SETH KLARMAN NOTES FROM 5-17-2010 MEETING
Jason Zweig interviewed Seth Klarman and these are my incomplete notes scribbled in haste and not direct quotes.
In value investing, you should think about investing Graham & Dodd style. Volatility works in your favor in terms of providing mispriced assets. Volatility shouldn’t be viewed as a problem. You should be seeking to buy bargains, and the best bargains often are found in the “hairiest” situations, such as in distressed securities or securities in litigation.
The business climate is more volatile today than during Graham’s time. What’s on the books today may not be as reliable as during Graham’s days. You need to look behind the numbers. There are more fads today in consumer goods i.e. Lady Gaga sneakers.
Seth Klarman previously worked for Michael Price and Max Heine of Mutual shares. The lesson he learned from Michael Price was the endless drive to get information by pulling all threads on a business in the efforts to seek value. Seth described Max Heine as a very kind person…he always had a smile and kind word for everyone in the shop from a junior analyst to the receptionist.
Seth was asked why so many value managers underperformed the market in 2008. He said over time value investing works and provides outperformance of 1-2% over the S&P 500. While this may seem like slender outperformance, it really adds up over time. There will be periods, however, when value investing underperforms. Many value investors were looking at the book value of banks and thinking they knew what was in it. However, instruments rated AAA weren’t all the same. During 2007/2008, investors needed to be more nimble and pull all the threads together on a business. Banks got cheap…and then cheaper. Many equity investors weren’t looking at the whole picture…they should have been looking at the credit bubble. Many investors also are pressured to be fully invested all the time. However, once the plug was pulled out of the tub in 2008, it was a long way down. Even for investors that were right, it wasn’t easy. Seth went on to discuss Michael Burry’s position as described in “The Big Short.” Burry had to defend his short position against his own investors.
Seth Klarman’s organization, Baupost, is organized to attract great clients, which is the key to maintaining investment success. His clients have a long-term perspective. They consist of highly knowledgeable families and sophisticated institutions. He described the ideal client as the one who agrees with them when they think they have had a good year and adds capital at times when Seth calls saying he is seeing good buying opportunities…which are usually the times other firms are facing redemptions. Seth was thus able to actively buy investments in 2008 when others had to sell. Many money managers had to liquidate positions just based on the fear or redemptions.
During 2008, Baupost went from zero exposure in distressed debt and mortgage securities to having 1/3 of their assets in distressed debt and mortgages, which subsequently grew to half of their total assets by 2009. They always look for mispriced securities and evaluate the opportunity costs and are prepared to act when opportunities become available.
Klarman quoted Ben Graham:
Those with the enterprise lack the money and those with the money lack the enterprises to buy stocks when they are cheap.
During the fourth quarter of 2008, it was easy for Klarman to buy securities. He doesn’t look at investments as pieces of paper like Cramer or Kudlow. He knows he is buying a fractional interest in a business. When you buy distressed bonds and you expect them to return to close to par, they become more compelling investments as the price goes down. If you have staying power and the conviction of your analysis, you won’t panic when prices drop.
Baupost always looks for compelling bargains and then stress tests all their assumptions, asking things like what happens to the investment if interest rates rise from 8% to 9%? They always buy with a margin of safety. One needs to have humility when investing–always worry about that which could go wrong with the investment.
An investor’s own confidence and temperament will impact their performances. One needs to be a highly disciplined buyer and seller and avoid the round trips. Temperament and a disciplined process will lead to successful investing.
Ben Graham said you need both cash and courage when investing. Having only one is not enough.
Klarman thinks indexing is a “horrible idea.” Most stocks run up prior to being put into the index, so the index is buying high. Klarman would rather buy stocks that are kicked out of the index, since they are likely to be a better value. For the average person, indexing may work but the entry point is critical.
Given the stock market rally since last year, Klarman is now worried of zero to low returns from the stock market for the next decade.
