Wisdom from Seth Klarman - Part 1
Seth Klarman and Baupost are in the news lately regarding the CIT Group Inc (CIT) bailout. While I do not want to delve into specifics, I will say that, outside the chance of fraudulent transfer / conveyance / some other quirky bankruptcy ruling dealing with the rescue financing, I would buy the new L+1000 loan (3% floor) all day long...especially if I was getting a 5 point advance fee. Currently in the grey market (when-issued) it is trading at 104-105 without the fee.
As we have not discussed Klarman or Baupost in the past few months, I thought I would take a few moments to pull out some of the more educational quotes from his fund letters through 2004-2007 (note: I do not have the fund letter from 2008...just the portions that were posted in a recent issue of Value Investor Insight).
Before I start pulling out some of my more favorite Seth Klarman quotes, I want to point our reader to a post by Sivaram Velauthapillai, at his contrarian investment blog, where he discusses Seth Klarman's performance in relation to Warren Buffett (WEB). Now admittedly, Sivaram admits he does not know much about Seth Klarman, and really was pulling information from a document I alerted readers to a while back: old Seth Klarman Fund Letters. A few comments have already corrected him, but just to reiterate: As of the end of 2007, Klarman was CRUSHING the S&P since the inception of the fund. The lowest return of the three classes of his funds, from inception, was 5903.7% cumulative return (10434.2% for the largest inception return). And no I did not place the decimal in the wrong point. The S&P in the same period return came in at 1828.4%. So despite lagging the S&P in the go/go years of the 90s, he maintained his capital base when the market gave a lot back in 2000-2002 and the rest is history. In 2008, press reports stated that Klarman was down low double digits. I can neither confirm nor deny this. Nonetheless, the S&P was down ~38.5% ... further extending Baupost's lead.
In response to the blog post specificially: I understand the point about Klarman under-performing the S&P in the go-go years. I get it. But, the problem in looking at any one's record at any one point in time is that the past is the past. If you had looked at John Paulson's merger arbitrage flagship fund in the beginning of 2007 you may say to yourself: "Well, this fund...you know, it has been just doing OK" ... and then he goes out and throws a +50% net to investors year in 2007 versus a nearly flat market. On the flip side you could look to any number of funds that were putting up annualized returns in the high 20s to low 30s up to 2008 and were down 50-60% last year bringing their cumulative returns to mere marginal levels.
Extending this to fundamental analysis, take a guess who's returns these are:
They are the reported return on equity of Bear Stearn (as reported from Bloomberg)...right up until the very end. As Seth Klarman writes in his 2004 letter, "While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish."
Now onto some more Seth Klarman wisdom. I am going to a few quotes from each letter (2004-2007) that I find particularly insightful regarding the investment and portfolio management process.
From the Baupost 2004 letter:
"By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, "I would rather lose half our shareholders...than lose half our shareholder's money..."
That is just a spectacular quote (both Klarman's and Eveillard's). It's also why, as my readers are more than aware, I prefer current paying, senior-secured bank debt. Risk of permanent capital is low, I am getting paid to wait, there is a definite catalyst in emergence, and I have some control over the process. More quotes from the 2004 letter:
"We continue to adhere to a common-sense view of risk - how much we can lose and the probability of losing it. While this perspective may seem over simplisticor even hopelessly outdated, we believe it provides a vital clarity about the true risks in investing."
Another great quote from Seth Klarman. Risk is not beta or standard deviation...it is how much you can lose on an investment and what the chance is that "loss" scenario is going to play out.
And finally, from the 2004 letter (I am going to jump around on this one for full effect):
"Markets are inefficient because of human nature - innate, deep-rooted, permanent. People don't consciously choose to invest with emotion - they simply can't help it.
"So if the entire country became securities analysts, memorized Benjamin Graham's Intelligent Investor and regularly attended Warren Buffett's shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads...People would, in short, still be attracted to short-term, get rich quick schemes.
"In short, we believe market efficiency is a fine academic theory that is unlikely ever to bear meaningful resemblance to the real world of investing."
