Baupost Letters: 2000-2001

This concludes 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 those of you wishing to read the actual letters, they are available on the internet. We are not posting them here because we don’t want to tango with the Baupost legal machine.

Volatility, Psychology

Even giants are not immune to volatility. Klarman relays the story of how Julian Robertson’s Tiger Fund closed its doors largely as a result of losses attributed to its tech positions. As consolation, Klarman offers some advice on dealing with market volatility: investors should act on the assumption that any stock or bond can trade, for a time, at any price, and never enable Mr. Market’s mood swings to lead to forced selling. Since it is impossible to predict the timing, direction and degree of price swings, investors would do well to always brace themselves for mark to market losses.

Does mentally preparing for bad outcomes help investors “do the right thing” when bad outcomes occur? 

When To Buy, When To Sell, Selectivity

Klarman outlines a few criteria that must be met in order for undervalued stocks to be of interest to him:

• Undervaluation is substantial
• There’s a catalyst to assist in the realization of that value
• Business value is stable and growing, not eroding
• Management is able and properly incentivized

Have you reviewed your selectivity standards lately? How do they compare with three years ago? For more on this topic, see our previous article on selectivity. 

Psychology, When To Buy, When To Sell

Because investing is a highly competitive activity, Klarman writes that it is not enough to simply buy securities that one considers undervalued – one must seek the reason for why something is undervalued, and why the seller is willing to part with a security/asset at a “bargain” price.

Here’s the rub: since we are human and prone to psychological biases (such as confirmation bias), we can conjure up any number of explanations for why we believe something is undervalued and convince ourselves that we have located the reason for undervaluation. It takes a great degree of cognitive discipline & self awareness to recognize and concede when you are (or could be) the patsy, and to walk away from those situations.

Risk, Expected Return, Cash

Klarman’s risk management process was not after-the-fact, it was woven into the security selection and portfolio construction process.

He sought to reduce risk on a situation by situation basis via

• in-depth fundamental analysis
• strict assessment of risk versus return
• demand for margin of safety in each holding
• event-driven focus
• ongoing monitoring of positions to enable him to react to changing market conditions or fundamental developments
• appropriate diversification by asset class, geography and security type, market hedges & out of the money put options
• willingness to hold cash when there are no compelling opportunities.

Klarman also provides a nice explanation of why undervaluation is so crucial to successful investing, as it relates to risk & expected return: “…undervaluation creates a compelling imbalance between risk and return.”

Benchmark

The investment objective of this particular Baupost Fund was capital appreciation with income was a secondary goal. It sought to achieve its objective by profiting from market inefficiencies and focusing on generating good risk-adjusted investment results over time – not by keeping up with any particular market index or benchmark. Klarman writes, “The point of investing…is not to have a great story to tell; the point of investing is to make money with limited risk.”

Investors should consider their goal or objective for a variety of reasons. Warren Buffett in the early Partnership days dedicated a good portion of one letter to the “yardstick” discussion. Howard Marks has referenced the importance of having a goal because it provides “an idea of what’s enough.”

Cash, Turnover

Klarman presents his portfolio breakdown via “buckets” not individual securities. See our article on Klarman's 1999 letter for more on the importance of this nuance. 

The portfolio allocations changed drastically between April 1999 and April 2001. High turnover is not something that we generally associate with value-oriented or fundamental investors. In fact, turnover has quite a negative connotation. But is turnover truly such a bad thing?

Munger once said that “a majority of life’s errors are caused by forgetting what one is really trying to do.”

Yes, turnover can lead to higher transaction fees and realized tax consequences. On taxes, we defer to Buffett’s wonderfully crafted treatise on his investment tax philosophy from 1964, while the onset of electronic trading has significantly decreased transaction fees (specifically for equities) in recent days.

Which leads us back to our original question: is portfolio turnover truly such a bad thing? We don’t believe so. Turnover is merely the consequence of portfolio movements triggered by any number of reasons, good (such as correcting an investment mistake, or noticing a better opportunity elsewhere) and bad (purposeful churn of the portfolio without reason). We should judge the reason for turnover, not the act of turnover itself.

