Investment Theory #18: Klarman’s 1996 Letter

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 the economy, 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 (plenty of pdfs floating around the internet though).

This series of posts will reflect on Klarman’s activity throughout 1995-2001. Links to past posts: 1995

Historical Context

In 1996, the S&P 500 returned 22.68%.

In January, one of the worst blizzards in American history hit the eastern states, killing more than 150 people and closing the federal government for days. In February, computer program Deep Blue defeated world chess champion Garry Kasparov for the first time. In March, the British government announced that Mad Cow disease had likely been transmitted to people. In April, a regional security treaty was signed by the “Shanghai Five”. In May, the Supreme Court ruled against a law that would prevent cities from protecting the rights of homosexuals. In June, The Nintendo 64 video game system was released in Japan. In July, Dolly the sheep, the first mammal to be successfully cloned, was born in Scotland. In August, Bill Clinton signed welfare reform into law and Bob Dole was nominated as the GOP candidate for president. In September, the U.S. launched Operation Desert Strike against Iraq in reaction to an Iraqi offensive in the Kurdish Civil War. In October, News Corporation launched the Fox News Channel to compete against CNN. In November, Bill Clinton was reelected President of the United States. In December,  Federal Reserve Board Chairman Alan Greenspan gave the now famous “irrational exuberance” speech in reference to rising asset prices.

Midyear Update

Klarman’s midyear update reveals a shift away from US markets:

The Fund ends the first half of its fiscal year 91% invested, with a number of new positions in European holding companies and small capitalization U.S. stocks. The Fund also initiated positions in the U.S.-listed ADR’s of three Russian companies.

The Fund’s exposure to the U.S. stock market totaled only 29% of net assets at April 30, a level that reflects our opinion of the frothiness now present in U.S. share prices.

Even the slightest association with the Internet is cause for an upward thrust in a company’s share price. This is reminiscent of so many similar episodes over the last few decades, where everything from technology stocks to gambling shares to gold mines had their moment in the sun. We know the current mania will end badly; we do not know when.

One thing that separates great investors from average investors is the ability to put the present in historical context. When average investors fall victim to projecting current trends in perpetuity, great investors remember that the only certainty is that this too shall pass (reversion to the mean). When news stories fluctuate between everything is horrible and everything is amazing, great investors remember the truth is usually somewhere in between. As Buffett often says, the United States has survived multiple world wars, epidemics, and depressions, how do today’s fears or hopes stack up to that larger history?

Another interesting point here is that Klarman remains nearly fully invested while at the same time thinking the market is overvalued. The great thing about value investing — purchasing undervalued securities when available and holding cash when not — is that the playbook remains the same no matter where we are in the market cycle. A Bottoms-up search for value.

Performance in 1996

We are pleased to report a gain of 22.51% for the year ended October 31, 1996. Due to our significant underinvestment in the U.S. stock market (a topic to which we will return shortly) this gratifying result comes in spite of, rather than as the result of, similarly robust results for the U.S. equity markets. We are chagrined that we could have achieved approximately the same returns had we initiated the Baupost Index Fund a year ago. We are pleased, however, that we managed to do so with a vastly lower risk profile.

Value investing is about getting more return for less risk. For example, imagine that we estimate the fair value of the market at $1. We would be happy owning it at $2, if we thought someone would come along later and give us $3. But we would always be wondering if the music would stop and we would be left holding the bag. On the other hand, imagine we estimate the fair value of another asset at $3. We would also be happy owning it at $2, and would get the same return if someone came along and gave us $3. But we would probably sleep better at night. That margin of safety is the secret sauce of value investing. It allows us to be wrong and still come out alright.

Adapting to Markets

Like Baskin Robbins ice cream, opportunities come in dozens of flavors, not all of which are served at the same time. (Like Haagen Dazs, some of these flavors are fantastic.) Investors who find an overly narrow niche to inhabit prosper for a time but then usually stagnate. Those who move on when the world changes at least have the chance to adapt successfully.

The same flexibility that led us into a heavy concentration in thrift conversions in the mid 1980’s and distressed corporate debt in the mid-late 1980’s, and a smaller hedging bet on Japanese stock market puts in the late 1980s, has led us into a moderate investment in Russian stocks earlier this year, and an important position in European holding companies in 1995-1996.