Wisdom from Seth Klarman - Part 2
Last week, we posted some quotes and commentary on the Baupost 2004 Letter to Investors penned by Seth Klarman. We continue our wisdom / quotes from the Baupost 2005 letter.
First of all, they posted a return of 11.22% for the year, with 3.32% of the gain coming from "non-performing debt." Further this position represented ~15% of the NAV at year end. When the odds are in your favor, you bet big. Most people in the distressed debt can guess what this position is...My personal guess is Enron. There was a video floating around on the interweb, where Seth Klarman gave a speech to Columbia business school students, where he mentions Enron. From Gurufocus (via Alex Bossert's Value Investing Blog):
"Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18 billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were low balling what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents."
My old fund had a large position in Enron, in which I was the analyst, and the time frame pretty much matches with the movements of the bonds. We owned the Class 4's with S (if you do not know what that means, don't worry about it). I do not know the exact vehicle Baupost would of invested, but it looked like they made a nice chunk of change (as many distressed funds did).
Back to the Baupost letter now.
"For most investments, much can go wrong, including numerous factors beyond an investor's control: the economy, the markets, interest rates, the dollar, war, politics, tax rates, new technology, labor problems, competition, litigation, natural disasters, fraud, dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these risks can be hedged, often only imprecisely and always at some cost. Other factors are under an investor's control, but are not always controlled: discipline; consistency; remaining within your circle of competence; matched duration of client capital with underlying investments; prudent diversification; reacting rationally to news or market developments; and of course, not overpaying"
One of the characteristics that has impressed from reading Klarman is how consistent he seems. He does not seem to waver from his strategy. I know he has used options and very tight CDS (specifically sovereigns) to hedge his portfolio. Those factors where he commented that are under our control...well we should spend 90% of our time thinking about them and not worrying if the market will finish higher a month from now. For our next quote, Klarman discusses Baupost's investment returns:
"Is or past success the result of skill or luck? Is it replicable, or merely a lengthy run of good fortune? We are confident that our success has not been the result of a favorable spin of a roulette wheel or a timely roll of the dice. It has been truncated, not heightened, risk. Our gains over the years have been earned, banked, redeployed into the next advantageous investment, and thereby compounded, again and again. With sound investment principles, a committed and dedicated investment organization, a healthy and vigilant awareness of what can go wrong, and a strong sell discipline, investing is more akin to a high-yielding, periodically volatile, and non-guaranteed bank account than a game of chance. Can gains be lost? Of course they can, through laziness, sloppiness or hubris. Buck such a reversal is hardly inevitable, especially when one is aware of these risks. We work assiduously to maintain our gains, emphasizing as always the preservation of capital and, only when attractive opportunities become available, its enhancement."
One of the reasons I like this quote is because it pretty much puts to rest the buy and hold argument. Klarman buys, and when the offered return vs downside risk is against him, he banks the gain and waits for another attractive opportunity. Too many times, hedge fund managers get sucked into a story of a never ending bullish sentiment on a particular stock. Yes, intrinsic value changes throughout the life of an investment. But when a stock is trading at 125% of your IV target, it's hard not to bank some of those gains. And in the final sentence, Klarman again differentiates the return of capital vs return on capital, something that I talk about way too much on this medium.
A few other sets of quotes I really liked:
"While you know that our investments often stand apart from those of the crowd, you may not be aware of how deeply this contrarianism permeates our activities. Our investments can be remarkably contrary; we regularly search the "new low" list for investment ideas, while shunning names on the "new high" list. We purchase what the crowd is dumping. We typically buy stocks in the face of Wall Street "sell" recommendations, and reduce positions in their "buys" We eagerly assess financially distressed companies for opportunity while the world experiences revulsion. For us, analytically complex, litigious, stigmatized, and shunned situations bought at the right price form the backbone of a limited risk portfolio of opportunity."