He compared the stock market to a Hostess Twinkie, which has totally artificial ingredients. Given the financial crisis, the market has been manipulated by the government with interest rates kept close to zero, TARP, Cash for Clunkers and Caulkers, the government buying dubious assets, etc. The government wants people to buy stocks to restore confidence. However, Klarman is worried about what the markets and the economy would look like if they hadn’t been manipulated…if the market wasn’t a Twinkie. The bailouts continue with the latest being put into place by the European governments. These bailouts probably won’t work.
Klarman said he is more worried about the world broadly than at any time in his career. There is now a new element to the investing game…will the dollar be worth anything if the government intervenes each time to prop things up? There are not enough dollars in the world to solve all the problems. He worries about all paper money. It is easy to imagine that politicians will find it easier to debase the currency with inflation than solve the hard problems. However, they can’t just keep kicking the can down the road. There is no free lunch and inflation is not zero.
The trouble is that we didn’t get “value” out of this crisis. There has been no Depression mentality. We’ve had “Just a Bad Week” mentality and there is still speculation going on.
We’re at a tipping point with sovereign debt. If investors think the U.S. will pay back debt, they won’t be worried. However, if they become worried, we could have failed Treasury auctions. The tipping point is invisible. Our Treasury Secretary is lulled into thinking we are AAA, but we have an eroding infrastructure and no fiscal responsibility.
How do you go bankrupt? Gradually and then suddenly…like Greece.
Commodities are not investments as they don’t produce cash flow. They only have value if you can sell them to a “greater fool.” They are only worth what some future buyer will pay for them. They are a speculation. Gold is somewhat different in that it is seen as a store of value. Investors might consider having some exposure to gold due to the worry of debasement of currency.
The investing game was checkers, now it is more like three-dimensional chess due to the potential destruction of dollars. Klarman is seeking an inexpensive hedge against dollar destruction as he is trying to protect against catastrophic tail risk. His way to hedge against inflation is through way out of the money puts on bonds. If interest rates go to double-digit ranges, he will make a lot of money. As long as the insurance is cheap enough, he will do it.
Baupost is managing $22 billion and said size is an anchor when it comes to investing. However, when he anticipated buying opportunities in early 2008, he called folks on his waiting list and allowed them to take advantage of the buying opportunities he was seeing so he could put greater capital to work.
He is worried a great deal about a double-dip recession due to debt morphing to sovereign risk. He now has about 30% in cash in his partnership. He will return the cash to clients if the cash increases much more and he doesn’t find any buying opportunities. He has no real lock ups in his hedge fund and calibrates his firm size to manage the right amount of the money dependent on market opportunities. His goal is excellence. He doesn’t want to take his company public as it would ruin the firm. He wants to retire at the end of his career knowing that he put his clients first, and he doesn’t care if he doesn’t charge as much as others.
Klarman had a bad visceral reaction to the Goldman hearings. Goldman’s hedging should have been celebrated as they were the Wall Street firm least likely to blow up thanks to the hedging. The world is a wild and woolly place. Brokers may have more conflicts of interest, but he knows Wall Street will always try to “rip out our eyeballs” on a trade. He said they go to Wall Street with their eyes wide open. He doesn’t know how to police Wall Street better. As market-makers, Wall Street doesn’t owe them any fiduciary duty.
Klarman would welcome more regulation if it helps the country. Limits on leverage and more disclosure would be fine. He wishes proprietary trading would go away. He knows firms front run Baupost trades. Bank capital requirements need to be higher. The bank rescue fund, however, has problems. It will penalize successful firms like J.P. Morgan due to their dumber competitors. He agreed with Bill Ackman who thinks if the bank’s equity gets wiped out, the subordinated debentures should be converted to equity.
