The World According to Seth Klarman

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Includes: AGG, DBC, DBV, GLD
by: Balkar Sivia

Mr. Klarman runs Baupost Group, a Boston-based investment firm with about $22 billion under management. He doesn't share his market insights that often, so when he does it's worth listening. Tuesday morning he spoke at a conference for financial industry professionals at the CFA Institute in Boston. In particular, he is looking at the deluge of government interventions to prop up the financial system in the past couple of years and what those may mean down the road. And he is talking about the danger–not a certainty, merely a danger–that governments around the world will trash their currencies in a continuous free-for-all of "handouts and no taxes." The near-$1 trillion bailout in Europe is just the latest worry.

Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash. On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit side it's been overblown. Things are now being priced for almost perfection."

Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again. On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example.

Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies." He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to." Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value. Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.

Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits. These puts, which Klarman said he viewed as "cheap insurance," will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value. "We are highly opportunistic," he said. "I will be buying what other people are selling. I will be buying what is loathed and despised." That today would be Europe, Oil and Gas Services, Large Caps...