Klarman: A buying opportunity (but not for the faint of heart)

Patrick Poke

Livewire Markets

Seth Klarman, CEO and Portfolio Manager of the US-based hedge fund, Baupost Group, has been touted widely as “the next Warren Buffett”. The nickname The Oracle of Boston (a reference to Buffett’s “Oracle of Omaha” nickname) has even been used to reference him. However, unlike Berkshire Hathaway, which is a public company, Baupost Group is a private partnership. This makes his annual letters much more difficult to get your hands on than Buffett’s, as they’re not publicly released. Generally, you’ll need to be an investor in his firm (which is closed to the public) to get your hands on one.

In my daily rummaging through the depths of online investment discussion forums, I was lucky enough to stumble across a copy of his latest letter, just released overnight. Given this rare opportunity to gain insights into one of the world’s great hedge funds, and the length of the note (21 pages), I’ve summarized some of the best parts here.

Synchronized global disappointment

Klarman’s summary of the current state of financial markets, and their potential future, seemed decidedly bearish. He invoked the wisdom of Hyman Minsky (“stability itself could be destabilizing”), warned on the dangers of algorithmic trading (“we simply cannot know how those algorithms might respond to new and unexpected conditions”), and shared his fears of a bear market in bonds and corporate credit. Despite all this, he was explicitly clear that he remained a net-buyer of equities in the current market:

“Today’s markets feel strange and enigmatic. We will not complain about this; indeed, we see it as an opportunity. While the indices remain historically expensive, many stocks – of growing, not cyclical or declining firms – recently hit 52-week lows and trade at single-digit P/Es. These are levels that traditionally occur closer to market bottoms than tops. The recent selloff likely presented a buying opportunity – you can go years without seeing such valuations – but not across the board and not one for the faint of heart.”

As usual, the large institutions failed to see what was coming. Klarman quoted the IMF’s forecast of “synchronized global growth” at the beginning of 2018, and suggested 2018 could be better characterized as “synchronized global disappointment”.

Sounds a lot like ‘blood on the streets’

“During the worst moments of the fourth-quarter market carnage, we were entering buy orders and our bids were getting hit. We were adding to positions which had become cheaper, and moving into attractively priced new investments. We are particularly energized to be making new investments when other investors have pulled back, competition is subdued, and prices are in near free-fall. As this was unfolding, we also reduced several positions that seemed less attractive than other opportunities that were emerging, and we redeployed those funds...

...Stocks plunged indiscriminately – on some days, resembling a post-Thanksgiving sale with storewide markdowns. We did what we usually do amidst market turmoil, which is to re-check our analysis, prioritize our opportunities, and buy.”

The essence of value investing

“It’s always hard to know why the market does what it does. That’s part of the ever-interesting challenge we face in traversing the twists and turns of fluctuating prices and evolving fundamentals. On any given day, the sheer number of players, behaviors, economic factors, and business developments defy anyone’s ability to fully grasp what is going on and why. That’s why we develop and follow a game plan that does not purport to tell us what to do moment by moment, but rather is intended to help us successfully navigate the most challenging tumult. This is the essence of value investing.”

Bond bear market could be treacherous

“There are also concerns that the lengthy 36-year bond bull market is nearing its end. At one point last year, rates on U.S. Treasury 10-year bonds had more than doubled from their 2016 lows. Given the length of the bond buying spree, many of today’s market participants have never experienced a bear market in bonds. The riskiness of their exposures may surprise them. And because marketplace conditions have evolved greatly over the last three decades, when we do eventually enter a fixed income bear market, neither historical correlations nor prior experience are likely to provide much guidance for how to successfully navigate this treacherous terrain.”

Risk vs caution: Striking a balance

Like sailors navigating the turbulent waters between Scylla and Charybdis, investors must regularly set a course between excessive caution and excessive risk-taking. Erring in the overly cautious direction leads to potentially meager returns, missed opportunities, and a failure to compound capital. On the other hand, the pressure of never- ending performance comparisons may drive normally cautious investors to embrace greater risk. Sitting on the sidelines is not typically seen as a viable option for many investors. They share the view of a former bank CEO who, a decade ago, quipped “as long as the music is playing, you’ve got to get up and dance.”

But an excessively risky course may well lead to capital destruction. No one can embrace risk with impunity; it almost always catches up with you. The obvious path to safe navigation is to balance an energetic offense with a strong defense. But in investing, there are no offensive and defensive units. There is no effective way in investing for the offense to scramble off the field and have the defense replace them; you need to excel at both, and at the same time.”

Avoiding bias in decision making

In order to strike a balance between risk taking and risk aversion, investors must avoid behavioural biases, Klarman explains.

“Avoiding these biases at a firm like ours involves building a culture of humility, intellectual honesty, and open debate as well as maintaining a rigorous and robust investment process, consistently applied. Hedging the greatest risks at reasonable prices is also imperative.”

Reducing your correlation to the market

Market multiple and macroeconomic developments aren’t under your control (nor are they easy to predict), so reducing exposure to these factors can help your portfolio when markets get stormy. Klarman says that including assets exposed to a catalyst in your portfolio can help to achieve this:

“Catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments (which are not at all under your control) to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events, including mergers and acquisitions, bond maturities, debt restructurings, bankruptcies, major corporate asset sales, spinoffs, and tender offers. No strategy can avoid all risk of loss. But we believe our approach should increase the likelihood of achieving sustainable gains with limited downside risk over the long- run.”

Mr Market reimagined

“When you make an investment and the price drops, the key is to see the fall in price as not necessarily indicative of a past error or failure (no one, after all, can predict the daily meanderings of the markets), but as an opportunity. It’s not a do-over – what’s done is done – but it is a fresh chance to make another good investment, potentially an even better one now that those shares are lower in price. As we’ve said before, the key in investing is to see the market’s fluctuations not as a source of feedback, a report card if you will, but as a potential driver of opportunity…

…We have known many people who find the daily report card the market hands them a source of consternation and even anxiety. If the stock they recently purchased falls in price, they feel like they failed. Had they waited after all, they could buy more shares for the same capital invested. But in investing, it’s necessary to experience those price drops and see them as a source of further and greater opportunity and not as a problem. Similarly, price gains should not be experienced as a pat on the back from the market.

We wish we had perfect market timing (as well as the ability to fly). The reality is that no one does or ever will. The key is to find a way to care about one’s investment results over time, but to not feel burdened by the daily fluctuations of Mr. Market. The only way to invest, after what you purchased has fallen in price, is to be that successful relief pitcher. Put yesterday’s outcome out of your mind, get back on the mound, and make the best decision you can today with all the information at hand.”

Read the full, 21-page letter.

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Patrick Poke
Patrick Poke
Managing Editor
Livewire Markets

Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.


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