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 1998, the S&P 500 returned 28.34%.
In January, Russia began to circulate new rubles in response to a financial crisis. In February, a massacre in Likoshane, Yugoslavia marked the beginning of the Kosovo War. In March, the first evidence that the universe was expanding at an accelerating rate was published by the High-Z Supernova Search Team. In April, the Belfast Agreement was signed between Irish and British governments as part of a larger peace process. In May, the first euro coins were minted in France. In June, Microsoft released Windows 98. In July, Harry Potter and the Chamber of Secrets was published. In August, U.S. embassy bombings killed 224 people and injured over 4,500. In Septemeber, Google was founded. In October, Mathew Shepard was beaten, tortured, and left to die in Wyoming, bringing international attention to hate crime legislation. In November, Nintendo released The Legend of Zelda: Ocarina of Time. In December, The U.S. House of Representatives forwarded articles of impeachment against President Clinton.
Klarman uses the midyear update to reflect upon the Perma-bull environment in the U.S. stock market. For years now, the market had only moved up:
“Into Thin Air”, the title of a recent bestseller about an ill-fated expedition to climb Mt. Everest, could also aptly describe the U.S. stock market, which has only infrequently reached such rarefied heights. Like the Everest climbers, the problem with reaching the summit is that from there every way you go is down. Not wanting to overuse the metaphor, I won’t go on to recount the sudden storm which seemed to come out of nowhere that brought peril to a number of the climbers.
Fly too high and the wax melts, fly too low and the sea mist dampens your feathers. In investing, too greedy and you get slaughtered, too fearful and you never earn more than the risk-free rate. As with most things, avoid extremes.
Klarman goes on to discuss the madness of the dot-com craze:
Consider the case of K-Tel International, the company best known for selling music CDs and tapes on late night television. After hovering in a narrow trading range around $7 a share (for its 4.1 million outstanding shares) since January, the announcement that K-Tel plans to sell its music on the internet caused its shares to skyrocket from $7 to $45 in just one week and to $80 a week later with daily volume exceeding 100% of the freely tradeable shares outstanding.
An analyst at the time claimed all you needed to do was put dot-com behind a company name and everyone would jump to buy it. Internet companies were trading at 30x, 60x, 100x revenue. For comparison, Facebook IPO’d at about a 25x revenue and that was considered high for today.
The point is that the behavior of market participants during the 1990s was so mind boggling egregious that today’s market participants look wise and cautious in comparison. Sure we have pockets of madness and fraud, but nothing on the scale of what took place during the Dot-Com bubble.
Drinking the Kool-Aid
Klarman reflects on how many smart, professional investors are abandoning reason and jumping into the market:
Even hordes of formerly risk averse investors, who have seemingly adopted the Massachusetts State Lottery’s slogan (you gotta play to win) for their new investment guidelines. Clearly, the greater perceived risk is no longer that of being in the market but rather remaining on the sidelines, risk being defined not in terms of yield to maturity but rather yield to termination of the money manager.
We have entered greater fool territory, and decent market returns from here, while still a distinct possibility, will depend on an even greater sucker showing up. No one should be surprised if one does; however, no one should base their investment program on his or her existence.
As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision. Isn’t this what always happens at the top of historic bull markets? The answer, of course, is of course.
It is no secret that most institutional fund managers underperform the market. One explanation for this argues that the efficient market hypothesis makes it impossible to outperform the market. The problem isn’t with bad research, but with research that is so good profits are just competed away.
A simpler and more accurate explanation is that institutional investors just aren’t incentivised to outperform. Instead, they are incentivised to raise capital and not get fired. In order to build and protect their management fee, institutional investors focus on the short-term, relative performance and are happy to be wrong so long as everyone else is wrong too. Standing out from the herd is what gets people fired.
Charlie Munger put it best, “Back in 2000, venture-capital funds raised $100 billion and put it into Internet start-ups — $100 billion! They would have been better off taking at least $50 billion of it, putting it into bushel baskets and lighting it on fire with an acetylene torch. That’s the kind of madness you get with fee-driven investment management. Everyone wants to be an investment manager, raise the maximum amount of money, trade like mad with one another, and then just scrape the fees off the top. I know one guy, he’s extremely smart and a very capable investor. I asked him, ‘What returns do you tell your institutional clients you will earn for them?’ He said, ‘20%.’ I couldn’t believe it, because he knows that’s impossible. But he said, ‘Charlie, if I gave them a lower number, they wouldn’t give me any money to invest!’ The investment-management business is insane.”
Manias are often characterized by extreme behavior and aggressive accounting. The late 1990’s was no different:
These “onetime” write-offs, purported to reflect non-recurring charges related to mergers, plant closings, corporate restructurings and the like, are hardly one-time when they recur year after year. (These write-offs also result in an overstatement of return on equity; high return on equity is another argument used to justify record stock valuations.)
There has been considerable publicity about the dilutive impact of management stock options on shareholder returns. Reported earnings per share are potentially overstated to the extent that additional shares can be issued to management at fixed prices. The magnitude of this dilution is well known among investment professionals; they simply choose to downplay it as fundamentals increasingly take a back seat to adrenaline.
