Seth Klarman, the renowned and tried-and-true practitioner of value investment, started his career as an intern at the Mutual Shares Corporation (now under the umbrella of Franklin Templeton) that was managed by Max Heine and Michael Price. In 1982, after being employed with them for two years and concurrently graduating from Harvard Business School, Mr. Klarman founded Baupost Group with an initial investment of $27 million from four wealthy and prominent Boston-based families. Today, after an astounding gross return of 20% per year and only one negative year to boot, the group boasts assets of 24 billion dollars and places among the top ten hedge funds both in size and long-term returns.
Regardless of size, though, the same value investment philosophy continues to dictate the group. The original mandate and operation of the new firm was highly influenced by his former employers, emulating their philosophy of risk and investing. As Mr. Klarman points out often, in his formative years he learned immensely from both Mr. Heine and Mr. Price. More specifically, it was Mr. Price’s endless drive to gather enormous amounts of information and to seek value which set the stage for him to pursue this path. His detail-oriented analysis of stocks in regards to their complex and interwoven ownerships and affiliates, led him to unusual investment opportunities which were not in plain sight of other analysts who found “comfort in consensus”. To relentlessly pull the proverbial threads to see where they lead and then contextualize potential investments became the cornerstone of his investment strategy.
Mr. Heine influenced him in another significant manner. No doubt, he was an astute analyst, but it was his kindness that most amazed Mr. Klarman. Mr. Heine’s interpersonal skills towards his employees, irrespective of their rank and file, were accentuated by the fact that he treated them as though they were most important to him, as they were. The gentle and soft-spoken demeanor of Mr. Klarman is in stark contrast to many boastful hedge fund managers today.
Apart from these two gentlemen, Mr. Klarman, akin to any true value investor, is indeed highly indebted to Mr. Graham and Mr. Dodd in forming his investment style, both in terms of specific security selection and outlook on the overall capital markets. Mr. Klarman openly acknowledged his reliance on the Graham-Dodd model when he titled his own book “Margin of Safety”, a central concept that insists on the discipline of walking away from an investment if after deep scrutiny the opportunity does not offer a reasonable room for error. In the book (which is out of print and fetches up to 2700 dollars as a collectible, ironically despite Mr. Klarman’s open disregard for asset classes that do not generate cash flow), he demarcates three main elements of successful investing: (1) where and why most investors fail, (2) a value-investment philosophy, and (3) the value-investment method.
Mr. Klarman expounds extensively about the negative effects of the “Performance Derby” in which mutual funds and organized investors focus on comparative performance in lieu of absolute performance. This popular obsession with how an investment fund performs relative to the broader market (say to the S&P 500 index) leads to avoidable risk-taking and the consequent (and sometimes irreversible) loss of capital.
According to Mr. Klarman, this phenomenon results in most of the investment managers because of their focus on short term outperformance of the market on a weekly, monthly, quarterly or annual basis, thereby sacrificing long term higher returns and most importantly avoidance of unnecessary risk. They have the propensity to sell investments that are good buys, and buy stocks that are performing well for fear of missing the ride their peers are enjoying. (These misguided trades, on the other hand, supply value investors with an opportunity to buy undervalued stocks even more inexpensively.)
Further, the frenetic trading of these stocks adds volatility and risk to them, thereby making the managers’ portfolios riskier than the overall market. It is a vicious cycle: The more their stocks fluctuate the higher the degree of risk and vice-versa. While the typical fund manager (egged on by the typical client) might justify this risk as necessary volatility to achieve higher returns, as a value investor Mr. Klarman posits that risk constitutes of two simple components: the probability of loss and the potential amount of loss. Additionally, the first and foremost goal of the investor should be to avoid or minimize risk and only then focus on returns (not the other way round). In short, capital preservation should override any excitement about potential gains.
Precisely because of this maddening chase to high returns in short term, the book’s preponderant psychological tenet is that value investors must be overly patient. Throughout Mr. Klarman’s career he has held as much as half of his portfolio in cash, earning only a few percentage points until he found investments with enough margin of safety to invest in. Instead of chasing stocks and bonds and commodities and other assets or sectors of de jour, he awaits for them to come to him at prices he is comfortable paying.
In order to have manageable information that can truly provide insight into the asset’s intrinsic value, Mr. Klarman’s focus is on individual security selection and purchasing undervalued assets of the same, rather than gambling on whether the economy or the market is steering towards a particular direction. Because of the psychology of the short term investors that dominate the markets, undervalued assets have a tendency to stay cheap (or even get cheaper) for a long period of time before rebounding to their real value. This tends to create nervousness in an investor: falling securities prices trigger the tendency to trade out of them in fear that the prices may plunge further. A true value investor, then, has to also circumvent the all too human emotion of fear.
