Wisdom from Seth Klarman - Part 1

Seth Klarman and Baupost are in the news lately regarding the CIT bailout. While I do not want to delve into specifics, I will say that, outside the chance of fraudulent transfer / conveyance / some other quirky bankruptcy ruling dealing with the rescue financing, I would buy the new L+1000 loan (3% floor) all day long...especially if I was getting a 5 point advance fee. Currently in the grey market (when-issued) it is trading at 104-105 without the fee.

As we have not discussed Klarman or Baupost in the past few months, I thought I would take a few moments to pull out some of the more educational quotes from his fund letters through 2004-2007 (note: I do not have the fund letter from 2008...just the portions that were posted in a recent issue of Value Investor Insight).

Before I start pulling out some of my more favorite Seth Klarman quotes, I want to point our reader to a post by Sivaram Velauthapillai, at his contrarian investment blog, where he discusses Seth Klarman's performance in relation to Warren Buffett (WEB). Now admittedly, Sivaram admits he does not know much about Seth Klarman, and really was pulling information from a document I alerted readers to a while back: old Seth Klarman Fund Letters. A few comments have already corrected him, but just to reiterate: As of the end of 2007, Klarman was CRUSHING the S&P since the inception of the fund. The lowest return of the three classes of his funds, from inception, was 5903.7% cumulative return (10434.2% for the largest inception return). And no I did not place the decimal in the wrong point. The S&P in the same period return came in at 1828.4%. So despite lagging the S&P in the go/go years of the 90s, he maintained his capital base when the market gave a lot back in 2000-2002 and the rest is history. In 2008, press reports stated that Klarman was down low double digits. I can neither confirm nor deny this. Nonetheless, the S&P was down ~38.5% ... further extending Baupost's lead.

In response to the blog post specificially: I understand the point about Klarman under-performing the S&P in the go-go years. I get it. But, the problem in looking at any one's record at any one point in time is that the past is the past. If you had looked at John Paulson's merger arbitrage flagship fund in the beginning of 2007 you may say to yourself: "Well, this fund...you know, it has been just doing OK" ... and then he goes out and throws a +50% net to investors year in 2007 versus a nearly flat market. On the flip side you could look to any number of funds that were putting up annualized returns in the high 20s to low 30s up to 2008 and were down 50-60% last year bringing their cumulative returns to mere marginal levels.

Extending this to fundamental analysis, take a guess who's returns these are:

1991: 14.9%
1992: 28.1%
1993: 27.7%
1994: 22.3%
1995: 11.3%
1996: 21.2%
1997: 22.1%
1998: 19.2%
1999: 16.1%
2000: 15.9%
2001: 11.7%
2002: 15.7%
2003: 17.7%
2004: 17.0%
2005: 15.2%
2006: 18.3%
2007: 1.8%

They are the reported return on equity of Bear Stearn (as reported from Bloomberg)...right up until the very end. As Seth Klarman writes in his 2004 letter, "While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish."

Now onto some more Seth Klarman wisdom. I am going to a few quotes from each letter (2004-2007) that I find particularly insightful regarding the investment and portfolio management process.

From the Baupost 2004 letter:

"By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, "I would rather lose half our shareholders...than lose half our shareholder's money..."

That is just a spectacular quote (both Klarman's and Eveillard's). It's also why, as my readers are more than aware, I prefer current paying, senior-secured bank debt. Risk of permanent capital is low, I am getting paid to wait, there is a definite catalyst in emergence, and I have some control over the process. More quotes from the 2004 letter:

"We continue to adhere to a common-sense view of risk - how much we can lose and the probability of losing it. While this perspective may seem over simplistic or even hopelessly outdated, we believe it provides a vital clarity about the true risks in investing."

Another great quote from Seth Klarman. Risk is not beta or standard deviation...it is how much you can lose on an investment and what the chance is that "loss" scenario is going to play out.

And finally, from the 2004 letter (I am going to jump around on this one for full effect):

"Markets are inefficient because of human nature - innate, deep-rooted, permanent. People don't consciously choose to invest with emotion - they simply can't help it.

"So if the entire country became securities analysts, memorized Benjamin Graham's Intelligent Investor and regularly attended Warren Buffett's shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads...People would, in short, still be attracted to short-term, get rich quick schemes.

"In short, we believe market efficiency is a fine academic theory that is unlikely ever to bear meaningful resemblance to the real world of investing."

Take that Burton Malkiel.

In the next few weeks, we will offer more wisdom from Seth Klarman, from both his fund letters, and other public sources. Stay tuned.