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Seth Klarman 2013 Letter to Investors: The Truman Show

Below is an excerpt from the Buapost Group’s 2013 shareholder letter from Seth Klarman (Trades, Portfolio). Klarman has recently given back 4 billion to investors due to lack of ideas, 40% of the portfolio being cash, and a “Truman Show” style market where everything is make believe and everyone is pretending. Baupost Group “has drawn a line in the sand and also cautioned “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test, what investors see in the inkblots says considerably more about them than it does about the market."

"Born Bulls"

In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test. What investors see in the inkblots says considerably more about them than it does about the market.

If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stock probably look attractive, even compelling. Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.

But if you have the worry gene, if you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about. A policy of near-zero short-term interest rates continues to distort reality with unknown but worrisome long-term consequences. Even as the Fed begins to taper, the announced plan is so mild and contingent – one pundit called it “taper-lite” – that we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences. Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings? Pretty clearly, lower than otherwise. Yet Robert Schiller’s cyclically adjusted P/E valuation is over 25, a level exceeded only three times before – prior to the 1929, 2000 and 2007 market crashes. Indeed, on almost any metric, the U.S. equity market is historically quite expensive.

A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.

There is a growing gap between the financial markets and the real economy.

"Flash-Mob Speculation"

When it comes to stock market speculation, it’s never hard to build a “coalition of willing.” A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities. Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500, Dow Jones Industrial Average, and Russell 2000 regularly posted new record highs (45 for the S&P, 52 for the Dow, and 66 for the Russell) while gaining a remarkable 32.4%, 29.7%, and 38.8% including dividend reinvestment, respectively, in 2013. It was the best year for the S&P 500 since 1997... In the closing weeks of 2013, it was as if the strong gravitational pull of valuation had been temporarily suspended and stock prices had been launched by a booster rocket, allowing them to reach escape velocity. As with bull markets past, favored stocks started to become unmoored and unbounded.

"Speculative Froth" and Dot-Com 2.0

Whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences in the markets and how you interpret them. Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth. Margin debt measured as a percentage of GDP recently neared an all-time high. IPO activity in 2013 was greater than it has been in years, with 230 offerings taking place, 59% more than last year and approaching 2007’s record of 288 transactions.

Twitter, for example, surged from $26 to almost $45 on day one, and closed the year around $64. It was priced, after all, at only twenty times its projected 2015 revenue. One analyst suggests the profitless company might achieve $50 million of “adjusted” cash earnings this year, giving it a P/E of over 500. Some hedge and mutual funds are again investing in late-stage, pre-IPO financing rounds for hot Internet companies at valuations that only seem reasonable if the companies go public, soon, and at astronomical prices.

Amazon.com, with a market cap of $180 billion, trades at about 15 times estimated 2013 earnings, Netflix at about 181 times. Tesla Motors’ P/E is about 279; LinkedIn’s is 145. Even though Netflix now carries some original programming, we’re pretty sure we’ve seen this movie before. Some 23-year-olds have sold their startup Internet companies for hundreds of millions of dollars, while the profitless privately held Snap chat has turned down a $3 billion buyout offer.

In Silicon Valley, it seems that business plans – a narrative of how one intends to make money – are once again far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses.

“Ominous Signs”

In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987. A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does.

Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?

“The Continuing Problems in Europe”

Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment. One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008. Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008. That doesn’t look fixed to us. The EU credit rating was recently reduced by S&P. European unemployment remains stubbornly above 12%. Not fixed.

Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending. Again, not fixed.

“Bitcoin And Gold”

Only in a bull market could an online “currency” dubbed bitcoin surge 100-fold in one year, as it did in 2013. The phenomenon spurred The Wall Street Journal to call it a “cryptocurrency” craze, with dozens of entrants. Bitcoin now has an estimated market “value” in excess of $6 billion, leaving alphacoin, fastcoin, gridcoin, peercoin, and Zeuscoin in its wake. Now most sell-side firms are rushing to provide research on this latest fad, while “bitcoin funds” are being formed. Recent recruitment e-mails to staff such a platform reassure that even though experience is preferred, it is not required.

While bitcoin is yet another bandwagon we are happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality.

If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money? The dollars and yen are, of course, legal tender issued by governments, but in an era in which governments are neither popular nor trusted, that is not necessarily a big plus.

Gold, at least, has been regarded as “money,” for thousands of years, and it is relatively stable and widely accepted store of value and medium of exchange. It’s a well-known monetary “brand.” It doesn’t exist only (or at all) in cyberspace, and it cannot be printed on the whim of authorities. Ironically and perplexingly, while gold, the hard money alternative to the printing press kind of money, dropped 28% in 2013, the untested and highly speculative bitcoin went completely through the roof.

