"...Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market out performance by one investor is necessarily offset by another's under performance. Consequently, you keenly watch your competitors to see not only what they are doing right, but what they are doing wrong. You observe carefully to identify their investment constraints and limitations, their time horizon and liquidity requirements, areas that they ignore and areas that they avoid. It is in these areas that opportunity is often greatest; that is where bargains regularly surface, with your best competitors not only failing to compete but sometimes serving as the seller. It is here, where others panic, sell mindlessly, neglect, or fear to tread that investors have a chance to develop and sustain an edge."
From a speech that Seth Klarman gave to a group of Professor Greenwald's Value Investing Class, we know that he has analysts that just focus on spin offs, changes in indexing, bankruptcy etc. These create vacuums where force sellers rule the day due to investment constraints. In the example of an index fund trade, imagine a somewhat illiquid stock dropping from an index. Index funds across the board need to sell the holding to maintain their index match which creates a situation of uneconomic selling which in turn may create a dispersion between price and intrinsic value. It is also rumored that Baupost's investments in MLPs in late 2008/early 2009 stemmed from the fact that Lehman brothers held 20% of the float of the companies and were forced sellers as their prop desk unwound.
"The single greatest edge an investor can have is a long-term orientation. In a world where performance comparisons are made not only annually and quarterly but even monthly and daily, it is more crucial that ever to take the long view. In order to avoid a mismatch between the time horizon of the investments and that of the investors, one's clients must share this orientation. Ours do."
It is a sad, but true fact in the investment industry that limited partners and general partners, specifically in the context of a hedge fund, have different investment and liquidity time constraints. Many analysts reading the blog today will have experienced a situation where an investment looks particularly compelling, but the idea was kibashed, or sold early, because the portfolio manager had to raise cash, or was painting the monthly numbers. Despite their obviously strong investment skills, an advantage of Baupost is how sticky the capital is as opposed to a number of other funds that have had to put the gates up. I do not know who said it, but I remember hearing a quote: "You deserve the capital you attract." Unfortunately, for a small manager, any capital is good to get the ball rolling. And that creates a mismatch which is one of the fundamental flaws of this business.
"We are able and willing to concentrate our capital into our best ideas. These days, other investors' idea of "risk control" is to own literally hundreds of small positions while making no size able bets, a strategy that might also be labeled "return control". It is clearly an advantage, but by no means without risk, to be able to concentrate our exposures. We work exceptionally hard to ensure that our largest positions are indeed our most worthwhile opportunities on a risk-adjusted basis."
What is interesting, is that this quote somewhat ties in with the previous two. Having a large diversified book helps when capital it quick to exit. Further, a massive position in two or three stocks when limited partners are redeeming can cause returns to become even worse as you put pressure on the stock. The opportunistic investors should see this and buy the stock you are selling (uneconomically I might add) on the cheap. But they will wait until you are fully out, further depressing returns, and inciting more limited partners to redeem.
This is where portfolio management becomes so important. Managing the book to allow for sufficient liquidity in case of redemptions, but at the same time placing your bets in a way to maximize risk return. This is where people discuss the Kelly Formula...or better yet, the modified Kelly Formula. As has been reported in many places, Monish Pabrai moved his allocations to 10% per position to a smaller number. I think this makes sense, but there will be times (like Enron for example) where a 10% position makes sense.
Now remember, Klarman wrote these words in early 2006:
"The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly ever investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedented low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. "
Take about having a crystal ball.
Stay tuned for the next part of the Seth Klarman series where we dig into the 2006 Baupost annual letter.
I believe Buffett is the one who says that in the long run you get the investors you deserve.
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