On the flip side, it is equally important and challenging to overcome greed and anxiety. The strong motivation of greed leads to jumping on the band wagon of a new fad to achieve higher daily or weekly gains and the whimsy to invest all available cash. The anxiety to not miss the gravy train (and pressure from clients for the same) accounts for investors overlooking the ignored opportunities such as distressed loans, mispricings and spin-offs.
To summarize, value investing only works over a substantial period of time, outperforming the markets through compounding returns by risk avoidance and patiently waiting for undervalued opportunities. Managers controlled by greed and fear who tend to pursue short-term gains by sacrificing long-term wealth usually don’t survive to see the long term. In Mr. Klarman’s words, “money is made when the crop is planted and not when it’s harvested.”
All that is “wrong” with the market participants and its effects on the markets, however, does not deter Mr. Klarman but actually emboldens him. The reason for his intrepid attitude relies upon his close relationship with his clients. It is his belief that it is crucial that all his clients be in agreement with him at all times giving him the confidence to pursue his strategy to buy what others are selling, the most undervalued and contemptible assets. This only works because his investors concur when being called upon to by the team to consider adding capital rather than redeeming when a unique and unprecedented mispricing arises.
Not only does Mr. Klarman rely on his clients’ approval and confidence in him but also in the manner in which he has organized the team at Baupost. The analysts in the firm are not assigned to specific sectors of the market (pharmaceutical, oil/gas or financial etc.) but instead to opportunity types. They are oriented towards distressed debt, post-bankrupt equity, spinoff and index fund deletions etc.
Given the constraints of time it is next to impossible to try to look for every opportunity that is available, so after casting a wide net they quickly zero-in to a select few. Indeed, they spend significant time on sourcing of opportunities, i.e. identifying where to find bargains and not wasting time to keep up with the quarterly earnings of companies. The focus lies “on where the misguided selling is, where the redemptions are happening, where the overleveraged is being liquidated – and so we are able to see a flow of instruments and securities that are more likely to be mispriced.”
In addition to the mispricing of an asset, the team is also focused on catalysts that will trigger the asset back to fair value – while that may take longer than anticipated, it is imperative to reevaluate the investment if the catalyst fails to cause the expected re-pricing . They also continuously reassess the investment in light of new information that becomes available, especially when the degree of uncertainty is at a high level.
One can best see Mr. Klarman and his team at work on two high profile deals: Enron and CIT.
In 2006, Enron’s senior debt — due to the complicated, litigious, difficult-to-analyze, and anomalous situation it presented– kept potential investors at bay, resulting in a massive mispricing. Enter Mr. Klarman, who feeds on this type of investment and the uncertainty that comes with it. Baupost bought the debt for 10 to 15 cents on the dollar. For them, it boiled down to assessing Enron’s assets sans liability.
Enron’s assets were mainly in cash, 16 to18 billion dollars; however its liabilities were complicated with over a thousand subsidiaries. Baupost assigned an analyst whose sole purpose was to focus on Enron configuring its liabilities and what their returns would be on the bands. Even though the liquidators estimated that bonds would get back 17 cents, the debt traded at 14-15 cents. Baupost estimated a recovery to 30-40 cents with a margin of safety, believing that it might actually reach 50 cents. It is reported that Baupost realized the higher price.
In 2008, Mr. Klarman was buying distressed credits in spring and was attracted to CIT’s senior debt. Baupost bought CIT bonds, which were then yielding about 12%, contingent to the fact that CIT had good quality assets buttressed with an equity cushion making it an attractive candidate for a healthy risk-return. Even though later into the year the bonds fell further, Baupost persisted in buying them.
In 2009, CIT was in such a dire state that Baupost and five other hedge funds injected a supplementary $3 billion in loans. An additional lending of $4.5 billion expanded the facility to not only buy time but also to give Mr. Klarman a comfortable margin of safety. The debt was accessorized by assets worth quadruple the face amount and Baupost ended up getting the 12% yield. He was confident that even if CIT went bankrupt, Baupost would recover, thanks to the assets, at the least 80 cents on the dollar for the unsecured bondholders.
After Mr. Icahn, who had a $2 billion stake in CIT, pulled away when a proposed bid for $6 billion failed, the coast was clear for bankruptcy. Mr. Klarman’s analysis hit the bull’s eye as CIT entered in a prepackaged bankruptcy from which it came out in just 38 days. This culminated in a portfolio of securities with a market value of 80 cents on the dollar for Baupost’s CIT debt.
This deal together with Mr. Klarman taking a significant stake in Facet Biotech, buying shares at $17.50 which eventually climbed to $27 per share offer from Abbott Laboratories, helped him create average returns of almost 27% in the 11 partnerships of Baupost.
Although Mr. Klarman does not usually predict overall market directions and comment on the macro situation, he recently stated today’s overpriced markets will most probably have a decade of zero returns and that he is worried about the world more so than ever in his career.
