Lately, it appears 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 narrative that tax cuts and deregulation will jump-start the economy, while at the same time ignoring the risks inherent in an “America-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 book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.
In 1997, the S&P 500 returned 33.1%.
In January, Bill Clinton was sworn in for a second term as President of the United States and Madeleine Albright was confirmed as the first female Secretary of State. In February, the Dow Jones Industrial Average closed above 7,000 for the first time. In March, the prime minister of Papua New Guinea resigned after a scandal involving the use of a UK-based private military company. In April, the popular television series Pokemon debuted on TV Tokyo. In May, Tony Blair was elected Prime Minister and the Labour Party of the UK returned to power for the first time in 18 years. In June, J.K. Rowling’s Harry Potter and the Philosopher’s Stone was published in London. In July, The Dow Jones Industrial Average closed above 8,000 for the first time. In August, Steve Jobs returned to the helm of Apple. In September, over 2 billion people worldwide watched the funeral of Princess Diana. In October, the Dow Jones Industrial Average plunged 7.2% amid the Asian Financial Crisis – it quickly recovered. In November, WorldCom and MCI Communications announced the largest merger in U.S. history – WorldCom would declare bankruptcy in 2002. In December, the Kyoto Protocol was adopted by the United Nations in an attempt to stem climate change.
It’s been two and a half years of underperformance, but Klarman still has no interest in jumping on the bandwagon:
We remain risk averse value investors and will never own what we perceive to be expensive stocks in the hope that they could somehow rise even higher.
As Graham noted in the first chapter of his book The Intelligent Investor, “an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” The greater fool theory of investing may make money for a while, but eventually, the music always stops. If we forget this, we might end paying the equivalent of a house for some tulips.
Gains in the U.S. stock market, it seems to us, are being fueled by two important factors. First, the U.S. economic situation has been and remains very favorable, with low inflation, relatively low interest rates and steady GDP growth. The world is at peace, the U.S. has emerged as the sole superpower, and capitalism has never been more popular.
Second, investors have come to expect (and depend on?) handsome returns from investing in equities, and money has been relentlessly flowing into U.S. stocks. We believe that this has in the short run become a self-fulfilling prophecy, as funds flows lift share prices to produce the profitable returns that investors have sought.
John Templeton, the legendary investor, once said: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” One thing in favor of the current market rally is that no one is really optimistic about it. It has even been called the most hated bull market in history.
Interest rates and inflation are low, but the world is definitely not at peace nor on a stable political footing. Investors are still waiting on the China debt bubble to burst (10 years and counting). Populism angst and protectionism are spreading. Inflation and interest rates are creeping up. Investors seem to understand that future returns are likely to be lower than what they experienced in the past. Investors are definitely not as optimistic as they were in the late 1990s.
Performance in 1997
We are pleased to report strong results for the year ended October 31, 1997. For the twelve months, the Fund achieved a total return of 27.04% despite holding on average over 20% of its net assets in cash during the period. Our result was, however, somewhat below the exceptional return for the S&P 500 of 32.11% over the same period.
It’s not often that a 27% return underperforms the market. The results are even more impressive when we add in the fact that the portfolio had little correlation with the soaring bull market and that the large cash balance acted as a weight on performance. This just reinforces the idea that there are always opportunities that don’t sacrifice our margin of safety.
Investing during panics
Klarman goes on to talk about investing when you feel a correction is imminent:
Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing.
Eventually, every market cycle will hit a downturn. When that happens is anyone’s guess and luckily we aren’t in the business of predicting the timing. Instead, value investing is a strategy for all seasons: When there is an opportunity, we bet and bet big. When there isn’t, we hold cash and view it as a call option on future opportunity.
In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk.
In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts. But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value.
Whether the market is raging higher or crashing lower makes no difference. The playbook is still the same: Analyze individual companies and buy when there is a satisfactory margin of safety.
Klarman talks a bit about his decision to look internationally for ideas:
The most important investment decision we have made over the past several years is the one to increase our international efforts. This decision resulted in part from a realization that opportunities in the U.S. were considerably less attractive than they had been, and that the situation would not necessarily improve. Our assessment was in part due to much higher valuations as well as to a perception of increased market efficiency over time, as more and larger investors have come into existence.
A simple rule of thumb is that markets are efficient most of the time, but not all the time. Sometimes, like the case of the late 1990s, markets will be inefficient to the upside and reduce future returns. Sometimes, like early 2009, markets will be inefficient to the downside and increase future returns. But most of the time, markets will be efficient and provide mediocre future returns. When a given market isn’t providing adequate returns, it is best to just look elsewhere.
I frequently hear the argument that the rules are different overseas: the accounting murky, the annual reports unreadable, the currencies sometimes unhedgable. All of these points are fair, but, rather than being arguments to avoid foreign markets, they are instead arguments to embrace them. After all, as an investor you never have perfect information, and the biggest profits are always available (just as they have been in the U.S.) when competition and information are scarce. The payoff to fundamental analysis rises proportionately with the difficulty of performing it.
It is often said that investors hate uncertainty. In reality, the only times that investors have been certain about anything are during market tops and market bottoms. That certainly never turns out well. In order to find a bargain, you have to be comfortable with uncertainty. You have to be willing to go where others won’t and you have to be comfortable with looking like a fool for a while.
Klarman goes on to succinctly explain the core idea of value investing:
Value investors should buy assets at a discount, not because a business trading below its obvious liquidation value will actually be liquidated, but because if you have limited downside risk from your purchase price, you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favor. If an undervalued stock drops after you buy it and you are confident in your analysis, you simply buy more. All of these points apply equally well regardless of the market on which a stock trades or where a company does business.
An asset being cheap is not the same thing as an asset going up in price tomorrow. Plenty of cheap stocks will stay cheap or get cheaper for longer than you can justify holding the position. The key point is, given accurate analysis, the cheap stock shouldn’t be able to get that much cheaper.
This asymmetric nature, high upside and low downside, is the secret sauce of value investing. Klarman describes it as a free option on upside.
Klarman is still unwavering in his adherence to the value investing discipline. Having given up on finding bargains in the U.S., Klarman continues to search overseas for opportunities and to hold cash when none are found. Warren Buffett and Charlie Munger have often attributed their success in life to their ability to sit on their hands and do nothing. When investors start to force returns by jumping into trends they don’t understand, or even believe in, is when thoughtful investors turn into gamblers.