Contrarian for the win. Some more nuggets:
"Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity, accepting a minor diminution in expected return where, and only where, the historic returns have been particularly out sized for the risk. There was never any logic, for example, behind the consensus industry annual return targets of 20% or more on bankrupt bonds or private investments. At times, an expected 15-18% return is ample, given the qualify of the underlying assets, the conservative nature of the assumptions made, and the limited spectrum of things that can go wrong. Other times, even a projected 25-30% return might be inadequate, where the quality of the assets is suspect, the return is earned in a risky and unhedged currency, and the downside risk is larger than usual. The quality of management must be factored in. The expected duration of an investment may also play a role; a short-dated investment earning inadequate return is over soon, and one can move on to better opportunity. Long duration mistakes are the gifts that keep on taking, locking you in to low returns, or significant capital losses if you exit early."
"We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What's your edge? To succeed in today's overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resource provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work."
This 2005 Letter may need a second post. Seth Klarman offers many more nuggets of wisdom. Stay tuned.
Wisdom from Seth Klarman - Part 3
If you remember, in the beginning of August, we grabbed some quotes from the Baupost letter from 2005. We continue with that same letter, as it provided a number of fantastic investing gems.
"...Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economicout performance by one investor is necessarily offset by another's under performance. Consequently, you keenly watch your competitors to see not only what they are doing right, but what they are doing wrong. You observe carefully to identify their investment constraints and limitations, their time horizon and liquidity requirements, areas that they ignore and areas that they avoid. It is in these areas that opportunity is often greatest; that is where bargains regularly surface, with your best competitors not only failing to compete but sometimes serving as the seller. It is here, where others panic, sell mindlessly, neglect, or fear to tread that investors have a chance to develop and sustain an edge." growth, market
From a speech that Seth Klarman gave to a group of Professor Greenwald's Value Investing Class, we know that he has analysts that just focus on spin offs, changes in indexing, bankruptcy etc. These create vacuums where force sellers rule the day due to investment constraints. In the example of an index fund trade, imagine a somewhat illiquid stock dropping from an index. Index funds across the board need to sell the holding to maintain their index match which creates a situation of uneconomic selling which in turn may create a dispersion between price and intrinsic value. It is also rumored that Baupost's investments in MLPs in late 2008/early 2009 stemmed from the fact that Lehman brothers held 20% of the float of the companies and were forced sellers as their prop desk unwound.
"The single greatest edge an investor can have is a long-term orientation. In a world where performance comparisons are made not only annually and quarterly but even monthly and daily, it is more crucial that ever to take the long view. In order to avoid a mismatch between the time horizon of the investments and that of the investors, one's clients must share this orientation. Ours do."
It is a sad, but true fact in the investment industry that limited partners and general partners, specifically in the context of a hedge fund, have different investment and liquidity time constraints. Many analysts reading the blog today will have experienced a situation where an investment looks particularly compelling, but the idea was kibashed, or sold early, because the portfolio manager had to raise cash, or was painting the monthly numbers. Despite their obviously strong investment skills, an advantage of Baupost is how sticky the capital is as opposed to a number of other funds that have had to put the gates up. I do not know who said it, but I remember hearing a quote: "You deserve the capital you attract." Unfortunately, for a small manager, any capital is good to get the ball rolling. And that creates a mismatch which is one of the fundamental flaws of this business.
"We are able and willing to concentrate our capital into our best ideas. These days, other investors' idea of "risk control" is to own literally hundreds of small positions while making no size able bets, a strategy that might also be labeled "return control". It is clearly an advantage, but by no means without risk, to be able to concentrate our exposures. We work exceptionally hard to ensure that our largest positions are indeed our most worthwhile opportunities on a risk-adjusted basis."
What is interesting, is that this quote somewhat ties in with the previous two. Having a large diversified book helps when capital it quick to exit. Further, a massive position in two or three stocks when limited partners are redeeming can cause returns to become even worse as you put pressure on the stock. The opportunistic investors should see this and buy the stock you are selling (uneconomically I might add) on the cheap. But they will wait until you are fully out, further depressing returns, and inciting more limited partners to redeem.
This is where portfolio management becomes so important. Managing the book to allow for sufficient liquidity in case of redemptions, but at the same time placing your bets in a way to maximize risk return. This is where people discuss the Kelly Formula...or better yet, the modified Kelly Formula. As has been reported in many places, Monish Pabrai moved his allocations to 10% per position to a smaller number. I think this makes sense, but there will be times (like Enron for example) where a 10% position makes sense.
