Chris Lau - Seeking Alpha

Friday, July 03, 2009

Seth Klarman: Why Most Investment Managers Have It Backwards

If you don't follow him, Seth Klarman is the founder and president of the Boston-based Baupost Group. He is a true "value investor." I originally found this post from Jack McHugh (The Big Picture site).

In brief, Klarman talks about the problems of rewarding fund managers for short-term performance. This form of compensation is especially prevalant in the mutual fund industry.

Here is the link:

http://www.advisorperspectives.com/newsletters09/pdfs/Seth_Klarman-Why_Most_Investment_Managers_Have_It_Backwards.pdf

Key Points:

Performance is almost universally evaluated using short-term results – managers are compared using quarterly, monthly, or even daily returns, creating extreme short-term pressures. “Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”

It is better to invest the way endowment funds are managed:

Klarman strives to avoid such counterproductive incentives, mostly by investing for clients – like endowments – with a long-term focus, and avoiding others – like funds-of-fund and unsophisticated investors – whose goals may be at odds with his own.

On Fear and Greed:
Having a long-term focus requires keeping the emotions of fear and greed in check. For most of the last 12 months, fear dominated greed, causing investors to flee to cash, despite its negative yields.
Side Comment: It continues to be quite a feat to have 540 members in my Intelligent Investing group on kaChing (a site that opens transparency in the industry with virtual portfolio mirroring management).

Be Focussed:

Narrowly focused managers, such as junk bond managers, he said, are often forced to be 100% invested, regardless of the risk/return profile of their investable universe. Such constraints eliminate the potential for contrarian thinking, which is critical to the success of value investors like Klarman.
Klarman's Comments on the Current Rally:

Klarman called the market rally that began in March “increasingly speculative” and driven by investors who “looked for and saw green shoots – or thought they did.” He questioned whether we can know if things are “stabilizing or pausing before they get worse.”

Recently, Klarman has spent a lot of time thinking about what a bear market rally would look like. He concluded that it would closely resemble the current rally – a bold move, fueled by speculation based on green shoots or similar wishful thinking, led by more speculative securities.

Predicting the Future?

“Value investors don’t know what will come next,” he said. “They must focus on the issue of price versus value and owning things because they are cheap.” The problem, he noted, is that undervalued stocks can remain cheap for a long time.

Inflation, however, is one outcome that Klarman clearly fears, and he has taken out “massive” portfolio protection through interest rate caps and swaptions, he said. He prefers these two hedging techniques because he pays a one-time premium and can tailor them to the maturities he wants to protect. If rates do go up, he can take the protection off.


What is Klarman Investing in NOW?
Klarman has moved portions of his portfolio into deeply discounted senior corporate and securitized mortgage debt, which he said offer very attractive returns relative to their risk.

Investors “overreacted” and sold off these securities, he said. Valuations were further depressed by legal uncertainties – in some cases, companies must go through bankruptcy before investors will earn satisfactory returns. The analytical complexity of evaluating securitized assets, each of which has unique characteristics, also contributed to their being underpriced.

[...]

Klarman sees fewer opportunities today – a “sudden dearth” that “makes us more than a little bit miserable,” he said. But he recognizes that “money is made when the crop is planted, not when it is harvested,” acknowledging that he expects a strong payoff from the repositioning of his portfolio last fall.


What Klarman is Asking:
The biggest question in Klarman’s mind concerns moral hazard, and whether the government has created “the mother of all moral hazards” by instilling a belief in investors’ minds that all crises can and will be solved by government actions. Such a belief, he fears, would skew every investment decision toward unnecessary risk taking.

Comments:
Klarman assesses the risk of higher inflation, higher taxes, and the loss in faith in the U.S. dollar. He says investors must determine the right multiple to pay "for companies that benefit from government backing and when government intervention will end. "

The mini-bubble now forming exists in sectors and companies being bailed out. This in turn expanded the price price multiples, since investors are willing to take on more risks. Klarman recognizes this, yet his deepest concern is on the area of moral hazards.

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