"The Truman Show" Market

Welcome to “The Truman Show” market. In the 1998 film by that name, actor Jim Carrey is ignorant of the fact that his life is a hugely popular reality show. His every action, unbeknownst to him, is manipulated while being broadcast to millions of TV viewers worldwide. He seemingly lives in an idyllic seaside community where the manicured lawns are always green and the citizens are always happy. These people are, of course, actors. The world Truman inhabits turns out to be phony: a gigantic sound stage created for a manufactured “reality.” As Truman starts to unravel the truth, his anger erupts and chaos ensues.

Ben Bernanke and Mario Draghi, as in the movie, are the “creators” who have manufactured a similarly idyllic, if artificial, environment for today’s investors. They were the executive producers of “The Truman Show” of 2013. A global audience sat in rapt attention before this wildly popular production. Given the U.S. stock market’s continuing upsurge, Bernanke is almost certain to snag yet another People’s Choice Award for this psychological “thriller.” Even in “The Truman Show,” life was not as good as this for investors.

But there is one fly in the ointment: in Bernanke’s production, all the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface. The Fed and the Treasury openly discuss the aim of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect.” Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored, and markets go asymptotic. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal (12/20/13), the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.

Like a few glasses of wine with dinner, the usual short-term performance pressures on most investors to keep up with the market serve to dull their senses, which makes it a bit easier to forget that they are being manipulated. But what is fake cannot be made real. As Jim Grant recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.” According to John Phelan, a fellow at the Cobden Centre in the U.K., “the Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent.”

Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.

A marketplace of knowing Trumans seems even more unstable than the movie sound stage character slowly awakening to reality. Can the clued-in Trumans be counted on to maintain their complicity or will they go off-script? Will Fed actions reliably be met with the desired response? Will the program remain popular? Could “The Truman Show” be running out of material? After all, even Seinfeld ended.

Someday, the Fed’s show will be off the air and new programming will take its place. And people will debate just how good it really was. When the show ends, those self-deluded Trumans will be mad as hell and probably broke as well. Hopefully there will be no sequels.

“Someday...”

Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy – maybe not today or tomorrow, but someday. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.

Someday, professional investors will come to work and fear will have come to the markets and that fear will spread like wildfire. The news flow will be bad, and the markets will be tumbling.

“Here We Are Again

When the markets reverse, everything investors thought they knew will be turned upside down and inside out. “Buy the dips” will be replaced with “what was I thinking?” Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it’s easier to buy than to sell, and that in bear markets, all too many investments turn into roach motels: “You can get in but you can’t get out.” Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill-prepared will find there’s a long way to fall. Few, if any, will escape unscathed.

Six years ago, many investors were way out over their skis. Giant financial institutions were brought to their knees when untested structured products that were too-clever-by-half turned toxic and collapsed. Financial institutions and institutional investors suffered grievous losses. The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented.

But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to many markets and asset classes, and where caution seems radical and risk-taking the more prudent course. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs. Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


Rating: 4.7/5 (28 votes)

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Comments

AlbertaSunwapta
AlbertaSunwapta - 5 months ago

Hussman and Watsa will be ready.

csucag2
Csucag2 - 5 months ago

This is only an excerpt of Klarmans letter of course and it warns us and says few will be ready. It would be of interest to have Klarmans advice on how to get ready?

tonyg34
Tonyg34 - 5 months ago

just reinforces the benefits of an allocation plan that forces you to buy more of what's cheapest b/t stocks bonds and cash

TannorP
TannorP premium member - 5 months ago

I was also thinking the same Alberta.

Tilson and Einhorn have juicy short books as well. I would also be very interested in "How to get ready" Csucag, I would assume a portfolio composed of liquidity + durable businesses valued less than intrinsic value would hamper the storm.

Cheers.

TannorP
TannorP premium member - 5 months ago

Agreed Tony,

Knowing what you own and why you own it, is a key to being a prudent and confident investor. That could be added to the "How to get ready" checklist.

vgm
Vgm - 5 months ago

Thanks Tannor for the extended excerpt. We've been exceedingly fortunate in the past week or so to have had letters and/or interviews with the giants of investing - Klarman, Buffett, Watsa, Marks - and to be able to compare and contrast their views.

