When the Stock Markets will Blow Up

Seth Klarman wondered when the meteoric rise in stock markets will rise. Howard Marks wondered that too. In Marks' latest memo, he answered by saying the markets will fall when it will. He does not know when, but knows that eventually, it will.

Marks' Oaktree Capitall recently issued shares for its stock (OAK). Insiders are cashing out.

Klarman wrote:
Someday...

Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy – maybe not today or tomorrow, but someday. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.

Someday, professional investors will come to work and fear will have come to the markets and that fear will spread like wildfire. The news flow will be bad, and the markets will be tumbling.

My Guess

The markets played euphoria before. Well before 2008. Back in 1999-2001, batteries were all the rage. Batteries are once again in vogue. See PLUG. In the electric car market, look at Tesla.

Image source: Yahoo Finance

In social media, Facebook and Twitter get all the headlines, but Amazon and Yelp are the ones to watch.

In the end, all roads could lead from China. Demand for iron ore and energy dropped. Exports dropped 18% last month. China allowed its first debt default. This is unprecedented.

Click here the scoop on author's past performance.

Klarman and Security Analysis (Financial Analysts Journal)

Seth A. Klarman is president of The Baupost Group, LLC, Boston. Jason Zweig is a columnist for the Wall
Street Journal, New York City. In the October publication of Financial Analysts Journal , Klarman offers his views on securities analysis work of Graham and Dodd. By that extension, this would include securities analysis by Warren Buffett:

The world is different now than it was in the era
of Graham and Dodd. In their time, business was
probably less competitive. Consultants and
“experts” weren’t driving all businesses to focus on
their business models and to maximize performance.
The business climate is more volatile now.
The chance that you buy very cheap and that it will
Also, the financial books of a company may not
be as reliable as they once were. Don’t trust the
numbers. Always look behind them. Graham and
Dodd provide a template for investing, but not
exactly a detailed road map.

Klarman is most definitively one of the few modern investors following Buffett who is "one-of-a-kind." Let us be realistic: although the teachings of Buffett are covered here, few readers are likely to be as successful as Buffett. This reality should not prevent investors from analyzing securities and the market diligently and thoroughly:

Our approach has always been to find compelling
bargains. We are never fully invested if there
is nothing great to do. We test all our assumptions
with sensitivity analysis. Through stress testing,
we gain a high degree of conviction that we are
right. We are prepared for things to go slightly
wrong because we adhere to a margin-of-safety
principle that gives us the necessary courage to go
against the tide.

Yet, we don’t actually think of it as courage, but
more as arrogance. In investing, whenever you act,
you are effectively saying, “I know more than the
market. I am going to buy when everybody else is
selling. I am going to sell when everybody else is
buying.” That is arrogant, and we always need to
temper it with the humility of knowing we could be
wrong—that things can change—and acknowledging
that we have a lot of smart competitors. Thus, in
worrying about all the things that can go wrong, you
can prepare, you can hedge—and you must remember
to sell fully priced securities so that you are
underexposed when things go badly. All these elements
give us the courage to follow our convictions.
The last point I would make is that your psychology
as an investor is always important. If you
lose your confidence, if you’ve made too many
mistakes, if you are down too much, it becomes
very easy to say, “I can’t stand being down more
than this.” Unless you have a bet-the-business
mentality, you would worry about your business,
about client redemptions, and about your own net
worth in the business.
So, by being conservative all the time—by
being both a highly disciplined buyer to ensure that
you hold bargains and a highly disciplined seller to
ensure that you don’t continue to own things at full
price—you will be in the right frame of mind.
Avoiding round trips and short-term devastation
enables you to be around for the long term.

So, what is Klarman buying?

Right now, we are buying, or trying to buy,
private commercial real estate because the stresses
in that market are creating bargains. The private
market in commercial real estate, especially the
private market for anything less than center city
Class A office or malls, has terrible fundamentals,
and the likelihood that they will get better soon is
not good. Yet the government has propped the
market up with TARP money and Public-Private
Investment Program money and also, essentially,
by winking at the banks. I think the Federal Deposit
Insurance Corporation has told banks, “Don’t be in
a hurry to sell your commercial real estate. We will
bear with you.” Servicers of commercial real estate
securities and mortgage securities have also been
slow to sell and eager to restructure.

About the stock market rally:

In contrast to the private markets, the public
market in real estate has rallied enormously. Many
REITs are yielding 5 or 6 percent, which reflects
vastly higher prices and less attractive yields than
the private market offers.

Nevertheless, we are not making any money in
real estate right now. We are putting money to
work in private commercial real estate when we
can, very selectively, because those investments
will yield a good return over time, unlike the public
part of real estate that is quite unattractive.
We are making money on the distressed debt
we bought two years ago, which has gone from 40
or 50 or 60 to 90 or par, and on other similar securities
that have been grinding along, throwing off
cash, mostly rising in price or going through a
process that will ultimately deliver a profit to us.

Further reading as advised by Seth Klarman

• Graham’s The Intelligent Investor
• Graham and Dodd’s Security Analysis (6th ed with updated comments)
• Joel Greenblatt’s You Can Be a Stock Market Genius

 This book is tactical and includes some very specific and interesting strategies

• The Aggressive Conservative Investor,7 by Marty Whitman and Martin Shubik
• Anything from Jim Grant writes is wonderful

In regards to Grant, Klarman notes that even if he’s not always right on his predictions, he is among the best thinkers and financial historians.

• Michael Lewis has never written a bad book

Moneyball is about value investing. Looking back 20 years from now, The Big Short9 may be the definitive
book about this era. It is about a microcosm, but the microcosm explains everything.

