Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.
Mandate, Trackrecord, Expected Return
For the past several years, Klarman had invested heavily into Baupost’s international efforts/infrastructure because he believed that opportunities in the U.S. marketplace were less attractive than those found abroad, due to increased competition and higher market valuations.
Did Baupost’s flexible investment mandate give it an advantage in trackrecord creation and return generation?
For example, a healthcare fund cannot start investing in utilities because the latter provides better risk-reward, whereas Baupost can invest wherever risk-reward is most attractive.
The trackrecord creation and return generation possibilities for those with more restrictive mandates are bound by the opportunities available within the mandate scope. Baupost, on the other hand, has the freedom to roam to wherever pastures are greenest.
Cash, Expected Return, Risk Free Rate
In the category of largest gains, there was a $2.2MM gain for “Yield on Cash and Cash Equivalents” which at the end of Fiscal Year 1997 (October 31, 1997) consisted of $39MM or 25.5% of NAV.
In 1997, cash earned 5-6% ($2.2MM divided by $39MM) annually, in drastic contrast to virtually nothing today. I point this out as a reminder that historically, and perhaps one day in the future, cash does not always yield zero. In fact, cash interest rates are often highest during bull markets when it’s most prudent to keep a higher cash balance as asset values increase.
For those who fear the performance drag from portfolio cash balances, or those who feel the pressure to “chase” yield in order to boost portfolio returns, this serves as a reminder that cash returns are not static throughout the course of a market cycle.
At 10/31/97, value of “Market Hedges” was $2.0MM, or 1.4% of NAV. Hedges were also the source of his second largest loss that year, declining $2.1MM in value.
That’s a whole lot of premium bleed worth $2.0MM or ~1.5% of NAV! Interestingly, this is almost the exact gain from portfolio cash yields (see above). Coincidence?
If you believe that the phenomenon of the last 20 years will continue to hold – that interest rates will increase as the underlying economy recovers and equity markets move higher, then one can roughly use interest rates (and consequently portfolio cash yields) as a proxy to determine how much hedging premium to spend.
Theoretically, this should be a self-rebalancing process: higher cash yields in bull equity markets = more hedging premium to spend (when you need it most) vs. lower cash yields in bear equity markets = less hedging premium to spend (when you need it least).
Cash, Opportunity Cost
Klarman comments that cash provides protection in turbulent times and ammunition to take advantage of newly created opportunities, but the act of holding cash involves considerable opportunity cost in the form of foregoing attractive investments in the interim – but investors must keep in mind they cannot earn investment returns without actually investing.
After a temporary hiccup in the markets, Klarman discusses portfolio repositioning: adding to some positions while reducing or deleting others, to take advantage of the shifts in the market landscape.
It’s a delicate balance determining when to deploy capital, and when to hold it in the form of cash. You can’t run an investment management business holding cash forever – that would make you a checking account with extremely high fees.
The second point serves as an excellent reminder that the “opportunity cost” calculation involves not only the comparison between cash and a potential investment, but also between a potential investment and current portfolio holdings.
Klarman held a wide variety of options and swaps in his portfolio, such as SK Telecom equity & swaps, Kookmin Bank equity and swaps, etc.
In Klarman’s writings, you’ll generally find warnings against using leverage, and equity swaps definitely constitute leverage. I wonder if the derivative swaps were a product of his interest in emerging markets. For example, perhaps Baupost was not able to trade directly in certain markets, and therefore utilized swaps to gain exposure through a counterparty authorized to trade in those countries.
When To Buy
In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts.
In extreme market downside events, patterns & trends in liquidity, trading volume, sales growth, etc. – that may have existed for years – disintegrate. Therefore, investors who rely on those patterns and trends become disoriented, which then fuels and reinforces more market chaos. This is what we witnessed in 2008-2009, and the time for fundamental investors, and those with intuition and foresight, to shine.
Capital Preservation, Compounding,
Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains.
Toward the end of the December 1997 letter, Klarman praises his team of analysts and traders who, like himself, hate to lose money, even temporarily, for any reason at any time.
So let it be written! Klarman acknowledges that he doesn’t like to lose money, even temporarily in the form of volatility.