“Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.” — Seth Klarman year-end 2015 letter to investors.
2015 was a bad year for Seth Klarman and his Boston-based hedge fund Baupost. The fund lost money for its investors, a rare event -- it's only happened three times since the fund's founding in 1982.
[drizzle]Off the back of such a terrible performance, Seth Klarman devoted the majority of his year-end letter to investors explaining that value investing isn't a precise science in his usual calm and philosophical manner.
It's unlikely that Klarman would have been aware what was in store for the markets in the first few months of 2016, but as it turns out, his words couldn't have come at a better time for value investors seeking reassurance in a turbulent market.
More ValueWalk coverage on Seth Klarman's 2015 year-end letter to investors:
- Seth Klarman: Now’s Not The Time To Give Up On Value
- Baupost: Making Use Of Market Inefficiencies To Find Bargains In Distressed Debt
- Klarman “Catching Knives” Experiences Rare Yearly Loss, Looks Forward
Seth Klarman: Take advantage of Mr. Market
"Value investors gain clarity by thinking about their investments not as quoted stocks whose prices whip around on a daily basis, but rather as fractional ownership of the underlying businesses." -- Seth Klarman year-end 2015 letter to investors.
To be a successful investor, you must be able to take advantage of Mr. Market's bipolarity. You must be able to step in and buy shares when Mr. Market offers them to you at a knock-down price, but you need to be able to ignore his calls to sell at lower levels. Klarman writes that the two extremes of human nature, fear and greed drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. Your shares still represent the same fractional ownership in a business as when they traded higher yesterday, however, people are now en masse delivering the verdict that your shares are actually worth less.
"You have to find a way not to care or even to relish this eventuality. Warren Buffett has written that one should not invest in stocks at all if uncomfortable with the possibility of a 50% drawdown. The mistake some investors make is to accept the market’s immediate verdict as fact and not opinion, and become disappointed, even frustrated." -- Seth Klarman year-end 2015 letter to investors.
Losses can cause people to lose their bearings. It's natural to want to sell everything after your portfolio has been marked down sharply. Watching your net worth evaporate in front of you as the market falls isn't a pleasant experience. However, this is the wrong way of thinking about equities. Klarman writes that for an investor to overcome the desire to sell at the bottom and take advantage of Mr. Market's erratic movements, they must think not about what the market will pay for the securities today, (the stock price) but rather the true value of the securities you own based on such attributes of the underlying businesses as free cash flows, private market values, liquidation values, downside protection, and growth prospects.
Klarman continues, saying that when the market, in the absence of adverse corporate developments, drives an undervalued security down in price to become an even better bargain, that’s not a reason for panic, or even for mild concern, but rather for excitement at the prospect of adding to an already great buy. When tempted to sell:
"Investors must think not only about what they would be getting (the end of pain that accompanies the certainty of cash) but also what they’re giving up (a significantly undervalued security which, emotion aside, may be a far better buy than a sell at today’s market price)." -- Seth Klarman year-end 2015 letter to investors.
This is why conducting your own rigorous due diligence is essential. The insights gained from due diligence give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market.
Seth Klarman: Don't be greedy
Greed works alongside greed to eat away at your confidence and push you to make decisions that are hazardous to your wealth. The angst felt when others are succeeding while you are not can lead you to make poor decisions, on this topic Klarman cities J.P. Morgan, who said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich," and Gore Vidal who dryly noted, “Whenever a friend succeeds, I die a little.” What's more, the fear of missing out can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long.
"Fear of missing out, of course, is not fear at all but unbridled greed. The key is to hold your emotions in check with reason, something few are able to do. The markets are often a tease, falsely reinforcing one’s confidence as prices rise, and undermining it as they fall. Pundits often speak of the psychology of markets, but in investing it is one’s own psychology that can be most dangerous and tenuous." -- Seth Klarman year-end 2015 letter to investors.
To show just how dangerous (and damaging) fear and greed can be to investors' returns, Klarman lets the figures do the talking.
The data shows that over the 30-year period from 1984 to 2013, the S&P 500 Index returned an annualized 11.1%. However, according to Ashvin Chhabra, head of Euclidean Capital and author of “The Aspirational Investor,” the average returns earned by investors in equity mutual funds over the same period was “a paltry 3.7% per year, about one-third of the index return.” Bond investors were dealt even more pain. While the Barclays Aggregate Bond Index returned an annualized 7.7% over the 30-year period from 1984 to 2013, bond funds produced an annualized return of 0.7%.
The underperformance in both cases was a direct result of investors pulling money out of the funds at precisely the wrong times. In short, by letting fear and greed take over their emotions, retail investors have underperformed both the markets and the very funds in which they were invested since 1984. That's a statistic that's difficult to ignore.
So to conclude:
"In the moment, public market investors have no ability to control investment outcomes, but they can control and improve their own processes. We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk...We believe that by remaining focused on following a well-conceived process, we will make good risk-adjusted, long-term investments. And we know that if