Here are my notes on Seth Klarman's presentation at the CFA Institute's Annual C

onference today. It was a discussion with Jason Zweig of the Wall Street Journal
.
by XMFMrchw
Sourced from http://boards.fool.com/Message.asp?mid=28520259&sort=whole#28523424
JZ: How have you followed Graham and Dodd, and how have you deviated?
SK: Graham and Dodd is really a way to think about investing, think about bargai
ns and where they come from. Our search process is definitely based on G&D. We d
eviate by investing in instruments that didn't exist then, and the business is m
ore competitive than it was then. Also, what is on the books is not as reliable,
we don't trust the numbers, we look behind them.
JZ: What lessons did you learn from Mutual Shares working with Mike Price and Ma
x Heine?
SK: From Mike Price, endless desire to get into and seek out value. Mike once fo
und a mining stock he thought was undervalued and drew up a map of interlocking
ownership structures and found about 10 securities he could buy that owned part
of this company. From Max Heine: While he was a great analyst, he was a better m
an. He was very kind to everyone, from the receptionist on up, I learned how to
treat people well.
JZ: What went wrong in 2008, and how did so many Value Investors get hammered?
SK: Value investing doesn t work all the time, you need to expect periods of under
performance. In the Pre 08 period, the world was valued on an invisible LBO Mode
l. Stocks were not allowed to get cheap because of an underlying expected LBO bi
d. But when the model got fragmented, the template no longer made sense. So in o
rder to do well, equity minded investors needed to be more agile in 07/08 and ha
ve an opinion on subprime mortgages and the ripple effect. Bank stocks looked ch
eap unless you thought their capital would be destroyed. Also the modern day pre
ssure to be fully invested and on short term performance didn t help.
JZ: In Michael Lewis s book The Big Short, Mike Burry finds himself in the situati
on in 2007 of defending himself to his investors at the precise moment that he s d
oubting himself. How is Baupost organized to avoid this?
SK: Having great clients is the key to investment success. We have emphasized ve
ry sophisticated families and Institutions as our clients, who had the ability t
o see through the financial crisis as opposed to many individuals who felt as if
they were staring into the abyss.
JZ: Any advice on how to raise the quality of your clients?
SK: Avoid Fund of Funds since you don t see the actual client, they are at the mer
cy of their clients and don t have staying power. Our ideal client has two charact
eristics: 1.) If we feel we have had a good year, they agree, regardless of rela
tive performance and 2.) when we call, asking them to consider adding new capita
l, they a.) appreciate the call and b.) add new capital. It s not only actual with
drawals that matter but the fear of redemptions as well.
JZ: Baupost is organized for the long term, but can be opportunistic in the shor
t term, such as in 2008 when Mortgage Backed Securities went from 0% to 30% of t
he fund
SK: And got as high as 50% in early 2009. I have incredible partners, with commo
n investment approaches. We have a non conventional approach to organizing our a
nalysts. We don t have Pharma or Oil/Gas analysts, but they re organized by opportun
ity: Spinoffs, Bankruptcy, Legal, etc. They don t waste their time keeping up on l
atest quarterly earnings from companies we will never invest in, but spend their
time looking for irrational sellers.
JZ: In 1932, Benjamin Graham wrote in Forbes, Those with the enterprise lack the
money and those with the money lack the enterprise to buy stocks when they are c
heap. How did you have the courage, was it easy to step up and buy in the fall of
2008?
SK: Yes, it was easy. The critical thing to understand is that securities are not
pieces of paper that fluctuate in price tick by tick like Cramer says on TV, ins
tead they are in fact claims on earnings or assets of businesses. If you are afr
aid a security will go lower then you worry about what clients, or partners, wil
l think. If you have conviction in your analysis, you will hold and buy more. So
what do we do to give us conviction? 1.) Find compelling bargains, not slight b
argains. 2.) Test everything with sensitivity analyses. 3.) Prepare to be wrong.
It s not courage, it s Arrogance, when you buy something, you re saying you re smarter
than everyone else. We realize we have lots of smart competition and temper our
arrogance with humility to realize that many things could go wrong. Our own conf
idence matters, and we re highly disciplined buyers and sellers to avoid round tri
ps and take advantage of short term sell offs.
JZ: So Investors need cash and courage
SK: Courage is a function of process.
