Investment Theory #21: Klarman’s 1999 Letter

I’ve been awol while studying for the CFA. With level 3 hopefully behind me, I’m going to get back into the habit of writing. Let’s jump back into our series on the 1990’s with Seth Klarman’s letters as our guide to the period.

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.

This series of posts will reflect on Klarman’s activity during the period 1995 to 2001. Links to past posts: 1995, 1996, 1997, 1998

Historical context

In 1999, the S&P 500 returned 21.04%.

In January, the euro was established. In February, Bill Clinton was acquitted in impeachment proceedings. In March, Enron energy traders routed 2,900 megawatts of electricity destined for California to a small Nevada town with population 200. In April, NATO continued air strikes against the Federal Republic of Yugoslavia – the first time NATO attacked a sovereign country. In May, the Dow Jones Industrial Average closed above 11,000 for the first time. In June, Napster debuted. In July, the first version of MSN messenger was released. In August, the second Chechen war began. In September, Viacom and CBS merged. In October, the last Russian military soldiers withdrew from the Baltic states – ending a presence that lasted since 1940. In November, ExxonMobil completed its merger and formed the largest corporation in the world. In December, Boris Yeltsin resigned as President of Russia – leaving Vladimir Putin as the acting President.

Midyear update

At the midpoint of 1999, the market continued to roar upward, but not without some interest rate hike jitters. Klarman, feeling no desire to climb aboard the rocket ship, positioned himself accordingly — 42% cash, 25% special situations, 32% deeply undervalued hedged securities. He noted:

The broad market indices remain extremely expensive and have, despite a brief retreat by some of the highest multiple stocks, charged ahead to repeated record highs.

The U.S. economy remains robust (for now), and long-term U.S. Treasury bond yields have climbed to over 6.0 % from 5.1% at the end of January. Most asset allocation models contrast bond yields to stock price-earnings multiples. At 6.0% bond yields, the S&P 500 Index is calculated by these models to be more than 30% overvalued. It would be far more overvalued were earnings to fall or interest rates to rise from current levels.

Academics tell us that three things matter when valuing an asset — the cash flows, the timing of those flows, and the discount/interest rate. I’d add a fourth factor that includes the special feeling customers get when thinking about a Tesla or their favorite soft drink, but I digress, and the academics would just argue that is incorporated in the discount rate anyway.

Here, Klarman is pointing out that third and probably most important factor – interest rates. In 1999, the S&P 500 P/E got up to about 30, or in other words, for every 1 dollar paid, you could expect 3.3% (1/30) in earnings yield. Compare this to the 6% “risk free” return offered in bonds and you can start to see the issue (6 > 3).

Recently, Warren Buffett talked about the same issue during his 2017 annual meeting saying, “Everything in valuation gets back to interest rates … The most important thing is future interest rates and people frequently plug-in the current interest rate saying that’s the best they can do.” In 1999, Klarman noted things were bad and could get worse depending on what interest rates did in the near future. With the Fed signaling interest rate hikes, this wasn’t that far a leap.

Today’s S&P P/E of 25 implies an earnings yield of 4% compared to the 30 year bond yield of 2.8%. Assuming interest rates don’t jump tomorrow, the market isn’t overvalued based on this metric. That’s not to say there is any one silver bullet metric that tells you if the market is overpriced or not, but rather to contrast today’s market with the late 1990s. Though we are facing similar rate hikes, inflation appears contained for now. Klarman continues:

The $200 billion market capitalization of America Online recently exceeded that of IBM. Charles Schwab was recently valued 50% more highly than Merrill Lynch. Priceline, the Internet company that sells airline tickets, was valued more highly than the three largest airlines, combined! eToys came public and immediately jumped to a valuation well above that of the well established Toys “R” Us.

Recent exuberance notwithstanding, at today’s valuations it is clear that Wall Street is certain to continue issuing shares of new Internet companies until the supply of shares overwhelms the resources of the buyers.

