My Three Favorite Quotes from Baupost's 2012 Year End Letter

In the past, Distressed Debt Investing has taken snippets from Baupost's year end letters, which are always a treasure trove of information from possibly the greatest investor living: Seth Klarman. This year's letter is, as usual, simply amazing and below I've stripped out my three favorite quotes from the letter with some commentary. Enjoy!

"As investors have become accustomed to sputtering economies and massive government intervention, episodic "risk-on" and "risk-off" behaviors drive the capital markets. Unexpected bad news means risk off. A stopgap solution to the crisis du jour is offered -- i.e., a bailout, a rescue, a Band-Aid deal, QE(n) -- and risk on resumes. We have been on a roller-coaster ride for the last four years and counting, with no meaningful recovery, no feasible solutions, and ineffectual leadership. Investors conditioned to the short-term trading mentality are increasingly ill prepared for policy changes. What will happen when the Fed declares, as it someday must, that the era of low interest rates is at an end? What if governments holding trillions of dollars of sovereign debt and other securities stop buying and begin to sell? Or if another serious crisis -- economic, political, international -- materializes and governments have insufficient ammunition to intervene? The content, though not the timing, of the next chapter in market history is quite predictable. Few will say they saw it coming, though, in fact, everyone could have seen it if they had only chosen to look."

I have often written about hope not being an investment strategy - especially when that hope stems from a central bank put. The fiscal and monetary situation / climate we find ourselves in today would look like Mars ten or twenty years ago. What scares me is that the climate is starting to be regarded as status quo or a background noise in the environment in which we are asked to generate returns of and on our capital base. In the long run, short term pain is always better to push excesses out of the system. Managing volatility (Klarman discusses this later in the letter) conditions investors to environments that, once the rug is pulled out, could be very painful.

"We pursue opportunity largely off the beaten path, sifting through the debris of financial wreckage, out of favor securities and asset classes in which there is limited competition. We specialize in the highly complex while mostly avoiding the plain vanilla, which is typically more fully priced. We happily incur illiquidity but only when we get paid well for it, which is usually when others rapidly seek liquidity and rush to sell.

We make no heroic assumptions in our analysis, hoping, instead, that by compounding multiple conservative assumptions, we will crease such a substantial margin of safety that a lot can go wrong without impairing our capital much or even at all..."

This is the first time I have ever heard the term "compounding multiple conservative assumptions." It really is a beautiful concept. If I use two very conservative assumptions in my calculation of valuation, which estimate of intrinsic value will be substantial (exponentially) lower than someone using a bullish or even for that matter fair assumptions. Oftentimes I've read Klarman using the term "conservative assumptions" and by adding conservative assumption to others in the same estimate for securities one can be comfortable that risk of permanent capital loss is low.

In terms of complex securities: Its a place where Baupost shines. Later in the letter, tere is disclosure that Lehman entities make up more than 20% of Baupost's NAV. Lehman (they discuss LBIE) is an inordinately complex situation that few across the street have an understanding (some may understand the valuation, but adding in process and cross border issues makes the situation very complex). The Lehman trade has been a home run for many funds that got involved shortly after the following with capital distributions already ahead of initial purchase price with significant distributions coming over the next 2-3 years.

And finally from Jim Mooney's section on Baupost Public Investment Group:

"Looking ahead, it is quite difficult, as always, to predict what 2013 will bring in the public markets. On some level, much of the landscape appears to be relatively benign, with a seemingly insatiable investor appetite for corporate credit, a broadly held view that Europe is 'fixed' or a least on long-term life support, and many forecasters predicating continued strong performance in equity markets. However, we continue to see many potential cracks in the facade. As anyone with a passing view of credit markets knows, we have entered uncharted territory for flows into the leveraged-loan and high-yield space, and, with that, new lows in yields and default rates. While some would argue that because credit spreads remain near historical averages, the market isn't that  overheated, we remain of the view that, at best, the level of absolute yields is yet another manifestation of the overall interest rate bubble and, at worst, is evidence that investors are accepting insufficient returns for the risk they are taking. Whatever the case, we are optimistic that there will be many opportunities for distressed investments in the future."

Since the dawn of credit and lending, borrowers have over extended themselves. When the cycle turns, and it will definitely turn (its just a question of when), distressed opportunities and forced selling will abound. It's going to be fantastic.