Tuesday, October 15, 2013

Patience and Capacity to Suffer - Lessons From a Legendary Value Investor

Here is the return information for a fund manager:

Year Fund Manager S&P With Dividends
1 7.91% 37.60%
2 22.51% 23.00%
3 27.04% 33.40%
4 -16.30% 28.60%
5 8.29% 21.00%
Cumulative 49.45% 143.60%
Annualized 8.77% 28.57%

Question: Given the above returns, would you give your money to this fund manager?

I doubt many people will say yes. After all, this manager has seemingly vastly underperformed the market during this specific 5 year period.

Probably a surprise to many of us, the preceding returns were produced by one of the greatest investors of all time - Seth Klarman. And most likely not a surprise to many of us, this 5-year period represents the technology bubble years from 1995 to 1999. I want to clarify that Baupost Group had a year-end of October 31st during this time period. Therefore, the comparison in the table above does not represent the exact degree of under-performance. However, it is close enough to draw conclusions thereof. 

During the tech bubble, even some renowned value investors eventually capitulated to the runaway bull market in growth and technology stocks. It takes a tremendous amount of patience and capacity to suffer in order to maintain the value investing discipline in a soaring market. How did Seth Klarman stick to the value proposition and margin of safety principle during the bubble years and how did he construct his portfolios in a raging bull market? I found the answers in Klarman's letters to investors.


"The primary reason for our underper-formance, of course, is that the Fund has relatively little exposure to the U.S. stock market."

"The Baupost Fund is managed with the intention of earning good absolute returns regardless of how
any particular financial market performs. This philosophy is implemented with a bottom-up value
investment  strategy  whereby  we  hold  only  those  securities  that  are  significantly  undervalued,  and
hold cash when we cannot find better alternatives. Further, we prefer investments, when we can find
them at attractive prices, that involve a catalyst for the realization of underlying value. This serves to
reduce  the  volatility  of  our  results  and  de-emphasizes  market  movements  as  the  source  of  our  in-
vestment  returns.  Positions  with  catalysts  tend  to  lag  a  rapidly  rising  stock  market  (like  this  past year's) and outperform a lackluster or declining one (like we used to have every few years!)."

"We firmly believe that one of Baupost's biggest risks, and, needless to say, that of other investors, is that we will buy too soon on the way down. Sometimes cheap stocks become a whole lot cheaper; it simply hasn't happened lately. (And when that happens, expensive stocks will fare far worse.) "


"In  making  tradeoffs among competing alternatives, we have distinguished ourselves from other professional investors in  several  ways:  our  willingness  to  hold  cash  balances,  sometimes  substantial,  awaiting  opportunities;  our preference for investments with a catalyst for the realization of underlying value; our willingness  to accept varying degrees of illiquidity in exchange for incremental return; and our flexibility in pursuing opportunities in new areas."

"Baupost has long enjoyed a very flexible investment charter, one that has permitted us to depart con-
siderably from our initial conception as US equity and high quality debt investors. This flexibility
has been, we believe, at the core of our investment success over the years." 

"Investors who find an overly narrow niche to inhabit prosper for a time but then usually stagnate. Those who move on when the world changes at least have the chance to adapt successfully."

"The same flexibility that led us into a heavy concentration in thrift conversions in the mid 1980's and distressed corporate debt in the mid-late 1980's, and a smaller hedging bet on Japanese stock market puts in the late 1980s, has led us into a moderate investment in Russian stocks earlier this year, and an important position in European holding companies in 1995-1996."

"Risk is also mitigated by both our constant emphasis on investment fundamentals and on knowing
why each investment we make is available at a seeming bargain price. We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and
the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a
good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking
whether we have an apparent advantage over other market participants in any potential investment.
If the answer is negative, we do not invest."


