Wisdom from Seth Klarman - Part 8

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.

If anyone ever asks you why the "Great Recession" transpired:
"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."
Incredible right? You can take that one to the bank.
"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 so interesting to me. So many of the great investors (Klarman, Buffett, Icahn) all espouse the benefits of holding cash. Many investors (whether that be of the advisory or even the corporate side) look up to these people. But nonetheless, so few are committed to holding cash as a strategic asset. Whether it be the "institutional imperative" to always be fully invested or the fact that it is difficult to defend to stakeholders being only 50-60% long when the market is going up, it seems like so few people feel comfortable holding excess cash. Think of all the corporations that bought back stock in 2006 and 2007, only to see their stock prices down 50-80% ... think of deploying all that capital at early 2009 levels - now that is a smart capital allocation choice.
"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."
I remember the "dark days" of late 2008, when literally a bond would be quoted down 20 or 30 points on no news. Nothing. Everyone always blamed Lehman's prop desk from blowing out a position. But really - there were no buyers. So few of us were pounding the table saying things like: "Listen - I know the markets are trading like the world is coming to an end - But if I can create HCA through the bank debt at at 2x EBITDA, the upside-downside on that trade is out of this world and one we may never see again in our life times."
"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."
There folks, are two of the greatest paragraphs on investing that I have ever read. Klarman has written extensively on the problem of "catching a falling knife" in investing...i.e value investors tend to buy early. But in the end, we have to stick by two truths: 1) None of us can consistently call the bottom 2) Buying a dollar for 50 cent as opposed to buying a dollar at 30 cents, is still better than buying a dollar for 90 cents. If we come from a position of strength (with cash and with capital that will not flee at every rocking of the boat), and practice the tenets of value investing, we should come out on top.
"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."
Theoretically this is fantastic. But most of us do not have a 25+ year track record to lock investors in. I have a theory on the best way to accomplish this and am working on some practical applications for it - more detail in the future.

Later in the week, will discuss more of the 2008 Baupost annual letter. It really provides some fantastic investing lessons.



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.