We continue our long-running Seth Klarman series where we analyze Baupost's annual shareholder letters with the second half of the 2008 annual letter.
"Baupost build numerous new positions as the markets fell in 2008. While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up, and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better."
"Most of our new investments in 2008 were in deeply discounted senior corporate and residential mortgage debt. Debt instruments, because they occupy a senior position in a corporate capital structure and pay interest and principal on a contractual basis, are typically considered less risky than equities. For this reason, when corporate debt become troubled and the possibility of default rises, holders often overreact. When the promise to timely pay interest and principal is on the verge of being broken, many will urgently sell either from fear or due to restrictions in their investment charters. Enormous legal and process complexity create great uncertainty, which adds to the pressure to sell. Prices often overshoot to the downside, creating an attractive risk-return proposition, especially for those able to analytically deal with complexity.Beyond favorable pricing, distressed debt involves multiple catalysts for the realization of underlying value. If a troubled company is able to recover, whether through operational turnaround, asset sales, or capital infusions, the contractual repayment of principal is a catalyst of full value realization. Alternatively, if the company fails to recovery, reorganization through the Chapter 11 bankruptcy process, whereby a company satisfies claims in the order of their legal hierarchy, can itself result in value realization. In bankruptcy, senior debt holders often receive cash, new debt, equity or some combination thereof, in return for their defaulted securities. Being first in line for recoveries from the corporate estate can confer a valuable margin of safety."
"Many of the distressed debt investments we bought in 2008 declined further after our initial purchases, inducing us to buy more, as we often do, after thoroughly checking and rechecking our analysis and assumptions. Although most investors find it painful to have positions decline in price after purchase, we remained focused on the silver lining: the ability to building large positions at increasingly favorable prices. In many ways, this temporary market decline represents delayed gratification. When we buy a four-year bond with a 5% coupon at $70.7 to yield 15% to maturity and the price drops immediately to $60.0 where it now yields 20%, we have a 15.1% mark-market loss, but (assuming no new fundamental developments) now hold an even more attractively priced investment while experiencing an even better buying opportunity. A rise in the market's required yield to 25% would cause a further 14.6% price decline. Clearly, if our initial analysis was correct, these temporary price declines, as significant as they are, will be far more than offset by the eventual profitable recoveries."
"When the government prints money to solve a problem, the result is almost always inflation. The history of paper money, back by nothing except a government's promise to pay, is that it will be debauched. Politicians are good at spending money that is not theirs; they can please all, antagonize none, by going on a spending spree while asking no one to pick up the tab. But the bill will come due and taxpayers are ultimately on the hook. National wealth cannot be created by a printing press but only be education, hard work, saving, and investment. "
"Over the next several years, inflation seems inevitable, along with much higher interest rates, which will surely impact the value of most investments. We have put hedges in place that we hope will protect our portfolio should such risks materialize."
"...James Montier, Societe Generale's market strategist, recently pointed out that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the consistent response was a focus on process, not outcome. The same ought to be true for investors.According to Montier, during periods of poor investment performance, the pressure builds to change the process to enable immediate gratification. But, so long as the process is sound, this would be a big mistake. It is so easy for one's investment process to break down. When an investment manager focuses on what a client will think rather what they themselves thing, the process is bad. When an investment manager worries about their firm's viability, about possible redemptions, about avoiding loss to the exclusion of finding legitimate opportunities, the process fails. When the manager's time horizon become overly short-term, the process is compromised. ..."
"Once we decide to invest, the work continues. Are their new developments? What additional information should we seek? Are their affordable hedges that can limit our risk? If the price falls should we increase our position? If a price rises, at what point should we start to sell and at what point should we wholly liquidate our position? If dealing with a private real estate investment, should we raise or lower rents, reposition or spruce up the asset, refinance, or offer the property for sale?Perhaps most crucial to the success of this process is intellectual honest. Have the facts changed? Was our original judgement wrong? Are their better investment to hold? If we made a mistake, we need to recognize it and learn from it."
"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security's price begins to reflect full value, because we are never sure that our thesis will be precisely correct. While we typically concentrate our investment in the most compelling situations measured by reward compared to risk, we know that we can never be full certain, so we diversify. And, in the end, out uncertainty prods us to work harder and to be endlessly vigilant."