Looking back on the interview with Seth Klarman at the CFA event in May 2011, there are a lot of lessons to learn from him and his views on value investing, the recent crisis, gold and human resources. According to him, the general value investing philosophy is still Benjamin Graham and Dodd, but the way to invest is maybe a little bit different. In Graham’s time, there were no such investing instruments as options, swaps, etc. Business was probably less competitive. People weren’t driving business to their focus and to maximize the performance. Now the business environment may be more volatile. The chance to buy a stock cheap and it revert to the mean is probably lower today than in the past. Klarman added: “Today, some of the biggest bargains are in the hairiest, strangest situations, such as financial distress and litigation.”
Before starting his own firm, Klarman was working under Mike Price and Max Heine, and was learning a lot from them. He remembered, “What I learned from Mike… was the importance of an endless drive to get information and seek value. I remember a specific instance when he found a mining stock that was inexpensive. He literally drew a detailed map – like an organization chart – of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull threads is the lesson that I learned from Mike Price.” And what he has learned from Max was the way Max treated people. Max treated everyone, including the receptionist and the youngest analyst at the firm, with a smile and a kind word.
Lesson learned from the recent crisis
Seth Klarman pointed out the high valuation in the stock market pre-2008. All stocks seemed to be valued on an invisible temple of a Leveraged Buy Out (LBO) model. At that time it was easy. “Stocks were never allowed to get really cheap, because people would bid them up, thinking they could always sell them for 20 percent higher.”
In addition, Klarman mentioned that the world has changed, so it would be unrealistic to keep assuming that a bank’s return on book value would always stay at 12-15%/year. The instruments which were rated Triple A weren’t all the same anymore. And watching home building stock movements was not giving any clue as to what was going on in mortgage and housing markets. What has primarily driven the crisis is that the deterioration in subprime mortgages led to the problem in the housing markets. And its financiers, which are banks, had stock getting cheaper and cheaper while their earning power was getting weaker and weaker, until the equity was wiped out.
Another issue with investors is the pressure to stay invested all the time. It is exactly what I felt several years ago when I started to invest and manage other people’s money. Klarman has described that the inability to hold cash and pressure to be fully invested at all times meant that “the plug was pulled out of the tub; all boats dropped as the water rushed down the drain.”
Blessed to have great clients
In the interview, Klarman shared that having great clients is the key to investment success. It enables the manager to have a long-term view when the world is having short-term pressure. For him, the ideal clients often have two characteristics. “One is that when we think we’ve had a good year, they will agree. It would be a terrible mismatch for us to think we had done well and for them to think we had done poorly. The other is that when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming. At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and – most of the time, if not all the time – add, rather than subtract, capital."
He also mentioned that the actual redemptions were just one side of the problem; the other was the fear of redemptions happening in fund managers. When the managers fear that there will be massive redemptions, they have to stay very liquid. He has seen many managers go from leveraged long in 2007 to huge net cash in 2008, when the right thing to do would be the opposite.
Investment philosophy
Seth Klarman has discussed how unconventionally organized Baupost is. In the firm, there aren’t analysts specifically in different sectors such as pharmaceutical, oil/gas or financials, etc. Instead, the firm is organized by opportunity. It has analysts focused on spin-offs or distressed debt or post-bankrupt equities.
Dated back in May 2010, Seth Klarman has mentioned the issue in the triple-A rating of the U.S. Treasury. People often think that the U.S. would always be triple A. That kind of thinking would guarantee someday the U.S. would no longer be triple A. Any triple-A Treasury would have to have valuable assets, a good education system, a great infrastructure, and the rule of law. There is one old saying: “How did you go bankrupt?” and the answer is “Gradually, and then suddenly.”
Commodities are the kind of asset that non-producing, which do not have the cash flow for analysis purpose. “If any asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.”
However, he argued that gold was a unique asset, and often seen as the store of value. But it has no tangible value, so it was purely speculation. But he feared about the potential debasing of paper money, and paper money might not be the store of value anymore, he would want some exposure to gold.
Hiring and choosing the best people
On the question of how to hire for intellectual honesty, Klarman has said that he would dwell a lot on the past experiences. The firm would ask people what the biggest mistake that candidates have ever made was. It is open ended question, not particularly just an investment question. A lot of ethics questions should be asked to see the response to “morally ambiguous situations.” He cared whether the newly hired guy could identify a tough call and conflict of interest.
In addition, he is looking for ideational fluency. Just like Mike Price, when an issue pops up, he wants to know whether a candidate would immediately have 10-15 ideas, and how they are going to analyze it or do they feel surprised by the question. “We do not want them to be sitting at their desks not knowing how to pursue the next opportunity when it comes along. We throw out a lot of different things in the interviews, but we are looking for people who have it all: ethics, smarts, work ethic, intellectual honesty and high integrity.”
