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Seth Klarman CFA Presentation

Seth Klarman CFA Presentation

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September/October 2010
Financial Analysts JournalVolume 66
Number 5©2010 CFA Institute
Opportunities for Patient Investors
Seth A. Klarman and Jason Zweig
t the CFA Institute 2010 Annual Confer-ence in Boston (held 16–19 May), JasonZweig sat down with legendary investorSeth Klarman to gain insights into Mr.Klarman’s successful approach to investing.
The first question I would like to askyou, Seth, concerns your work at Baupost. Howhave you followed Graham and Dodd, and howhave you deviated from Graham and Dodd?
In the spirit of Graham and Dodd,our firm began with an orientation toward valueinvesting. When I think of Graham and Dodd, how-ever, it’s not just in terms of investing but also interms of thinking about investing. In my mind,their work helps create a template for how toapproach markets, how to think about volatility inmarkets as being in your favor rather than as aproblem, and how to think about bargains andwhere they come from. It is easy to be persuadedthat buying bargains is better than buying over-priced instruments.The work of Graham and Dodd has reallyhelped us think about the sourcing of opportunityas a major part of what we do—identifying wherewe are likely to find bargains. Time is scarce. Wecan’t look at everything.Where we may have deviated a bit fromGraham and Dodd is, first of all, investing in theinstruments that didn’t exist when Graham andDodd were publishing their work. Today, someof the biggest bargains are in the hairiest, strang-est situations, such as financial distress and liti-gation, and so we drive our approach that way,into areas that Graham and Dodd probablycouldn’t have imagined.The world is different now than it was in the eraof Graham and Dodd. In their time, business wasprobably less competitive. Consultants and“experts” weren’t driving all businesses to focus ontheir business models and to maximize perfor-mance. The business climate is more volatile now.The chance that you buy very cheap and that it willrevert to the mean, as Graham and Dodd might haveexpected, is probably lower today than in the past.Also, the financial books of a company may not be as reliable as they once were. Don’t trust thenumbers. Always look behind them. Graham andDodd provide a template for investing, but notexactly a detailed road map.
Seth, you started your career atMutual Shares, working for Max Heine and along-side Mike Price. Can you give us a couple of lessonsyou learned from those gentlemen?
What I learned from Mike—and Iworked most closely with him—was the impor-tance of an endless drive to get information andseek value. I remember a specific instance when hefound a mining stock that was inexpensive. Heliterally drew a detailed map—like an organizationchart—of interlocking ownership and affiliates,many of which were also publicly traded. So, iden-tifying one stock led him to a dozen other potentialinvestments. To tirelessly pull threads is the lessonthat I learned from Mike Price.With Max Heine, I learned a bit of a differentlesson. Max was a great analyst and a brilliantinvestor—and he was a very kind man. I was mosttaken with how he treated people. Whether youwere the youngest analyst at the firm, as I was, orthe receptionist or the head of settlements, healways had a smile and a kind word. He treatedpeople as though they were really important, because to him they were.
One of the striking lessons that cameout of the global financial crisis of 2008 and 2009 isthe way traditional value investors got slaugh-tered. What went wrong, and why did so manysmart people get caught by surprise?
Historically, there have beenmany periods in which value investing has under-performed. Value investing works over a longperiod of time, outperforming the market by 1 or2 percent a year, on average—a slender margin ina year, but not slender over the course of time,given the power of compounding. Therefore, it isnot surprising that value could underperform in2008 and 2009.
Seth A. Klarman is president of The Baupost Group,LLC, Boston. Jason Zweig is a columnist for the
WallStreet Journal
, New York City.
©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
September/October 2010
Opportunities for Patient Investors
leveraged long in 2007 to huge net cash in 2008,when the right thing to do in terms of value wouldhave been to do the opposite.
