16 Oct 2015

Seth Klarman – Value Investing in Bull Market.

What will you learn from this post:
. Aim for absolute, not relative return
. Contrarian Investing – What, Why and How
. Never capitulate at the worst moment
. Leverage is a two-edged sword

In this post, we learn from Seth Klarman - a renowned value investor - experiences during the great bull market prevailing during 1995-2000. Note that the text in italics is quoted from Baupost group’s letters to shareholders.

1. Aim for absolute, not relative return:
Seth Klarman has been investing money belonging primarily to him and his friends and families. Hence he has always emphasized on earning a return above US treasury with a reasonably degree of safety.

Quote from December 8, 1995
“The Baupost Fund is managed with the intention of earning good absolute returns regardless of how any particular financial market performs”

Value Investors should not be trapped in the mad horse race of relative returns, where losing money is fine, only condition is that you should lose lesser than your competitor.

2. Contrarian Investing 101:
It is well said that the four most dangerous words in investing are “its different this time”. Contrarian investors believe in mean reversion. Thus, according to a contrarian investor, good times will be followed by bad times and vice-versa with almost certainty over a period of time. Only an investor cannot predict when the cycle will turn from bull to bear and from bear to bull. A contrarian investor hence invests in companies at low multiples when sentiments and cycle is bad and sells those investments when multiples are high and cycles are good.
Quote from December 8, 1995
Bulls will patiently explain that "it is different this time", pointing to low inflation, high corporate profits, increased productivity, world peace (sort of), reductions in government spending, and the like. Of course, any contrarian knows that just as a grim present is usually precursor to a better future, a rosy present may be precursor to a bleaker tomorrow. Without me listing all the things that could go wrong, simply consider that none of these virtuous factors are cast in stone. Just as seeds are sown during the seven lean years that allow the seven fat years to ensue, so does the reverse hold true.

However, Seth points to pitfalls of contrarian investing. Once should not regard the seller as ignorant who knows less than you do. On the contrary, as Seth himself points out that an investor needs a ‘necessary arrogance’ when he is investing. He needs to satisfy himself that he knows more than the seller does, when engaging in contrarian investing. An investor should never fall prey to anchoring effect – a stock is cheap as it has fallen say 50% from its peak (an ‘anchor’). Cheapness should always be judged based on fundamentals and absolute valuations. For example, a stock may be attractive if it has a strong RoE and a dividend yield of 5%, when the treasury yield is just 2%.
Quote from December 17, 1999
a) it is important to never be blindly contrarian, betting that whatever is out of favor will be restored.
b) it is important to gauge the psychology of other investors. Being extremely early is tantamount to being wrong, so contrarians are well advised to develop an understanding of the psychology of the sellers
c) Investors must never mistake an investment that is down in price for one that is bargain-priced; undervaluation is determined only by a security's price compared to its underlying value.

3. Never capitulate at the worst moment:
While it is easier said than done, a value investor invariably faces moments in his investing career when he has been repeatedly proven wrong (read underperformance) by the market. An investor should keep reviewing his investments for their adherence to the investment process. If you have adhered to the process, if the rationale of investing in a particular security has not changed, then you should never change your process just because its ‘not working’. In fact the most important lesson from Seth Klarman’s experience during those tumultuous years is that you should not capitulate!

Quote from December 17, 1999
Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today's financial climate. Our answer, as you might guess, is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success.

4. Perils of using Leverage (Margin Debt):
An investor should abhor using debt to improve returns. Using debt results in taking away some of the advantages an investor possess. When using Debt, an investor becomes slave to volatility in the market and can succumb to ‘margin calls’ driven forced selling. How does it work?  Suppose you have Rs.5000 and you borrow another Rs.5000 (using loan against shares) to buy 100 shares of Company A at Rs.100. Due to volatility, the market price of the shares fall 60% to Rs.40. Your lender asks to deposit Rs.1000, which you unfortunately cannot deposit. The lender than sells all your shares, despite the fact that they are more cheaper now than the price you brought earlier.

Quote from June 13, 2000

Margin debt (which we do not utilize) should be considered extremely dangerous; investors should never enable Mr. Market's mood swings to result in a margin call which could necessitate forced selling. Investors should prepare themselves for a greater degree of portfolio volatility, because it is impossible to tell how wild Mr. Market's mood swings may become.

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