Seth Klarman (Trades, Portfolio)’s Baupost Group is one of the most successful hedge funds in the world. Since 1982, its various funds have earned average returns of more than 19%. Today, the firm manages more than $30 billion. Even more incredible, it’s reported that the investment team is made up of just 12 people.
What’s made the Baupost Group so successful? In 2015, Brian Spector, a senior partner on the verge of retirement, revealed several key insights into the inner workings of the famed hedge fund. At the request of Klarman, Spector wrote a letter to investors detailing his history at the firm.
"Because of his unique perspective and insights, I asked Brian to draft a letter to you that accompanies this letter,” Klarman told investors. “He alone determined the content. I hope you find that it furthers your understanding of Baupost."
What was in the letter? Let’s dive in.
Value investing isn’t for the weak
Value investing can be fun and easy, but often, it’s excruciating. By definition, value investing is purchasing an asset for less than it’s worth. To do that, an investor must disagree with popular opinion. Value investors are often told they’re wrong. They have to take criticisms from seasoned analysts, management teams and even other investors.
Thankfully, over the decades, value investing has proven to be a winning formula. But value stocks can go out of favor for years at a time. Just take a look at the chart below, which suggests value stocks are actually trading at a discount to the market. Not only do value investors have to deal with others telling them they’re wrong, but they often are wrong, sometimes for years at a time. Eventually, many are vindicated, but it’s a hard road getting there.
Spector provided some insight into how Baupost dealt with “being wrong” during the dot-com bubble. At the time, he was just 25 years old.
"Traditional metrics like cash flow and asset values were being blatantly disregarded by the market in favor of newfound metrics such as eyeballs and clicks,” he wrote. “High-tech companies were the darlings in a rapidly rising market while less-sexy value stocks significantly lagged."
In a rare occurrence, Baupost actually lost money during one of the most aggressive bull markets in U.S. history.
When the bubble burst, you would think Baupost would be gloating about staying on the sidelines. Instead, it purchased falling tech stocks as other panicked, and yet again was chided for “being wrong.”
“The bear market picked up steam and we found a number of stocks trading near or even below their net cash value. We bought baskets of formerly hot technology stocks that were getting pummeled, despite having good businesses with contracted revenues. Although many of these companies were experiencing negative cash flow, their management teams were shrinking headcount to align to the new economic reality and were successfully lowering or eliminating cash burn. It seemed like shooting fish in a barrel. We were buying cash at a discount with an option that the underlying businesses had real value. All we had to do was wait for that underlying value to be recognized. What could be easier than buying cash at a discount?”
Spector went on to cover one of the most underappreciated downsides of value investing: the mental toll.
“It turns out buying a dollar for 50 cents is a lot harder than it seems. Every day we added to these positions, thinking we were getting an even better bargain than the day before, only to wake up and watch prices drop further. Other respected investors would often comment about how 'value tech' was a 'value trap,' best to be avoided. It was as if the market was having a 'going out of business' sale and we happened to be the only customer who showed up. While both exhilarating and painful at the same time, what I remember most vividly is exhaustion. After countless late nights at the office, I would head home, collapse on my couch and stare at the ceiling. I was unable to read, watch television, or fall asleep. All I could do was worry about what we might have missed in our analysis.”
If you want to be a successful value investor like Klarman and his team, it’s important to have both investing acumen and courage.
Don’t time the market
Ray Dalio (Trades, Portfolio) once likened market timing to playing poker against the best. More often than not, you’re going to lose. The Baupost Group seems to take a similar approach. Over the years, its portfolio has had dramatically different cash balances, anywhere from 0% to 50%.
Today, reports suggest the firm’s cash position is roughly 30% of the portfolio. But don’t think Klarman is trying to time the market. According to Spector, the cash balance is simply a sign the firm is having a difficult time filling the portfolio with bargains. That may happen to coincide with a frothy market, but the team never makes top-down, market-wide calls. It simply plays with the cards that are dealt.
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"Most of the time, we are in periods of haystack investing," Spector wrote. "We sift through lots of investment ideas to find a few decent opportunities. We sell more securities than we buy and our cash reserves begin to build."
During bear markets, when bargains are widely available, Spector said the cash balance naturally shrinks.
"We see distressed sellers, illiquid securities, huge redemptions, and an excess of paranoia and fear. We quickly find a number of interesting opportunities, deploying our significant cash balances as we trade our precious liquidity for mispriced securities. We may lose money in the short term, as we add to our portfolio while prices are dropping. But when markets turn, we expect multiple years of strong profitability.”
Building cash balances when bargains are hard to come by sounds easy, but in practice, it can be terribly difficult.
“Investing in tide markets takes chutzpah,” Spector wrote. “To do so effectively, you need to fly in the face of public opinion, you have to fight normal human emotions, and you have to be prepared to double down on your bets when your conviction is most in question. As Benjamin Graham once said, the investor's chief problem and even his worst enemy is likely to be himself.”
Value investing takes a ton of time
While the efficient market hypothesis is untrue in practice, market securities very often are fully priced, at least in terms of what is widely known and understood. That means finding undervalued stocks should be a rare occurrence. In Baupost’s experience, it is.
“On most days, [the market] offers a menu full of bland, unhealthy, and fully-priced choices,” Spector wrote. “We do enough work on the offerings to make sure we aren't missing anything and often go home feeling unsatisfied and unproductive.”
When the Baupost team does find a promising opportunity, that means a significant amount of research must be completed in as little time as possible.
“We work furiously to understand the drivers of the investment. We spend an enormous amount of time focused on the downside and the risk of permanent capital loss. We also try to understand potential optionality and upside. We ask ourselves, 'How and when will the market eventually see the situation differently?' Once we have a hypothesis about why an investment may be interesting, we start down the path of trying to confirm or reject our original thesis. Depending on complexity and price, this process may take days, weeks, or even months. Oftentimes we place investment ideas back on the shelf and wait for a lower price. Only when the investing stars line up will we add the position to our portfolio.”
Value investing takes a ton of time not just because of the research that’s involved, but also because value investors frequently have to wait months, if not years, to purchase something on their watchlist. As Spector noted:
“We can do this successfully because we have a culture of patience. Even though we work hard every day trying to uncover the next great investment, we only deploy our capital when we have real conviction that we have found one. When we don't find interesting ideas, we do nothing and hold cash. For this reason, I've often joked that I'm 97% unproductive. While this means I better be damn productive the other 3% of the time, it also means exercising patience often and waiting for great opportunities. On the flip side, when an idea has been analyzed and is fully baked, we drop whatever else we are doing, discuss the investment, and make a decision. Our portfolio decision process must be incredibly efficient, as we recognize that good ideas are scarce and may prove fleeting.”
Because value investing takes a significant amount of research, time and patience, it’s important to bet big on your highest-conviction ideas. While Baupost often holds big cash positions, it also regularly sizes its biggest bets as double-digit positions. That’s a practice that many hedge funds actively avoid.
“Warren Buffett (Trades, Portfolio) said, 'Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble.' When a great opportunity comes around, it is imperative to size it correctly,” Spector concluded.
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