This is part six of a multi-part series on Seth Klarman, value investor and manager of Boston-based Baupost Group. Parts one through five 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 six: Yield Pigs
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.
"There are countless example of investor greed in recent financial history. Few, however, were as relentless as the decade-long "reach for yield" of the 1980s." -- Seth Klarman
Greed and the Yield Pigs of the 1980s, was not only a chapter of Margin of Safety but a also warning; a warning that today's investors seem to have forgotten. Early in the 80s, the double-digit yield on government securities gave investors the false notion that double-digit returns were the norm. This way of thinking drove investors to sacrifice credit quality for higher yields when interest rates started to decline, similar to the environment we are in today.
"Yield pigs" became a term for investors who were susceptible to any investment product that promised a high current rate of return, without properly assessing the risk that the product carried. Seth Klarman uses Margin of Safety to try an prevent investors from becoming yield pigs, warning that if high yield assets were indeed low risk, they wouldn't be offering a high yield in the first place.
In order to achieve higher levels of return, above that of U.S. government securities (the "risk-free" rate), increasing levels of risk must be taken in line with the premium over the risk-free rate. Higher risks will often erode capital. Of course, higher returns for higher risk only applies on average and over time; as returns of the wider market will justify.
Seth Klarman wrote the following statement during February 1992:
“…These days, however, I don't believe investors are being compensated sufficiently to venture beyond risk-free instruments…”
At this time, the yield spread of the Credit Suisse High Yield Index versus Treasuries stood at around 544 bps. Over the past 26 years the median spread has fallen to a similar level. There are only three times during the past two decades (after the dot-com bubble and 2008/09) where the yield on junk bonds has exceeded the 800 bps spread mark over Treasuries (I am making the assumption here, based on Seth Klarman's buying activities, that a spread of 800 bps over Treasuries is enough to compensate for the risk of investing in junk). During both of these periods we know Seth Klarman was buying distressed junk debt. He has avoided the sector when yields have traded lower.
The environment Seth Klarman was describing during 1992 has many similarities to today's market. Seth Klarman describes the trend of the yield pig, desperate for yield, throwing money at stocks, despite the high valuation and historically low dividend yield. This statement, published by Morningstar earlier this year implies that the same is happening in today's market:
“…With rates at all-time lows investors have been forced into higher risk asset classes such as equities to maintain the same level of income. Defensive equities with stable and rising dividends have become a target for yield-hungry investors who might not otherwise consider the stock market at all…”
But what if you have no option? Many investors strive to live off the income from their investments and are being forced to take on extra risk, in order to achieve the level of income required to sustain their lifestyle. Seth Klarman's advice on the matter:
“... I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss…”
Unfortunately, in today's world where interest rates have been so low for so long, this advice isn’t practical. If risk-adverse investors had taken this advice several years ago, they will have seen the majority of their capital erased if they had just lived off the cash. Still, if you’ve no other option:
“...Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable…”
While this advice was given in the early 90s, it is still relevant in today's environment.
Seth Klarman may have written his piece on yield pigs in the early 90s, but it is extremely relevant in today's market. The key take away is that investors should not chase yield, it’s better to preserve capital rather than risk capital for a lower-than-acceptable rates of return and high levels of risk.
While interest rates are low now, there’s no guarantee that rates will remain low forever (no matter what some economists might think). It's better to preserve you capital than take on additional risk for a return that is unlikely to compensate you for the additional risk. It's better to wait for a time when you can carefully place your bets, buying debt with only the most financially stable companies at an attractive rate of interest.
I should state that this article is not designed to be investment advice, from the author, or ValueWalk.
Stay tuned for Seth Klarman part seven.