Seth Klarman (Trades, Portfolio) is the founder and Chief Executive of the Baupost Group, a Boston-based private investment firm. In this investor letter from 1997, Klarman explores a number of interesting issues. Two parts in particular stood out -- one addressing the question of hedging, and other explaining why value strategies tend to outperform in turbulent markets.
How to hedge
Klarman states that there are two main ways to protect oneself in the event of a market downturn: holding market hedges and cash. Holding short positions also accomplishes this goal, but at the time that Klarman was writing, short sellers had been severely tested by the 90s bull market. He points out that since hedges are a form of insurance, their premiums rise during volatile periods:
“We hold both [cash and market hedges], although never enough in a downturn, because both are costly. Hedges, like any insurance, involve paying a premium. Premiums have skyrocketed in lockstep with the market's surge over the past two years, and have risen even more in the current volatile environment.
Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments. Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing.”
Klarman believed at the time of writing that there were still value opportunities to be found, and that buying cheap assets was preferable to holding cash, even if that meant having to hold them through periods of market turbulence.
The value investing philosophy in turbulent times
Value investing, by its very nature, is not well-suited for overperformance in a bull market. In an environment where the rising tide is lifting all boats, the most depressed boats will by definition be lifted less than the high-flyers:
“I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk.”
It is only in bad times when value investing really comes into its own, as it is one of the few strategies available to retail investors that can still generate positive returns:
“In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don't like their charts. But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value.
And, because you cannot tell what the market is going to do, a value investment discipline is important because it is the only approach that produces consistently good investment results over a complete market cycle.”
The last sentence is particularly important. We do not know when the market is going to turn against us (although we do know that it will definitely happen at some point). Therefore, we should follow strategies that will cover us in all possible situations.
Disclosure: The author owns no stocks mentioned.