"The most favorable position going into a sudden downdraft (if you could correctly anticipate one) is
to hold market hedges and/or cash (or better still, short positions, but short sellers have been aging
in dog years for a long time). We hold both, although never enough in a downturn, because both are
costly. Hedges, like any insurance, involve paying a premium. Premiums have skyrocketed in lock-
step with the market's surge over the past two years, and have risen even more in the current volatile
environment. "

"Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments. Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing."

"If the financial markets remain turbulent and retrace some of their decade-long gains, I believe we
will be in a strong position. Despite delivering good investment performance over the Fund's first
seven years of operations, I must remind you that value investing is not designed to outperform in a
bull market
. In a bull market, anyone, with any investment strategy or none at all, can do well, often
better  than  value investors. It is  only in a bear  market that  the value investing discipline becomes
especially important because value investing, virtually alone among strategies, gives you exposure to the  upside  with  limited  downside  risk.

"In  a  stormy  market,  the  value  investing  discipline  becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible. In a market  downturn,  momentum  investors  cannot  find  momentum,  growth  investors  worry  about  a slowdown, and technical analysts don't like their charts.  But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value.  And, because you cannot tell what the market is going to do, a value investment discipline is important  because it is the only approach that produces consistently good investment results over a complete market cycle. "

"The most important investment decision we have made over the past several years is the one to in-
crease our international efforts. This decision resulted in part from a realization that opportunities in
the U.S. were considerably less attractive than they had been, and that the situation would not necessarily improve."

"Value investors should buy assets at a discount, not because a business trading below its obvious liquidation value will actually be liquidated, but because if you have limited downside risk from your purchase price, you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favor."

"In investing, nothing is certain. The best investments we have ever made, that in retrospect seem like
free money, seemed not at all that way when we made them. When the markets are dropping hard
(as they are right now in Asia) and an investment you believe is attractive, even compelling, keeps
falling in price, you aren't human if you aren't scared that you have made a gigantic mistake.
challenge is to perform the fundamental analysis, understand the downside as well as the upside, remain rational when others become emotional, and don't take advice from Mr. Market, who again and
again is a wonderful creator of opportunities but whose advice should never, ever be followed."


"Like the Everest climbers, the problem with reaching the summit is that from there every way  you  go  is  down.  Not  wanting  to  overuse  the  metaphor,  I  won't  go  on  to  recount  the  sudden  storm which seemed to come out of nowhere that brought peril to a number of the climbers."

"What is clear to us, and relatively few others, is how disappointing those long-term returns will actually be from today's market levels. Future returns have increasingly been accelerated into the present and recent past. We have entered greater fool territory, and decent market returns from here, while still a distinct possibility, will depend on an even greater sucker showing up. No one should be surprised if one does; however, no one should base their investment program on his or her existence."

"Persuading budding analysts to postpone the immediate gratification of a momentum or growth stock career for a long-term value investment philosophy is a formidable challenge indeed. Leaving this extraordinary party early, or contemplating not even going, isn't very appealing if all your friends will be there having a great time while it lasts, which appears to be well into the night. To many, the really bad hangover will have been worth it."

"Many of our most promising new ideas are in Western and Eastern European equities. As we started to see in 1996  and  1997,  corporate  restructuring  has  accelerated  in  many Western  European  countries. We
have identified numerous companies in the midst of asset sales, spin-offs, and share repurchases, and
others  actively  exploring  such  transactions. "

"We intend to persevere in our search for value, and remain confident that our cash balances (17% of Fund assets at April 30) are likely to be most valuable just as fewer and fewer investors choose to hold any."


"Sentiment, existing only in the minds of investors, is subject to change quickly and without notice."

"Real value, of bricks and mortar, finished goods inventories, accounts receivable, operating factories and businesses, and even brand names, is hard, although far from impossible, to destroy. If you don't  overpay  for  it,  your  downside  is  protected.  If  you  purchase  it  at  a  discount,  you  have  a  real margin of safety."

"Our concern is that we cannot know when the current love affair with large capitalization growth stocks will end, and what sort of havoc this will wreak on smaller stocks, however inexpensive. As we have explained before, the only logical way to hedge against this risk is to protect an investment in these undervalued smaller stocks with a put option on or short sale of more expensive stocks. We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect."