At Baupost, they try to avoid groupthink. They recently had a conference in which they invited a variety of speakers. Most of them described the terrible problems we face; think the ECU will likely break up and that gold should be held. Following the meeting, members of Baupost questioned whether this was groupthink? They are very good at intellectual honesty and learn from their mistakes. There is no yelling at the firm over mistakes. They are aware of their biases in either direction.
Investors need to pick their poison. You either need to protect on the downside, which means you may not be at the party as long. Or you stay at the party and make money, but realize you will have a bad year or so. At Baupost, they prefer to be conservative. Klarman would rather underperform in a big bull market than get clobbered in a bear market.
In hiring folks, they try to find intellectually honest folks by asking them “What is the biggest mistake you ever made.” They also ask lots of ethical questions. Everyone they interview is smart, but they are seeking folks with idea fluency and high integrity.
Klarman believes short-sellers do better analysis than long-only investors since they have to due to the upward bias of the stock market over time. The Street is biased on the bullish side. Short sellers are the policeman of the market. It is not in the country’s interest to limit short-sellers. The one exception is on CDS buyers, who want a company to fail rather than recover and shout “Fire in the theatre” to make it happen. However, the burden should be on companies to not get into a position where their access to capital can be roiled by the short-sellers. GE was irresponsible in thinking they could always roll over their debt. However, if short sellers short on fundamentals and are wrong then Klarman welcomes them being stupid. He also said that if a computer wants to sell him a stock for a penny, he also would like that. When asked about how the flash crash hurt people who had in market orders, he thundered back that no one should ever put in a market order.
When asked about his asset allocation strategy, he just smiled since he doesn’t have one. He is highly opportunistic and buys what is out of favor. He goes where the trouble is…and can’t predict where that will be in the future.
He said “we make money when we buy bargains and count the profits later.” He currently is buying commercial real estate as the fundamentals are terrible. The government is winking at banks and telling them not to sell the real estate. While he isn’t currently making money in real estate, he is putting money to work in real estate. He is making money currently on the distressed debt he purchased two years ago which has nearly doubled in value.
His holding period is maturity for bonds and “forever” for stocks. This doesn’t mean that his turnover might be quicker if a bond rises rapidly from depressed prices to close to par.
When asked to describe a value company, he said there is no such thing. Price is the determinant for every investment.
When asked if he was worried about the counterparty risk for his out of the money puts, he said they worry about everything as there is risk in everything they do. However, they try to choose the best counterparties they can and require collateral posting.
When asked how he was confident enough to be fully invested in 2008, he said they over worry. They considered that the market could drop 40% and the economy could fall off the cliff. Even after considering a Depression scenario, they were still able to find things to buy like the bonds of captive auto finance companies, especially when they could pick up Ford bonds at depressed levels. They stress tested the loan portfolio and thought the bonds were worth significantly more than they were trading for as there wasn’t the same overbuilding in the auto industry as in the subprime housing market. As a result, there wasn’t the same deterioration in the loan portfolio. Klarman saw amazing upside in buying the bonds with Depression-proof downside, so he invested.
Credit risks remain real, however. The credit market rallies are now overblown especially in the junk market. Lessons were not learned even as investors stared into the abyss. Investors are back to drinking the Kool-Aid. There could be another collapse and people are not prepared for it.
Investors should think about disaster scenarios and prepare for them, although the preparation is more art than science. Klarman is trying to protect his client’s assets in the even the world gets really bad. When asked if he plans to re-release his book, “Margin of Safety,” he said he has no immediate plans to do so although he has thought about doing it with a new introduction and perhaps a companion volume to raise money for charity. He just hasn’t had time.
When asked about other book recommendations, he gave the following:
- The Intelligent Investor-Ben Graham
- You Can Be a Stock Market Genius-Joel Greenblatt
- The Conservative Investor-Marty Whitman
- Too Big to Fail-Andrew Sorkin
- Anything written by Jim Grant, Roger Lowenstein and Michael Lewis
- He said folks should never stop reading as history doesn’t repeat but it rhymes, and in finance, progress is cyclical.