Seth Klarman on 'Born Bulls', the 'Speculative Froth' and Dot-Com 2.0

As with bull markets of yore, valuations of favored stocks eventually become untethered to reality

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Oct 21, 2019
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How does an investor, who has experienced the best of times as well as the worst of times, view the widely-held expectation that a low-risk, low interest rate market environment that encourages risky asset allocations will continue indefinitely? How does one explain current valuations of certain stocks, accepted by individual and institutional investors alike, that are increasingly untethered to reality?

In view of the recent WeWork debacle,

Seth Klarman (Trades, Portfolio)’s 2014 warning to investors about the attendant risks presented by an overheated market that was causing many to throw caution to the wind now appear prescient.


Warren Buffett (Trades, Portfolio), Klarman believes that humility is an indispensable trait for successful investing. Nonetheless, in view of the rampant speculative fever that has engulfed the new issues market, culminating in the implosion of a sub-leasing company that was going to change the world, Klarman could justifiably say, “I told you so.”

In his 2014 letter to investors, Klarman looked askance at the unbounded and increasingly speculative nature of the market. His comments reflect his view on the important roles that an understanding of history as well as of human nature play in successful long-term value investing.

Klarman is particularly critical of the follow-the-herd mentality that has been so prevalent for the past decade on Wall Street. He notes that the lack of historical perspective, so endemic among market participants today, instills a dangerous bias for those who are ahistorical by nature, as well as for those whose investing careers blossomed during the decade-long bull market that they have become conditioned to believe will never end:

“If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stock probably look attractive, even compelling. Price-earnings ratios, while elevated, are not in the stratosphere.”

Indeed, Klarman’s analysis concerning the characteristics of “born bulls” is bolstered when one realizes that many investors an security analysts received their education and experience during a period that never saw a down market. For a decade, the stock market thrived in a historically unprecedented low interest rate environment. Those investors and fund managers who came of age during the bull market run have been characterized by some as “QE” babies, or by Klarman as “born bulls.”

Markets go up, markets do down. But, throughout these vacillations, the foibles of human nature remain constant; institutions are no less susceptible than individualas to the unwavering sentiments of fear, panic and greed.. In 2014, Klarman saw this reality manifested in how quickly the lessons of 2008 were forgotten.

Despite the fact that many investors were, “way out over their skis,” and pledged that they would be more prudent and restrained, more judicious and less greedy, the voice of reason inevitably fell upon deaf ears:

“But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to rainy markets and asset classes, and where caution seems radical and risk-taking the prudent course. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs.”

And, what are the current tell-tale signs of this historical ignorance that contribute to the current speculative fervor? In his letter, Klarman anticipated the madness of the tech unicorn initial public offering craze that coursed through investors’ veins, ending in the collapse of WeWork. The capitalization rates for many stocks were detached from any rational computation of value:

“, with a market cap of $180 billion, trades at about 15 times estimated 2013 earnings, Netflix at about 181 times. Tesla Motors’ P/E is about 279; LinkedIn’s is 145.”

Investors who are now bearish on Netflix may wish to ask themselves why paying a price 181 times earnings for the company’s projected growth rate, even if accurate, under any scenario could have been considered a sound investment?

How distorted has the current, irrepressible investing environment become?

“Some 23- year-olds have sold their startup internet companies for hundreds of millions of dollars, while the profitless privately-held Snapchat has turned down a $3 billion buyout offer.”

Klarman notes that along with “nosebleed valuations,” the “speculative froth,” or dot-com 2.0, has created a situation where:

“In Silicon Valley, it seems that business plans – a narrative of how one intends to make money – are once again far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses.”

As an investor who has experienced a range of market environments, Klarman is astute enough not to predict with any certainty when equilibrium will be established, but he is certain that change will come, upending the inverse bond/equity relationship that has prevailed over the past decade:

“Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy – maybe not today or tomorrow, but someday.”

One day, the Federal Reserve will no longer be a guarantor of investor tranquility and bliss and will cease distorting reality through its near zero-interest rate policy:

“Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.”

Klarman’s message for individual investors is be selective in your purchases and be wary of buying stocks at their current valuation levels if the chasm between their current price and their reasonable intrinsic value remains insurmountable.

Disclosure: I have no position in any of the securities referenced in this article.

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