There was some magical thinking going on in the 1990s, which simply said expenses were no longer expenses. CEOs could pay themselves millions of dollar in stock options, and then turn around and say it didn’t cost the company anything. But of course, it did since more shares outstanding meant less earning per share. The accountants countered that argument by buying back stock to offset the options. So companies were now buying shares with cold hard cash to give their employees, and yet this still wasn’t an expense?
For a concrete example, in 2000, Dell repurchased $1.1 billion in shares to offset the Company’s employee stock plans. Had the company reported this as an expense, Dell’s income would have been about 60% lower than reported.
Today, these practices are no longer allowed under GAAP but this hasn’t stopped clever accountants from putting forth new gimmicks like “adjusted EBITDA”. Just look at Valent, where for years their adjusted earnings were skyrocketing while the reoccurring “one-time” costs were being ignored. Once that accounting veil was removed, all that was left was a barely solvent company.
Performance in 1998
Klarman begins the full year report with a discussion of returns, which were not pretty:
For the year, the Fund posted a market value decline of 16.3%. To add insult to injury, the large cap U.S. stock market indices posted substantial gains over the same period. In a year characterized by extreme divergence in a number of markets and asset classes, market indices of small cap stocks posted material declines.
This was actually the first down year in Baupost’s history and looked even worse in light of the S&P’s 29% return. It proves that it doesn’t matter how smart we are or how safe our investment strategy is perceived to be. Eventually, there will be down years. The law of mean reversion is inescapable.
As such, it is important to reflect on and learn from our mistakes. This isn’t easy. Humans aren’t like dogs, who when punished for an action tend to reduce that action. Instead, we rationalize away the parts of reality that conflict with our worldview and seek out evidence to reinforce that rationalization. In other words, we suffer from cognitive dissonance and confirmation bias.
Great investors understand these biases and seek to reduce them. They spend a disproportionate amount of time analyzing their mistakes and creating processes to minimize them in the future. Klarman understands this and spends the next section going over the mistakes of the year.
Reasons for loss
First, it is clear that we took on too much emerging market exposure in 1998. While we were able to identify many outstanding bargains in this area, emerging markets involve both political risk and macroeconomic risk, and have a potentially high degree of correlation with one another. These risks make emerging market investments difficult to hedge. We were simply overexposed to emerging markets this year.
It is important to remember that in times of panic, the correlation of everything goes to 1. Klarman began the year with a well-diversified portfolio of undervalued securities in multiple emerging markets. Then the Asian financial crisis hit. Then the Russian ruble crisis hit. It didn’t matter if his holding were in Eastern Europe or South America, everything sold off.
Second, we had too much of our money in equities and too little cash during the year. Given our recurrent fear of a severe market correction and spreading economic weakness, this required us to maintain expensive and imperfect hedges. A substantial portion of our equity exposure was in small cap stocks (this is where the bargains were), and our results suffered when that part of the market became considerably more illiquid than usual.
The decision to hold cash is a hard one. As value investors, we don’t try to time the market but instead look for undervalued securities in all cycles. The problem with this is that a general market selloff leads to indiscriminate selling. The baby (undervalued securities) get thrown out with the bathwater. To get around this market risk, investors should search for catalyst investments that are less correlated with the general market. When those can’t be found, cash is the best option. View it as a call option on future opportunity.
Third, while we do not believe we were wrong to attempt to hedge our market exposure (we have been doing this in various ways for years), the mismatch between our long positions (mostly small cap) and our hedges (mostly large cap) caused us to lose money on both. It makes logical sense to hedge inexpensive small cap stocks against very expensive large cap stocks. However, we might have been better served finding more closely correlated hedges which acknowledged both the continuing trend toward indexation and the possibility that investor preference for a small number of very large cap growth stocks could continue for a protracted period.
By definition, a hedge should be inversely correlated with the position being hedged. It’s no secret that hedge funds rarely hedge in these terms. Instead, they make directional bets on the market and pay lip service to downside protection.
In much the same way, Klarman admits that his hedges were more a bet on overpriced securities falling, than actual hedges on what he owned. Going forward he put forth a plan to reduce these errors:
The combination of greater undervaluation, catalysts, potentially higher cash balances, and hopefully better aligned hedges should result in much improved performance.
This brief except on indexing rhymes a bit with the current boom in passive investing that we are experiencing today:
Part of the reason for the return to a nifty-fifty era has been the increasing use of indexing by large institutional investors … This has fueled more and more money going into the largest stocks, which have continued to surge while other parts of the market have slumped. While we sympathize with the difficulty the largest institutional investors face in achieving superior results, we believe the concentration of funds in a handful of stocks is in the process of creating a staggering opportunity amidst the neglected (or even totally ignored) thousands of smaller stocks.
We intend to be well prepared for the period when big cap stocks return to earth and small cap stocks are offered at almost any price to anyone able to supply fresh capital to the sector.
People often talk about the death of active investing, but ignore the inverse relationship between active and passive strategies. As the market becomes more passive, more inefficiencies are created for active investors to exploit. As the market becomes more active, more efficiencies are created for passive investors to exploit. The real question is at what margin does the balance shift.
It wasn’t easy being risk averse during one of the biggest bubbles in market history and Klarman’s down year gave him the wounds to prove it. In hindsight, Klarman made the mistake of overweighting volatile emerging markets, underweighting cash, and using imperfect hedges.