Hedging, Expected Return

The Fund’s returns in one period were reduced by hedging costs of approximately 2.4%. A portfolio’s expected return is equal to the % sizing weighted average expected return of the sum of its parts (holdings or allocations). Something to keep in mind as you incur the often negative carry cost of hedging, especially in today’s low rate environment.

Baupost Letters: 1999

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.

Sizing, Catalyst, Expected Return, Hurdle Rate, Cash, Hedging, Correlation, Diversification

In the 1999 letter, Klarman breaks down the portfolio, which consists of the following components:

1. Cash (~42% of NAV) – dry powder, available to take advantage of bargains if/when available
2. Public & Private Investments (~25% of NAV) – investments with strong catalysts for partial or complete realization of underlying value (bankruptcies, restructurings, liquidations, breakups, asset sales, etc.), purchased with expected return of 15-20%+, likelihood of success dependent upon outcome of each situation and less on the general stock market movement. This category is generally uncorrelated with markets.
3. Deeply Undervalued Securities – investments with no strong catalyst for value realization, purchased at discounts of 30-50% or more below estimated asset value. “No strong catalyst” doesn’t mean “no catalyst.” Many of the investments in this category had ongoing share repurchase programs and/or insider buying, but these only offered modest protection from market volatility. Therefore this category is generally correlated with markets.
4. Hedges (~1% NAV)

Often, investments are moved between category 2 and 3, as catalyst(s) emerge or disappear.

This portfolio construction approach is similar to Buffett’s approach during the Partnership days (see our 1961 Part 3 article for portfolio construction parallels). Perhaps Klarman drew inspiration from the classic Buffett letters. Or perhaps Klarman arrived at this approach independently because the “bucket” method to portfolio construction is quite logical, allowing the portfolio manager to breakdown the attributes (volatility, correlation, catalysts, underlying risks, etc.) and return contribution of each bucket to the overall portfolio.

Klarman also writes that few positions in the portfolio exceed 5% of NAV in the “recent” years around 1999. This may imply that the portfolio is relatively diversified, but does lower sizing as % of NAV truly equate to diversification? (Regular readers know from previous articles that correlation significantly impacts the level of portfolio diversification vs. concentration of a portfolio.) One could make the case that the portfolio buckets outlined above are another form of sizing – a slight twist on the usual sizing of individual ideas and securities – because the investments in each bucket may contain correlated underlying characteristics. 

Duration, Catalyst

Klarman reminds his investors that stocks are perpetuities, and have no maturity dates. However, by investing in stocks with catalysts, he creates some degree of duration in a portfolio that would otherwise have infinite duration. In other words, catalysts change the duration of equity portfolios.

Momentum

Vicious Cycle = protracted underperformance causes disappointed holder to sell, which in turn produces illiquidity and price declines, prompting greater underperformance triggering a  new wave of selling. This was true for small-cap fund managers and their holdings during 1999 as small-cap underperformed, experienced outflows, which triggered more selling and consequent underperformance. The virtuous cycle is the exact opposite of this phenomenon, where capital flows into strongly performing names & sectors.

Klarman’s commentary indirectly hints at the hypothesis that momentum is a by-product of investors’ psychological tendency to chase performance.

Risk, Psychology

Klarman writes that financial markets have been so good for so long that fear of market risk has completely evaporated, and the risk tolerance of average investors has greatly increased. People who used to invest in CDs now hold a portfolio of growth stocks. The explanation of this phenomenon lies in human nature’s inability to comprehend that we may not know everything, and an unwillingness to believe that everything can change on a dime.

This dovetails nicely with Howard Mark’s notion of the ‘perversity of risk’:

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

When To Buy, Psychology

Klarman writes that one should never be “blindly contrarian” and simply buy whatever is out of favor believing it will be restored because often investments are disfavored for good reason. It is also important to gauge the psychology of other investors – e.g., how far along is the current trend, what are the forces driving it, how much further does it have to go? Being early is synonymous to being wrong. Contrarian investors should develop an understanding of the psychology of sellers. Sourcing

When sourcing ideas, Baupost employs no rigid formulas because Klarman believes that flexibility improves one’s prospectus for returns with limited risk.

