A friend sent me a video of a speech given by Seth Klarman at the Columbia Business School in 2006. Klarman’s hedge fund the Baupost Group has done over 20% a year since he founded the firm in 1983, with only one down year. Also, Seth Klarman’s book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor is one of the best books I’ve read on value investing. It’s currently out of print and selling for about $1,600, but I got a copy through my library’s intra-library loan program.
Of all the articles/speeches/interviews of value investment managers this is one of the best speeches I’ve ever watched. Klarman discusses how he made over 5 times his money investing in Enron debt, what his investment principles are, his thoughts on the investment management industry, why he doesn't go short and why he uses derivitives.
This speech is not posted anywhere else on the internet. Here is my summary:
Thoughts on the Investment Management Industry
- The investment management industry is not set up to achieve market-beating returns. Instead they are incentivized to get big and act like asset gatherers. At the same time there is little incentive to take risk and deviate from the mean because if they strike out and underperform for even a short period clients will be lost quickly. It’s an enforced mediocrity (if you want to get big just do what everyone else is doing and settle for average results).
- Klarman said he would rather hold treasury bills than invest in many of the hedge funds out there. If stocks do 10% going forward and a hedge fund that charges 2 and 20 takes 3% of your money in fees, you’ve only got 7% left, plus it’s leveraged, holds illiquid securities, etc. He would much rather get 4.5% risk free.
- Tweedy Brown is today’s manifestation of Benjamin Graham
- Value investing is risk aversion
- Baupost charges a 1 percent management fee plus 20 percent of profits.
How Baupost Invests
- Rule #1: Don’t lose money. Rule #2: Never forget Rule #1.
- Baupost always looks for catalysts in its investments. If you find a stock trading for 50% of what you think it’s worth, you want there to be something that will trigger it to reach fair value.
- Baupost will always sell an investment as soon as it nears their estimate of fair value. Baupost has analysts focused around the type of opportunity; Baupost has a spinoff analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst and an analyst looking at companies that are depressed because of a bad earnings announcement.
- Baupost invest in: Both public and private distressed debt, Real estate (Baupost has done over 200 real estate deals including biding on RTC auctions), U.S. and foreign equities, LBO’s and Derivatives.
- The portfolio at the time of the talk was 45% cash, 20% equities, around 17% distressed debt, 11% real estate, 7% private investments (distressed debt, small LBO’s, financial restructurings), 6% in South Korean equities and a small % in hedges.
- Baupost looks at every merger, rights offering, privatization of government business, spinoff, major share repurchase, dutch auction tender, thrift conversion or anything else that could cause mispricings.
- Post-bankruptcy situations are a good place to look for bargains because people avoid them and don’t understand them. A lot of good things can happen in bankruptcy such as terminate overpriced contracts or leases, shed extraneous business units or, deal with union problems or settle contingent liabilities; all under the protection of bankruptcy court. Then all the debt holders have equity and they will want to sell.
- Baupost opened over 1,000 savings accounts across the country to take advantage of thrift conversions.
- Baupost doesn’t go short because, unlike going long when you can take advantage of a drop in the value of an undervalued security by just buying more, if you're short, even though you may be right that it’s worth less then the trading price you can still go broke. It’s way more risky and you can lose to infinity. Think tech stocks - if you shorted them in '97, '98 or even '99 you would have been killed. It works for a while, and then the market goes berserk and you get killed.
- Baupost uses hedges to reduce risk. For example, they use derivatives to hedge the interest rate risk in their real estate holdings. They hold credit default swaps on the government debt of countries they have investments in (S. Korea). They also hold credit default swaps in a bunch of European countries not necessarily because they have holdings there but because it reduces risk and they were very cheap ($60, 000 a year for $100 million in insurance).
- Baupost does best when there is high uncertainty and little information. When they research a company they do whatever they can to find information; they talk to everyone to get information including management, industry people, former executives, customers, suppliers; they sometimes hire consultants and talk to analysts on buy and sell sides.
- They constantly reassess to find new information, if they’ve overlooked something or if something has changed.
- Employees own the second largest position in Baupost.
Baupost’s 3 investment principles:
1. Focus on risk before return. This is why Baupost has so much cash, currently 45% of the fund is in cash. If they could find undervalued investments, they would put all their money to work tomorrow. If they had to they would have no problem holding 100% cash. People fail to have sell discipline because they can’t hold cash.
2. Focus on absolute returns. Institutions focus on relative returns but Baupost doesn’t because Klarman can’t imagine writing a letter to clients saying "we performed well during the year, the market was down 25% and we were down only 20%"; also clients will pull money out at the wrong time and it has a strong psychological effect.
3. Only focus on bottom-up investing. He has views on the macro but doesn’t think he has an edge in that type of investing. Klarman said that it’s really hard to turn a macro idea into an investment.
Klarman's 5-fold investment in Enron debt
- Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron, creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash, $16-18 billion, but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were lowballing what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents.
- Investments like Enron debt are possible because the market doesn’t assess risk correctly by relying on volatility (beta).
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