As a low profile legendary value investor, Seth Klarman (Trades, Portfolio) doesn’t appear in the spotlight very often, but when he does, it’s always the best learning opportunity for every value investor. While reading an old issue of OID (the March 2009 issue), I was lucky to bump into some excerpts from Klarman’s comments and answers to the questions during the 19th Annual Graham & Dodd Breakfast held on Oct. 2, 2008. Below is part I of my notes:
1. On being too early in an investment:
For years, when someone asked me what my biggest fear was as an investor in managing my portfolio, my answer was that it was buying too soon on the way down from often very overvalued levels. I knew a market collapse was possible. And sometimes, I imagined that I was back in the 1930s after the market had peaked the year before and then dropped 30%. Surely, there would’ve been some tempting bargains then. And just as surely, you’d have been crushed by the market’s subsequent plunge over the next three years – down to below 20% of 1929 levels. A fall from 70 to 20, and from 100 to 20, would feel almost exactly the same by the time you hit 20. Sometimes being too early becomes indistinguishable from being wrong.
Of course, getting in too soon as the market falls involves great risk for all investors, including value investors. Certainly, when a few securities start to get cheap even as the bull market continues, a value-starved investor will step up and buy them. Soon enough, many of these prove to be no bargain at all, as the flaws that caused them to be rejected by the bulls become more glaringly apparent when the world gets worse.
After a stock market has dropped 30%, there’s no way to tell how much further it might have to go. It’d be silly to expect every bear market to turn into the Great Depression, but it would be equally wrong to expect that a fall from overvalued to more fairly valued couldn’t badly overshoot on the downside.
So when individual stocks reach levels where they are truly undervalued, what are value investors supposed to do other than to buy them? Anything else is marking timing.
2. On investment process and approach:
It is critical that you remind your clients, your investment team and, as often as necessary, yourself that you can only control your process and approach – that you cannot forecast the vagaries of the market, which in any case are an opportunity and not a problem for value investors. According to James Montier, during periods of poor performance, the pressure builds to change your process. But so long as the process is sound, this would be exactly the wrong thing to do.
When investors worry about what a client will think rather than what they themselves think, the process is bad. When an investor is worried about the firm’s viability, about constant redemptions, about avoiding losses to the exclusion of finding a legitimate opportunity, the process will fail. When one’s time orientation becomes absurdly short term, the process is compromised. When tempers flare, when recriminations abound, when second-guessing proliferates, the process cannot work properly. When investors worry about the good of the firm or its publicly traded share price rather than the long term best interest of the clients, the process is corrupted.
When the process is broken, you can’t invest well. It’s hard enough to invest well when the process is good. So it’s crucial to have a sound process that will enable you to perform this difficult task with intellectual honesty, rigor, creativity and integrity.
3. On how to think about investing:
It is important to remember that value investing is not a perfect science. Rather it is an art, with an ongoing need for judgment, refinement, patience and reflection. It requires endless curiosity, the relentless pursuit of additional information, the raising of questions and the search for answers. It necessitates dealing with imperfect information – knowing you will never know everything and that that must not prevent you from acting. It requires precarious balance between conviction, steadfastness in the face of adversity and doubt – keeping in mind the possibility that you could be wrong.
Ultimately, Graham and Dodd teach us not only about investing, but also thinking about investing. At the core of its wisdom are not mechanical rules to be blindly adhered to, but a way of thinking that allows us never to be blinded by rapidly changing facts or conditions. Mechanical rules are dangerous – requiring the world to be more constant and predictable and analyzable than it can be. In this sense, Graham and Dodd’s principles are perhaps best utilized as a screen – a sieve to sort through the mass of securities to find those of greatest interest, with rigorous analysts and keen judgment then used to make the final investment decision.
4. On failure and “money of the mind”:
The reason people panic out of their minds these days at a relatively moderate market drop is because the government has, in one way or another, encouraged us to do that. At various difficult times – like '87 or possibly '98 – the Fed, under irresponsible leadership for so many years, has jumped in to bail out real and imagined problems and restore investors’ confidence, effectively giving them the well-named “Greenspan put.” And we’re now asking the government to save us from what wouldn’t perhaps have been necessary if it had not saved us so many times already when the problem was not that large.
So I just think that it’s incredibly important to note that when you don’t allow failure, you get more failure. When you take away the price of personal risk in your decisions, you get much more risk taking. So we are harvesting what we’ve sown. The government needs to learn how to intervene on both sides. If we are going to prop things up when they are down, we perhaps also ought to take away the punch bowl much earlier so we wouldn’t be in this mess.
Jim Grant called the liquidity and credit “money of the mind.” It’s there – and then it’s not there. It’s amorphous. You can’t see it. It’s not real. And in a way, to me, anybody that ever says, “How can the market go down – there’s a wall of liquidity?” or “There are structural imbalances” As long as I’ve been alive, there have been structural imbalances. And most of the time, they don’t matter: but once in a while, they really matter.
That’s what’s hard – if you run your portfolio to do fine in an up market, you will have exposure that you wish you didn’t have in a worse market. Don’t be unprepared for something out of the blue that’s really bad. (I personally think that this is particularly relevant today.)
That’s it for today. The rest of my notes will be posted in another article.