This is part seven of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group. Parts one through six can be found at the respective links below. To ensure you do not miss the rest of the series sign up for our free newsletter.
Seth Klarman – Part seven: Wall Street Is The Average Investors Worst Enemy
The information below is based on Seth Klarman’s out of print book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor; hopefully you’ll find some useful tips.
Wall Street is plagued by conflicts of interest and short-term bias, which does nothing to improve the performance of the average investor according to Seth Klarman. The issue of trading costs, fees and management charges all act as conflicts of interest — Wall Street gets paid for what it does, not how well it does it (this refers to all wealth managers, not just those on Wall Street).
For the first quarter of 2022, the Voss Value Fund returned -5.5% net of fees and expenses compared to a -7.5% total return for the Russell 2000 and a -4.6% total return for the S&P 500. According to a copy of the firm’s first-quarter letter to investors, a copy of which ValueWalk has been able Read More
There’s a wealth of information out there that shows trading costs, can have a drastic effect on performance therefore, the portfolios that trade the least outperform. However, for Wall Street this is a catch-22 as brokers are paid to trade, and the broker who makes no trade all year, may be labeled as lazy by his client.
Seth Klarman is well aware of this catch-22 situation and does everything he can to discourage investors from dealing with Wall Street. Seth Klarman’s average holding period for his investments is indefinite, reducing the need to rack up trading fees that eat away at returns.
Seth Klarman on short-termism
On top of the need and commissions eating away at returns, Seth Klarman writes that Wall Street is increasingly focused on short-term returns, which are driven by an up-front-fee orientation. Brokers, traders, and investment bankers all find it hard to look beyond the next transaction, when the current one is so lucrative regardless of merit.
Of course, in today’s world of low-cost online brokers, the issue of fees and a short-term focus driven by these fees is less apparent than it once was. Nevertheless, it’s easy to notice Wall Street’s short-term view, the overriding importance of quarterly earnings and the constant commentary supplied by financial news channels.
Seth Klarman – A bullish bias
Seth Klarman writes that investors should, at all times, remember that Wall Street has a bullish bias. Wall Street can conduct more IPO’s in a bull market and brokers get more business from new clients. It’s a Wall Streeters job to be optimistic and bullish, that’s why there are always more “buy” ratings out there than “sell” ratings. As Seth Klarman puts it:
“…Perhaps this is the case because anyone with money is a candidate to buy a stock or bond, while only those who own are candidates to sell. In other words, there is more brokerage business to be done by issuing an optimistic research report than by writing a pessimistic one…”
It can also be assumed that many investors don’t like to admit their own mistakes, so they are not willing to pay for research that tells them they are wrong.
“… Many of the same factors that contribute to a bullish bias can cause the financial markets, especially the stock market, to become and remain overvalued…Since security prices reflect investors’ perception of reality and not necessarily reality itself, overvaluation may persist for a long time…”
Seth Klarman on investment fads
It’s not only single securities that can become overvalued, whole industries can see their valuations rocket as they become an investment fad and note, when an industry is in fad mode, very few Wall Streeters will call the fad out. The e-cig, marijuana and solar industry are three current example. However, in the words of Seth Klarman:
“…It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad become dangerous however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying business…”
Seth Klarman on the downfall of money management
“…The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve…”
With Wall Street focused on short-term benchmarks and performance, Seth Klarman writes that the Street has now lost the ability to management money over the long-term. Pension funds and institutions are now the greatest stockholders in terms of volume, outnumbering private investors but institutions are no more qualified that private investors to look after your money. As Seth Klarman writes:
“…If the behaviour of institutional investors weren’t so horrifying, it might actually be humorous…The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance…”
Seth Klarman notes that Wall Street is a performance derby. Many institutional managers are all trying to improve their relative performance and keep it equal to, or greater than an index. But the money managers are also faced with several self-imposed constraints. Such as illiquidity; institutional investors will not spend days researching a small-cap illiquid stock that may, or may not become a winner, they move with the rest of the group. Pressure to be fully invested is another constraint; unlike many fund managers, Klarman keeps around a third of his portfolio in cash.
Further, the overly narrow categorization of stocks in the intuitional investment business (emphasis on rigidly defined categories) restricts returns; the best, and undiscovered, opportunities lie outside the clearly defined categories, hidden away from institutional investors. When the opportunities are discovered by institutional investors, it is often too late. Other factors that constrain performance include the use of index funds, or as Seth Klarman puts it, the mindless acquisition of stocks on the basis that the efficient market hypothesis holds true. (Unsurprisingly, Seth Klarman is not a supporter of the EMH. His returns over the past few decades support his conclusion that the EMH does not hold true.)
Seth Klarman: Conclusion
But what’s the point of all the above information? Many readers will know that Wall Street is bias and has a short-term focus, therefore cannot be trusted. So how can value investors benefit? As usual, Seth Klarman has the last say on the matter:
“…Investors must try to understand the institutional investment mentality for two reasons. First, institutions dominate financial market trading; investors who are ignorant of institutional behavior are likely to be periodically trampled. Second, ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by the investment elephants can be rewarding…”
On a final note, one of the most surprising statements Seth Klarman made in this part of the book was the revelation that when he wrote Margin of Safety, an increasing number of money managers were investing in stocks with little to know in-depth fundamental research. An extremely concerning revelation.
Stay tuned for Seth Klarman part eight.