Lately it appears that a fresh wave of animal spirits has gripped the markets — just look at the post-election rally in equities. Investors seem to have bought into the hype that tax cuts and deregulation will jump-start economic growth, while at the same time ignoring the risks inherent in an “American-First” protectionist agenda.
In times of market loftiness it serves us well to reexamine how similar cycles have played out in the past — and there is probably no better case study than Seth Klarman’s handling of the late 1990s. Klarman is a well-respected value investor who founded the Baupost Group in 1982. Since then he has generated an average annual return of 19%. Klarman’s investing philosophy can be summed up by the title of his hard to find book: Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.
This series of posts will reflect on Klarman’s thinking throughout the period 1995-2001.
In 1995, the S&P 500 returned 37.2%.
At the end of 1994, the republicans took control of Congress on a platform of balancing the budget and reforming welfare. In January, President Clinton invoked emergency powers to grant a bail out to Mexico — often cited as a turning point in corporate moral hazard. In April, Timothy McVeigh and Terry Nicholas used a truck bomb to destroy the Murrah Federal Building killing 168 people. In October, O.J. Simpson was found not guilty of killing his wife after a long and very public trial. In August, Netscape Communications IPO’d and quickly doubled in price — marking the beginning of the dot-com boom. In November, Israeli Prime Minister Yitzhak Rabin was assassinated by a right-wing Israeli opponent of the peace process.
Performance in 1995
Klarman opens the letter with a discussion of performance:
We are pleased to report a gain of 7.91% for the year ended October 31, 1995. This result, while ahead of our self-imposed bogey of exceeding the return on U.S. treasury bills, falls considerably short of the performance of various U.S. stock market indices.
Klarman’s yardstick is earning a good absolute return regardless of what the broader market is doing. Where most funds would be happy just outperforming the market, Klarman would see being down 1% as a failure, even if the market was down 20%. It is understandable then that his investment philosophy revolves around a bottom-up search for deeply undervalued securities with a large margin of safety. The “cigar-butt” approach to investing.
Only three positions provided profitability in excess of one million dollars during the year. Maxwell Communications was a large position in the senior debt of a U.K. insolvency. The value rose significantly after the company announced the first of three substantial distributions to creditors. Emcor and MBO both involve securities of post-bankruptcy companies that initially received little attention in the market.
Let’s take a closer look at the Maxwell Communications position. Maxwell was a leading British media business that was established in 1964, when Hazell Sun merged with Purnell & Sons to form the British Printing Corporation. During the 1970s the company expanded while running into many trade union disputes which froze publication for months at a time.
In 1981, Robert Maxwell, a British Media proprietor and former Member of Parliament, launched a hostile takeover of the British Printing Corporation. The following year Maxwell secured full control of the company and in 1987 he renamed it to Maxwell Communications. Under Maxwell’s management the company began a debt-fueled acquisition spree.
During his reign it turned out that Maxwell was raiding his company’s pension fund to bid up the share price of Maxwell Communications. After Maxwell’s death in 1991 — and amid charges of fraud — panicked banks began calling in their massive loans. Maxwell Communications filed for bankruptcy protection in 1992.
The important thing to note here was the frantic scramble on the part of the banking and financial community to salvage whatever they could from Maxwell’s disintegrating empire. It was apparent that Maxwell Communication’s media assets would be auctioned off to pay the debt, and if someone like Klarman calculated that those assets would be sufficient to do so, they could pick up that debt for pennies on the dollar. It seemed to have worked out.
We experienced four significant losing positions this year. The largest was a position in various equity and debt market hedges that mostly expired worthless. Our policy is to continue to protect ourselves from serious market declines through the purchase of out-of-the-money put options.
Remember that the dot-com bubble wasn’t set to pop for another 5 years, while Klarman was already taking sizable losses with his hedges. It is simple to say that being right and early is the same thing as being wrong, but that ignores the benefit of hindsight. Michael Lewis, in The Undoing Project, gives a better approach in the context of how Kahneman and Tversky worked: “They would learn to evaluate a decision not by its outcomes — whether it turned out to be right or wrong — but by the process that led to it. The job of the decision maker wasn’t to be right but to figure out the odds in any decision and play them well.” Klarman’s use of out-of-the-money puts turned out to be overly cautious in the version of reality that played out, but the decision process remained sound.
This Time is Different
Klarman goes on to discuss the current state of the markets:
Once again in 1995, the U.S. stock market has delivered investment performance appreciably ahead of underlying business results. Over the past thirteen years, the S&P 500 with dividends reinvested has delivered a compound annual return of 15.9%, the best such result ever. For the last five years, the S&P 500 has returned 17.2%, while the NASDAQ Composite Index has returned a staggering 25.7%. Assuming a 10% long term rate of return from equities, the NASDAQ would need to drop a whopping 49% tomorrow to simply return to trendline for the latest five year period.
Bulls will patiently explain that “it is different this time”, pointing to low inflation, high corporate profits, increased productivity, world peace (sort of), reductions in government spending, and the like. Of course, any contrarian knows that just as a grim present is usually precursor to a better future, a rosy present may be precursor to a bleaker tomorrow.
When everyone starts to think that nothing can go wrong, something is going to go wrong. There is two sides to investing: 1) figuring out what something is worth and 2) figured out what the market is pricing in. Only when these two steps are in contradiction can someone profit from an investment. To quote Peter Thiel, “If you can identify a delusional popular belief, you can find what lies hidden behind it: the contrarian truth.” To quote Howard Marks, “Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while.”
Passive vs Active Investing
Klarman succinctly resolved the passive vs active debate years before it hit the mainstream:
We have said before and will repeat here that you do not really need Baupost to invest your money in bull markets. An index fund could likely perform better. The true investment challenge is to perform well in difficult times. It is unfortunately not possible to reliably predict when those times might be. The cost of performing well in bad times can be relative underperformance in good times. We have always judged that a worthwhile price to pay.
Anyone who can comfortably ride out a 50% drop in the markets on any given year should be a passive investor. However, Klarman’s guiding principle over the next 5 years will be avoiding that 50% drop. Unsurprisingly, investors quickly began to doubt his ability to handle the new economy. Warren Buffett was getting the same critiques at the time.
Klarman would end up proving that concentrating on downside protection isn’t mutually exclusive with gaining excellent long-term returns. As counter-intuitive as it seems, with value investing, less risk often means more reward. In other words, the cheaper something is, the less downside, the more upside. The more expensive something is, the more downside, the less upside.
In 1995, the dot-com bubble was beginning to form and Seth Klarman was already pessimistic about this — five years too soon. Over the years to come, Klarman will position Baupost Group to profit from the market, while at the same time protecting it from the eventual correction. His performance is a masterclass in defensive investing.