12.02.2009

Wisdom from Seth Klarman - Part 6

This is the 6th installment of our "Wisdom from Seth Klarman" Series:



In this edition, we will be discussing the 2007 Baupost Annual Letter. 2007 was a monster year for Baupost: Up ~52% for all their respective funds. Given how large their asset base was in the beginning of the year, as well as the amount of cash that was held on the sidelines, this is an incredibly impressive result. Baupost breaks out their return by asset class each year: In this year, like many other funds, benefited largely from gains from credit protection - i.e. shorting sub prime MBS.

Before getting the fund commentary, Klarman discusses Baupost's use of cash in the portfolio.
"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."
Running with cash is not a bad thing. Think about all the companies that bought back massive amounts of their stock in 2006 and 2007 at prices well above today's levels. A lot of companies may not have seen their credit ratings dropped if they were better stewards of shareholder (and creditors) capital.

An interesting point to note in their holdings is that Special purpose acquisition companies (SPACs) represented a nice chunk of the portfolio. If you look at Baupost's current 13F you will still see many of these SPACs. There are so many strategies that funds have employed with SPACs (long warrant, short common; long common, block vote, get paid back at a boosted treasury yield, etc) that it is hard to speculate what they were actually doing here.

On the rating agencies and CDOs:
"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."
Ouch. As Klarman has said in previous letters, investors need to focus on risk (i.e. the amount of probability of permanent loss of capital) instead of return.

If you remember 2007 (what a year), around late summer there was news everyday about another quant fund blowing up. Klarman, on these events:
"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."
I see so often the weighing machine quote of Ben Graham tossed around. Klarman brings to light how value investors should view the market - not as a guide, but as something that presents your current opportunity set.

On investing throughout the cycle:
"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."
In a word, and with the benefit of hindsight (see: Freddie, Fannie, Lehman): dangerous. I have actually heard Klarman use this 1930 analogy before - i.e. one of the most difficult things to do as an investor is figure out where you are at in the cycle...are things going down another 40%? Or are we at the 666 S&P bottom? He continues:
"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."
It has been reported that Klarman does not short securities because the risk is unlimited (see: VOW / PAH3 stub trade for a killer short squeeze). That being said, in a credit default swap, versus a short sale, risk is contained to the loss of premium on the contract. Yes, if you shorted the ABX 2006 BBB- at 80 point up-front, you exposed yourself to heavy losses (but in the end would have still made money). But Baupost looks like they were putting these trades on at ridiculously tight levels...I'd venture a guess (depending on vintage, single vs index) of 150-300 bps running. So the most they could lose in any one year was the notional value of their contract times 1.5%-3.0%. If you wanted to limit your total portfolio loss to 1.00% and had to pay 300bps on the contract, you could of effectively bet 33% of your total portfolio in notional value in these contracts...and the most you could lose (outside of mark-market tightening) was 1% in return....Talk about upside, downside.

On his performance in 2007, and a caution to investors (similar to something WEB has said in the past):
"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."
In the next few days, I will follow up with more Wisdom from Seth Klarman, continuing with Baupost's 2007 letter where Klarman discusses the pitfalls of leveraged investors, disaster hedging, and Baupost's culture among other things.

7 comments:

Ken Kaufman 12/03/2009  

I appreciate your point at the end of this post - expectations have to be lowered by everyone. In some ways what we have seen happen is merely a correction to where things should be relative to the risk vs. reward scenario. Great insights!

Anonymous,  12/03/2009  

If anyone hasn't seen the WaMu opinion and order from last night, it's worth checking out. Distressed funds were ordered to divulge thier positions, similar to the Northwest case in SDNY. First time it's happened in Delaware.

hfguy 12/03/2009  

"If you wanted to limit your total portfolio loss to 1.00% and had to pay 300bps on the contract, you could of effectively bet 33% of your total portfolio in notional value in these contracts...and the most you could lose (outside of mark-market tightening) was 1% in return".

This is actually inaccurate - 300bps running on a 5-year contract will cost you around 4% for every 100bps of tightening because you have to multiply your annual loss by the WAL of the contract (assuming a 5-year contract has a 4-year WAL at 300bps running). Thus, the max loss on a 300bps running CDS contract is actually 12pts if it were to go to zero overnight and you had to mark it to market that day.

Hunter 12/03/2009  

It is correct - outside of mark-market tightening like I noted. You are also correct if you are worried about tightening to 0.

Hunter 12/03/2009  

WAL for a 5 year CDS should be 5. And my point was OUTSIDE of mark-market tightening. I agree you exposure yourself to market gyrations on tightening.

Andrew Hendel 12/03/2009  

The lesson from the VOW / PAH3 stub trade is to not short stub equities, not to give up short selling altogether. For small and mid cap companies, you might have a compelling view that the stock price is too high but the option contracts might be too expensive. Take Palm and GE. A little more than a month ago, both stocks were trading around $16 but the Jan 2011 Put options at a $10 strike price for Palm were more than twice as much as they were for GE. Granted Palm is a smaller cap company with growth on the come but no current cash flow, the risk profile for GE is also high. The stock price for both companies has been very volatile with Palm bottoming at $1.30 and GE at $5.87. If you think a company is overvalued but that the premium for out of the money put options is too high, it may make sense to take a short position instead.

Anonymous,  12/04/2009  

What are your thoughts on General Growth? I am really new to distressed assets, but have been reading your blog to learn more about the topic. How would one go about valuing the GGP's equity when its unclear how much of the equity will go to the bondholders?
THanks

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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.