"It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been subpar returns.
"The alternative is to remain liquid, defy the steady drumbeat of performance pressures and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.) This path also involves risk in that there is no certainty whether or when this will occur; indeed, securities prices could rise further from today’s lofty levels, making the decision to hold cash even more painful.
"While we have strong suspicions, it cannot be said with certainty which path will prove wisest. What is clear is that just about everyone will choose the former one. Those in the investment business compete on the basis of short-term, relative (not absolute) investment performance and prefer to follow the herd (at the price of assured mediocrity) rather than stand apart (risking severe underperformance)." – Seth Klarman, Baupost Limited Partnerships’ 2004 Year-End Letter
Seth Klarman (Trades, Portfolio), who is one of the world’s greatest value investors, is not afraid to hold cash. Cash holdings at his Baupost hedge fund average more than 30% and frequently hit 40% as he waits for the perfect opportunity.
Recently, though, Klarman’s cash problem has become even worse. Last month Bloomberg reported that Baupost’s cash balance had increased to 42% of assets under management as the fund has taken profits on existing positions it has struggled to find opportunities for reinvestment.
Since inception the fund has produced a return for investors of around 16% per annum, generating total profits of more than $30 billion, and it has only returned cash to investors twice before, in 2013 and 2010. Now it has been reported that Klarman is looking to return cash once again, reducing the size of the fund thanks to the lack of opportunities in the market.
Is this move by Klarman a signal to the rest of the market that it’s time to get out?
Watching Klarman's actions
Klarman is one of the world’s best and most experienced value investors. Over several decades he has been able to refine and streamline his value process. His strict discipline and rigorous valuation model mean that he will only buy the best assets at the best price and not chase valuations higher.
So this move could be interpreted as a signal for investors to get out of the market. That being said, Klarman still owns a portfolio of equity and debt. The equity portfolio of Baupost is around 30% to 35%, far lower than cash at 42% but overall, assets including equity, debt and property amount to 58% of the portfolio. Klarman still has skin in the game.
Rather than a signal to sell, Klarman’s move is just a natural reaction to the fact that he can’t find any other assets that meet his investment criteria. He could keep the cash in Baupost, but this would hold back future returns and possibly even inspire him to make investments he would not usually make. The manager of Baupost is known for his iron will, but so much cash sloshing around and a market that only seems to want to head higher is a dangerous combination for anyone.
Specialist style
Klarman has his own investment style and notion of value. For example, most value investors wouldn’t make Cheniere Energy (LNG, Financial) their largest holding (11% of the equity portfolio, $950 million, approximately around 3% of the overall portfolio), but Baupost sees value here.
Overall then, Klarman’s actions are not a sign to sell, but they are a lesson in discipline for investors. The founder of Baupost sees little to no value in today’s equity market. Therefore he’s happy to sit on the sidelines – a lesson for other investors. Even after cash returns, he still has plenty of resources to act if Mr. Market gives him the opportunity.
Disclosure: The author owns no share mentioned.
