Value of Not Being Sure Seth Klarman
Value of Not Being Sure Seth Klarman
Value of Not Being Sure Seth Klarman
Editors’ Note: With the possible excep- sale resulting from a margin call. Usually, has come to justify the lower market
tion of Warren Buffett, no investor plying fearful overreaction equals opportunity. prices. Many forced sellers, through their
the trade today commands more respect In today’s market, however, where early exits, inadvertently achieved better
than Baupost Group’s Seth Klarman. almost everything is down sharply, distin- outcomes than the value-oriented bargain
Since founding his investment partnership guishing legitimate reaction from emo- hunters who bought from them.
in 1983, Klarman has not only produced tional overreaction is much more diffi- Warren Buffett has said – and others
peerless returns, but he has also from time cult. This is because there is a vicious cir- have endlessly repeated – that you can’t
to time offered wise and timeless com- cle in effect (the reverse of the taken-for- tell who is swimming naked until after the
mentary on markets and the craft of granted virtuous circle that buoyed the tide goes out. This turns out to be only
investing. With his permission, we repro- markets and economy in good times). partially true. The tide has receded, and
duce here various excerpts from his latest This vicious circle results from the feed- most portfolios are down. But not all
annual letter, published late last month. back effects on the economy of lower declines are equal. Some investors have
securities and home prices and a severe lost money and locked in those losses by
Erratic Mr. Market credit contraction, and, in turn, effects of going to cash. Some have made invest-
It is easy for the volatility of one’s a plunging economy on credit availability ments in failed or failing banks, brokers,
thinking to match the volatility of prevail- and securities and home prices. and homebuilders, or toxic subprime
ing conditions. Time horizons have short- With residential and commercial real mortgage securities; these losses are large-
ened even more than usual, to the point estate prices collapsing and global stock ly permanent and irreversible. But the
where the market’s 4:00 p.m. close seems markets down 40%, 50%, and more this investment baby has been thrown out
to many like a long-term commitment. To year alone, tremendous damage has been with the bathwater, and some who invest-
maintain a truly long-term view, investors done to individual and institutional ed wisely aren’t naked, it just seems that
must be willing to experience significant wealth. Suddenly, new corporate, univer- way. Buying early on the way down looks
short-term losses; without the possibility sity, and hospital facilities are on hold, a great deal like being wrong, but it isn’t.
of near-term pain, there can be no long- and big ticket items like automobiles, It turns out you won’t be able to accurate-
term gain. The ability to remain an consumer electronics, and luxury goods ly tell who’s been swimming naked until
investor (and not become a day-trader or are going unsold. The worsening econo- after the tide comes back in.
a bystander) confers an almost unprece- my and rising unemployment portend a As Benjamin Graham and David Dodd
dented advantage in this environment. possibly protracted period of falling sales taught us, financial markets are manic and
The investor’s problem is that this per- volumes, with industry overcapacity lead- best thought of as an erratic counterparty
spective will seem a curse rather than a ing to pricing pressures, and thus sharply with whom to transact, rather than as an
blessing until the selloff ends and some lower earnings and cash flows. Consumer arbiter of the accuracy of one’s investment
semblance of stability is restored. spending declines could be more secular judgments. There are days when the mar-
The greatest challenge of investing in than cyclical; consumption patterns may ket will overpay for what you own, and
this environment is neither the punishing have changed in semi-permanent ways. other days when it will offer you securities
price declines nor the extraordinary Some of the lost demand simply may not at a great discount from underlying value.
volatility. Rather, it is the sharply declin- come back. Municipal governments face If you look to “Mr. Market” for advice, or
ing economy, which makes analysis of a severe crunch as tax receipts fall while if you imbue him with wisdom, you are
company fundamentals extremely diffi- entitlement spending rises. Ultimately, destined to fail. But if you look to Mr.
cult. When securities decline, it is crucial this vicious cycle will be broken and nei- Market for opportunity, if you attempt to
to distinguish, as possible causes, legiti- ther securities prices nor the economy will take advantage of the emotional extremes,
mate reaction to fundamental develop- go to zero, just as they did not go to infin- then you are very likely to succeed over
ments from extreme overreaction. At ity when the virtuous cycle was in place. time. If you see stocks as blips on a ticker
Baupost, we are always on the lookout for But throughout 2008, prudent investors tape, you will be led astray. But if you
such overreactions, whether due to the sifting through the rubble for opportuni- regard stocks as fractional interests in
disappointing earnings of a failed growth ty were repeatedly surprised by the mag- businesses, you will maintain proper per-
stock, a ratings downgrade of a bond, the nitude of the selling pressure, and, in spective. This necessary clarity of thought
deletion of a stock from an index or its many cases, by the extent to which the is particularly important in times of
delisting from an exchange, or the forced deterioration in business fundamentals extreme market fluctuations.