The first point here reminds me of the news that Telsa recently overtook the market cap of Ford (enterprise value not so much). The “new and growing premium” is real and can pay off like Amazon, but we would do well to not forget survivorship bias. For every Amazon, there are hundreds of pets.com.

That second point is also interesting, when there is demand for something, supply will increase to satisfy it and often overshoot. Consider the raise in popularity of Bitcoin and the advent of ICOs (initial coin offerings) which have led to no shortage of scams and bagholders. If someone will pay for it, someone will sell it. Klarman continues on to what I think the biggest issue with hype companies is, competition:

While most of these companies are growing rapidly and possess extraordinary technology, these businesses remain highly competitive. Very low costs of capital and high returns attract enormous competition, and companies have to innovate faster and faster to stay ahead of the pack. Product life cycles are shorter and shorter, and unit prices continue to decline. We understand that the technology content of these companies is fabulous. Whether they are good businesses, deserving of astronomical multiples of current earnings, is an entirely different matter.

Competition is the great Darwinian filter of business. Of the hundreds of car companies at the turn of the 20 century, there are now maybe 7 with more than 5% market share. Of the brilliant ideas today (ride sharing, blockchains, AI, etc), the barriers to entry are almost non-existent. A kid with a computer and internet connection can use Amazon Web Services and put up a fight. As Uber and Lyft compete for riders, often the ride is free for the consumer because of discounts and promotions. Where there are falling prices, there is almost always fierce competition and poor future returns. As customers and not investors, we should applaud this.

Performance in 1999

For the full year, Klarman managed to edge out a modest return of 8.29% – far short of the 21.04% return of the market. Klarman reflected on his strategy:

Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today’s financial climate. Our answer, as you might guess, is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.

Basically, you can go with the flow and be right and make some money, go with the flow and be wrong and lose a lot of money, go against the flow and be wrong and lose some money while looking dumb, or go against the flow and be right and make a lot of money.

Being right in the stock market doesn’t mean much when everyone else is also right. If a company is priced as though it will make X amount of money, and you also think the company will make X amount of money, there is no inefficiency to capitalize on. However, if  the company is priced like it will make X amount of money and double that every year from now until the end of time, and you think the company will go bankrupt instead, if you are right there is a fortune to be made. Being a contrarian is hard but profitable.

Mean Reversion in Investing

Klarman goes on to discuss mean reversion:

Historically, out-of-favor investments have typically performed best in the periods immediately following their underperformance, while those that have done well almost always follow their success by lagging badly. Human nature makes it unlikely for most investors to benefit from these predictive factors; the memory of most investors only incorporates what recently has been successful.

Mean reversion is tricky when it comes to investing. Part of the idea is that money will flow to ideas that are working, causing them to appreciate in value beyond intrinsic value, while the ideas that are left behind depreciate in value. Eventually this goes to far and inverts. It is the cornerstone of value investing.

The problem arises when we assume that the mean is stagnant. In reality, the fortunes of businesses are volatile. There is nothing stopping a business that averaged consistent returns for decades from going out of business tomorrow (see Kodak). This is where the idea of value traps come into play. Investing isn’t suppose to be easy and while reversion to the mean is useful for the macro scale, it can wipe us out at the micro scale.

Accounting Shenanigans

Klarman takes some time to discuss accounting:

Investors are particularly enamored with companies which are able to post long records of unflagging earnings growth. Companies which do so achieve very high stock prices which, in turn, generously reward stock-option-laden management teams.

Since businesses simply are not as steady or consistent as Wall Street number crunchers demand, there is enormous pressure on managements to smooth their results and pull the occasional rabbit out of a hat to deliver the desired quarterly outcomes

Remember that this was written 2 years before the eventual bankruptcy of Enron for exactly these reasons. Accounting is the best tool we have for recording the economic value of a business, but it is still just a crude approximation. As Charlie Munger has said, “It’s not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn’t make it anything you really know.” When we add management incentives to the subjective nature of accounting, bad stuff can happen.