JZ: In Margin of Safety, you were critical of Indexing, is that still the case?
SK: There is no perfect answer. Yes, I still believe indexing is a horrible idea
. Stocks trade up when they re added to the index so the index investor is paying
up. I m more likely to buy the companies kicked out of the index. For the average
person, however, they don t do enough research to own individual stocks. The idea
of owning stocks for the long run is a disservice to investors, because many are
not there for the long run. Many got out in 2008 when they should have been buy
ing, because the entry point matters most. Transaction costs and Taxes don t matte
r if the market goes nowhere. I m very worried about another 10 years of zero or l
ow returns since the market has run up so fast.
JZ: In the past you have referred to a Hostess Twinkie Market , can you explain wha
t you mean?
SK: Hostess Twinkies make childhood happier with totally artificial ingredients.
The market has been made happier by government manipulation. 0% interest rates,
Mortgage Lending Programs, Cash for Clunkers, Cash for Caulkers, Tarp, etc. We
don t know how much it went up because of these, but the Government wanted people
to buy equities to enact the wealth effect. I m worried to this day if all the man
ipulation wasn t happening what would happen. We can t know, no one can. And it s cont
inuing with the European bailouts. It s as if the Government is in business to giv
e bad financial advice and force unsophisticated (and sophisticated) investors t
o speculate. In the short term performance game, everyone needs to keep up.
JZ: How worried are you that we re in a giant world wide carry trade that will end
badly?
SK: I m more worried about the world then at any point in my career.
JZ: Why?
SK: The new element is will the US Dollars we make be worth anything? There s not
enough money in the world for all the bailouts unless it is debased. It s easier t
o debase than take hard problems, easier to kick it down the road. I want to see
someone that is willing to lose a re-election in Washington to tackle the hard
problems.
JZ: What is the chance of that? How much above zero?
SK: I m an optimist. Scott Brown has appeal. More politicians will come along who
see tackling the hard problems as a way to get elected. Lots of people in the co
untry realize there is no free lunch. Every adjusted economic number is in the g
overnment s favor. I m troubled that the country didn t get value out of the crisis li
ke we did in the 30s. Depressions aren t good but the depression mentality is good
. We developed a bad couple of weeks mentality.
JZ: Are you concerned about government debt?
SK: I m not an expert and don t have much to add. Think of it from a Gladwell Tippin
g Point perspective. I m not sure how much debt is too much. Sovereign debt is mone
y of the mind (James Grant Reference) and the tipping point is invisible, all is
fine until it is not fine. It will be fine until bidders don t show up at the Auct
ion. The Treasury Secretary has been lulled into thinking the US will always be
AAA Rated. That type of thinking ensures we won t always be AAA Rated. A Sovereign
debt crisis will be gradual until sudden.
JZ: In Margin of Safety, you said commodities were not investments since they do
not produce cash flows, one possible exception being gold. Do you still feel th
is way?
SK: I haven t changed my mind, but that statement was in reference to rare stamps,
or fine art, etc. Valuing collectibles based on a future sale to a greater fool
is speculating. There is no way to analyze what it will be worth in the future.
Land is complicated because it will be valuable to future buyers and it can hav
e cash flows. Gold has been thought of as a store of value but it is just a comm
odity and therefore it is a speculation. I own gold because I want exposure to a
devaluation of all paper monies.
JZ: Graham stated that an investment is anything you analyze, has safety of prin
ciple and an adequate return, and all else is speculation. But he speculated
JZ: Graham wasn t thinking about currency devaluation. If you want to short the do
llar, you need to short it against something, what is that something? No other c
urrency makes sense. Gold is an expensive hedge to protect against severe erosio
n in purchasing power, but it s something we feel is worth it. We are looking to p
rotect tail risks that could be catastrophic, one of which is hyperinflation. We
don t like TIPS since the government keeps the inflation data. It s more likely the
Bond Market would call the government on inflation before it shows up in govern
ment data. So what we did is buy way out of the money puts on bonds. We lose 100
% if rates go to 5% or 6%. However, if rates get to double digits, we ll make 10,
15, 20 times our money. If they get to 20-30%, we ll make 50-100x. And there s way l
ess than a 50/50 chance this would happen in 5 years or less. But we view it as
very cheap insurance and it s worth risking our capital to buy that insurance.
