Seth Klarman: Second Coming of Benjamin Graham?

by: Stone Street Advisors

With the scrutiny that comes with big money, it is very rare that a big-time money manager can trounce the market year after year, and continue to evade said scrutiny.  There is one man though, that has for the most part achieved this goal, and even the few publications (e.g. FT) that have mentioned him or his firm have been unable, as far as I can tell, to garner any idea as to the size or performance of this manager's operation.  Since the early 80's, one man, and one firm have somehow, in this Internet age, managed to consistently make the market their bitch, all the while flying mostly under the radar of both the media and investor communities.

His name is Seth Klarman.

And he is, in fact, kind of a big deal.  According to my sources, his firm, the Boston-based Baupost Group currently manages roughly $26 billion, up from about $16 billion the prior year.  Those in-the-know will immediately question these figures, as that AUM would put them squarely in the top-10 largest hedge funds globally, per rankings data from Institutional Investor Alpha, and such a return (net, btw) of mid-to-high double digits on such a large base would surely put him amongst the highest-earning managers last year.   How then, does such a large, market-destroying fund (or fund manager) happen to stay off the radar of most journalists and market followers for so long?  How has he managed this seemingly impossible task, especially when he has even published a book, now out of print, which sells for well over $1,000 on Amazon.com? To that, well, I'm as stumped as the next guy, but I imagine when you're minting that kind of money, you can pretty much set terms with your investors, business partners, and the like.

More important than the issue of his anonymity though, is what he stands for, and how that has enabled him to crush the market for the past 25 years.  To this end, I submit exhibit A: speech given by the man himself at MIT back in October, 2007.  Just a warning, as it's a bit on the long side, but definitely well worth reading in its entirety.  Seriously.  It is one of, if not THE most prescient, cogent, and frankly, intelligent things I've read in recent memory with regards to finance and investing.

Klarman may very well be the second coming of Benjamin Graham, the father of value investing.  True to form, he echoes the words of Warren Buffet, and is well on his way to achieving a track record that would make even the Oracle proud:

 

Right at the core, the mainstream has it backwards. Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money—successfully for 24 of those 25 years—and, by investing cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio—and with risk comes losses...there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher return. The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.

 

His views, not just on investing, but on the macro-factors that have affected everyone from the biggest institutional managers to Joe and Jane Doe, are critical of the 'easy-money' policies that have, in large-part, fueled the economic growth of the past 1/2-century:

 

We live in an era of leverage not just on Wall Street but on Main Street. For two generations, credit has become much more widely available and acceptable. In our grandparent’s era, there were no credit cards, home equity or subprime loans, or CDOs. People paid cash for what they purchased, and worked hard to earn that cash. The sequencing of that mattered, too: first you worked hard, then you bought what you wanted. Even the federal government was expected—except in times of war—to run a balanced budget. But during our parents’ lifetimes and our own, credit has become increasingly available and standards increasingly lax, to the point where credit cards and checks backed by credit lines arrive unrequested in the mail, where your house can be used as an ATM, where people with dismal credit histories are eagerly sought after to provide them with loans, where investors flock to buy junk bonds and shaky companies seek to issue them, and where investment funds are offered the opportunity to enhance their return through structured products, derivatives and exotic financings, all of which embed high amounts of leverage.

The moral imperative of repaying the banker—your neighbor—who granted you the loan across his imposing desk has been replaced by the moral vacuum of anonymous lenders using credit scoring—who quickly resell your loan to someone you will never meet—and who are actually comfortable with the actuarially determined probability that you may default. Credit rating agencies have embraced the debt orgy with lax standards and naïve models, brewing conflicts of interest and accepting healthy fees to label toxic waste as investment grade.