Here is the full interview in great detail:
Seth Klarman CFA presentation May 2010
Before starting his own firm, Klarman was working under Mike Price and Max Heine, and was learning a lot from them. He remembered, “What I learned from Mike… was the importance of an endless drive to get information and seek value. I remember a specific instance when he found a mining stock that was inexpensive. He literally drew a detailed map – like an organization chart – of interlocking ownership and affiliates, many of which were also publicly traded. So, identifying one stock led him to a dozen other potential investments. To tirelessly pull threads is the lesson that I learned from Mike Price.” And what he has learned from Max was the way Max treated people. Max treated everyone, including the receptionist and the youngest analyst at the firm, with a smile and a kind word.
Lesson learned from the recent crisis
Seth Klarman pointed out the high valuation in the stock market pre-2008. All stocks seemed to be valued on an invisible temple of a Leveraged Buy Out (LBO) model. At that time it was easy. “Stocks were never allowed to get really cheap, because people would bid them up, thinking they could always sell them for 20 percent higher.”
In addition, Klarman mentioned that the world has changed, so it would be unrealistic to keep assuming that a bank’s return on book value would always stay at 12-15%/year. The instruments which were rated Triple A weren’t all the same anymore. And watching home building stock movements was not giving any clue as to what was going on in mortgage and housing markets. What has primarily driven the crisis is that the deterioration in subprime mortgages led to the problem in the housing markets. And its financiers, which are banks, had stock getting cheaper and cheaper while their earning power was getting weaker and weaker, until the equity was wiped out.
Another issue with investors is the pressure to stay invested all the time. It is exactly what I felt several years ago when I started to invest and manage other people’s money. Klarman has described that the inability to hold cash and pressure to be fully invested at all times meant that “the plug was pulled out of the tub; all boats dropped as the water rushed down the drain.”
Blessed to have great clients
In the interview, Klarman shared that having great clients is the key to investment success. It enables the manager to have a long-term view when the world is having short-term pressure. For him, the ideal clients often have two characteristics. “One is that when we think we’ve had a good year, they will agree. It would be a terrible mismatch for us to think we had done well and for them to think we had done poorly. The other is that when we call to say there is an unprecedented opportunity set, we would like to know that they will at least consider adding capital rather than redeeming. At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and – most of the time, if not all the time – add, rather than subtract, capital."
He also mentioned that the actual redemptions were just one side of the problem; the other was the fear of redemptions happening in fund managers. When the managers fear that there will be massive redemptions, they have to stay very liquid. He has seen many managers go from leveraged long in 2007 to huge net cash in 2008, when the right thing to do would be the opposite.
Investment philosophy
Seth Klarman has discussed how unconventionally organized Baupost is. In the firm, there aren’t analysts specifically in different sectors such as pharmaceutical, oil/gas or financials, etc. Instead, the firm is organized by opportunity. It has analysts focused on spin-offs or distressed debt or post-bankrupt equities.
Not only do we not miss too many opportunities, but we also do not waste a lot of time keeping up with the latest quarterly earnings of companies that we are very unlikely to ever invest in. Instead, we spend a lot of our time focusing on where the misguided selling is, where the redemptions are happening, where the overleveraged is being liquidated – and so we are able to see a flow of instruments and securities that are more likely to be mispriced. The investing approach of the firm is to find great bargains. It never stays fully invested if there are no opportunities present. The assumptions are tested with sensitivity analysis.Treasury, commodities and gold
And the psychology is very important to any investors. If we make too many mistakes, lose confidence, or the positions are down so much from the buying point, it would become easier to say, “I can’t stand being down more than this.” But investor should have the business mentality, the things managers should worry about is the business, about client redemptions and about the own net worth in the business. The right thinking would be conservative all the time, highly disciplined to hold bargains and highly disciplined seller to ensure that we do not have things at its full price.
Dated back in May 2010, Seth Klarman has mentioned the issue in the triple-A rating of the U.S. Treasury. People often think that the U.S. would always be triple A. That kind of thinking would guarantee someday the U.S. would no longer be triple A. Any triple-A Treasury would have to have valuable assets, a good education system, a great infrastructure, and the rule of law. There is one old saying: “How did you go bankrupt?” and the answer is “Gradually, and then suddenly.”
Commodities are the kind of asset that non-producing, which do not have the cash flow for analysis purpose. “If any asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.”
However, he argued that gold was a unique asset, and often seen as the store of value. But it has no tangible value, so it was purely speculation. But he feared about the potential debasing of paper money, and paper money might not be the store of value anymore, he would want some exposure to gold.
Hiring and choosing the best people
On the question of how to hire for intellectual honesty, Klarman has said that he would dwell a lot on the past experiences. The firm would ask people what the biggest mistake that candidates have ever made was. It is open ended question, not particularly just an investment question. A lot of ethics questions should be asked to see the response to “morally ambiguous situations.” He cared whether the newly hired guy could identify a tough call and conflict of interest.
In addition, he is looking for ideational fluency. Just like Mike Price, when an issue pops up, he wants to know whether a candidate would immediately have 10-15 ideas, and how they are going to analyze it or do they feel surprised by the question. “We do not want them to be sitting at their desks not knowing how to pursue the next opportunity when it comes along. We throw out a lot of different things in the interviews, but we are looking for people who have it all: ethics, smarts, work ethic, intellectual honesty and high integrity.”
Here is the full interview in great detail:
Seth Klarman CFA presentation May 2010