Questions from the audience, as filtered by Jason Zweig:
JZ: Do you give money back when the market is overvalued?
SK: The number one thing on my mind at most times. I ve said for years size is neg
ative for performance. I said that at $200m in AUM and now at $22B I still think
so. However, in Feb 2008 we went to our wait list for the first time in 8 years
to raise more capital as we thought opportunities would be plentiful, large, lu
mpy, and unpredictable. I thought being larger was better at that time. And it w
as. We got a lot of calls from distressed sellers and couldn t have acted on them
without the additional capital. I am prepared to return capital but am worried a
bout a double dip. We re at 30% cash now and I would not raise more cash without r
eturning some to investors.
JZ: Sounds like the size of your firm is market dependent?
SK: Our firm s only goal is Excellence. I have no plans to sell out, or to go publ
ic, as that would hurt the firm. I feel great knowing I made a fraction of what
I could. The key is doing right by clients, not making more money for myself or
partners.
JZ: Any comment on what appears to be a change in morals among execs?
SK: Regarding the Goldman Sachs hearings, I know the world is wild, that Wall St
. exists to make money, not to benefit Baupost. I know that Wall St. will always
try to take our money, I go in with open eyes, you need to think Caveat Emptor wh
en dealing with Wall St. I don t know how to police it, they don t owe us a fiduciar
y responsibility when we trade, they re either a counterparty or a market maker. W
e should celebrate GS that they didn t go bankrupt and were hedging, we shouldn t wi
sh they d gone bankrupt sooner.
JZ: What reforms would you welcome?
SK: We d welcome more registration if it helps the country, it would not affect us
on a disclosure level. As a competitor, I d like Prop Trading to go away, and I d
o think there is a conflict there. A single regulator won t work, regulating risk
won t work (people like risk in an up market, but don t like it in a down market). I
think required bank capital ratios should be raised. The Bank Bailout fund is r
idiculous as it penalizes those firms that didn t need bailouts (why is Jamie Dimo
n/JPM paying for BAC/C bailouts?). Bill Ackman was the first I heard to suggest
that in a bailout all equity should be made worthless and subordinate debt shoul
d be automatically converted to new equity, which makes sense to me, as we d avoid
the unnecessary bailouts such as all the AIG holders/creditors.
JZ: How do you avoid group think?
SK: We recently had an investment team retreat with leading thinkers. They all s
aid there was a terrible problem with paper money, we should consider gold, the
EU would break up. Our partner s immediate thought was that gold was a group thoug
ht and we should be cautious holding it. So we focus on intellectual honesty and
try to learn from mistakes, accept them, and move on. We spend a lot of time on
this in our hiring process. When there s a mistake, there is no yelling, it s never
the analyst s fault (unless it s a dumb formula error, etc), everything is reviewed
by senior people and we re wrong together. We re aware of our biases and the risk o
f being biased. As an investor you need to decide if you d rather make more money
in up years and have a few bad years, or protect your downside, and we ve obviousl
y chosen the latter. We d rather underperform a huge bull market then get clobbere
d in a bear.
JZ: Everyone says it s never the analyst s fault, but often they don t stick to this w
hen something goes wrong. How do you screen for Intellectual Honesty in your hir
ing process?
SK: We ask about their biggest mistake, which doesn t have to be investing related
. But if you say your biggest mistake is wearing mis-matched socks one day, then
that s likely not being intellectually honest. We ask ethical questions, ask them
how they d respond in morally ambiguous situations, we want to see that they real
ize conflicts can exist. We want people who fit in. One key thing is idea fluenc
y, if I present a thesis I want people to immediately come up with 10 places to
look to exploit it, I don t want them sitting at their desk thinking, hmm, where sh
ould I look?
JZ: Is Short Selling market manipulation?
SK: I m surprised by that question. We don t short unless it s a stub we re trying to is
olate. But I believe that Short Sellers do better analysis than buyers. The worl
d is biased against them, they re the market policemen, it s not in the country s best
interest for short sellers to go away. Short Sellers are more patriotic than th
e CNBC Perma Bulls. There is one exception, and that s yelling fire when companies n
eed access to capital to roll their debt. If they buy Credit Default Swaps and w
ant a default to happen, that s troublesome. But some of this fault lies on CFO s wh
o assumed that markets would always be accessible. GE was irresponsible heading
into the crisis, they should have extended maturities. Short Sellers need to be
right more than buyers. If a computer wants to sell stocks short at $0.01, let t
hem do it.
