Friday, May 28, 2010

Recent Comments from Seth Klarman

                                            Elihu Vedder, The Pleiades, 1885

Seth Klarman, the founder and president of Baupost Group, is a highly successful and very conservative investor who formerly worked with Max Heine and Michael Price at Mutual Shares. Klarman's own funds have continued in the value tradition and are known for holding high levels of cash, investing in distressed situations, and using a variety of hedging methods.

It is unfortunate that Klarman makes few public statements, because his portfolios have averaged an annual return of around 20% since the founding of Baupost in 1982 and 17% over the past decade, a period when equity index returns have been flat. Fortunately, some of his remarks at the recent annual meeting of the CFA Institute have appeared in the press, and Jason Zweig published additional comments in the Wall Street Journal.

Currency Devaluation Threat

The world seems to be in deflationary mode right now, but Klarman is looking at the future. "Will money be worth anything if governments keep intervening anytime there's a crisis to prop things up?" The point is that it doesn't matter if you make wise investment allocations, because you will lose money anyway if that money is in a depreciating currency. If all currencies suffer relative to real things, you can lose out in any currency. For that reason, Klarman said, "I am more worried about the world, more broadly, than I ever have been in my career."

Cheap Inflation Hedges

If the government is borrowing every-increasing amounts, what to do? Klarman's Baupost funds are focusing on the "tail risk" that bond prices will increase not modestly, but to levels unheard of in the US since the inflation of the 1970s. Baupost's response is to purchase "way out-of-the money puts on bonds" because "It's cheap disaster insurance for five years out." Focusing on tail risk means that Baupost holds options that will expire worthless if long-term interest rates rise to the 6 percent to 7 percent level, but will appreciate considerably if long-term rates rise to the 10 percent range, and 50 to 100 times if long rates pass 20 percent.

Traditional Hedges Are Expensive

Klarman has a very specific reason for using options on bonds to protect against future inflation and currency devaluation, rather than some other vehicle: "All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive." This applies also to gold: "Near its all-time high, it's a very hard moment to recommend gold."

What to Think of This?

Not everyone would agree that expanding government debts will lead to inflation and a declining currency. As many people like to point out, the US is not Greece. Our debt is denominated in our own currency, and the government can simply rearrange accounting entries to control the amounts in various accounts. In this view, higher bond rates (and associated troubles managing debt) are not as inevitable as Klarman asserts. Because the whole issue is subject to credible contending opinions, it is interesting that someone with Klarman's investing record does view bond rates as a substantial risk. He is not alone.

Patient Value Strategy

If traditional hedges are expensive, what is the individual investor to do when faced by hyperinflation and declining purchasing power? Not surprisingly, a value investor like Klarman advises buying things that are "out of favor, loathed, and despised". So, all that is needed, according to him, is to have patience and fortitude -- wait until things are hated that they are cheap, and then buy them. For example, Klarman is looking into private commercial real estate, although he cautions that publicly-traded REITs are "quite unattractive" because they have "rallied enormously."

Investing When Government Determines the Winners and the Losers

This blog has previously complained of the difficulty of investing when traditional valuation measures have lost their meaning, and government policies determine the winners and losers. Klarman has the same complaint: "There is nothing natural in the markets. Everything is being manipulated by the government." Zweig's article mentions that Klarman compared the financial markets to a Hostess Twinkie in a recent newsletter.

"The government is now in the business of giving bad advice." He explained this comment as follows: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

You may have noticed that, despite these complaints about government interference, Klarman is still plugging his value approach to investing.