In my previous article (link), I posted the first part of my notes from Seth Klarman's comments and answers during the 18th Graham & Dodd Breakfast held in October 2008. This article contains the second part of my notes:
5. On insurance:
In terms of Baupost, I tried really hard to learn the lessons of 1998 in particular. This was: Don’t be unprepared for something out of the blue that’s really bad. To some extent, we were prepared this time. However, you can never be prepared enough. We had a lot of macro protection in terms of credit default protection on bonds where we were just betting that credit spreads would widen. That’s been incredibly helpful. But we’ve gotten really tired of buying market puts (Klarman’s 1997 to 1999 letters disclose that Baupost owned some S&P put options back then), or anything like that, because they inevitably are expensive and expire worthless.
All of us – every day, every week, every month – have to deal with things we’ve never seen before. In every previous downturn in my investment career, some things would be getting killed while a lot of things would be recovering. In this environment, it’s been straight down for everything. We’ve had almost no respite. So the idea that you can recycle money from one holding that has recovered into another one – that has just not happened. So you need to be prepared for that.
6. On when to buy bargains:
You buy one security at a time. And if somebody wants to sell you something at 60 cents that is worth par, you buy it – because you don’t know if tomorrow someone will sell it to you at 50 cents, or if it’ll be at 70 cents or 90 cents.
Many of us, myself included, have seen opportunities and have bought. History says that most of the time when you see things that meet an absolute standard of value, you buy them. So, we bought knowing that the economy was very likely to slow down and that banks are were going to fail and knowing that real estate prices were going lower, but knowing also that mortgage security prices more than fully discounted that in our estimation.
Perhaps we should have changed everything we’ve done for 26 years to anticipate this 1% probability environment that we are in today. Or, perhaps, one should do what one always does: take advantage of the opportunity – if more opportunities show up, take advantage of that, too – while never using leverage, never being in a position where one can’t take advantage and hopefully, having opportunities that will let you.
7. On adapting to a changing world:
I think investors need to use all the tools at their disposal. Sadly, for many value investors I know – that everybody in the room probably knows – a lot of value investors bought financial institutions at prices that were historically cheap. But had they broadened their analysis to understand and factor in where the mortgage – backed or securitization markets were trading, they might have understood that at least some securities were pricing in levels for housing prices that would be devastating to those same financial institutions. You can’t ignore what’s going on in the world. You must adjust for what’s there and for what’s not there on the balance sheet.
8. On avoiding competition than trying to beat them:
In terms of my thinking since 1992, I guess what I’d say first of all is that we follow the same principles that we’ve followed all 26 years we’ve been in business.
The major change is we’ve come to realize that there are many more smart competitors in public capital markets – especially in the equity market. Every investor should be in a position where they can identify what their edge is. And if you are investing and don’t have an edge, then you probably shouldn’t be. We think about that a lot. There are many formidable, smart, capable investors with long-term time horizons. And there are obviously also people who know a huge amount about specific industries because they use specialists or former corporate executives from those industries, or even from those very companies. It’s very competitive out there most of the time.
Therefore, we’ve drifted into the less liquid, less public parts of the universe. Competition is a key consideration for us. We’d rather not try to outsmart somebody – and I’m not sure we even could. Therefore, we’d rather hunt where they are not looking.
That’s why we own real estate. We got in when the RTC (Resolution Trust Corporation) was formed and the government was selling assets at pretty crazy prices because there were no buyers. There were very few people able to bid on large portfolios of non-performing loans or foreclosed real estate back then. And that simply led us to a journey where we looked for value, whether it’s public or private.It’s a little bit like Warren Buffett (Trades, Portfolio), who’s happy to buy a cheap stock, but for reasons that involve both opportunity and perhaps liquidity – or the ability to put large amounts of money to work – has gotten into negotiated transactions of all sorts as well.
9. On position sizing:
A lot of people don’t think about that right. In the last 10 or 15 years of the proliferation of hedge funds, many have come to view risk control in terms of thinking about position size and, in effect, saying, “I don’t want to lose more than 10 or 20 or whatever basis points on a position. Therefore, it can never be more than a 1% or 1.5% position."
Maybe a dozen times over 26 years we’ve had a 10% or so position. Most of the time, we have position of 3% or 5% or 6% in our favorite ideas. We will take them higher when a cheap position becomes a much better bargain, or when there’s a catalyst for the realization of underlying value. We favor catalysts because it suggests a much shorter duration – and much greater predictability that we’ll in fact make money – on that investment. And it suggests that we won’t be quite as subject to the vagaries of the market, the economy, and even the business over a longer period of time.
By the way, we wouldn’t consider owning a 10% position in a common stock just because it was cheap unless we had both a seat on the board and control – because too many bad things could still happen. On the other hand, we would consider taking a 10% position in a senior distressed debt investment where there was a plan already in place and we believed that the assets were very safe – because they were backed by either cash or receivables or something else. But again, we’d have to believe that we could count on getting our money back, see almost no chance whatsoever of incurring a principle loss in the next couple of years, and expect a very high (20% plus) rate of return.
