Baupost Group, among the largest hedge funds in the world, returned $4 billion in assets to clients at the end of 2013 because it didn’t want to grow too quickly and dilute performance, according to an investor letter reviewed by ValueWalk. Seth Klarman’s fund, which in 2013 had a high of 50% of his portfolio in cash, up from 36% in 2012, posted 2013 returns in the mid-teens consistent with the fund’s nearly 22-year track record. The hedge fund also announced Elaine Mann was appointed Chief Operating Officer, replacing Paul Gannon who retires in June, implementing a longer-term management plan. (See part two here)
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Seth Klarman on Baupost’s returns
Saying the fund “drew a line in the sand” when it decided to return roughly $4 billion to clients at year end, Seth Klarman reflected on the decision, saying he wanted to control the fund’s head count, noting “we could not allow the firm to grow without limit. We are wise enough to know a good thing when we see it, and cautious enough to want to cherish, protect and nurture it so that we might maintain its essential qualities for a very long time.” A 50% cash position for a hedge fund might be construed as an indication the fund has grown to the point it was having difficulty allocating all the capital in appropriate trades.
Seth Klarman noted the 2013 performance occurred “despite the drag of large, zero-yielding cash balances throughout the year.” Seth Klarman, author of the popular and now out of print book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, said the performance resulted from “considerable progress in event-driven and private situations, and at least some uplift from the strong equity rally. Distressed debt, public equities, structured products, and real estate led the gains.” Tail risk hedges, the only material area of loss in the portfolio, cost approximately 0.2% as the fund reduced exposure to distressed debt, structured products, and private investments while public equity exposure increased modestly.
In 2013 Seth Klarman noted the market bifurcation, which he describes as “a momentum environment of market haves (which we avoid spending time on) and have-nots (which receive our undivided attention) – coupled with our energetic sourcing efforts and valued long-term relationships,” and he expressed optimism for the fund in 2014 amidst what might be a stock market subject to individual interpretation. “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test,” he wrote. “What investors see in the inkblots says considerably more about them than it does about the market.”
Seth Klarman noted that those “born bullish,” those who “never met a stock market they didn’t like” and those with “a consistently short memory,” might look to the positives and ignore the negatives. “Price-earnings ratios, while elevated, are not in the stratosphere,” he wrote, stating the bull case. “Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.” (Seth Klarman has much more to say in regards to the Fed, which will be published in an article tomorrow.)
Seth Klarman’s market analysis
Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. “If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about,” he wrote. Citing a policy of near-zero short-term interest rates that continues to distort reality and will have long term consequences, he ominously noted “we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences,” a thought pervasive among many top fund managers. “Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?”
As he outlined the bear case, he started to divulge his own analysis that “on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix, Inc. (NASDAQ:NFLX) and Tesla Motors Inc (NASDAQ:TSLA).”
As it turns out he was just warming up. “There is a growing gap between the financial markets and the real economy,” Seth Klarman wrote, noting that even as the Fed promised that interest rates would stay low, they did get out of control to some degree across the yield curve in 2013. “Medium and long-term bond funds got hammered in 2013. Meanwhile, corporate earnings sputtered to a mid-single digit gain last year even as stocks drove relentlessly higher, without even a 10% correction in the last two and a half years,” a concern among many professional traders.
When it comes to stock market speculation and jumping on the bull market happy talk, Seth Klarman notes it’s never hard to build a “coalition of willing” who are willing to climb on the bandwagon. “A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities,” he wrote. “Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500 (INDEXSP:.INX), Dow Jones Industrial Average 2 Minute (INDEXDJX:.DJI), and Russell 2000 (INDEXRUSSELL:RUT) regularly posted new record highs.”
Seth Klarman noted that whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences. “Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth,” he noted, while citing numerous examples of overvalued internet stocks that defied value investing logic.
“In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987,” he wrote. “A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does. Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?” he said in a somewhat hilarious moment that bears a degree of truth.
Seth Klarman on Europe
Seth Klarman still isn’t much of a bull in Europe, as we noted in a previous ValueWalk. “Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment,” he noted. “One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008,” he said, noting a growing concern among fund managers regarding the government debt crisis getting out of hand.
Seth Klarman noted that Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008, and said “That doesn’t look fixed to us.” The EU credit rating was recently reduced by S&P, he noted, while European unemployment remains stubbornly above 12%. “Not fixed,” he said. “Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending.” While he notes the problems in Europe, Seth Klarman did not rule out that opportunity might be found in the region.
Seth Klarman on Bitcoin
Seth Klarman also weighed in on Bitcoin, noting that “Only in a bull market could an online ‘currency’ dubbed bitcoin surge 100-fold in one year, as it did in 2013. Now most sell-side firms are rushing to provide research on this latest fad,” he also noted that while “bitcoin funds” are being formed, the fund is “happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality. If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money?”
Comparing the economy and the Federal Reserve’s management of it to the movie The Truman Show, where the lead character lived in a false, highly-orchestrated environment, Seth Klarman notes with insight, “Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.” Then he quotes Jim Grant who recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.”
This is the first of two articles, the second of which will be published tomorrow. Sign up for our free newsletter to make sure you do not miss it.