacitated. Then, then junior tranche trail could end up wagging the sub prime dog, causing the sub prime mortgage window to slam shut and thereby begin to restore sanity to the home lending market.
I think an interesting lesson to take from this: The area of excesses can be evidenced from which product Wall Street is pumping the most. Whether that be SIV's, Alt-A RMBS, CLO and levered loans, etc...this is where you have to worry.

Stay tuned in coming weeks as we explore the 2007 and 2008 Baupost Annual letter and discuss more about Seth Klarman and his fantastic investment record.



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.