Wisdom from Seth Klarman - Part 7

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.
One of the concepts that so impresses me with Klarman's investment approach is his position that some buyers and sellers are irrational and it his his job, at Baupost, to capitalize on those investment opportunities. I remember him buying a number of MLPs which were believed to be widely held by Lehman Brothers - as Lehman's prop book unwound, this created uneconomic pressure on the stock - i.e. the connection between price and value disintegrated for no reason other than Lehman had to dump the stock on the market. I know he has also talked about in speeches at Columbia that Baupost has an analyst who's sole job is to follow index additions and deletions...That blew my mind.
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.
This is such a wonderful quote statement because it lays out what Klarman believes are the requirements for success for a hedge fund. IMO Aligned interests is so important: I.E. You eat your own cooking. I believe Baupost's employees are the largest holders of the fund.

He continues:
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.
That first quote, about investing being a marathon, is something I pound on repeatedly on this blog. It is so important, especially when allocating outside capital, to remember that the rug could be pulled out from under your whenever those quarterly redemptions hit. A string of big numbers multiplied by zero is equal to zero. Do not lose money. That is the first rule.

And on hedging: That is one of the reasons I believe looking at Baupost's 13F is somewhat a futile effort. Their equity portfolio is so small relative to their assets under management that it would be impossible to mirror the performance. Further, you have no idea what hedges have been put in place, or whether being long News Corp was just a dual-class arbitrage play.

I am going to make it a mission of mine to better understand how they hedge individual investments. Would they for instance go long a distressed bond and long a put on the equity? Or long an equity and long credit protection? I'll report back when I have more information in the future.
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.
Cash is king? One complaint I hear from a number of my peers is that fact that their portfolio managers abhor holding cash - especially now the expectations for inflation are sky high. And I understand the reasoning that if you are not fully invested, and the market rips, you will get redemptions. I believe if you can manage your investors expectations better (i.e. like 1950s Warren Buffet), you would be able to use cash as a valuable asset versus a potential liability.

And my favorite quote thus far in all of the series:
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.
Stay tuned for future editions of our Seth Klarman series - we will analyze a few videos and audios of Klarman speeches. After that we will look at the 2008 Baupost letter (but only after the 2009 Baupost letter is published).


Rich,  1/05/2010  

Great post (and series). I recently read "Margin of Safety" and I think Seth Klarman is quickly becoming one of my favorites to follow.


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.