My Favorite Quote from Baupost's 2011 Annual Letter

Readers know in the past we have covered Seth Klarman's letter to investors numerous times (here is one such post: Wisdom from Seth Klarman).  This week, we received Baupost's 2011 Letter to Investor where Seth Klarman, along with heads of the public investing, private investing, and operations group talk about everything from the investment climate, the government policy, and Europe among many topics.  A special emphasis, like we've seen in past years, was on the process, culture, and modus operandi of Baupost.  It is a fantastic letter.

While I will not post or quote the entire letter, as a distressed debt investor, I found one set of paragraphs particularly relevant:

"But in a field where the vast majority of our competitors spend their time looking exclusively at equities to buy or sell short, we are truly fortunate to have a broad mandate and stable, long-term oriented client base that allows us to emphasize in our portfolio more complex, less liquid, and less widely analyzed investments, such as distressed debt--and the ability to concentrate our capital in the areas of greatest opportunity, which inevitably evolve over time.

A follow-up question was asked: Why, if distressed debt is such an attractive arena, didn't many more funds sprout up to take advantage of the excess returns there? I replied that there were indeed very capable competitors in this space, but that opportunities in distressed debt ebb and flow with economic cycles. At the not infrequent moments when there is literally no distressed debt worth purchasing, these competitors (especially narrowly siloed ones) often stray (dangerously) into origination of new debt instruments at par. They are unable to sit on their hands, fearing that their businesses would wither and their people would depart. While the yield expectations for newly-issued debt may, at times, superficially appear similar to the returns on distressed debt, new origination occupies a very different place on the risk/return spectrum, and also requires an extraordinary underwriting discipline that few firms have. Sometimes, the competition moves into highly subordinated junk bonds, reaching for current yield while ramping up risk. Such diversions usually end badly, leaving these competitors wounded and mostly on the sidelines when the distressed opportunity set once again becomes compelling."

This is an amazing quote. While a distressed fund investing in new issues may not represent "style drift", to me it does represent "upside/downside drift."  When marginal issuers come to market, they come with substantial OID (original issue discount or priced below par).  For instance, Station is in the market now trying to clear a bond deal in the 60s.  That is somewhat a special circumstance.  More often than not, this OID will be 5ish points (i.e. bond issued at 95) with a fat coupon.  Let's say you have a hold period of 2 years.  In theory the best you could ever do in that circumstance  is a T+50 make whole on a big coupon which could get you to 140 bond price.  Two years of say a 12% coupon so 45 points (140-95 issue price) + 12% coupon ~ 32% IRR.  This is fantastic. Unfortunately, this is the very best case, and the downside in this situation is a zero.  Ex the coupon, the upside downside is then 45 points up, 95 points down: Round numbers 1 up/2 down.

Let's take a distressed bond trading at 50.  Again the worst case is a total loss, but this is only 50 points.  On the flip side, a big win would be a pull to par and possible more depending if you get cheap equity (i.e. your recovery can be significantly more than par).  For simplicity less say best case is a par recovery:  2 up/1 down risk reward.  And as you buy bonds lower, and lower this upside / downside ratio works out better and better for you.  Readers will ask: Doesn't a lower bond price mean a worse credit?  Absolutely not - remember price does not determine whether a company is good or bad.  Warren Buffett said: "Price is what you pay, value is what you get."  He also said "Mr. Market is there to serve you, not to guide you."

One thing that I have become acutely aware in my years of investing is the effect of overall market sentiment on the risk and reward of individual value opportunities. In his most recent letter to investors, Third Avenue Management's Marty Whitman discusses this topic at length.  In discussing Graham and Dodd:

"G&D believe it is important to guard against market risk, i.e., fluctuations in security prices. Thus, it becomes important in their analysis to have views about general stock market levels. FF (fundamental finance) practitioners guard only against investment risk, i.e., the problems of companies and/or the securities they issue. In FF analysis, market risk is mostly ignored except when dealing with “sudden death” securities – derivatives and risk arbitrage securities; when dealing with portfolios financed by heavy borrowing; and when companies have to access capital markets, especially equity markets"

While I completely agree that an analyst should spend all energy understanding the individual aspects of nuances of the securities and companies he is investing in, one also has to remember another Warren Buffett quote: "We know that the less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs."

Intuitively this makes sense.  But a second order effect that many people miss is alluded to in the Klarman quote above which I'll repeat again: "Such diversions usually end badly, leaving these competitors wounded and mostly on the sidelines when the distressed opportunity set once again becomes compelling".  The fact of the matter is that buying a well followed, well covered large cap stock as an individual investor that may look cheap in an overbought market could produce good relative returns (i.e. your stock is marginally down, where the broad market is down harder), you'll still have capital at work.  In my opinion, it is better to wait until market sentiment is "blood in the street" to purchase anything.

And professional money managers / hedge funds also have to deal with the fear that comes with allocating capital when you are down.  If you haven't been in that spot before, you probably can't understand the feeling.  If you do not have a sound process, you can freeze, or worse, get short, just went the opportunity set is at its ripest.

I often gets asked what my personal investment portfolio looks like.  Outside of my retirement accounts, here is an approximating of my portfolio:

• Cash: 30%
• Liquidating Bankrupt Trust (cash like): 15%
• Insurance Stocks: 15%
• Bankrupt Equities: 20%
• Special Sits (net): 10%
• Leaps: 2%
• Other "Value" Investments / Shorts: 8% (net)

(No distressed / high yield bonds: conflicts of interest)

In effect, I have approximately 45% of dry powder now (including the liquidating trust that is earning about 12-15% right now).  Some of this is a function of selling some winners earlier in the month.  

The two questions that will inevitably follow:

1. Why insurance stocks?
2. Bankrupt equities...are you crazy?

For insurance stocks: As I've mentioned a few times on the blog before, this is the industry I am most confident in my ability to analyze with the deepest set of connections across the industry's supply chain (brokers, producers, adjusters) as well as management teams.  I also think the insurance industry is one of the most misunderstood industries out there.  Further, if you had to look at a the hedge fund's universe of analysis of financials: Banks would take up about 95% of that analytical brainpower, with insurance capturing the balance.

For bankrupt equities: Would you be surprised that at one point my PA was 70% in bankrupt equities?  I read and do a quick analysis on every public company that files for bankruptcy. I understand the bankruptcy process, have my own PACER and CourtCall accounts, and know many players in the industry.  I also "riding the tide" as it were as many funds cannot invest in small bankrupt companies (they can't get any substantial size to move the needle) and many people shrug these investments off.  I'm playing against the general investment public the proliferate Yahoo! message boards and don't know what EBITDA or exit facility means.

I want to have the liquidity to get very aggressive when the cover of the New Yorker looks like this:

The corollary to an institutional investor reaching down for yield in Klarman's quote above for an individual investor is buying a marginally cheap, marginally out of favor big cap.  Don't be tempted to settle for marginal.  Patience is the HARDEST part of allocating capital.  But those that practice it will often be rewarded when everyone else is running for cover.