Here is the first installment of a 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 for this series.
When To Buy, Risk
In a previous article on The Pensioner in Steve Drobny’s book Invisible Hands, we discussed how most people analyze risk as an afterthought once a portfolio has been constructed (whether by identifying factors, or by analyzing the resulting return stream), and not usually as an input at the beginning of the portfolio construction process.
Klarman’s discusses how risk can slip into the portfolio through the buying process, for example, when investors purchase securities too soon and that security continues to decline in price.
This would support the idea of controlling risk at the start, not just the end. To take this notion further, if risk can sneak in through the buying process, can it also do so during the diligence process, the fundraising process (certain types of client, firm liquidity risk), etc.?
Benchmark, Conservatism, Clients
Baupost is focused on absolute, not relative performance against the S&P 500.
Similar to what Buffett says about conservatism, Klarman believes that the true test for investors occurs during severe down markets. Unfortunately, the cost of this conservatism necessary to avoid losses during these difficult times is underperformance during market rallies.
Klarman also deftly sets the ground rules and client expectations, such that if they did not agree with his philosophy of conservatism and underperformance during bull markets, they were more than welcomed to take their money and put it with index funds.
We’ve discussed in the past the concept of selectivity– a mental process that occurs within the mind of each investor, and that our selectivity criteria could creep in either direction (more strict or lax) with market movements.
Klarman is known for his comfort with holding cash when he cannot find good enough ideas. This would imply that his level of selectivity does not shift much with market movements.
The question then follows: how does one ensure that selectivity stays constant? This is easily said in theory, but actual implementation is far more difficult, especially when one is working with a large team.
Catalyst, Volatility, Special Situations
Following in the tradition of Max Heine and Michael Price, Klarman invested in special situations / catalyst driven positions, such as bankruptcies, liquidations, restructurings, tender offers, spinoffs, etc.
He recognized the impact of these securities on portfolio volatility, both the good (cushioning portfolio returns during market declines by decoupling portfolio returns from overall market direction) and the bad (relative underperformance in bull markets).
Many people made money hedging in 2008. In the true spirit of performance chasing, hedging remains ever popular today, 4 years removed from the heart of financial crisis.
Hopefully, our Readers have read our previous article on hedging, and the warnings from other well-known investors (such as AQR and GMO) to approach with caution. I believe that hedging holds an important place in the portfolio management process, but investors should hold no illusion that hedging is ever profitable.
For example, even the great Seth Klarman has lost money on portfolio hedges. However, he continues to hedges with out-of-the-money put options to protect himself from market declines.
The moral of the story: be sure to carefully consider the purpose of hedges and the eventual implementation process, especially in the context of the entire portfolio as a whole.