Spin-off Investments

Klarman talks a bit about his defensive Spin-off investments:

Currently, a number of spinoffs are truly orphaned securities trading at giveaway prices. For example, we have recently purchased shares of both of the recently separated subsidiaries of Tenneco, Inc. … Due to indiscriminate post-spinoff selling pressure, the shares have slumped to around 10 times currently depressed after-tax earnings and about 5.5 times pretax cash flow.

We are also buying shares of the Tenneco Automotive spinoff … It’s shares have been particularly brutalized as a result of its deletion from the S&P 500 Index … In effect, there is now a class of shareholders who must sell a stock simply because it trades at a depressed market valuation.

As investors we never want to be forced sellers, but we have no issue with buying from those who are. Whether it is the firesale that results from margin calls during a crisis, or the selling of recently removed securities from an index, there is often a profit to be made in providing liquidity to those who need it.

Thrift Conversions

We have recently become more active investors in thrift conversions. Thrifts at one time had a large dedicated community of investors, but after a period of overvaluation and poor stock performance, this is no longer true. While there are generally no short-term catalysts for value realization in this area, stock repurchases are accretive to shareholder value and industry consolidation seems likely to continue at a healthy pace. In short, the opportunity to buy significantly overcapitalized, conservatively managed thrifts between 50% and 75% of book value and at reasonable earnings multiples offer a low-risk investment with significant return potential.

Think of a thrift as a sort of credit union that specializes in real estate. Where a commercial bank is owned by shareholders and has the goal of earning a profit, a thrift is technically owned by its depositors and has the mandate of providing real estate loans to its members.

A thrift conversion can be thought of as going from a thrift to a commercial bank by means of an initial public offering (though this is a simplification). For example, a thrift with $1 million in net worth could offer one million shares at $1 each. The magic occurs when we realize what happens to those funds raised in the IPO, they get added back into the thrifts net worth. So the $1 million thrift just raised another $1 million in the IPO, bringing its new net worth to $2 million. We just bought the conversion for 50% of book value. The alchemy of finance.

Undervalued securities

Klarman moves on to his bread and butter, undervalued securities:

We own shares in Stewart Enterprises, a funeral home and cemetery company which currently trades at approximately six times after-tax earnings per share. The death care industry has come under pressure as a result of overpriced acquisitions, excessive levels of debt, a recent, temporary decline in the death rate, and increased competition in some regional markets. All of the public companies in this industry are trading at extremely depressed levels. Stewart has some of the best properties in the industry; the company has recently repurchased its stock around current levels, and insiders have added to their holdings. A new management team is expected to reorient the company to maximize free cash flow generation.

This is a reoccurring theme in history. An industry becomes exuberant from its recent success, overpriced debt fueled acquisitions occur, unit prices fall, everyone panics. Recently, we can point to dry shipping, shale-gas, met coal, housing, etc. In every case, every company in the sector is indiscriminately punished – the baby thrown out with the bathwater effect. Sometimes this is the right thinking, but most of the time there is money to be made in differentiating between the companies that will survive the downturn and the companies that wont. Klarman then talks about another investment:

Ucar is the world’s leading manufacturer of graphite electrodes which are used in steel production. The company came under a cloud a few years ago when the industry admitted to price-fixing. Results were then adversely affected by the Asian crisis last year.

This reminds me of all the recent news based company drops that reversed after a modest period of time. After the BP oil spill the stock crashed to $20 then rebounded to $30 a couple of months later. A similar sell-off and bounce occurred with Volkswagen after their emission scandal broke. Most recently was the drop and pop of United after a viral video showed mistreatment of a passenger.

This isn’t to say that every negative news story can be ignored. Just look at Valeant Pharmaceuticals.

Conclusion

Everyone is partying like it is 1999 but Seth Klarman is holding 50% in cash and patiently waiting for the party to end. Elsewhere, FOMO is causing much of the public to jump into the market at the top. A mistake that most haven’t forgotten to this day.

 

 

 

 

 

 

 

 

 

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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