This is our 8th edition of Wisdom from Seth Klarman. In this edition, we will analyze the 2008 Baupost Annual letter. This, like other parts of the Seth Klarman series, will be split into two posts.
"The implosion of the subprime mortgage market in 2007 let to losses that ultimately precipitated a collapse of financial institutions and markets and nearly the system itself. The 2008 financial market sell-off accelerated into a panic after September's Lehman Brothers bankruptcy filing, as no one could figure out who was, or would remain solvent. Selling by financial institutions, desperate to rein in their balance sheets, put sustained pressure on securities prices. Strategies that relied on leverage were the first to fail as the downdraft triggered margin calls. Dismal investment performance drove redemptions from equity and debt funds alike, necessitating further selling, and thereby creating a downward spiral that overwhelmed investment fundamentals. With the exception of mispricings that have ensued, this is actually value heaven; it just feels like value hell."
"In today's unforgiving environment, buying anything has become so punishing that few (we are one of the few) want to do it any more. Numerous competitors have gone into hibernation or become extinct, victims of the market selloff, investor redemptions, or margin calls. Even those with capital, unsure of their staying power, seem unwilling to invest it. Holding cash, which would have been a far better idea had people thought of it when prices were at their highs, is now in vogue."
"It is easy for the volatility of one's thinking to match the volatility of prevailing conditions. Time horizons have shorted even more than usual, to the point where the market's 4:00 p.m. close seems to many like a long-term commitment. To maintain a truly long-term view, investors must be willing to experience short-term losses; without the possibility of near-term pain, there can be no long-term gain. The ability to remain an investor (and not become a day-trader or bystander) confers an almost unprecedented advantage in this environment. The investor's problem is that this perspective will seem a curse rather than a blessing until the selloff ends and some semblance of stability is restored."
"Warren Buffett has said - and other have endlessly repeated - that you can't tell who is swimming naked until after the tide goes out. This turns out to be only partially true. The tide has receded, and most portfolios are down. But not all declines are equal. Some investors have lost money and locked in those losses by going to cash. Some have made investments in failed or failing banks, brokers, and homebuilders, or toxic subprime mortgage securities; these losses are largely permanent and irreversible. But the investment baby has been thrown out with the bathwater, and some who invested wisely aren't naked, it just seems that way. Buying early on the way down looks a great deal like being wrong, but it isn't. It turns out you won't be able to accurately tell who's been swimming naked until after the time comes back in.As Benjamin Graham and David Dodd taught us, the financial markets are manic and best thought of as an erratic counterparty with whom to transact, rather than as an arbiter of the immediate accuracy of one's investment judgement. There are days when the market will likely overpay for what you own, and other days when it will offer you securities at a great discount from underlying value. If you look to 'Mr. Market' for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of his emotional extremes, then you are very likely to succeed over time. If you see stocks as blips on a ticker tape, you will be led astray. But if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations."
"Most investments - illiquid private transactions, but also publicly traded stocks and bonds - are like roach motels, easier to get into that out of. When you make an investment you give up liquidity and valuation certainty of holding cash. You do so, presumably, to earn a higher return while accepting the risks of diminished liquidity, price volatility, and fundamental value impairment. To be successful, you must maintain the thought process articulated by Graham. When a seemingly attractive investment suddenly retreats in market price in the absence of adverse fundamental development, you must have the psychological makeup t see it as more, not less attractive. If you have either investment constraints or flighty capital which makes it impossible for you to favor an investment more after its price falls, then you shouldn't be investing at all."