 

Some of you may invariably and immediately label this as old-fogey "back in my day" rhetoric, but Klarman is no octogenarian (he's in the 50-ish range), nor is he a staunch conservative (based in Boston? me thinks not!).  Those theoreticians and quants amongst you will likely be part of this critical group, as his ideas present a direct affront to that worldview.  To you, my mathematically-inclined friends, Mr. Klarman responds (highlights are mine):

 

As value investors, our business is to buy bargains that financial market theory says do not exist. We’ve delivered great returns to our clients for a quarter century—a dollar invested at inception in our largest fund is now worth over 94 dollars, a 20% NET compound return (note: as of YE 2005, this number was $55, which means the fund almost DOUBLED over the past TWO years!). We have achieved this not by incurring high risk as financial theory would suggest, but by deliberately avoiding or hedging the risks that we identified. In other words, there is a large gap between standard financial theory and real world practice. Modern financial theory tells you to calculate the beta of a stock to determine its riskiness. In my entire professional career, now twenty-five years long, I have never calculated a beta. This theory urges you to move your portfolio of holdings closer to the efficient frontier. I have never done so, nor would I know how (note: this is where quant's head's explode!) I have never calculated the alpha or beta of my firm’s investment performance, which is how some people would determine whether or not we have done a good job.

Some people stick to elegant theories long after it is apparent that the theories do not explain reality. The Chicago School of Economics has said the financial markets are efficient.  They conveniently explain away Warren Buffett’s incredible investment record as aberrational.  The second richest man in the country is a value investor; he built his net worth gradually over nearly 50 years of successful investing. And his net worth continues to grow handsomely! Fifty billion dollars are a lot of aberrations! Rather than abandon their theorizing to study Buffett exhaustively to see what lessons could be learned, too many people cannot bear to re-examine their faulty theories.

 

Before you guys rip my head off for this veritable heresy (HE CAN'T EVEN CALCULATE BETA, HA!), take a step back and try to un-learn all of your MPT; forget your scandalous quant dreams of RenTech-esque perfection, and embrace the empirical evidence before you:

 

It is easy to peruse stock tables from the comfort of your office or living room and declare the market efficient. Or you can invest other people’s capital for a number of years and learn that it is not. What is amazing to me is that...the burden of proof somehow is made to fall on the practitioner to demonstrate that they have accomplished something that so-called experts said couldn’t be done (and even then find yourself explained away as aberrational). Almost none of the burden seems to fall on the academics, who cling to their theories even in the face of strong evidence that they are wrong.

 

Seth Klarman is a value investor, although as he points out, this definition embraces a slightly wider array of complex securities and strategies applicable to today's far-more evolved (and ye,s I use that word somewhat in jest) financial world:

 

At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, value investors will thrive.

 

As he puts it, the reasons for his tremendous success seem immediately obvious - almost too-much so - that you sort-of want to bang your head against a wall in one of those "Duh, why didn't I think of that?!?!" moments.  This may very well be the most obvious, yet most apropos point he makes throughout the entire speech:

 

Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil. Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance. If a company fails to declare an expected dividend, institutions restricted to owning dividend-paying stocks may unload shares. Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies. Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index. These causes of mispricing are deep-rooted in human behavior and market structure, unlikely to be extinguished anytime soon.

 

Even more obvious, when he describes his strategy, it becomes (if it hasn't already) immediately clear that he is not a man of high-brow, self-aggrandizing style.  The strategy is simple, although it requires patience many investors lack, as often times, it's a "hurry up and wait" proposition:

 

My firm’s approach is to seek situations where there is urgent, panicked or mindless selling. As Warren Buffett has said, “If you are at a poker table and can’t figure out who the patsy is, it’s you.” In investing, we never want to be the patsy. So rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers. This concept applies to just about any asset class: debt, real estate, private equity, as well as public equities.

 

That Buffet quote, above, may very-well sum up Klarman and the uncanny results the Baupost Group have achieved.  Wait for others to screw up, and then pounce on the opportunity, profiting out of others' weakness.  Whatever criticisms can be levied upon him, or the strategy he espouses, one thing is absolutely incontrovertible, and that is his consistently market-beating performance.  And in the end, as they say, money talks, BS walks.

Thank you to Dr. Adrian Saville for his help with this article.