Re-Reading Seth Klarman

Excerpts from 2 OID issues

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Nov 09, 2017
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I sat on a couch and re-read two old issues of OID – one from March 2009 and one from February 2008. Seth Klarman (Trades, Portfolio) was featured in both issues. His warnings in the February 2008 issue turned out to be prescient, and his comments in the March 2009 issue were both timeless and timely.

Bargains are extremely rare in today’s markets and despite the risks, uncertainties and political turmoil, the markets are making all-time highs day after day. The combination reminds me of how Klarman answered the question of what his biggest fear was; his response – buying too soon on the way down from often overvalued levels.

I’m aware that not all of us subscribed to OID, which was an outstanding publication in the investment world. The following are excerpts from the February 2008 and March 2009 issues that I think are equally, if not more, timeless and timely in today’s environment. They are lengthy, I know. But believe me, it’s worth the time.

Imagining a market downturn and recognizing that being too early is indistinguishable from being wrong

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 have 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. (This is particularly applicable in today’s market and we should all be reminding ourselves before making any purchases.)

The most important thing is to get the process right

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 clients 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.

The government and the Fed, by not allowing failure, may have set up for more failure

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.”

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.

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.

It’s critical to maintain rational thinking when faced with today’s uncertainty

Most declines have matched deteriorating fundamentals. As we waited patiently for opportunity to arise during 2007, we refused to deviate from our high standards. Some stocks and corporate bonds fell to levels that looked tempting, but in most cases the declines merely matched deteriorating fundamentals – especially in the financial, housing and retail sectors – and were no real bargain.

One of the greatest risks we – and all investors – face is the danger of catching falling knives: expensive securities that decline without reaching bargain levels. Often, the near absence of bargains works as a reverse market indicator for us: When we find little that is worth buying, there may be much that is worth selling. Indeed, we maintained a strong sell discipline throughout the year to good effect.

Remaining rational in today’s market

But remaining rational is easier said than done. While investors will obviously achieve the best result by remaining rational thinkers at all times, this is easier said than done. In the financial markets, emotion often takes over, and greed and fear come to dominate investor behavior.

Even those who are aware of this, who expect always to invest rationally and to be able to resist their own greedy temptations and panicky reactions, cannot always carry through on their plans.

It's easy to blink when bargains become far better bargains. Top-down or momentum investors – especially if leveraged – are at a loss when confronting the unexpected. Should they hang on and risk ruin, or capitulate and lock in painful losses? Even those with the benefit of a value investing roadmap – which ensures a fundamental, long term-oriented approach to investing, a disciplined pursuit of bargains and an imperative to view the market as an irrational creator of opportunity – may blink when faced with the unexpected.

When you buy bargains, and they become far better bargains, it is easy to start to question yourself, which can begin to impair your judgment. Real or imagined concerns – about client redemptions, employee defections and even a firm's viability can greatly influence behavior away from the rational.

One of our strategies for maintaining rational thinking at all times is to attempt to avoid the extreme stresses that lead to poor decision-making. We have often described our techniques for accomplishing this: willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity and avoidance of recourse leverage, among others. Even the most conservative investors can become paralyzed by large losses, whether due to mistakes, premature judgments or the effects of leverage.

If losses impair your future decision-making, then the cost of a mistake is not just the loss from that investment alone, but the impact which that loss may have on the future chain of events. If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost of a loss may be far greater than the initial loss itself.

Similarly, a substantial profit, a timely sale or an impactful hedge paying off may serve as an important link in a long chain connecting a successful past to a prosperous future. Avoiding being a deer in the headlights, and thereby having your confidence justifiably bolstered by recent successes, enables incremental exposures that might not be possible after a series of losses.

The reinforcing effect of sustained success comes particularly to mind as we enter 2008. A series of sound decisions has served Baupost well in recent years, helping us to build a strong track record and talented team. We've been able to confidently match the size of our exposures with our investment judgments while maintaining the humility necessary to avoid overconfidence.

By contrast, it would be extremely difficult to incur a particularly large exposure, even if it seemed compelling, after a sharp down year or lengthy period of disappointing returns. And a 50% annual decline – as some funds have experienced – effectively ends the chain forever as the clients and employees rush for the exits, rendering whatever might have come in the years ahead completely moot

Our next investments, in a sense, always stand on the shoulders of our past ones. If the past investments were too often mediocre, the next ones rest on a weak foundation. Approaching the future, always with humility, from a position of strength – good results, a strong and cohesive team, and loyal clients – will hopefully enable us to remain fully rational investors, able to take full advantage of the opportunities that come along.

I hope you all have enjoyed Klarman’s wisdom.