Baupost Letters: 1998

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.

Hedging, Opportunity Cost, Correlation

Mid-fiscal year through 4/30/98, Klarman substantially increased exposure to disaster insurance (mainly out of the money U.S. equity put options + hedges against rising interest rates and currency fluctuations) because of his fear of a severe market correction and economic weakness. To maintain these hedges, Klarman stated he was willing to give up a portion of portfolio upside in return for protection against downside exposure. For fiscal year ended 10/31/98, these hedges accounted for a -2.8% performance drag.

The performance drag and mistake occurred as a result of expensive & imperfect hedges:

• cheapest areas of the market (small-cap) became cheaper (Baupost’s portfolio long positions were mainly small cap)
• most expensive areas of the market (large-cap) went to the moon (Baupost’s portfolio hedges were mostly large cap)

In assessing the performance results, Klarman stated that he did not believe he was wrong to hedge market exposures, his mistake was to use imperfect hedges, which resulted in him losing money on both his long positions and his hedges at the same time. Going forward, he would be searching for more closely correlated hedges.

In many instances, hedging is a return detractor. The trick is determining how much return you are willing to forego (premium spent and opportunity cost of that capital) in order to maintain the hedge, and how well that hedge will actually protect (or provide uncorrelated performance) when you expect it to work.

The only thing worse than foregoing return via premium spent and opportunity cost, is finding out in times of need that your hedges don’t work due to incorrect anticipation of correlation between your hedges and the exposure you are trying to hedge. That’s exactly what happened to Baupost in 1998.

Catalyst, Volatility, Expected Return, Duration

Attempting to reduce Baupost’s dependence on the equity market for future results, and the impact of equity market movement on Baupost’s results, Klarman discusses the increase of catalyst/event-driven positions (liquidations, reorganizations) within the portfolio, which are usually less dependent on the vicissitudes of the stock market for return realization.

Catalysts are a way to control volatility and better predict the expected return of portfolio holdings. Catalysts also create duration for the equity investor, such that once the catalyst occurs and returns are achieved, investors generally must find another place to redeploy the capital (or sit in cash).

Cash

Klarman called cash balances in rising markets “cement overshoes.” At mid-year 4/30/98, Baupost held ~17% of the portfolio in cash because Klarman remained confident that cash becomes more valuable as fewer and fewer investors choose to hold cash. By mid-December 1998, Baupost’s cash balance swelled to ~35% of NAV.

Risk, Opportunity Cost, Clients, Benchmark

In the face a strong bull market, Klarman cites the phenomenon of formerly risk-averse fund managers adopting the Massachusetts State Lottery slogan (“You gotta play to win”) for their investment guidelines because the biggest risk is now client firing the manager, instead of potential loss of capital.

Klarman observes the psychological reason behind this behavior: “Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd…the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. 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.”

The moral of the story here: it’s not easy to stand alone against waves of public sentiment. For more on this, see Bob Rodriguez experience on the consequences of contrarian actions & behavior.

When the world is soaring, to hold large amounts of cash and spending performance units on hedges could lead to serious client-rebellion and business risk. I do not mean to imply that it’s wrong to hold cash or hedge the portfolio, merely that fund managers should be aware of possible consequences, and makes decisions accordingly.

Expected Return, Intrinsic Value

Klarman discusses how given today’s high equity market levels, future long-term returns will likely be disappointing because future returns have been accelerated into the present and recent past.

Future returns are a function of asset price vs. intrinsic value. The higher prices rise (even if you already own the asset), the lower future returns will be (assuming price is rising faster than asset intrinsic value growth). For a far more eloquent explanation, see Howard Mark’s discussion of this concept. 

Baupost Letters: 1997

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.

Hedging, Cash

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.

Derivatives, Leverage

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.

