Reading through Patrick Poke’s article yesterday analysing Seth Klarman’s annual letter for Baupost Group ("Klarman: A Buying Opportunity"), a particular passage stood out. Unsurprisingly, not least because of our history in championing the strategy, the passage focused on reducing correlation to broader equity markets.
In our most recent Livewire article, "The Little Known Buffett Strategy", we drew attention to a 1988 Berkshire Hathaway Annual Letter detailing Buffett’s engagement in the practice of arbitrage as a means of providing superior risk-adjusted returns to cash in the absence of compelling investment ideas. In Buffett’s case, engaging in arbitrage tempered desires to chase equity investments for the sake of performance when long term investments weren’t sufficiently compelling.
After the well publicised falls in global equity markets in the last quarter of 2018, it is interesting to now note Klarman’s comments about strategies uncorrelated to the market. A significant driver of returns over the last several years has in part been due to multiple expansion as asset valuations have outstripped the underlying returns (Shiller’s CAPE ratio is but one example quantifying this phenomenon). Late 2018 certainly asked investors to reassess the assumption that multiple expansion would continue to play a part in generating returns. Multiple contraction can negatively impact an asset’s valuation even in the face of growing underlying returns.
“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.”
Our takeaway: In the face of uncertainty, take the market out of the equation where possible.
Stocks exposed to catalytic events typically decouple from the market. Hypothetically, the market can halve and an unconditional takeover offer is legally compelled to proceed at the stated price – should the share price fall below the unconditional offer price, it is the equivalent of purchasing cents on the dollar for zero risk.
Very few corporate transactions are as simple as the hypothetical transaction above, though. The share prices and associated valuations are driven in the short term by the probability of an event occurring, which involves a certain degree of subjective estimation. This subjective estimation opens the door for potential mispricing, where better returns can be achieved without a commensurate, objective increase in risk.
A portfolio containing event driven positions can limit the impact external factors have on investors’ portfolios. On a more granular level, a portfolio consisting of only event driven positions not only exhibits minimal correlation to the market, but also limited correlation amongst the portfolio itself.
"A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous in navigating through turmoil."
While investors ask questions as to whether growth or value investing may be better suited over the coming years, two of the most revered investors of our time both suggest that limiting exposure to the market may very well be the key to beating it in the long term.