Last time, in our Wisdom from Seth Klarman series, we grabbed quotes and commentary from Baupost's 2007 Annual Letter. In this edition, we continue with the 2nd half of the 2007 letter. As usual expect some gems from Klarman - who I consider the best hedge fund manager out there.
While investors will obviously achieve the best result by remaining rational thinkers at all times, this is easier said than done. In the financial markets, emotion often takes over, and greed and fear come to dominate investor behavior. Even those who are aware of this, who expect always to invest rationally and to be able to resist their own greedy temptations and panicky reactions, cannot always carry through on their plans.A top-down or momentum investor - especially if leveraged - is at a loss when confronting the unexpected. Should they hang on and risk ruin, or capitulate and lock in painful losses? Even those with the benefit of a value investing roadmap - which ensures a fundamental, long-term oriented approach to investing, a disciplined pursuit of bargains, and an imperative to view the market as an irrational creator of opportunity - may blink when faced with the unexpected. When you buy bargains, and they become far better bargains, it is easy to question yourself, which can impair your judgement. Real or imagined concerns - about client redemptions, employee defections, and even a firm's viability - can greatly influence behavior away from the rational.
Every day, every investor squints into the murkiness of present-day ambiguity and an unknowable future and has to make decisions. Even when these decisions are made for the right reason-not based on greed, not under undue pressure, not from intellectually dishonest motives, but because the investments appear sound and secure - much can still go wrong. Despite a strong first 25 years, our performance in the years ahead is unknowable; however, with aligned interests, a long-term approach, sound judgement, a keen sense of risk aversion, a nose for value, valuable experience on the front lines, an unwavering alertness, a successful result seems reasonably likely.
We tried to remember that investing is a marathon and not a spring, and we conditioned ourselves to go the distance.We have consistently prepared for the worst, incurring significant hedging costs on an ongoing basis. Sometimes these were designed to protect single investments, and other times they provided downside protection for the broader portfolio. While many of our holdings did not truly require hedges in order to be attractive, and while many of our hedges ultimately proved unnecessary because the anticipated risks failed to materialize, our hedges were quite valuable as enablers, in that they gave us the comfort and the confidence to, at times, incur fairly concentration positions that have produced such excellent long-term, risk adjusted returns for Baupost.
Our strict value discipline has been a critical component of our success.. When you have carefully analyzed what you own, and buy at a sufficient discount to underlying value to ensure a significant margin of safety, you are likely to do well. Our willingness to hold cash during fallow periods has enabled us to maintain a strict sell discipline regardless of whether we had anything promising to replace what we sold. This view on cash, combined with a truly long-term investment perspective, has also enabled us to avoid the gun-to the-head mentality that pressures many investors to own less than stellar investments.
We have a culture of intellectual honesty and curiosity, always looking for more information to confirm a thesis or disprove it; never settling for good-enough investments, but always striving to find the best ones; not satisfied with the knowledge that our investments are bargain-priced but always searching to discover why they are undervalued so as to remove as much risk as possible from the investment equation. We strive to eliminate biases in our decision-making that could cause us to reject new information or cling to erroneous beliefs. We pride ourselves on making tough and sometimes painful decisions to exit from investments where prospects have soured. This curiosity extends fully to the operations side of Baupost, where we always want to find smarter and more effective procedures and processes, to identify new ways to serve our clients better, and to know not only that something is the case but why it is so.