CNBC got hold of a letter by billionaire hedge fund manager Seth Klarman (Trades, Portfolio). His letter to investors is typically extremely hard to get, but this is the second year in a row that I’ve seen it surface while Davos was going on.
In the letter, Klarman apparently defended value investing and attacked passive investing, which he believes is creating distortions. He’s certainly not alone in that belief. Murray Stahl (Trades, Portfolio) and Steven Bregman of Horizon Kinetics have been arguing that for years and almost literally wrote the book on it. So is Mike Green here on the Hidden Forces podcast.
“We believe that ongoing selling pressure of value names has contributed to mispricings that represent potential opportunity for long-term investors.”
Klarman specifically pointed out that small-cap value stocks are relatively undervalued to an extent only seen in 1929 and 1999.
Value investing as a strategy (at least applied in the academic sense) has not been working over the past 12 months, or 10 years for that matter.
In the letter, Klarman said his fund has been withdrawing and ended December 2019 with a cash balance of 31% of holdings.
The current trend-following environment has left Baupost looking flat-footed, as some of the publicly traded bargains we identify and accumulate drift relentlessly lower – even as we believe they demonstrate their underlying value in several ways
Klarman chalks that up to the market structure that is now revolving around passive funds, where all the flows are going, and as a result, the prices of the companies within those indexes are rising. He’s fairly worried about passive investing, however. He wrote:
“As funds continue to flow into the hands of indexers, stocks not included in prominent indices relentlessly lag, while the beneficiaries of such inflows move more or less in tandem, sometimes seemingly regardless of diverging fundamentals.”
Klarman also defended Baupost’s large cash position, which is counter to a common idea that it is best to remain fully invested, saying that it makes sense in some cases to wait on the sidelines for more attractive investments:
“Unless the opportunities are truly and historically compelling, full exposure in this environment seems dangerous, given prevailing lofty valuations. Should corporate earnings weaken, record-high profit margins shrink, markets falter, or inflation pick up (driving central bankers to reverse current easy money policies), the downside from here could be quite significant.”
Several value gurus have been arguing this point for years as well.
"The low-interest rate environment that served as 'rocket fuel' for expanding valuations is not sustainable and the lofty market caps of cash flow-burning companies such as Netflix (NFLX, Financial) and Uber (UBER, Financial), like the private valuation of WeWork before its failed IPO, may prove to be mirages."
WeWork turned out to be a mirage and it went from over $50 billion to effectively bankrupt. Here's an overview of Buapost's holdings.
Klarman's solution is to keep investing in small-cap value. The top five positions are more weighted toward large-cap stocks. However, these look like they are moving out of history. Liberty Global (LBTYK, Financial), Viasat (VSAT, Financial) and Fox Corp. (FOXA, Financial) are his top three holdings. The two largest have predictable cash flows and are very well suited to a concentrated model.
Disclosure: Long Liberty Global.
Read more here:
- Gundlach on the Economy and Markets for 2020
- Apple: Recent Gains Are Bad News For Investors
- FedEx: The Good, the Bad and the Ugly
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