Markets aren’t totally efficient, but some markets are more efficient than others. Investing is an example of a complex adaptive system, meaning that the actions of investors have an affect on the actions of other investors, which has an affect on the actions of the original investors. In other words, if investors discover a sure-fire way to make money in the market, the simple act of using it will stop it from working.

This is what makes investing so hard, there is no one silver bullet that beats the market in all cycles. Any magic formula or statistical advantage will only be useful until it isn’t. Given this reality, great investors have to be able to adapt. Buffett did great with cigar butts and special situations when he started out, but overtime others caught on, and those opportunities disappeared. Buffett’s response was to shift to a more active strategy. Klarman’s shift this time was to other countries.

The primary risk of entering new investment areas is unfamiliarity itself: the rules of the game might be unfamiliar or changing; others that have been in the area longer might have a significant advantage; and to paraphrase Warren Buffett, if you look around the poker table and cannot identify the patsy, it is probably you.

All of this is not to say that shifting strategies is easy. Never bet big when you aren’t sure you’re not at a disadvantage.

We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.

It is important to remember who is on the other side of every trade you make: namely well-funded large institutions with thousands of employees who are working 14 hours a day to make sure they aren’t going to lose. If you don’t think you have an advantage over them, whether it be informational, analytical, or behavioral, you probably shouldn’t be making that trade in the first place.

Foreign Investments

One of the consequences of entering new areas has been an increase in the portion of our assets invested in opportunities outside the U.S. This has not been the result of some top down asset allocation strategy, but rather the outcome of a bottom up, investment by investment search for opportunity.

Thus the most important investment criterion for us is not where a company does business, or where it is listed, but an understanding of the factors that might cause a company or security to be particularly undervalued in the market.

All of this has led up to a simple insight: if there is no value here, go somewhere else. If there is no value there, hold cash. For Klarman, there was no value in the U.S. so he went somewhere else. As all of the expert investors around the world focused their attention on the U.S. technology sector, the rest of the world was free for the picking. Think of competition like the Eye of Sauron, when it is focused on the Battle of the Black Gate, you can move freely elsewhere and destroy the one ring.

Thus late last year when European holding companies sank to record-wide discounts to underlying asset values, which themselves were quite depressed, we were in a position to act.

Similarly, when we identified the opportunity unfolding in the former Soviet Union, we were able to dispatch three different analysts to cover the area, spending several man-months on the ground there and building relationships with brokers, analysts, and other emerging market investors.

It’s interesting to compare Klarman’s entry into Russia with Long-Term Capital’s statistical arbitrage positions at the time. Both were diverging from their core competency, but the former entered with a size that assumed they could be wrong and still be fine, while the latter entered with a size that required them to be right or risk losing everything. Leverage and hubris, when paired is the greatest enemy to successful investing.


A key component of our investment strategy is sufficient but not excessive diversification. Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely.

However, we are always conscious of whether these different investments involve essentially the same bet or very different bets. If each of our holdings turned out to involve similar bets (inflation hedges, interest rate sensitive, single market or asset type, etc.), we would be exposed to dramatic and sudden reversals in our entire portfolio were investor perceptions of the macroeconomic environment to change.

The key thing about diversification is that it only works when risks are uncorrelated. Buying 100 different homes might seem like a sensible diversification strategy, but if they are all in the same neighborhood, not so much. Even if they aren’t in the same neighborhood, we still leave ourselves open to a nationwide recession, sudden interest rate spikes, government policy change, etc.

The same is true for securities, even of very different companies, trading in a single stock market. Owning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once.

In a panic, the correlation of everything goes to 1. The good is thrown out with the bad and everyone rushes for the safest and most liquid assets. This story has played out time and time again throughout history. Remember that the investors with free capital are the ones who can take advantage of these fire-sales.


Seeing a dearth of opportunity in the U.S., Klarman started to branch out to countries and assets with less competition. At first glance, it seems like a lot of time and effort taken to still under-perform a simple U.S. index fund, but remember that all returns aren’t created equally. There are returns from betting everything on red, and then there are returns from counting cards and betting when the odds are in your favor.


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