Investment Theory #22: Klarman’s 2000 Letter

Let’s continue our series on the 1990’s. You may recall that 2000 was the year the bubble popped and Klarman began putting his large cash balances to work.

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, 1999

Historical context

In 2000, the S&P 500 returned -9.10%.

In January, America Online agreed to purchase Time Warner for $162 billion. In March, The NASDAQ reached an all-time high of 5,048, ending a bull market run that lasted over 17 years. In April, Microsoft was ruled to have violated United States antitrust laws. In May, computer pioneer Datapoint filed for bankruptcy. In June, the preliminary draft of genomes by the Human Genome Project was completed. In July, a Concorde aircraft crashed into a hotel in Gonesse. In September, Apple introduced the first public beta of Mac OS X. In October, the first resident crew arrived at the International Space Station. In November, Iraq rejected U.N. Security Council weapons inspections. In December, the U.S. Supreme Court stopped the Florida presidential recount, giving the Presidency to George W. Bush.

Midyear Update

In mid-2000, it was becoming apparent that the Dotcom bubble was over. The ride from bottom to top left many professional investors out of a job – some for missing the ride up and some for getting hit on the ride down. For his part, Klarman spent most of the bubble just avoiding U.S. markets. This seemed like a winning strategy until he got caught up in the Russian Ruble Crisis. After that event, his strategy shifted towards holding larger cash balances and hedging his modest exposure. He spends the midyear letter talking about what he looks for when putting that cash back to work:

Because investing is a highly competitive activity, we consider for each of our investments not only whether a security is undervalued but why it is undervalued. If the reason is that there are uninformed or emotional sellers, we become more comfortable. Conversely, we do not want to ever be in the situation of having less information than the party selling to us. In effect, we seek an edge in all of our investments, a reason to believe we will have the wind at our backs, not in our faces, as we seek good investment returns over time with limited risk. Situations analytically complex, or where there are forced, mechanical or panicked sellers, nicely fit this criterion.

It is often said that there are only three competitive advantages in investing: behavioral, analytical, and informational. Can we emotionally divorce ourselves from the manic fits of Mr. Market (Value investing)? Are we better at analyzing public data than other parties (Quants)? Or do we just have access to data that other parties don’t (HFTs)? As with any business, it is important to understand where our advantages come from in order to reinforce and defend them. Klarman’s advantage was both emotional and analytical.

Performance in 2000

As always, Klarman opens the full year letter with a discussion of performance:

We are pleased to report a gain of 22.4% for the fiscal year ended October 31, 2000. This result was achieved amidst a challenging and unusually turbulent market environment.

Clearly, the Internet bubble has burst. Nearly all publicly traded Internet stocks have come up snake-eyes, and there is considerable doubt about whether there is or ever was a “new economy.” No longer can you add “dot com” to a word, sell shares to the public, and join the Forbes 400. No longer can entrepreneurs count on investors to fund enormous and protracted operating losses.

As far as WallStreet was concerned, the internet had been a lie and it was time to face reality. Of course, WallStreet was culpable for pushing that lie in the first place. Marc Andreeson likes to point out that all the crazy ideas of the dot-com bubble – internet clothing/groceries/music/banking/video/etc – eventually worked out, just not as fast enough for WallStreet’s expectations.

This is a reoccurring pattern with new technology: invention > hype > boom > can’t match hype > bust > renaissance. It happened with railroads, cars, planes, radio, tv, the internet, bitcoin, etc. The lesson is that an idea can be both right from a business perspective and wrong from an investment perspective. The business plan determines the former, the price paid determines the latter.

This too shall pass

In his magnum opus, the General Theory, Keynes described the market as a beauty contest where investors are trying to pick the stock most other investors will find beautiful, rather than the stock they find beautiful. Klarman talks a bit about this heard mentality:

I sometimes joke about the new market valuation rules of thumb: stocks that fail to meet earnings expectations all seem to trade at 10 times reduced earnings, while formerly profitable companies that report losses all seem to trade at five dollars per share. Many investors avoid these stocks precisely because others are staying away. Why would those kind of stocks ever go up, they wonder. Even those of us with value investing in our DNA generally prefer situations with catalysts for the realization of underlying value.

Over time, this will change. At some unknowable future point, the undervaluation of small capitalization stocks lacking exciting growth characteristics will become so gaping that investors will once again be attracted. The point of investing, after all, is not to have a great story to tell; the point of investing is to make money with limited risk. At some point, investors will drop their Pulitzer prize winning story stocks and revisit their attention on the old classics, stocks that make you money because their undervaluation creates a compelling imbalance between risk and return.

There’s that saying that what the smart do in the beginning, the foolish do in the end. The crowd will always move towards what has worked in the past, and the profit motive will always encourage contrarians to move towards what will work in the future. Though the crowd usually has more wind to its back, this competing force will eventually correct any excess.

Value Investing

As with most years, Klarman takes some time to discuss the philosophy of value investing:

Investors who look to Mr. Market for advice will inevitably do the wrong thing at the wrong time. Investors who attempt to profit from Mr. Market’s manic depressive nature will be successful over the long run.

In our view, investors should, more than ever, act on the assumption that any stock or bond can trade, for a time, at any price. Margin debt (which we do not utilize) should be considered extremely dangerous; investors should never enable Mr. Market’s mood swings to result in a margin call which could necessitate forced selling.

One of the most important lessons in investing is that systems that are overly optimized tend to blow up. In other words, there is no single strategy that always wins. Just look at Long Term Capital Management. The quant firms that have survived adjust and adapt their models constantly. To be successful in investing we want to have coarse and redundant strategies. The idea of a margin of safety is one such example that has survived the test of time.

My favorite example of this concept is Richard Bookstaber’s story of the cockroach: “The cockroach has survived through many unforeseeable (at least for it) changes: jungles turning to deserts, flatland giving way to urban habitat, predators of all types coming and going over the course of three hundred million years. This unloved critter owes its record of survival to a singularly basic and seemingly suboptimal mechanism: the cockroach simply scurries away when little hairs on its legs vibrate from puffs of air, puffs that might signal an approaching predator, like you. That is all it does. It doesn’t hear, it doesn’t see, it doesn’t smell.”

Rather than thinking we can beat unpredictability, we should instead focus on building systems that can handle unpredictability. Avoiding leverage, as Klarman pointed out, is one such system.

Conclusion

It is easy to say be greedy when others are fearful, but that requires having available capital in the first place. More often, investors are fully invested or even leveraged when the panic hits. They are forced to be sellers when they know they should be buyers. Thus, the more important part of that saying and the harder emotionally is to be fearful when others are greedy. It requires us to go against the crowd and ignore the fear of missing out on a party. In 2000, that strategy finally paid off for Seth Klarman.

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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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