Portfolio manager’s Letter April 2011
Seth Klarman founded Baupost Group in 1982. Since then he has been able to consistently beat the market. In fact, from 1998 to 2008 he was able to top the performance of the S&P 500 by 14.5% per year.
In his annual letter to partners for 2010 he outlined the characteristics he feels are important for successful investment management or to be a successful investor. Financial markets are highly competitive, with thousands of very smart, hardworking participants, yet there is a select group of investors like Klarman, Bruce Berkowitz or Warren Buffett who consistently beat the market.
What are the skills that will enable the investor or successful investment management to outperform the market? What follows is my attempt to summarize some of Klarman’s thoughts and add a few of my own.
Counterintuitive physiology of successful investment management helps to have your brain wired incorrectly (to be fearful when others are greedy and greedy when everyone is fearful).
“Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one’s stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset’s lower market valuation. Successful investment management requires standing apart from the frenzy – the short-term, relative performance game played by most investors”. Seth Klarman.
For successful investment management investor should study the competition; take advantage of what your opponents give you. If the broad market is committed to fast-growing technology stocks, avoid tech if you want to outperform. In financial markets popularity is a much better measure of risk than volatility.
“If your competitors are not paying attention to, or indeed are dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention, regardless of the currently poor fundamentals that are driving others’ decisions. Where to best apply your focus and skills depends partially on where others are applying theirs. When observing your competitors, your focus should be on their approach and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others’ portfolios, but on looking for opportunities where they are not.” Seth Klarman.
In the successful investment management business, the investment manager’s income is based on the amount of customer assets he manages. This forces much of the money held by professional investment managers to focus on short term results. It is popular to criticize professional investment managers for their mediocre results, whereas the truth is that most investment managers could do successful investment management if they did not have customers. The problem being that if you do not have customers you do not have a business. So it is, that it is the customer’s mindset that rules the market.
“Thus, because protracted periods of underperformance can threaten one’s business, most investment firm’s aim for assured, trend-following mediocrity while shunning the potential achievement of strong outperformance.” Seth Klarman.
An institutional manager may be one or the other, but seldom both. The asset gatherer concentrates on opening new accounts, and spends a lot of time on personal service and client relationships. With investments he tends to be short term results oriented, because his clients require it. This short term perspective leads to acceptance of “Trend following mediocrity” in order to avoid the career risk involved in client exits if he ignores the short term results.
There is a good deal of asset envy in the business, and managers tend to be judged more by their AUM (assets under management) than by their performance. Yet for the customer, size is not a good way to judge the value of that manager. The larger the manager, the more pressure he will feel to become an asset gatherer. Size is an anchor to performance and huge size is a huge anchor, and it can be assumed that any manager with more than $20 billion of AUM is a asset gatherer because at that level it becomes very difficult to out-perform the market.
The point at which size makes outperformance difficult varies from investment manager to investment manager, but certainly it is much easier to outperform when a managers assets under management are under $500 million. The point at which a manager settles for the “assured, trend following mediocrity” varies but it is rare to see consistent outperformance by investment managers with over $30 billion.
Klarman closed his Partnerships to new customers in 2000 when his Assets under successful investment management were something over $2 billion. Jim Simons Closed Medallion Fund 1994 when its assets where a mere $280 million. Medallion was a quant fund so it probably could not handle as much capital as hedged stock fund like Klarman’s partnerships, but these figures give you a good idea what two very successful managers thought about size and its impact on successful investment management.
Traditional investment wisdom preaches that there is protection in diversification. In contrast, Charlie Munger says that the average investor should follow six stocks and invest in three. While we have never felt confident enough in our stock selection ability to limit Losch Management portfolios to three stocks, we do feel that Charlie’s point is legitimate, and that any diversification beyond an individual’s limited area of competency is diversification. Your tenth best idea is, after all, only your tenth best idea.
Price is, of course, a most important criterion in sound investment decision making at the successful investment management. Yet most investors love a good story and feel more comfortable buying stocks that have been going up. They can feel risk in stocks that have been declining, whereas real risk in the market place is measured by a stock’s popularity. The more the market loves a stock the more risk it carries.
All investments carry risk, but the best way to lessen that risk and for successful investment management is to buy what is unpopular and wait till it becomes popular.
“Investment success also requires remembering that securities prices are not blips on a Bloomberg terminal but are fractional interests in – or claims on – companies. Business fundamentals, not price quotations, convey useful information. With so many market participants fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements.” Seth Klarman.
Most investors feel compelled to be fully invested at all times, partially because this is the way that portfolio management is taught in business schools, but also because cash generally produces very poor returns. But, to require full investment all the time is to remove an important tool from investors’ toolkits. Investors such as Klarman or Buffett like to have dry power for successful investment management in the belief that the best opportunities appear at unexpected times. In 2005 Klarman was holding 45.8% cash, in 2006 49.8%; and in 2007 50%.
Often it is fear of missing the upside that exposes that investor to the most dangerous markets. This pressure is particularly intense for the investment manager who is watching client money march out the door if he tries to hold cash in the last stage of a bubble.
“In the markets of late 2008, everything was for sale as investors were caught in a contagion of selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative scenarios, many securities could have been purchased at extremely attractive prices – if one had capital with which to buy them and the stamina to hold them in the face of falling prices. By late 2010, froth had returned to the markets, as investors with short-term relative performance orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptions.” Seth Klarman.
In our case, we at Losch Management Company feel that our ability to outperform and successful investment management in the past has been largely been the result of highly concentrated portfolios and abnormally large cash positions in times of exuberant markets.
Traditional Value investors tend to play down the impact Marco-Economic policy. Yet, as governments get more involved in economics, this approach is dangerous. It is important for the investor and successful investment management to try to understand the impact of politics on the World’s economy.
Today, the greatest risk we face is from punch bowl monetary policy and possibility that runaway inflation will force interest rates to levels we have not seen in 30 years. This is probably not likely, but it is certainly a possibility that must be a part of our successful investment management.
“Government interventions are a wild card for even the most disciplined investors. On one hand, the U.S. government has regularly intervened in markets for decades, especially by lowering interest rates at the first sign of bad economic news, which has the effect of artificially inflating securities prices … As securities prices are propped up and interest rates are manipulated sharply lower (thereby justifying those higher prices in the minds of many), prudent investors must demand a wide margin of safety. This is especially so because financial excesses contain the seeds of their own destruction.” Seth Klarman.
The biggest mistake made by many investors is that they do not monitor their investment performance. For the individual who is managing his own investments this means finding software that will allow you track your results at least on a quarter by quarter basis, and to compare your results to an index such as the S&P 500. For successful investment management, I like to monitor results on a monthly basis, but for many investors this may require paying too much attention to market swings.
Individuals may want to avoid the extra bookkeeping, but without the discipline provided by performance tracking no one should be running their own money. For institutions it is entirely different problem. Mutual Funds provide performance figures because the law requires it. Hedge fund provide them (but not to outsiders) because that’s how they figure their fees.
Other than the above, large institutions (Brokers, Banks, Klarman’s “assured, trend following mediocrity” Managers) would prefer suicide to providing their clients with performance data. The upside of this for the investor is that it makes it easy to judge the value of a investment manager. If the institution does not provide performance data they are probably happy to settle for mediocrity (or worse), and can only hope that the client does not notice. In this case, no matter what the investment manager charges they are being paid more than they are worth.