When asked which investors he admired, Ted Weschler mentioned David Tepper (Trades, Portfolio) for his long record in making money in good times and bad. I guess that's what impresses me about people of the caliber of Klarman and Marks. Both made outsize gains in the past 4-5 years. They're now sitting pretty with plenty cash ready for the next round. Brilliant!

vgm
Vgm - 5 months ago

Arguably, Ted Weschler's commentary on Davita last week is exemplary of how we should "get ready". He described DVA as an essential-type business having a moat, high ROC, predictable growth, and a shareholder-friendly management. He added he did not know what the stock would do over the next couple of years, but was very confident it would be a more valuable franchise in five years' time. He has more than 30% of his portfolio in this one name, as well as a large personal holding of some 2M shares. Assuming we've bought with a margin of safety, then lining our portfolio with such robust companies would seem to be one way to "get ready" or 'be ready'. But then again, isn't this the way we should always invest? (I am long DVA)

csucag2
Csucag2 - 5 months ago

Thanks for the responses. I concluded i'm going to keep calm and carry on (by carry on i mean be fully invested in magic formula stocks or guru owned financials that are typically selling at below book)

vgm
Vgm - 5 months ago

One last word. Ron Muhlenkamp's comments on Seth's predictions are worth factoring in:

http://www.gurufocus.com/news/250775/value-investor-ron-muhlenkamp-doesnt-agree-with-seth-klarmans-stock-market-warning

TannorP
TannorP premium member - 5 months ago

Thanks for the comments and reading,

It doesn't look like Ron Muhlenkamp has very good performance so I personally would disregard his comments. Ted Weschler on the other hand would cause a serious investor to stop in their tracks and listen. I think he and everyone that has commented has the right idea about the best way to prepare being to hold great businesses at a discount from intrinsic value (that is growing) with a durable moat. If the price declines think of it as groceries or clothing... load up when there are large sales.

I find this quote from JM Keynes especially fitting given the discussion,

"I find no shame at being found still owning a share when the bottom of the market comes. I do not think it is in the business of . . . [a serious] investor to cut and run on a falling market . . . I would go much further that that. I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself. Any other policy is anti-social, destructive of confidence, and incompatible with the workingof the economic system. An investor . . . should be aiming primarily to long-period results and should be solely judged by these." - 1938 Nation Mutual, John Maynard Keynes

Cheers.

beltrancaceres
Beltrancaceres - 5 months ago

"...Amazon.com, with a market cap of $180 billion, trades at about 15 times estimated 2013 earnings.."

what does this mean? I'd definitely be interested in Amazon at a PE of 15.....

batbeer2
Batbeer2 premium member - 5 months ago

@ Beltrancaceres

I could only begin to explain that by assuming there's a typo. 15 should be 150.

If you adjust for all sorts of things, I can see how one could come up with earnings just north of $1B for Amazon.

But 180/15 => $12B......

No, I don't see how one could come up with an estimate of earnings of $12B.

Not this decade.

AshishGupta
AshishGupta premium member - 5 months ago

"and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk."

What does that mean? To put it in historical perspective what kind of return and risk are we talking about? I was looking at high quality Intermediate term corp bond fund DODIX in my 401k and I saw worst it has gone down is around -3% in a year.

"Both made outsize gains in the past 4-5 years. They're now sitting pretty with plenty cash ready for the next round. Brilliant!" - VGM

I did not make outsize gain becuase I never believed in the outsized opportunity in last 4-5 years. Too much listening to pundits is not good for your economic health or future.

TannorP
TannorP premium member - 5 months ago

Yes it is a typo and should be 150x FY2013.

TannorP
TannorP premium member - 5 months ago

The risk-free rate is artificiallylow due to demand the FED has created, lowering the yield curve or sending investors higher up the risk curve for the same return. That is essentially what is meant by "and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk."

"Too much listening to pundits is not good for your economic health or future." - could be changed to "any listening of pundits"

vgm
Vgm - 5 months ago

"I did not make outsize gain becuase I never believed in the outsized opportunity in last 4-5 years. Too much listening to pundits is not good for your economic health or future."

AG -- that's a tough but good lesson to learn. There are a select few superinvestors we should listen to - and listen to very very carefully. They don't say much or say it often, but their words are priceless - Buffett for example in 2008 urging us to "Buy American. I am". The rest - the pundits, the herd, the talking (and writing!) heads - are noise, and dangerous to our financial health as you discovered the hard way. Thanks for commenting.

vgm
Vgm - 5 months ago

Buffett talking today March 14 doesn't anticipate significant problems in the market:

"He predicted there will be another financial crisis "someday" in the years ahead that will shock financial markets, but he doesn't think it will happen anytime soon." ("We are not remotely close to it happening now.")

"Buffett said he's been bullish on the U.S. economy since the fall of 2008, but he doesn't expect it to rapidly accelerate this year. Instead, he thinks it will continue its slow upward trajectory."

http://finance.yahoo.com/news/buffett-id-surprised-stock-prices-120642587.html

http://video.cnbc.com/gallery/?video=3000257192&play=1

traderatwork
Traderatwork - 5 months ago

"Speculative Froth" and Dot-Com 2.0" - Indeed. Fool me once... ;)

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