This is the 6th installment of our "Wisdom from Seth Klarman" Series:
"Turbulent and declining markets have increased our opportunity set, and we have put considerable cash to work in recent months. We remind you that our cash balances are determined not from any top-down asset allocation decision, but as a residual of our bottom-up search for investment opportunity. Our willingness to hold cash in the absence of compelling opportunity seems once again vindicated in light of the negligible impact that the difficult markets of the past six months have had on our portfolios."
"Credit rating agencies were central to the disaster that played out. These formerly trusted assessors of credit quality had completely let down their guard over the last several years, blessing as investment grade a shocking large volume of securities backed by loans that should never have been made. One of their biggest mistakes was not understanding their central place in the virtuous circle that enabled, and even encouraged, the uncreditworthy to falsify loan applications to become homeowners. When these mortgages were pooled, sliced and diced, and securitized, they allowed dross to briefly become investment grade gold. CDOs holding junior tranches of subprime mortgage securities were able to carve up BBB- subprime mortgage tranches into large slugs of AAA rated paper, a modern-day financial alchemy based on backward-looking computer models and credulous buyers. Yield gluttons foolishly trusted these ratings enough to risk complete loss of principal for a handful of basis points of promised incremental return."
"Many quants said what was happening was virtually impossible, ignoring their own prominent role in making it so. Goldman's CFO, David Viniar, noted at the time in a conference call, "We are seeing thats that were 25-standard deviation events, several days in a row." For many companies in August 2007, the volatility of their stock price suddenly had nothing whatsoever to do with the company itself, but simply its shareholder list. Clearly, value investors such as ourselves, who view the manic nature of the financial markets as a source of opportunity rather than an accurate metric of risk, stand to benefit from such foolishness. As Ben Graham suggested three quarters of a century ago, those who view the market as a weighing machine - an accurate assessor of value - are destined to lose money. They who see it as a voting machine - a collection of ephemeral opinions - can derive from the volatility profitably opportunities to buy and to sell."
"One of the ongoing complexities of security analysis is that you can never satisfactorily determine where you are in a cycle. How long might a bull or bear market last? Had you avoided the upward frenzy of 1929 and miss the great crash only to jump into the market in early 1930, the pain you would have felt by 1933 would hardly have been different from the agony of those who invested at the 1929 peak. We will not be certain until much later whether the so-called bargains of January, 2008 were truly undervalued or merely dangerous temptations to value-starved investors."
"Some stocks and corporate bonds fell to levels that looked tempting, but in most cases the declines merely matched deteriorating fundamentals - especially in the financial, housing, and retail sectors - and were no real bargain. One of the greatest risks we-and all investors-face is the danger of catching falling knives: expensive securities that decline without reaching bargain levels. Often, the near absence of bargains works as a reverse market indicator for us; when we find little that is worth buying, there may be much that is worth selling. Indeed, we maintained a strong sell discipline throughout the year to good effect."
"As we enter 2008, we face the normal challenges of the investment business, as well as a few related to our success in 2007. Our 2007 profitability has resulted in an unprecedented one-year increase in our capital base. It could take some time to carefully build our team to a size that will allow us to consistently deploy it, and we cannot afford to become impatient in our approach. Despite a fabulous 2007, we know that we must remain humble, learning lessons both from our winners and our mistakes. We need to remember that we are usually a team of single hitters with a high-on base percentage, and remain resolute in following the low-risk strategy that has enabled us to grind out good results for over a quarter of a century.The next 25 years won't look like the last 25. If they did, our $11 plus billion under management today would approach or exceed $1 trillion by the end. Expectations will have to be lowered, ours as well as yours."