AHEAD OF PRINT
©2010 CFA Institute
Financial Analysts Journal
I would make two points. First, pre-2008,nearly all stocks had come to be valued, in a sense,on an invisible template of an LBO model. LBOswere so easy to do. Stocks were never allowed toget really cheap, because people would bid themup, thinking they could always sell them for 20percent higher. It was, of course, not realistic thatevery business would find itself in an LBO situa-tion, but nobody really thought much about that.Certainly, many of the companies had someelement of value to them, such as consumer brands or stable businesses, attributes that valueinvestors might be attracted to. But when themodel blew up and LBOs couldn’t be effected, theinvisible template no longer made sense andstocks fell to their own level.Second, because of the way the world hadchanged, it was no longer sufficient to assume thata bank’s return on book value would always be 12or 15 percent a year. The reality was that instru-ments that were rated triple-A weren’t all the same.Watching home-building stocks may not have beenthe best clue to what was going on in the mortgageand housing markets.Equity-minded investors probably needed to be more agile in 2007 and 2008 than they had everneeded to be before. An investor needed to put thepieces together, to recognize that a deterioratingsubprime market could lead to problems in therest of the housing market and, in turn, could blow up many financial institutions. If an investorwas unable to anticipate that chain of events, then bank stocks looked cheap and got cheaper andearnings power was moot once the capital basewas destroyed. That’s really what primarily drovethe disaster.
With hindsight, it strikes me that aproblem many traditional value investors had wasthat they didn’t have enough on their dashboard.They were accustomed to bubbles forming in theequity market, but the credit bubble was in theperiphery. Equity investors didn’t take the credit bubble seriously enough, because it wasn’t in theircentral field of vision.
Another issue that affected allinvestors, not just value investors, was the pressureto be fully invested at all times.When the markets are fairly ebullient, inves-tors tend to hold the least objectionable securitiesrather than the truly significant bargains. But theinability to hold cash and the pressure to be fullyinvested at all times meant that when the plug waspulled out of the tub, all boats dropped as the waterrushed down the drain.
A chilling moment in MichaelLewis’s wonderful book
The Big Short
is whenMichael Burry, a very talented hedge fund man-ager in California, finds himself, in 2007, in thedesperate situation of having to defend his shortpositions in leveraged mortgage securities againsthis own investors, who are just besieging him,screaming at him, why are you doing this? At thevery moment when his temperament is telling himthat he
be doubting his own judgment, hisclients are compelling him to explain to them whyhe has no doubts about his judgment.How have you organized Baupost to discour-age your clients from putting you in a similarposition?
We have great clients. Havinggreat clients is the real key to investment success. Itis probably more important than any other factorin enabling a manager to take a long-term timeframe when the world is putting so much pressureon short-term results.We have emphasized establishing a client baseof highly knowledgeable families and sophisti-cated institutions, and even during 2008, we couldsee that most of our institutional clients—althoughsome of them had problems—understood whatwas going on.
If you were to give one piece ofadvice on how to raise the quality of one’s client base, what would it be?
In our minds, ideal clients havetwo characteristics. One is that when we thinkwe’ve had a good year, they will agree. It would bea terrible mismatch for us to think we had done welland for them to think we had done poorly. Theother is that when we call to say there is an unprec-edented opportunity set, we would like to knowthat they will at least consider adding capital ratherthan redeeming.At the worst possible moment, when yourfund is down because cheap things have gottencheaper, you need to have capital, to have clientswho will actually love the phone call and—most ofthe time, if not all the time—add, rather than sub-tract, capital. Having clients with that attitudeallowed us to actively buy securities through thefall of 2008, when other money managers hadredemptions and, in a sense, were forced not onlyto
buy but also to sell their favorite ideas whenthey knew they should be adding to them.Not only are actual redemptions a problem, but also the fear of redemptions, because the moneymanager’s behavior is the same in both situations.When managers are afraid of redemptions, they getliquid. We all saw how many managers went from