Combing through the valuable archives of ValueInvestorInsight, I recently stumbled across this gem of an article. It is an extract from Seth Klarman (Trades, Portfolio)'s letter to Baupost investors in 2009. In the letter, he celebrates the one year anniversary of the financial crisis by going over some of the critical lessons investors learned from the event.
His lessons from the crisis are split in two buckets: Those lessons that are "true" and those that are "false." The lessons investors seemed to learn in the 2008 crisis might not be relevant for other market meltdowns.
I'm covering the "false" lessons in another article. In this part, I wanted to take a look at Klarman's top 2008 crisis lessons one year after the meltdown.
Klarman's top lessons from 2008
These lessons are in no particular order, and the original list is not limited to these seven. These are just the lessons I thought were most relevant.
Lesson one: Beware the perils of easy leverage.
Klarman notes:
"When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds."
Lesson two: Don't be in a rush to make money.
Klarman has said before that his favorite market hedge is cash. As you never know when the next downturn will arrive, it always pays to have this hedge ready to go:
"Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning enter-ing a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis."
Lesson three: Risk and uncertainty are two different factors.
The guru noted:
"Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty β such as in the fall of 2008 β drives securities prices to especially low levels, they often become less risky investments."
Lesson four: Don't be afraid to buy on the way down.
Timing the market perfectly is going to be impossible:
"You must buy on the way down. There is far more volume on the way down than on the way back up and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy."
Lesson five: Public markets offer more opportunity for profit, especially during selloffs.
Klarman wrote:
"At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down."
Lesson six: Beware leverage, not just on your own account but for the whole market.
The guru cautioned:
"Beware leverage in all its forms. Borrowers β individual, corporate, or government β should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be incredibly fickle and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn."
Lesson seven: Don't trust rating agencies.
"Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them."