JZ: What about the individual investors whose sell orders went off at $0.01?
SK: Never use market orders. You re not a seller at the market, the market changes
too fast.
JZ: What are the top asset classes for the next decade?
SK: Ask Jeremy Grantham! We re opportunistic, we ll buy what s out of favor, what s in f
inancial distress, in litigation, in trouble, whatever.
JZ: Tell us how you make money?
SK: <silence, laugh> we make money when we buy, not when something goes up in va
lue. We re trying to buy commercial real estate right now, but there is a problem.
There are 2 markets in Commercial Real Estate. The private market, for not Clas
s A stuff, is propped up by the government with TARP and PPIP. The FDIC told ban
ks with a wink to not be in a hurry to sell, so no one is selling. The public ma
rket through REITs trade as low as a 5% yield which is much, much less attractiv
e and not worth owning.
JZ: Can you define a Value Stock and what is your average holding period?
SK: As for a Holding Period, we buy expecting to hold a bond to maturity and a s
tock forever. Now we may turn over quicker if there s rapid appreciation and the r
eturn from the current price doesn t seem to compensate for the risks anymore. The
re s no such thing as a Value Company. Price is all that matters. At some price, a
n asset is a buy, at another it s a hold, and at another it s a sell.
JZ: With regard to your OTM puts, how do you think about counterparty risk?
SK: We worry about it in everything we do. We diversity amongst many counter par
ties, try to go with the best run / most solvent companies. We force them to pos
t collateral. But sometimes we realize that a 50% haircut to what we are owed, i
nstead of colleting 100%, can still be a good investment. We choose good enough ov
er not do .
JZ: What metrics did you look at that told you the time was right to deploy capi
tal?
SK: With most stocks down 40%, it wasn t economically too different form a depress
ion. We assumed a depression was going to happen, and looked for what would stil
l work out. One example was captive auto finance companies whose bonds were trad
ing at $0.40. We specifically liked Ford Motor Credit since they seemed to be th
e best run. And we said, ok, you have 5% of loans defaulting. What happens if th
is doubles, or quadruples, or goes up 8x? We decided that at a 20% default rate
the bonds would be worth par, and at 40% default, they d be worth $0.60. So we tho
ught we were pretty save buying since we didn t think defaults would go anywhere n
ear that high. In 07/08 there wasn t an erosion in auto loans, people just expecte
d there to be one. Autos didn t have over building and multiple investment cars li
ke homes had. So we looked for depression protection.
JZ: What about today?
SK: It s an indiscriminate rally that s over blown, at least on credit, specifically
Junk Bonds. There are now PIK and Dividend Recapture bonds. The market is not p
repared for another potential serious collapse.
JZ: How do you protect your clients against inflation/falling US Dollar?
SK: I mentioned the OTM puts on bonds, I don t feel comfortable mentioning anythin
g else and having 1600 people call up their brokers and over pay for protection.
But you need to think about and consider gold going down, the US Dollar not bei
ng the reserve currency (or continuing to be the reserve currency). It s more art
than science, and what we re doing could very well have a negative NPV, but we thi
nk it s a good idea to try to protect client purchasing power if the world gets re
ally bad.
JZ: When will we see a re-issue of Margin of Safety?
SK: I have no immediate plans, but I do want to bring it back with either a comp
anion manual or fresh introduction. I have no time to write it, however, so it s n
ot coming anytime soon. It s not intentionally out of print, it happened accidenta
lly. I d like to raise money for charity somehow when I do bring it back.
JZ: Any Book Recommendations (besides Margin of Safety and Security Analysis, of
course)?
SK: Read as much as you can about the markets, economy, and financial history. N
ever stop reading. Specific book recommendations include The Intelligent Investo
r, Greenblatt s You Can Be A Stock Market Genius, Whitman s Aggressive Conservative
Investor, Anything from Jim Grant (he s a great thinker, even if his predictions m
ay not turn out right), Roger Lowenstein has not written a bad book, anything fr
om him. Also Michael Lewis, who also hasn t written a bad book either, but specifi
cally MoneyBall which will go down as a definitive book on investing. Also Andre
w Ross Sorkin's Too Big to Fail is good.
JZ: I ll add How to Lie with Statistics.