Seth Klarman Interview with Jason Zweig

A very interesting interview by Jason Zweig with Seth Klarman in the Financial Analysts Journal (Volume 66, Number 5), September/October 2010, CFA Institute. Especially valuable I think are his thoughts on selling and holding periods. He also emphasizes the analytical approach to analysing investments using scenario analysis and the importance of tirelessly pulling threads.

Key points follow.

Where Bargain Are Found

1. Today, some of the biggest bargins are in the hairiest situations such as financial distress and litigation, so Baupost goes into those areas that Graham and Dodd couldn’t have imagined.

How to Invest

1. What he learned from Michael Price is the endless drive to get information and seek value. In a specific instance, Mike found an inexpensive mining stock, and drew a detailed map of interlocking ownership and affiliates, which led him to a dozen other potential investments, many of which are publicly traded (e.g. if the mining stock is undervalued, that might lead to the stocks of its shareholders being undervalued as well). The lesson learned is to tirelessly pull threads.
2. Equity investors need to be able to piece things together and anticpate chain of events (e.g. a deteriorating subprime market will lead to housing market problems, which would blow up financial institutions, destroying their capital base and future earnings power.
3. The pressure to be fully invested at all times and the inability to hold cash caused all investors to be pulled down with the market.
4. Baupost is organised by opportunity (e.g. analysts for spinoffs, distressed debt, post-bankrupt equities, etc.) so as to focus on where the misguided selling is (due to redemptions, liquidation of overleveraging).
5. We make money when we buy things. We count the profits later, but we know we have captured them when we buy the bargin.
6. Scenario analysis is key, e.g. on the decline of the dollar, Baupost has done scenario analysis in which the dollar remains the reserve currency and those in which it doesn’t; those in which gold goes berserk on the upside and those in which it stays flat and then falls, etc.

 How to Keep Your Frame of Mind

1. You do need to worry about market prices if you don’t have enough staying power to hold to maturity or beyond maturity in the case of a bankruptcy. You have to be sure that your analysis wasn’t optimistic. Baupost tests all assumptions with sensitivity analysis and stress testing. A margin of safety gives the courage to go against the tide. 
2. In worrying about things that can go wrong, you can hedge. You must remember to sell fully priced securities so that you are underexposed when things go badly.
3. By being conservative all the time – hold bargins and sell fully priced securites – you can be in the right frame of mind because it helps you avoid short-term devastation. This enables you to be around for the long-term.
4. On inflation and the decline in the dollar, Klarman highlighted that one goal is to offset as much as possible significant decline in market value to avoid the psychological problem of being down 30 or 40% and then being paralysed.

Holding Periods

1. Every trade is entered with the idea that we are going to hold to maturity in the case of a bond, and potentially forever, in the case of a stock.
2. Positions may turn over because the upside/downside has changed (e.g. something becomes fully valued). You need to compare the remaining return with the risk of continuing to hold. 

On the Crisis

1. Pre-2008 stocks were valued on an invisible template of an LBO model because LBOs were easy to do. Now LBOs cannot be effected, so stocks fell to their own levels.
2. Old saying: “How did you go bankrupt?”.. “Gradually, and then suddenly.” The impending fiscal crisis will happen the same way.
3. Baupost tries to protect against tail risk: the risk of unlikely but possible events that could be catastrophic. They have bought way-out-of-the-money puts on bonds to hedge against much higher interest rates. The bond market will likely hike up interest rates before the actual inflation shows up in the Government’s accounting.
4. During the crisis, bonds of auto finance companies were trading as low as 40 cents on the dollar. Ford Motor Credit was the most likely to survive. If Ford’s loan losses went from the exiting run rate to 8 times the run rate, 40% of the entire loan would be wiped out but the bonds would still be worth 60 cents on the dollar. These had amazing upside under almost any scenario and a depression-proof downside.

On Index Investing

1. Saving transaction costs and management fees ignores the fact that the underlying needs to produce for you.
2. The entry point is what matters. When you have unexpected pain (e.g. 2008), you need to be a buyer and not get out.
3. Different asset classes can attractive during different periods. E.g. debt was more attractive in 2009 than equities. 

On Commodities

1. If an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation.
2. Land is an asset that has value because it will deliver future cash flow.
3. Gold is a commodity and has no tangible value. Other than a recent sale or appreciation due to inflation, analyzing the current or future worth is nearly impossible. So gold is speculation.
4. Klarman still bought exposure to gold because he fears paper money not being a store of value. If he were to short the U.S. dollar against another currency, there is the problem of which currency pair.

Others

1. What he learned from Max Heine is how Max treated everybody as though they were really important, because to Max they were.
2. Never stop reading. History doesn’t repeat, but it does rhyme.

Recommended Books

1. The Intelligent Investor by Benjamin Graham
2. Graham and Dodd’s Security Analysis, 6th Edition (2009)
3. You Can Be a Stock market Genius by Joel Greenblatt
4. The Aggressive Conservative Investor by Martin Whitman and Marin Shubik
5. Moneyball by Michael Lewis
6. The Big Short by Michael Lewis
7. Too Big to Fail by Andrew Ross Sorkin
8. The End of Wall Street by Roger Lowenstein
9. Money of the Mind by Jim Grant
10. How to Lie with Statistics by Darrell Huff (recommended by Zweig)