Wiser Daily

Investment Theory #22: Klarman’s 2000 Letter

Posted on July 11, 2017 by David Shahrestani, CFA

Let’s continue our series on the 1990’s. You may recall that 2000 was the year the bubble popped and
Klarman began putting his large cash balances to work.

Klarman is a well-respected value investor who founded the Baupost Group in 1982. Since then he
has generated an average annual return of 19%. Klarman’s investing philosophy can be summed up
by the title of his book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
(https://www.amazon.com/Margin-Safety-Risk-Averse-Strategies-Thoughtful/dp/0887305105).

This series of posts will reflect on Klarman’s activity during the period 1995 to 2001. Links to past
posts: 1995 (https://wiserdaily.wordpress.com/2017/02/10/investment-theory-17-klarmans-1995-
letter/), 1996 (https://wiserdaily.wordpress.com/2017/02/20/investment-theory-18-klarmans-1996-
letter/), 1997 (https://wiserdaily.wordpress.com/2017/03/09/investment-theory-19-klarmans-1997-
letter/), 1998 (https://wiserdaily.wordpress.com/2017/03/24/investment-theory-20-klarmans-1998-
letter/), 1999 (https://wiserdaily.wordpress.com/2017/06/14/investment-theory-21-klarmans-1999-
letter/)

Historical context

In 2000, the S&P 500 returned -9.10%.

In January, America Online agreed to purchase Time Warner for $162 billion. In March, The
NASDAQ reached an all-time high of 5,048, ending a bull market run that lasted over 17 years. In
April, Microsoft was ruled to have violated United States antitrust laws. In May, computer pioneer
Datapoint filed for bankruptcy. In June, the preliminary draft of genomes by the Human Genome
Project was completed. In July, a Concorde aircraft crashed into a hotel in Gonesse. In September,
Apple introduced the first public beta of Mac OS X. In October, the first resident crew arrived at the
International Space Station. In November, Iraq rejected U.N. Security Council weapons inspections.
In December, the U.S. Supreme Court stopped the Florida presidential recount, giving the Presidency
to George W. Bush.

Midyear Update

In mid-2000, it was becoming apparent that the Dotcom bubble was over. The ride from bottom to top
left many professional investors out of a job – some for missing the ride up and some for getting hit
on the ride down. For his part, Klarman spent most of the bubble just avoiding U.S. markets. This
seemed like a winning strategy until he got caught up in the Russian Ruble Crisis. After that event,
his strategy shifted towards holding larger cash balances and hedging his modest exposure. He
spends the midyear letter talking about what he looks for when putting that cash back to work:
 Because investing is a highly competitive activity, we consider for each of our investments not
only whether a security is undervalued but why it is undervalued. If the reason is that there are
uninformed or emotional sellers, we become more comfortable. Conversely, we do not want to
ever be in the situation of having less information than the party selling to us. In effect, we seek an
edge in all of our investments, a reason to believe we will have the wind at our backs, not in our
faces, as we seek good investment returns over time with limited risk. Situations analytically
complex, or where there are forced, mechanical or panicked sellers, nicely fit this criterion.

It is often said that there are only three competitive advantages in investing: behavioral, analytical,
and informational. Can we emotionally divorce ourselves from the manic fits of Mr. Market (Value
investing)? Are we better at analyzing public data than other parties (Quants)? Or do we just have
access to data that other parties don’t (HFTs)? As with any business, it is important to understand
where our advantages come from in order to reinforce and defend them. Klarman’s advantage was
both emotional and analytical.

Performance in 2000

As always, Klarman opens the full year letter with a discussion of performance:

We are pleased to report a gain of 22.4% for the fiscal year ended October 31, 2000. This result was
achieved amidst a challenging and unusually turbulent market environment.

Clearly, the Internet bubble has burst. Nearly all publicly traded Internet stocks have come up
snake-eyes, and there is considerable doubt about whether there is or ever was a “new economy.”
No longer can you add “dot com” to a word, sell shares to the public, and join the Forbes 400. No
longer can entrepreneurs count on investors to fund enormous and protracted operating losses.

As far as WallStreet was concerned, the internet had been a lie and it was time to face reality. Of
course, WallStreet was culpable for pushing that lie in the first place. Marc Andreeson likes to point
out that all the crazy ideas of the dot-com bubble – internet
clothing/groceries/music/banking/video/etc – eventually worked out, just not as fast enough for
WallStreet’s expectations.