Volatility

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. 

Baupost Letters: 1996

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.

Risk, Sizing, Diversification, Psychology

In 1996, Baupost had a number of investments in the former Soviet Union. Klarman managed the higher level of risk of these investments by limiting position sizing such that if the total investment went to zero, it would not have a materially adverse impact on the future of the fund.

“Unfamiliarity” is a risk for any new investment. Klarman approaches new investments timidly to ensure that there isn’t anything that he’s missing. He does so by controlling sizing and sometimes diversifying across a number of securities within the same opportunity set.

Baupost mitigates risk (partially) by:

• Sizing slowly and diversifying with basket approach (at least initially)
• Balancing arrogance with humility. Always be aware of why an investment is available at a bargain price, and your opinion vs. the market. Investing is a zero-sum game, and each time you make a purchase, you’re effectively saying the seller is wrong.

Reading in between the lines, the Russian investments must have held incredibly high payoff potential (in order to justify the amount of time and effort spent on diligence). Smaller position sizing may decrease risk but it also decreases the potential return contribution to the overall portfolio.

Interestingly, this method of balancing risk and return through position sizing and diversification is more akin to venture capital than the traditional value school. For example, recently, investors have been buzzing about a number of Klarman’s biotech equity positions (found on his 13F filing). I’ve heard through the grapevine that these investments were structured like a venture portfolio – the expectation is that some may crash to zero, while some may return many multiples the original investment. Therefore, those copying Klarman’s purchases should proceed with caution, especially given Klarman’s history of making private investments not disclosed on 13F filings.

Diversification

Klarman believes in sufficient but not excessive diversification.

This may explain the rationale behind why Klarman has been known to purchase baskets of individual securities for the same underlying bet – see venture portfolio discussion above.

Correlation, Risk

Always cognizant of whether seemingly different investments are actually the same bet to avoid risk of concentrated exposures.

Mandate, Trackrecord

Baupost has a flexible investment mandate, to go anywhere across asset classes, capital structure, geographies, etc., which allows it to differentiate from the investment fund masses. Opportunities in different markets happen at different times, key is to remain adaptive and ready for opportunity sets when they become available.

The flexible mandate is helpful in smoothing the return stream of the portfolio, and consequently, the trackrecord. Baupost can deploy capital to where opportunities are available in the marketplace, therefore ensuring a (theoretically) steadier stream of future return potential. This is in contrast to funds that cannot take advantage of opportunities outside of their limited mandate zones.

Liquidity

Klarman is willing to accept illiquidity for incremental return.

This makes total sense, but the tricky part is matching portfolio sources (client time horizon, level of patience, and fund redemption terms) with uses (liquidity profile of investments). Illiquidity should not be accept lightly, and has been known to cause problems for even the most savvy of investors (for example: see 2003 NYTimes article on how illiquidity almost destroyed Bill Ackman & David Berkowitz in the early stages of their careers).

Patience

For international exposure [Russia], Baupost spent 7 years immersed in research, studying markets, meeting with managements, making toe-hold investments to observe, hired additional members of investment team (sent a few analysts to former Soviet Union, on the ground, for several months) to network & build foreign sell-side & counterparty relationships.

Selectivity, Cash

Buy securities if available at attractive prices. Sell when securities no longer cheap. Go to cash when no opportunities are available.

We’ve discussed the concept of selectivity standards in the past, and whether these standards shift in different market environments. For Klarman, it would seem his selectivity standards remained absolute regardless of market environment.

Hedging

Baupost will always hedge against catastrophic or sustained downward movement in the market. This can be expensive over time, but will persist and remains part of investment strategy.

Klarman embedded hedging as an integrated “process” that’s part of the overall investment strategy. This way, Baupost is more likely to continue buying hedges even after years of premium bleed. This also avoids “giving up” just as disaster is about to hit. For more on this topic, be sure to check out the AQR tail risk hedging piece we showcased a few months ago.

Baupost Letters: 1995

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.

Selectivity, Cash

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).

Hedging

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.