There is an interesting tension in theway Baupost operates. You are organized for thelong term, you invest for the long term, and yet youhave demonstrated that you can be extremelyopportunistic in the short term. For example, in2008, you took distressed debt and residentialmortgage-backed securities from basically zero tomore than a third of the fund in a matter of months.How do you take a firm that thinks long term yetget everyone to turn on a dime and jump on some-thing when it’s cheap?
Actually, we increased the positionto about half of the fund by early 2009. There is nosingle answer. First, I have incredible partners. Weshare common aspirations for the business and acommon investment approach. And we are not con-ventionally organized. We don’t have a pharma-ceutical analyst, an oil and gas analyst, a financialsanalyst. Instead, we are organized by opportunity.We have analysts whose focus is on spinoffs ordistressed debt or post-bankrupt equities.Not only do we not miss too many opportu-nities, but we also do not waste a lot of timekeeping up with the latest quarterly earnings ofcompanies that we are very unlikely to everinvest in. Instead, we spend a lot of our timefocusing on where the misguided selling is,where the redemptions are happening, where theoverleverage is being liquidated—and so we areable to see a flow of instruments and securitiesthat are more likely to be mispriced, and that letsus be nimble. It is fairly easy to say, “Well, this ismuch better than what we own. Let’s move fromthis direction to that direction”—and we aredoing that all the time.
In a
article in the summer of1932, Benjamin Graham wrote, “Those with enter-prise haven’t the money, and those with moneyhaven’t the enterprise, to buy stocks when they arecheap.”
Could you talk a little bit about courage?You make it sound easy. You have great clients andgreat partners. Was it easy to step up and buy in thefourth quarter of 2008 and the first quarter of 2009?
You may be skeptical of myanswer, but, yes, it was easy. It is critical for aninvestor to understand that securities aren’t whatmost people think they are. They aren’t pieces ofpaper that trade, blips on a screen up and down,ticker tapes that you follow on CNBC.Investing is buying a fractional interest in a business and buying debt claims on a business. Ifyou are afraid that a bond you bought at 60 mightgo to 50 or even 40, you may find it difficult to buymore; but if you know that the bond is covered,with extremely high likelihood, between 80 and paror even above par, the bond becomes more andmore compelling as its price falls.But you do have to worry about how a bondwill trade and what your clients will think if youdon’t have enough staying power to hold to matu-rity or even beyond maturity in the case of a bank-ruptcy. But if you have the conviction of youranalysis—are sure that your analysis wasn’t opti-mistic or flighty or based on a snapshot of aneconomic environment that cannot tolerate anystress—then you will not panic if the bond’s pricestarts to drop.Our approach has always been to find compel-ling bargains. We are never fully invested if thereis nothing great to do. We test all our assumptionswith sensitivity analysis. Through stress testing,we gain a high degree of conviction that we areright. We are prepared for things to go slightlywrong because we adhere to a margin-of-safetyprinciple that gives us the necessary courage to goagainst the tide.Yet, we don’t actually think of it as courage, butmore as arrogance. In investing, whenever you act,you are effectively saying, “I know more than themarket. I am going to buy when everybody else isselling. I am going to sell when everybody else is buying.” That is arrogant, and we always need totemper it with the humility of knowing we could bewrong—that things can change—and acknowledg-ing that we have a lot of smart competitors. Thus, inworrying about all the things that can go wrong, youcan prepare, you can hedge—and you must remem- ber to sell fully priced securities so that you areunderexposed when things go badly. All these ele-ments give us the courage to follow our convictions.The last point I would make is that your psy-chology as an investor is always important. If youlose your confidence, if you’ve made too manymistakes, if you are down too much, it becomesvery easy to say, “I can’t stand being down morethan this.” Unless you have a bet-the-businessmentality, you would worry about your business,about client redemptions, and about your own networth in the business.So, by being conservative all the time—by being both a highly disciplined buyer to ensure thatyou hold bargains and a highly disciplined seller toensure that you don’t continue to own things at fullprice—you will be in the right frame of mind.Avoiding round trips and short-term devastationenables you to be around for the long term.

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