I recently unearthed an old Seth Klarman (Trades, Portfolio)  interview, conducted by Jason Zweig of the Wall Street Journal. Although the whole piece is worth reading, I felt that Klarman’s comments on indexing and short selling, in particular, were worthy of discussion.
Indexing is not all it’s cracked up to be
When asked to clarify comments he had made previously about indexing being a horrendous idea, Klarman said he stood by that opinion, though he also acknowledged that the average retail investor doesn’t have a lot of good options anyway. One of his main objections to index investing is that the stocks in question tend to be overvalued simply by virtue of being in the index:
“Stocks trade up when they are put in an index. So index buyers are overpaying just because a stock is included in an index. I am much more inclined to buy a stock that has been kicked out of an index because then it may have value characteristics—it has underperformed. A stock is kicked out of an index because its market cap has shrunk below the top 500 or the top 1,000.”
Klarman also explained that the "buy and hold" mentality so often preached by money managers is often misunderstood. Yes, having a long time horizon is important, but the price at which you get involved with a stock is usually more important than the holding period:
“A tremendous disservice is perpetrated by the idea that stocks are for the long run, because you have to make sure you are around for the long run, that when you have unexpected pain, as many people did in 2008, you don’t get out and you actually are a buyer. The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but entry point is what really matters. We all know that the evidence shows that when you enter at a low price, you will have good returns, and when you enter at a high valuation, you will have poor returns.”
Short sellers are the market’s police officers
This interview was conducted in 2010, when the financial crisis was still very much in everyone’s minds. A number of high-profile short sellers had done well by forseeing the impending collapse of the housing market, and still more had made money selling the stocks of major financial institutions. As a result, there was a certain amount of clamour to regulate short selling. When asked about the practice, Klarman said that short sellers actually provide a service to the market:
“Short sellers are the market’s police officers. If short selling were to go away, the market would levitate even more than it currently does. In my opinion, it would not be in the country’s best interest to have short selling prohibited. There would be more scams, more potential for the little guy to rack up painful losses because securities would be allowed to rise unchecked. The act of selling something short, of voting that it’s overvalued, is a positive for the system. The one exception is when short sellers, in effect, yell 'Fire!' in a crowded theater in an attempt to create fear or spread malicious rumors.”
In a context where almost every market participant has an incentive to be bullish: from sell-side analysts and financial news media to governments and retail investors, it is undoubtedly a good thing that there exists this separate class of market participants who exert pressure in the opposite direction and inject at least a small degree of balance into the system.
Read more here:
- Buffett on Using Options as Compensation
- Seth Klarman: Value Investing in a Turbulent EnvironmentÂ
- Howard Marks: Doing the Right Thing at the Right TimeÂ
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