Age-Old Showdown their client base. Controlling your process their efforts and care, they may in fact be
There have been days recently where is absolutely crucial to long-term invest- wrong.
fear has completely dominated greed. ment success in any market environment. Robert Rubin once observed that some
While business fundamentals remain James Montier, Société Générale’s market people are more certain of everything
awful, the moment will arrive when some strategist, recently pointed out that when than he is of anything. We feel the same
of the cash on the sidelines will creep athletes were asked what went through way. One can see the investment universe
back into the markets, rejecting infinites- their minds just before competing in the as full of certainties, or one can see it as
imal yields and seeking better returns. Beijing Olympics, the consistent response replete with probabilities. Those who
The contrast between the exceptionally was a focus on process, not outcome. The reflect and hesitate make far less in a bull
attractive yield and low purchase price same ought to be true for investors. market, but those who never question
for “risky” corporate debt or mortgage It is so easy for one’s investment themselves get obliterated when the bear
securities, and the extremely low yields process to break down. When an invest- market comes. In investing, certainty can
and very full price for “safe” U.S. ment manager focuses on what a client be a serious problem, because it causes
Government bonds, is yet another will think rather than what they them- one not to reassess flawed conclusions.
demonstration of Mr. Market’s manic selves think, the process is bad. When an Nobody can know all the facts. Instead,
behavior. When economic recovery is investment manager worries about their one must rely on shreds of evidence, ker-
anticipated, when investors decide to take firm’s viability, about possible redemp- nels of truth, and what one suspects to be
a bit more risk, “safe” government bonds tions, about avoiding loss to the exclusion true but cannot prove. One must also bal-
will fall significantly in price and fright- of finding legitimate opportunities, the ance one’s own perception of the truth
ened investors who overpaid for safety process fails. When the manager’s time with one’s best assessment of what others
will be tallying their losses. As 2009 gets horizon becomes overly short-term, the believe. In investing, other people’s per-
under way, we expect a steady diet of process is compromised. When tempers ception of reality influences price more
bear market rallies and financial market flare, recriminations abound, and second than any underlying truth; your own
volatility, as economic woes and contin- guessing proliferates, the process cannot assessment, even if correct, is valueless if
ued deleveraging vie with government work properly. When investment man- it is already reflected in the market price.
intervention and bargain-hunting in a agers worry about maximizing the value It is much harder psychologically to be
continuation of the age-old showdown of their firm – or, if publicly traded, its unsure than to be sure; certainty builds
between greed and fear. share price – rather than the long-term confidence, and confidence reinforces cer-
best interest of clients, the process is cor- tainty. Yet being overly certain in an
Timing the Market rupted. Investing is hard enough. Success uncertain, protean, and ultimately
Baupost built numerous new positions virtually requires that a process be in unknowable world is hazardous for
as the markets fell in 2008. While it is place that enables intellectual honesty, investors. To be sure, uncertainty breeds
always tempting to try to time the market rigor, creativity, and integrity. doubt, which can be paralyzing. But
and wait for the bottom to be reached (as uncertainty also motivates diligence, as
if it would be obvious when it arrived), In Defense of Uncertainty one pursues the unattainable goal of elim-
such a strategy has proven over the years Successful investing requires resolve. inating all doubt. Unlike premature or
to be deeply flawed. Historically, little When taking a contrary approach, one false certainty, which induces flawed
volume transacts at the bottom or on the has to be able to stand one’s ground, be analysis and failed judgments, a healthy
way back up and competition from other unwavering when others vacillate, and uncertainty drives the quest for justifiable
buyers will be much greater when the take advantage of others’ fear and panic conviction.
markets settle down and the economy to pick up bargains. But successful Always remembering that we might be
begins to recover. Moreover, the price investing also requires flexibility and wrong, we must contemplate alternatives,
recovery from a bottom can be very swift. open-mindedness. Investments are typi- concoct hedges, and search vigilantly for
Therefore, an investor should put money cally a buy at one price, a hold at a high- validation of our assessments. We always
to work amidst the throes of a bear mar- er price, and a sale at a still higher price. sell when a security’s price begins to
ket, appreciating that things will likely get You can never be sure if the economy will reflect full value, because we are never
worse before they get better. grow or shrink, whether the markets will sure that our thesis will be precisely cor-
rise or sink, or whether a particular rect. While we typically concentrate our
Process, Not Outcome investment will meet your expectations. investments in the most compelling situa-
Especially in today’s difficult environ- Amidst such uncertainty, people who are tions measured by reward compared to
ment, money managers must keep firmly too resolute are hell-bent on destruction. risk, we know that we can never be fully
in mind that the only things they really Successful investors must temper the certain, so we diversify. And, in the end,
can control are their investment philoso- arrogance of taking a stand with a large our uncertainty prods us to work harder
phy, investment process, and the nature of dose of humility, accepting that despite and to be endlessly vigilant. VII