Seth Klarman (Trades, Portfolio) isn’t known for being flashy. That makes his most recent investor letter, totaling 22 pages, a must-read.
If you haven’t heard of Klarman, get acquainted. He established Baupost Group in 1982. After achieving 20% compound returns for more than three decades, he now manages more than $30 billion.
Many investors have called him “the next Warren Buffett (Trades, Portfolio),” but judging by his history of success, he deserves a classification of his own.
In summation, when Klarman speaks, it pays to listen. Here are five lessons from his latest letter sent to Baupost Group investors.
On Wall Street, anything can happen
Klarman’s long-term track record is especially impressive considering he’s held large cash stakes throughout most of his tenure. Over the last several years, as asset prices continued to surge higher, he has typically maintained a cash position in excess of 10%.
While this proved unwise recently, Klarman has a knack for coming out on top in the end.
In his latest letter, the guru reminded investors that “on Wall Street, anything can happen.” After accumulating 11 months of profits in 2018, Baupost’s portfolio was crushed in December, resulting in a breakeven year for the portfolio.
“Last year once again demonstrated that markets can be confoundingly fickle,” Klarman wrote.
While asset prices typically trend toward their intrinsic values, it can take months, years or even decades to do so. Klarman simply plays with the cards he’s dealt, acknowledging that market gyrations can always make him look like a fool over the short term.
“On any given day, the sheer number of players, behaviors, economic factors and business developments defy anyone’s ability to fully grasp what is going on and why,” he wrote. “That’s why we develop and follow a game plan that does not purport to tell us what to do moment by moment, but rather is intended to help us successfully navigate the most challenging tumultThis is the essence of value investing.”
Dangers are growing
Given his growing cash position in recent years, and the fact that it’s dragged down performance, the guru has received plenty of flak from the investment community. To Klarman, this is exactly the type of behavior you’d expect following a long bull run.
“The economic expansion, clocking in at nine-and-a-half years, neared the longest on record,” he wrote. “As usual in a bull market, the warm feelings generated by rising prices had the effect of overcoming any sense of looming danger in the hearts and minds of most investors…In August, the bull market became the longest on record – at nearly 3,500 days and counting. It felt like forever.”
Earlier in the report, he cited several reasons to fear ever-rising asset prices, much of which was fueled by one-time factors.
“Generally, rising share prices over the ensuing months more or less moved in tandem with higher corporate earnings, the result of massive fiscal stimulus, large corporate tax cuts, and historically low–albeit generally rising–interest rates,” Klarman said.
These factors have pushed valuations up to dangerous levels, prompting the guru to note: “Market pundits calculated that valuation multiples, with earnings assessed on a cyclically-adjusted basis, had reached the second-highest level ever (though reported earnings were more in line with historical averages)."
If you think you can avoid this danger by jumping off the speeding train just before impact, think again.
“Many investors had evidently adopted the usual dubious emergency plan: Get out when the market starts to fall,” Klarman said, noting this has rarely been a winning bet.
Bonds are no longer a safe haven
To diversify their portfolios, many investors have turned to bonds, typically income-producing securities with minimized downside risk in comparison to equities. That equation may soon be broken.
“There are also concerns that the lengthy 36-year bond bull market is nearing its end,” Klarman wrote.
Often, investors look at the past decade of results to determine “long-term” trends. Therefore, whenever a multi-decade trend ceases, portfolios everywhere risk blowing up.
“Given the length of the bond buying spree, many of today’s market participants have never experienced a bear market in bonds,” he said. “The riskiness of their exposures may surprise them.”
The last bond bear market occurred during the 1980s, when the financial system had major structural differences. Changes have occurred throughout every aspect of life, including the rise of globalization and the onset of mass indexing.
These shifts could leave investors with little insight into how to behave during a bear market.
“Because marketplace conditions have evolved greatly over the last three decades, when we do eventually enter a fixed income bear market, neither historical correlations nor prior experience are likely to provide much guidance for how to successfully navigate this treacherous terrain,” Klarman concluded.
We’re in a sovereign debt crisis
It’s always easier for politicians to borrow rather than maintain a responsible budget. According to Klarman, this will eventually have dire consequences.
“Since the 2008 financial crisis, aggregate global sovereign debt has nearly doubled, and most major sovereign debtors have experienced a significant increase in their debt-to-GDP ratios,” he noted. “The ratio of U.S. government debt to GDP, for example, has grown from over 74% of GDP in 2008 to 105% in 2017. For the U.K., the ratio has surged from 50% to 88%. For France, 69% to 98%. For Italy, from 102% to 132%. For Spain, from 39% to 98%. Canada has gone from 68% to 90%. China from 27% to 47%.”
Many pundits, particularly several economists ascribing to the Modern Monetary Theory, believe rising sovereign debt levels aren’t as risky as they seem. Klarman disagrees.
“The seeds of the next major financial crisis (or the one after that) may well be found in today’s sovereign debt levels,” he wrote.
The investor is specifically worried about the U.S., going on an extended diatribe that ends with a gloomy prediction.
“In 2018, the U.S. budget deficit soared to nearly $900 billion and could top one trillion dollars in 2019, a sorry consequence of the 2017 tax cuts that were funded with borrowed money. Growing deficits have ballooned the national debt, which by year-end hit a record $21.9 trillion (with potentially multiples of that in off-the-books entitlement promises), this while debt costs are suppressed by low interest rate policies. Approving massive tax cuts and generating the resultant huge deficits so late in the economic cycle while unemployment is so low seems particularly irresponsible, as there is little room for new fiscal stimulus if and when the economy softens. While the U.S. dollar maintains its de facto reserve currency status, this is a privilege (America’s exorbitant privilege, it was once called) never to be taken for granted. The nation’s fiscal irresponsibility jeopardizes this status, which has allowed Americans to live beyond our means for a long time without paying any price.”
In conclusion, Klarman wrote, “There is no way to know how much debt is too much, but America will inevitably reach an inflection point whereupon a suddenly more skeptical debt market will refuse to continue to lend to us at rates we can afford. By the time such a crisis hits, it will likely be too late to get our house in order.”
Bargains can still be found
Despite the doom and gloom, the investor is still finding plenty of worthwhile investments, even if they’re harder to ferret out compared to previous years.
“We believe the year-end valuation of our portfolio is extremely attractive,” Klarman wrote. “At the end of December, many of our public equity holdings were trading at high single-digit or very low double-digit forward earnings multiples, an attractive level for companies generally expected to significantly increase their earnings and cash flows well into the future.”
So while Klarman has been known to trend toward cash during bull runs, it’s hardly accurate to say he attempts to time the market. Even in pricey markets, he’s able to find investments at attractive prices. If those investments aren’t enough to fill an entire portfolio, he is happy to keep the excess in cash.
Either way, Klarman has proved that, with enough hard work and curiosity, investors can uncover hidden value in any market.
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