One of the recurring themes in Seth Klarman (Trades, Portfolio)’s writings is the value of contrarian thinking. Klarman advises investors to understand its benefits, but more importantly, to recognize the concomitant fortitude required for incorporating this principle within the framework of an overall investment strategy.
The guru has repeatedly emphasized the fact that intelligent investors realize that opportunity doesn’t necessarily mean riding the crest of a bull market wave, but rather availing oneself of the price-value opportunities during a bear market. As he said, “Those who reflect and hesitate make far less in a bull market, but those who never question themselves get obliterated when the bear market comes.”
In his 2009 letter to investors, Klarman noted that dealing with market uncertainty can be difficult in perilous economic times, which described the conditions at the time. He wrote,“It is easy for the volatility of one’s thinking to match the volatility of prevailing conditions.” But he also reminded us that bear markets are occasions for not following the conventional Wall Street wisdom.
The ability to profit from engaging in unpopular strategies requires humility, combined with conviction, the knowledge that you may be wrong, and the conventional wisdom, right, but you nonetheless abide by the courage of your convictions. In short, successful investing often entails maintaining a certain level of equanimity while most other market participants, due to their inveterate short-term thinking and time horizons, are in a panic and making investment decisions at a frenetic pace, based on fear of losing all their money.
Klarman notes that, for many inattentive and undisciplined investors, incipient fear about the future impairs their ability to assess risks intelligently and comprehend the merits of long-term investing:
“As Benjamin Graham and David Dodd taught us, financial markets are manic and best thought of as an erratic counterparty with whom to transact, rather than as an arbiter of the accuracy of one’s investment judgments. There are days when the market will overpay for what you own, and other days when it will offer you securities at a great discount from underlying value."
Klarman said that due to human frailties, opportunities in down markets abound, but require viewing the conventional thinking with a jaundiced eye:
“If you look to 'Mr. Market' for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of the emotional extremes, then you are very likely to succeed over time.”
Klarman believes that confronting the unknown without diffidence forces and facilitates our thinking: we are led to constantly question our underlying assumptions about the market or the merits of a particular stock: “In investing, certainty can be a serious problem, because it causes one not to reassess flawed conclusions.”
Klarman notes that even though no one is omniscient, a judicious analytical framework applied with rigorous discipline can help ensure that our decisions, albeit made in an environment of uncertainty, are based on more than mere happenstance or following the herd:
“But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction.”
In an environment of doubt, however, there is no easy prescription for making failsafe investment decisions: “Instead, one must rely on shreds of evidence, kernels of truth and what one suspects to be true but cannot prove. One must also balance one’s own perception of the truth with one’s best assessment of what others believe.”
Embracing the unknown makes us better investors because it instills in us the temperament of flexibility, a trait that is indispensable for successful long-term investing:
“It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Yet being overly certain in an uncertain, protean, and ultimately unknowable world is hazardous for investors. To be sure, uncertainty breeds doubt, which can be paralyzing.”
Additionally, although successful investing requires resoluteness and conviction, Klarman wrote it also:
“…requires flexibility and open-mindedness. Investments are typically a buy at one price, a hold at a higher price, and a sale at a still higher price. You can never be sure if the economy will grow or shrink, whether the markets will rise or sink, or whether a particular investment will meet your expectations. Amidst such uncertainty, people who are too resolute are hell-bent on destruction. Successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong.”
Klarman also advises that the vacillations of the market caused by the manic moods of Mr. Market can be used advantageously for those investors who have the requisite perspective to realize that:
“In investing, other people’s perception of reality influences price more than any underlying truth; your own assessment, even if correct, is valueless if it is already reflected in the market price.”
Klarman acknowledges that it can be unnerving for a value investor to embark upon a path that he believes is the most prudent for attaining a sufficient margin of safety, when no one else in the market is charting that course:
“Successful investing requires resolve. When taking a contrary approach, one has to be able to stand one’s ground, be unwavering when others vacillate, and take advantage of others’ fear and panic to pick up bargains.”
Following through on the strength of one’s own convictions, when other investors are momentarily profiting from taking the opposite bet, requires stamina and resolve, which, among most investors, are in short supply.
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