Now remember, Klarman wrote these words in early 2006:
"The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly ever investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedented low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. "
Take about having a crystal ball.
Stay tuned for the next part of the Seth Klarman series where we dig into the 2006 Baupost annual letter.
Wisdom from Seth Klarman - Part 4
In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it, thank you to Andy for his donation (for those so inclined, a donation link is on the right rail, lower in the page). More donations = the better.
In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in comparison to the S&P which was up 15.8% that year. Gains were made from a number of categories with approximately 7% of absolute gain coming from performing and non performing debt - with the largest gain coming from "unnamed non-performing debt" which I speculated in last post was a position in Enron. These results are even more impressive given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over 40% during the year.
After discussing the party that was 2006, Klarman writes:
"We maintained our discipline throughout the year: disciplined buying when bargains emerged, and disciplined selling when prices approached full value. Despite fairly expensive markets, robust competition, and a near complete dearth of distressed debt opportunity, our tireless, highly capable, and experience team was able to fairly regularly uncover new opportunities. Considerable fundamental progress in many of our holdings, along with our strong selling discipline, triggered realizations during the year that were approximately equal to new purchases, resulting in relatively flat cash balances that masked substantial underlying activity.
One adverse in evidence during the year is that the markets proffered fewer extreme mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of the correction of these mispricings accelerated. In other words, fewer investments become really inexpensive, more become somewhat inexpensive, and the correction of these smaller mispricings happened faster than usual, enabling a particularly favorable overall result for us and for many value-oriented investors. It is impossible to know if this paradigm will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and increasingly private equity pool suggest that it could.
The old saw reminds us never to confuse genius with a bull market. Anyone can become "expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is lifting all boats often proves irresistible."
This guy must have a crystal ball. Remember he wrote this in January 2007. He is also somewhat pointing the finger (I am sure unintentionally) to many of the value investors that kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an interview with a prominent value investor saying that Freddie Mac was one of the cheapest stocks he had ever seen - and he just kept buying and buying it.
After talking about the sheer magnitude of capital flowing into alternative investments (hedge funds, venture capital, and private equity), fueled by demand from institutions and pensions:
"Many of today's institutional asset allocators are not evidently worried about the enormous amounts of capital surging into alternative investments. They are now asking the relevant bottoms-up question: Where are today's bargains? They are not following that thread to build, investment by investment, or one carefully chosen fund at a time, a diversified portfolio of undervalued investments. Instead, they are typically focused on the answer to three questions, each of which demonstrates a reluctance to think for themselves:
1. What has worked lately?
2. How can I diversify my way to investment success?
3. How can I invest like the institutional thought leader of this era; in other words, like Yale?
Here's why these questions range from remarkably foolish to largely irrelevant.
Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the sky. Sustained out performance in any particular sector of the markets is eventually borrowed from the future, to be given back either slowly through sustained under performance or quickly through price declines. What has worked lately is popular, widely owned, and bid up in price, and therefore generally anathema to good future results. But human nature makes it extremely difficult for people to embrace what has recently fared poorly."
And further down the letter...
"The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, what at least avoiding under performance. This is the best that you can hope to do in an efficient market.
For any fundamental-based investor, this is complete hogwash. Investment come in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either."
I love it. Too many times, each of us get caught up trying to look at some many things that our heads spin. A number of value investors suffer from a problem I fondly dub "Everything is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at everything, and lots of the things you look at you think are cheap. Any investor can rationalize a price target for any asset. The goal is to be patient and swing at those once in a lifetime opportunities, and then not dilute those returns with mediocre value traps.
"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not too distant future."
The first rule of investing is to not lose money. And the second rule is to not forget the first rule. When approaching situations, always look to the possibility and magnitude of permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an event a year or so ago and she mentioned that Warren Buffett will not invest in a situation where there is even a remote chance of permanent capital loss.
Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006 Baupost Annual Letter.
Wisdom From Seth Klarman - Part 5
Wisdom From Seth Klarman - Part 6
Wisdom From Seth Klarman - Part 7
Dah Hui Lau (David)