Wisdom from Seth Klarman - Part 9

We continue our long-running Seth Klarman series where we analyze Baupost's annual shareholder letters with the second half of the 2008 annual letter.

"Baupost build numerous new positions as the markets fell in 2008. While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up, and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better."

A problem that many value investors complain about is buying too early. In distressed debt, transaction volumes at the bottom are nil at best. Even worse, some dealers will quote incredibly wide markets which can make buying an exercise in futility...for example: would you buy a bond when a dealer quoted you 10-30 ... you can buy at 30 or sell at 10...This was seen quite often in the months following Lehman brother's bankruptcy.

"Most of our new investments in 2008 were in deeply discounted senior corporate and residential mortgage debt. Debt instruments, because they occupy a senior position in a corporate capital structure and pay interest and principal on a contractual basis, are typically considered less risky than equities. For this reason, when corporate debt become troubled and the possibility of default rises, holders often overreact. When the promise to timely pay interest and principal is on the verge of being broken, many will urgently sell either from fear or due to restrictions in their investment charters. Enormous legal and process complexity create great uncertainty, which adds to the pressure to sell. Prices often overshoot to the downside, creating an attractive risk-return proposition, especially for those able to analytically deal with complexity.

Beyond favorable pricing, distressed debt involves multiple catalysts for the realization of underlying value. If a troubled company is able to recover, whether through operational turnaround, asset sales, or capital infusions, the contractual repayment of principal is a catalyst of full value realization. Alternatively, if the company fails to recovery, reorganization through the Chapter 11 bankruptcy process, whereby a company satisfies claims in the order of their legal hierarchy, can itself result in value realization. In bankruptcy, senior debt holders often receive cash, new debt, equity or some combination thereof, in return for their defaulted securities. Being first in line for recoveries from the corporate estate can confer a valuable margin of safety."

Many smart value investors were looking at Senior Secured debt in November and December 2008. For example, a company like Dollar General saw its bank debt trade to the mid 70s. This effectively created the company at 2x EBITDA through the senior secured bank debt. Equity Comps of the other hand, were trading 6-7x EBITDA - and with dollar general you were also getting a nice coupon stream equating to a size able IRR if the valuation discrepancy collapsed...which it did and investors earned ~40% return with minimal downside risks.

Even for those companies that filed, the ability to cease paying interest to creditors may create a windfall of cash to be distributed in reorganization. Further, we are always looking for value with a catalyst at Distressed Debt Investing, and bankruptcy is by far our favorite catalyst.

On thinking about declining security price:

"Many of the distressed debt investments we bought in 2008 declined further after our initial purchases, inducing us to buy more, as we often do, after thoroughly checking and rechecking our analysis and assumptions. Although most investors find it painful to have positions decline in price after purchase, we remained focused on the silver lining: the ability to building large positions at increasingly favorable prices. In many ways, this temporary market decline represents delayed gratification. When we buy a four-year bond with a 5% coupon at $70.7 to yield 15% to maturity and the price drops immediately to $60.0 where it now yields 20%, we have a 15.1% mark-market loss, but (assuming no new fundamental developments) now hold an even more attractively priced investment while experiencing an even better buying opportunity. A rise in the market's required yield to 25% would cause a further 14.6% price decline. Clearly, if our initial analysis was correct, these temporary price declines, as significant as they are, will be far more than offset by the eventual profitable recoveries."

An investor has to realize that a decline in price does not always equate to a decline in value. And when price declines significantly beyond the value of a business, a buying opportunity may arise.

On the government stimulus plan:

"When the government prints money to solve a problem, the result is almost always inflation. The history of paper money, back by nothing except a government's promise to pay, is that it will be debauched. Politicians are good at spending money that is not theirs; they can please all, antagonize none, by going on a spending spree while asking no one to pick up the tab. But the bill will come due and taxpayers are ultimately on the hook. National wealth cannot be created by a printing press but only be education, hard work, saving, and investment. "

Continuing...

"Over the next several years, inflation seems inevitable, along with much higher interest rates, which will surely impact the value of most investments. We have put hedges in place that we hope will protect our portfolio should such risks materialize."

I wonder what hedges he is talking about? Maybe buying calls on interest rates? But is he playing the long end or the short end of the curve? My concern in high yield, where I have been spending a lot of my time, is that even if you get your credit calls right and you find an improving story, if the curve widens 200+ basis points, you will show mediocre return.

"...James Montier, Societe Generale's market strategist, recently pointed out that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the consistent response was a focus on process, not outcome. The same ought to be true for investors.

According to Montier, during periods of poor investment performance, the pressure builds to change the process to enable immediate gratification. But, so long as the process is sound, this would be a big mistake. It is so easy for one's investment process to break down. When an investment manager focuses on what a client will think rather what they themselves thing, the process is bad. When an investment manager worries about their firm's viability, about possible redemptions, about avoiding loss to the exclusion of finding legitimate opportunities, the process fails. When the manager's time horizon become overly short-term, the process is compromised. ..."

How many of us are guilty of this? You have to maintain the discipline that the Graham and Dodd approach to investing is sound and not delve into the unfamiliar when your returns lag the market. You will never be right 100% of the time. Maybe this is why Joel Greenblatt's formula works so well over the long term - people lose the discipline to keep up with it out of sheer need for immediate gratification.

Klarman then goes on to talk about the investing process at Baupost. The relevant quote I think most pertinent:

"Once we decide to invest, the work continues. Are their new developments? What additional information should we seek? Are their affordable hedges that can limit our risk? If the price falls should we increase our position? If a price rises, at what point should we start to sell and at what point should we wholly liquidate our position? If dealing with a private real estate investment, should we raise or lower rents, reposition or spruce up the asset, refinance, or offer the property for sale?

Perhaps most crucial to the success of this process is intellectual honest. Have the facts changed? Was our original judgement wrong? Are their better investment to hold? If we made a mistake, we need to recognize it and learn from it."

Two takeaways for me here: 1) They do not liquidate a position all at once but will ease out of it as the price rises 2) They believe it just as important to monitor investments as it is to find new ones. A weakness of mine is wanting to look at new situations because the more information I get the better.

He closes out the letter with a section entitled: "The Value of Not Being Sure" ... I will not reprint the whole section, but will strip out what I think is my favorite paragraph of the entire letter:

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security's price begins to reflect full value, because we are never sure that our thesis will be precisely correct. While we typically concentrate our investment in the most compelling situations measured by reward compared to risk, we know that we can never be full certain, so we diversify. And, in the end, out uncertainty prods us to work harder and to be endlessly vigilant."

Fantastic. This concludes our reviews of Seth Klarman's shareholder letters (we will not review the 2009 letter for another 12 months). What I will do is continue the series, analyzing some of the Seth Klarman videos I have my hands on, as well as take a look at Baupost's portfolio when their various 13Fs come out.