This is a reoccurring pattern with new technology: invention > hype > boom > can’t match hype > bust
> renaissance. It happened with railroads, cars, planes, radio, tv, the internet, bitcoin, etc. The lesson
is that an idea can be both right from a business perspective and wrong from an investment
perspective. The business plan determines the former, the price paid determines the latter.

This too shall pass

In his magnum opus, the General Theory, Keynes described the market as a beauty contest where
investors are trying to pick the stock most other investors will find beautiful, rather than the stock
they find beautiful. Klarman talks a bit about this heard mentality:
 I sometimes joke about the new market valuation rules of thumb: stocks that fail to meet earnings
expectations all seem to trade at 10 times reduced earnings, while formerly profitable companies
that report losses all seem to trade at five dollars per share. Many investors avoid these stocks
precisely because others are staying away. Why would those kind of stocks ever go up, they
wonder. Even those of us with value investing in our DNA generally prefer situations with
catalysts for the realization of underlying value.

Over time, this will change. At some unknowable future point, the undervaluation of small
capitalization stocks lacking exciting growth characteristics will become so gaping that investors
will once again be attracted. The point of investing, after all, is not to have a great story to tell; the
point of investing is to make money with limited risk. At some point, investors will drop their
Pulitzer prize winning story stocks and revisit their attention on the old classics, stocks that make
you money because their undervaluation creates a compelling imbalance between risk and return.

There’s that saying that what the smart do in the beginning, the foolish do in the end. The crowd will
always move towards what has worked in the past, and the profit motive will always encourage
contrarians to move towards what will work in the future. Though the crowd usually has more wind
to its back, this competing force will eventually correct any excess.

Value Investing

As with most years, Klarman takes some time to discuss the philosophy of value investing:

Investors who look to Mr. Market for advice will inevitably do the wrong thing at the wrong time.
Investors who attempt to profit from Mr. Market’s manic depressive nature will be successful over
the long run.

In our view, investors should, more than ever, act on the assumption that any stock or bond can
trade, for a time, at any price. Margin debt (which we do not utilize) should be considered
extremely dangerous; investors should never enable Mr. Market’s mood swings to result in a
margin call which could necessitate forced selling.

One of the most important lessons in investing is that systems that are overly optimized tend to blow
up. In other words, there is no single strategy that always wins. Just look at Long Term Capital
Management. The quant firms that have survived adjust and adapt their models constantly. To be
successful in investing we want to have coarse and redundant strategies. The idea of a margin of
safety is one such example that has survived the test of time.

My favorite example of this concept is Richard Bookstaber’s story of the cockroach

(https://www.amazon.com/gp/product/0691169012): “The cockroach has survived through many
unforeseeable (at least for it) changes: jungles turning to deserts, flatland giving way to urban habitat,
predators of all types coming and going over the course of three hundred million years. This unloved
critter owes its record of survival to a singularly basic and seemingly suboptimal mechanism: the
cockroach simply scurries away when little hairs on its legs vibrate from puffs of air, puffs that might
signal an approaching predator, like you. That is all it does. It doesn’t hear, it doesn’t see, it doesn’t
smell.”

Rather than thinking we can beat unpredictability, we should instead focus on building systems that
can handle unpredictability. Avoiding leverage, as Klarman pointed out, is one such system.
Conclusion

It is easy to say be greedy when others are fearful, but that requires having available capital in the
first place. More often, investors are fully invested or even leveraged when the panic hits. They are
forced to be sellers when they know they should be buyers. Thus, the more important part of that
saying and the harder emotionally is to be fearful when others are greedy. It requires us to go against
the crowd and ignore the fear of missing out on a party. In 2000, that strategy finally paid off for Seth
Klarman.
Posted in Investment TheoryTagged 2000, Bubbles, Dot-Com, Investor Letters, Seth Klarman, Value Investing,
Value Investors

Published by David Shahrestani, CFA

"I have the strength of a bear, that has the strength of TWO bears."
https://www.amazon.com/Navigating-Street-Better-Approach-Investing/dp/1098356403 View all posts
by David Shahrestani, CFA

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