"Our resolution to this dilemma is to position the Fund's portfolio in three parts. A major compo-
nent is cash (held in U.S. Treasury bills and/or in a U.S. Government securities money market fund), at around 42% of the Fund's portfolio at April 30. This asset is available to take advantage of bargains,
but represents important dry powder until some of today's market extremes resolve themselves. "

"Another segment, about 25% of the Fund's portfolio, involves numerous public and private investments  with  catalysts  for  the  partial  or  complete  realization  of  underlying  value. This  includes corporate bankruptcies, restructurings and workouts, liquidations, breakups, asset sales and the like. These situations are generally purchased at expected annual returns of 15% to 20% or more. The success of these investments depends primarily on the outcome of each situation rather than on the level of the stock market. There can, however, be month by month fluctuations in the market prices of these positions." 

"A number of these positions are former spinoffs, ignored and abandoned in a market not oriented toward smaller companies. Most of these situations involve partial catalysts for value realization such as ongoing share repurchase programs and/or insider buying, but these limited catalysts offer only modest protection
from the short-term volatility of the financial markets."

"We underperformed  in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market. "

"Occasionally we are asked whether it would make sense to modify our investment strategy to
perform better in today's financial climate. Our answer, as you might guess, is: No! It would be easy
for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And
irresponsible. And unconscionable. It  is always easiest to run  with the herd; at  times, it can take a
deep  reservoir  of  courage  and  conviction  to  stand  apart  from  it. Yet  distancing  yourself  from  the
crowd is an essential component of long-term investment success."

"Most companies in our portfolio, in addition to compelling undervaluation, have strong market positions, significant barriers to entry, substantial free cash flow, and catalysts in place to assist in the realization of underlying value. Almost all have managements who own significant amounts of stock personally."

"Given the competitiveness of the investment business, we believe it is important in every investment to have an edge, an advantage over the herd. This edge could be a willingness to take a long-term perspective in a short-term-oriented market, a tolerance of complexity when others crave simplicity, or the absence of constraints which either impede the ability of others to act or force them to act in uneconomic ways."


Reading Klarman's letters to investors has been an illuminating experience. His wisdom seems especially relevant in a market environment that we are presently faced with. Although we are not in a bubble territory yet, certain segments of the market have certainly exhibited bubble characteristics. Market leaders in this year's rally include Facebook, Tesla, Linkedin, Netflix and etc. Facebook's market cap is almost 75% of that of Coke Cola and Tesla's market cap is almost 40% of the market cap of GM with revenue only a fraction of that of GM. Neither Facebook nor Tesla has sufficient tangible asset value to serve as down-side protection yet investors seem to care little.

My expectation is that many famous value investor will under-perform this year, just like they have been during the past bull markets. Patience and capacity to suffer is again extremely vital in today's market condition. However, having the right temperament itself is not likely to be enough. The following lessons from Klarman may be beneficial:

1. Always hold cash, which "provides protection in a storm and ammunition to take advantage of newly created opportunities.

2. Adapt flexibility in your portfolio. Try not to limit yourself in an overly narrow niche (such as high quality U.S large cap stocks). Spend some time analyzing spin-offs, merger-arbitrage (such as the recent BBRY deal) situations, bank recapitalization, mutual conversions, or emerging markets. This flexibility will allow you to move into "areas of temporary and compelling opportunities and away from areas of full or excessive valuation, thereby enhancing return while simultaneously reducing risk.

3.Maintain sufficient but not excessive diversification. To quote Klarman, "owning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once. This is particularly true if that market is trading at record levels of valuation, supported more by money flows than by fundamentals,  as  happens  sometimes. "

4. Last but certainly not least, never forget "MARGIN OF SAFETY."  Real tangible value, such as real estates, cash, inventories is hard to destroy, while "a promising future" can quickly turn into a "sour land of disappointment." 

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