• Andrew Ross Sorkin’s Too Big to Fail is fabulous
• All of Roger Lowenstein’s books are excellent (we should read everything Roger has written)

Klarman's Final Thoughts:
Never stop reading. History doesn’t repeat, but it does rhyme.

Jim Grant has a wonderful expression: In science, progress is cumulative, and in finance, progress is cyclical. Fads will come and go, and people will think we are on to a new thing in finance or investing; but the reality is that it is probably not really new, and if we have seen the movie or read the book, maybe we know how it turns out.

Notes from Author of $2,397 Book (Amazon.com)

Seth Klarman recently made a speech at the CFA Conference in Boston last week. This speech was transcribed and posted on marketfolly.com.

Note: I am providing hedge fund analysis to marketfolly.com. Articles (co-analyzed/commented by Marketfolly) will appear on the Marketfolly site. The site has nearly 10,000 subscribers and x000,000 hits per month.

As you will recall, Klarman is author of 'Margin of Safety' and Fund Manager at Baupost Group. The fund has $20 billion in assets under management.


Klarman provides great insight on such things as group think, on taking action through courage.

On Conviction and Courage

So what do we do to give us conviction? 
1.) Find compelling bargains, not slight bargains.
2.) Test everything with sensitivity analyses.
3.) Prepare to be wrong. It’s not courage, it’s Arrogance, when you buy something, you’re saying you’re smarter than everyone else. We realize we have lots of smart competition and temper our arrogance with humility to realize that many things could go wrong. 

Our own confidence matters, and we’re highly disciplined buyers and sellers to avoid round trips and take advantage of short term sell offs. 

Jason Zweig: So Investors need cash and courage?
Klarman: Courage is a function of process.

On Group Think

One observation that can be made (at the danger of making false generalizations) is about large companies. Why is Microsoft referred to as "the evil empire?" Does a company become "evil" as it gets larger?

A company can get "dumber" as it gets larger. The same phenomenon is applicable in the group analysis of securities:


Zweig: How do you avoid group think?
(my emphasis in bold)

Klarman: We recently had an investment team retreat with leading thinkers. They all said
there was a terrible problem with paper money, we should consider gold, the EU
would break up. Our partner’s immediate thought was that gold was a group
thought and we should be cautious holding it.

So we focus on intellectual honesty and try to learn from mistakes, accept them, and move on. We spend a lot of time on this in our hiring process. When there’s a mistake, there is no yelling, it’s never the analyst’s fault (unless it’s a dumb formula error, etc), everything is reviewed by senior people and we’re wrong together. We’re aware of our biases and the risk of being biased. As an investor you need to decide if you’d rather make more money
in up years and have a few bad years, or protect your downside, and we’ve obviously
chosen the latter. We’d rather under-perform a huge bull market then get clobbered
in a bear.

On Intellectual Honesty

Zweig: Everyone says it’s never the analyst’s fault, but often they don’t stick to this
when something goes wrong. How do you screen for Intellectual Honesty in your
hiring process?

Klarman:  We ask about their biggest mistake, which doesn’t have to be investing related. But if you say your biggest mistake is wearing mis-matched socks one day, then
that’s likely not being intellectually honest. 

We ask ethical questions, ask them how they’d respond in morally ambiguous situations, we want to see that they realize conflicts can exist. We want people who fit in. One key thing is idea fluency, if I present a thesis I want people to immediately come up with 10 places to look to exploit it, I don’t want them sitting at their desk thinking, “hmm, where should I look?”

Lead by Example: Seth Klarman

Seth Klarman is the founder and president of The Baupost Group, a Boston-based private investment partnership. He is a topic of discussion on kaChing's Investing IQ App's "The Intelligent Investor" group (now with 1,270 members).

In the video, Klarman discusses his investment philosophy. He prefers to look for securities that fly below the radar, that are involved in complicated situations (and are therefore ignored by the investment community), stocks that are out of favor (kicked out of a major index or not belonging to one). He also prefers significant and illiquid securities over significant and liquid securities.


Klarman is worth listening to: Baupost manages $1.7 Billion for 40 families encompassing 700, and his book, "Margin of Safety," is $1,100 on Amazon.com (although the price of a book does not indicate the value of its content, but its lack of availability). Most importantly, his investment approach is to start cautiously by identifying all the risks and by avoiding them by hedging.

Klarman is rarely heard or followed by the media, unlike, for example, Warren Buffet. Yet, both investors have similarities in their approach to the selection of securities. For this reason,the Harvard Business Review interview (link below) is a worthwhile watch.

On Writing Margin of Safety:


Here is a link to the full interview provided by Harvard Business School.

These are some of the hi-lights from the video on leadership:

• On leadership, lead by example
• Be there and be available to staff (Klarman has an open trading desk as opposed to an office, even though he isn't a "trader")
• Empower others: let others shine if you know they can do so
• Set an example to colleagues on a having a balanced work-life

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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Interview of Seth Klarman

Seth Klarman is a true value investor. A true value investor is risk-averse. Therefore there is a greater desire to protect on the downside than to make a lot but which runs an enormous risk.

Here is the link:
http://valueplays.blogspot.com/2009/04/seth-klarman-video.html

Today's Economic Results:
From Bloomberg:

• A record 19.1 million homes stood unoccupied in the first quarter and the U.S. homeownership rate fell as the recession sapped demand for real estate
• The number of vacant homes, including foreclosures, properties for sale and vacation properties, jumped from 18.6 million a year earlier, the U.S. Census Bureau said in a report today.