My Favorite Quote from the Most Recent Baupost Letter

This week, in the wake of Sandy and the intermittent power outages, loss of internet, and general feeling of "can't get anywhere" due to subway restrictions, I've had time to catch up on a lot of reading. Luckily one of the items I had printed out before the storm was Baupost's most recent letter to its investors. While I will not post the entire letter I did want to pull out my favorite paragraph from the letter (I also wanted to point out that Klarman notes that 3rd quarter gains were led by the Lehman securities in the ongoing liquidation and that cash balances were at 33.5%)

 Many in the press have already commented and cited Seth Klarman's abhorrence for QE3 laid out in the letter.  The paragraph preceding the QE3 annihilation is what I find most interesting (my emphasis added):

"The overall market environment seems increasingly risky to us, as securities prices are rising despite weak and generally deteriorating global fundamentals. U.S corporate earnings are expected to be lower this quarter. Higher markets in the face of eroding fundamentals can be a toxic combination. A market rising for non-fundamental reasons (i.e., QE and ECB bond repurchases) is always one that demands a healthy dose of skepticism"
As noted in many posts in the past I am deeply involved in the primary markets in all US credit products: Investment grade, high yield, and bank debt. And as appetite for primary paper picks up, pricing (yields) tightens, terms get weaker, and the risk/return scales falls to where investors are not getting compensated for the risk they are taking. As primary markets strengthen, so do secondary markets as a rising tide lifts all boats (though one could argue secondary market strength could really be the driver of primary market strength. Either way, all boats are rising). With both primary and secondary markets strengthen, a prudent investor would reduce his or her exposure to the asset classes in question. Instead, we've seen more investors pile into the asset class as retail fund flows and a general "can't be left behind" feeling has pervaded the market.

I am definitely not a "perma-bear." But when I look out into the marketplace and see quite a few hold-co PIK toggle dividend deals getting done in drive-by fashion with 8 and 9 handles, it stands to reason that risk isn't being priced correctly in the market place. Non fundamental reasons whether it be fund flows or as Klarman points out a "Central Bank" put seem to be the reason.

Another reason I think is the general shortening of professional investor's time frames. In the most recent Graham and Doddsville, Joel Greenblatt goes on to say, on shortening of investor's time horizons: 
"I think the reason for this is that your investors – your clients – generally just don’t know what the investment manager’s logic was for each investment. What they can view is performance. It’s pretty clear that for mutual funds, for instance, the performance of a given fund over the last 1, 3, 5, and 10 years has very little correlation with the future performance for the next 1, 3, 5, and 10 years. So institutional investors are left with predicting who’s going to do well in the future, which they attempt to do by looking at the manager’s process. For most clients, the manager’s process is not transparent and the rationale behind investment decisions is not clear. Clients tend to make decisions over much shorter time horizons than are necessary to judge skill and judgment and other things of that nature. So I think time horizons are getting shorter, not longer. We’re not in danger of people expanding their time horizons when they’re judging managers. I think time arbitrage will be the “last man standing,” pretty clearly. "
If the short term opinion is that QE will be forever with us, and central banks across the world will provide endless levels of liquidity, then the next move, all else being equal is higher. Investors inherently will believe themselves to be smarter than the crowd and will tell themselves "We will know when to get out FIRST." or "We are the best TRADERS out there. We will know when the time has come to cash in OUR chips."

The "chase" factor, especially for under performing funds is starting to take hold. I often ask friends and colleagues: "Is the pain trade up or down?". A few months ago everyone would have said up. Now I am getting more and more mixed answers. Investors are much longer than they were a few months ago for all the same reasons. Many stocks can go much higher in one year, but then collapse in three years. And I think that's one of my biggest problems with the world today: The only margin of safety is continuous Fed and central government stimulus.

A margin of safety means you buy a stock that you think is worth $10/share, using conservative assumptions, for substantially less than that. You don't get the $10/share valuation using aggressive growth projections or valuation multiples. Conservative assumptions is the opposite of 'hope' and I tend to think this market has priced in a lot of hope.

All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.


Kyle 11/04/2012  


I found your last sentence about the next bankruptcy cycle to be an eye catcher -- something to take notice of but also one that raises a couple of follow up questions.

I have no trouble seeing and believing your comments on investor behavior -- performance chasing, yield chasing, mispriced risk, etc. What I am struggling with is thinking how can we top the outrageousness of the 2007 peak -- thinking in terms of the massing PE and PE related debt cycle peak more so than the RMBS issues. (amount and quality of corp debt worse in 2007 peak?)

Or is your point that ZIRP/QE cut that bankruptcy cycle short and you are expecting the next bankruptcy cycle to not be so lucky (i.e. the CB's are already "all in" and won't be able to stop the bankruptcies?)

Do you expect #/% of defaults to reach records or recoveries to be worse or both? When you imagine a cycle for the ages, what kind of metrics come to mind?

The History Squared blog (@historysquared) also got my attention a few months back with a comment that the peak corporate default rate in the US was 50% -- sometime in the mid to late 1800s. Guessing most debt was related to rail roads then so it may not be meaningful in a modern context. I'm no expert but it seems to me that default rates could peak well below 50% and still be memorable.

Thanks for sharing your thoughts -- I enjoy the blog.


capitalistic 11/06/2012  

The market hasn't priced in hope. The market is pricing in cost vs risk. Based on current VIX levels, there isn't enough risk appetite to justify current P/E ratios. Investors are better off investing in private companies or physical commodities (rice, soybeans, etc)

Anonymous,  11/07/2012  

Echoing Kyle, would be good to get your opinion on this, notwithstanding that fact that there is a lot of A&E and the moment is there really enough leverage out there to bring it down. Or am i'm being blinkered and not accounting for the larger corporates and their potential of fold?


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.