He traces the source of his worry to the financial crisis of 2008. According to him, the world of finance dramatically changed that year, so it would have been unrealistic to keep assuming that a bank’s return on book value would always stay at 12-15% per year going forward. After all, the instruments which were rated AAA were being downgraded, and watching home building stock movements were not giving any clue as to what was going on in mortgage and housing markets. What had primarily driven the crisis is that the deterioration in subprime mortgages led to the problem in the housing markets. In turn, its financiers, which are banks, had stock that was getting cheaper and cheaper while their earning power was getting weaker and weaker, until the equity was wiped out.
Yet, instead of acknowledging the new reality, the government enticed investors to buy equities, to invest to make the market higher by overpricing securities in the false optimism that the market will rebound. Government programs such as TARP, Cash for Clunkers, and Cash for Caulking, to name a few, have failed to deliver on their promise.
The ongoing government quick-fixes and manipulation of the market, the government bailouts and deliberate machinations, prompted Mr. Klarman to dub it the Hostess Twinkie market: the injection of artificial ingredients to make children delight in Twinkies. Now this phenomenon has spread to the Euro zone and the specific debt level in Greece makes the Euro currency highly suspect.
He posits that during the Great Depression, the general populace at least learned to live within their means as opposed to kicking the can down the road and falsely hoping things will be back to normal soon. What he calls the “depression mentality” was wisely adapted by a generation or two following the Great Depression, but this time around people worldwide have not learned any lessons of frugality or risk-avoidance. For instance, we had record Black Friday sales this year to the tune of $5 billion, proving that the consumer continues to believe this is a short bad economic cycle rather than a paradigm shift that will influence decades.
Mr. Klarman believes that the government’s wayward attitude towards borrowing, spending and printing money raises concerns about the value of the currency and that it will lead to rampant inflation. The obvious investment would be in gold, but Mr. Klarman takes the stance that since a commodity does not generate cash flow it is very difficult to value it. Further, since gold has climbed higher it does not entice him to invest in it as value investors tend to migrate towards assets that are at a discount to their historical average. To protect his clients’ portfolios against inflation, Baupost utilizes complex derivatives buying put options on long term government bonds. These are bets that long term interest rates will eventually rise.
Overall, the current government and market forces have made investing a lot more complex than he has ever seen. It used to be a game of checkers, as Mr. Klarman says, but now it is akin to playing three-dimensional chess. He recommends allocating a good portion of one’s portfolio to cash.
A Note on Short Selling:
While he rarely indulges in selling securities short because of the difficulty in execution and exposure to unlimited risk, he believes that short-selling serves an essential function. Due to the fact that markets fluctuate, driven by greed and fear, they can attain hugely overvalued levels. Mr. Klarman believes this can in turn result in “an improper allocation of society’s resources.” He cites the housing bubble as a primary example in which exorbitant home prices led to excessive home building ensuing in a price collapse and huge loan losses.
This descent that follows periods of market overvaluation depletes the general economy, confidence and rational thinking, usually triggering government intervention in markets. In the same manner that “value buyers can dampen downside volatility, short-sellers can dampen the upside excesses.” This puts the short-sellers in disfavor as the uneducated masses relish the high and rising securities prices creating further overvaluation.
Mr. Klarman’s expertise being in long-term analysis, he praises the short-seller analyst’s capabilities of being able to go against the long-term tide of economic growth and (always over-optimistic) public opinion. According to him, their analysis must always be of the highest order and instead of being vilified should be supported and noted. In essence, they are the watchmen of the financial markets pointing out deception and warning against possible market bubbles.
Even when short-selling can create a panic and its prediction can become a self-fulfilling prophecy (as investors rushing out of a security create a liquidity crunch for the targeted company), Mr. Klarman wonders whether that should actually make the over-leveraged company (or, for that matter, country) reassess their over-reliance on capital market funding. It is not surprising that the contrarian Mr. Klarman admires the analysts most despised by others.
“Most institutional investors feel compelled to swing at almost every pitch and forgo batting selectivity for frequency.”
“So if the entire country became security analysts, memorized Benjamin Graham’s ‘Intelligent Investor’ and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. People would still find it tempting to day trade and perform technical analysis on stocks. A country of security analysts would still overreact. In short, even the best trained investors would make the same mistakes investors have been making forever, and for the same immutable reason – that they cannot help it.”
“I will be buying what other people are selling. I will be buying what is loathed and despised.”
“In capital markets, price is set by the most panicked seller at the end of a trading day. Value, which is determined by cash flows and assets, is not. In this environment, the chaos is so extreme, the panic selling so urgent, that there is almost no possibility that sellers are acting on superior information. Indeed, in situation after situation, it seems clear that fundamentals do not factor into their decision making at all.”
“In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”
“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.”
“Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”