Morgan Creek Capital Management letter to investors for the second quarter ended June 30, 2016; titled, “The Value Of Value.”
Morgan Creek Capital Management – The Value Of Value
Contrary to recent media coverage, Seth Klarman is not most well known for being another billionaire who has just changed party loyalties in the current Presidential race, but rather for his incredible investing acumen that has generated 16.4% annual compounded returns for his investors over a remarkable thirty-three year career as the Chief Investment Officer of the Baupost Group. For all of you pulling out the calculators, yes, this amazing track record has compounded $1 into $150. Klarman grew up outside of Baltimore, the son of a college professor and a high school teacher, which helps explain his reputation for being incredibly intelligent, but it takes more than intelligence to be a great investor. Growing up near Pimlico Race Course there are rumors that he gained an interest in numbers at the track (as well as a love of race horses which continues today) and decided to attend Cornell and study math. However, as one who personally changed majors three times, this author can attest to the fact that college plans often change. Thanks to his early interest in the “stock pages,” perhaps, or some other influence (mine was a girl), he ended up followings his father’s footsteps and graduated with high honors and a degree in economics. One of my favorite sayings is, “life is a series of happy accidents,” and Klarman had the fortunate experience of having an uncle who helped him get a summer internship at Mutual Shares (the legendary Value Investment firm founded by Max Heine and later run by Michael Price). At Mutual Shares Klarman was “inoculated” with the Value Investing bug, and he returned to the firm after graduation. Although he left only eighteen months for Harvard Business School, Michael Price said in an interview that “Seth left us as a true believer”. At HBS, Klarman experienced another happy accident when he took a Real Estate class with Professor William Poorvu who immediately recognized Klarman’s intellectual abilities, later recalling in an interview that “He was the smartest person in the class” and said, “I realized he was a special guy.” Klarman graduated from HBS as a Baker Scholar (top 5% of the class). He was then invited to lunch one day by Poorvu where the professor explained that he and some associates had just sold their business interests. They planned to set up a family office to manage the “considerable sums” of money, and they wanted him to join. In 1982, Poorvu, Howard Stevenson, Jordan Baruch and Isaac Auerbach formed Baupost (an acronym using the first two letters of their four last names), and hired Klarman to manage their $27 million fortune (roughly $70 million in 2016 dollars) for a modest $35k salary. From those humble beginnings, Baupost has grown to be one of the largest, and most successful, hedge funds in the world with $30 billion in assets at the last count.
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The original plan was for Klarman to be the portfolio manager and Stevenson to serve as part-time President, since he was still teaching Entrepreneurship at Harvard. Baupost would then allocate the capital out to other managers. However, a problem quickly arose when the principals began to meet with investment firms. After just a few meetings they made two observations. First, there was a disconnect between the way the managers described how they managed their own money and that of their clients. Second, the young protégé, Klarman, was asking routinely insightful questions that they were often more impressive than the portfolio managers pitching them. Poorvu recalled in the interview how he was drawn to Klarman’s “curiosity and desire to explore things in depth” and his “fearlessness, in that he was not afraid to challenge anyone.” The group quickly decided that they would change the investment model of Baupost and Klarman would be the actual portfolio manager. Jim Grant (author of the famous Grant’s Interest Rate Observer newsletter) later described Klarman in a similar fashion in a profile, saying he was “ferociously smart, notoriously prickly and not one to engage in many soft preliminaries in a business context.” Grant went further to tell a story of how brokers at Goldman Sachs, afraid to endure Klarman’s barrage of questions on their investment ideas, would often chose not to answer the phone if the Caller ID flashed Baupost’s name on their screens, essentially forfeiting a potential commission in order to avoid Klarman’s fierce intellectual prodding. Armed with this intelligence and Value discipline instilled in him by Heine and Price, Klarman came to the conclusion that the best way to compound wealth was to avoid losing money and keep the power of compounding working in your favor (Baupost has only had three negative years in thirty-three, and none of them were significant). In order to not lose money, his differentiating insight was that an investor couldn't traffic in the most widely covered (and therefore over-owned and over-priced) names on Wall Street, but had to focus on buying those out of favor names he calls “bargains.” Klarman has described bargains as securities where “you are buying a big discount, buying a margin of safety.” Another key element of the philosophy was that an investor had to be patient in waiting for things to “go on sale,” and be willing to hold cash when securities (and markets) were overpriced. Perhaps one of the most remarkable things (among many) of the Baupost track record is that it is routine for them to hold 30% to 50% in cash while they are looking for things to buy. To generate the types of returns they have for over three decades with a huge percentage of the portfolio in cash offers a strong challenge to the traditional mantra that portfolio managers should be fully invested at all times. When one of Klarman’s chief lieutenants retired last year, he discussed the use of cash in his farewell letter saying, “one of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk- adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when we enter a tide market and great opportunities become widespread.” In other words, cash has protective and option value, keeping portfolios safe during dislocations and providing liquidity to buy bargains with high margins of safety after the corrections occur.
The concept of margin of safety is so important to Klarman and his Value investment style that he penned a book in 1991 with the simple title Margin of Satety (pictured above). This book has achieved a nearly cult-like status as one of the “Bibles” for Value Investors. Furthermore, due to its limited printing (only 5,000 original copies and has never been reprinted) copies now sell on Amazon and eBay for prices between $1,000 and $2,000 (depending on condition). There are many theories on why there have not been more printings. Some say the publisher didn't do a very good job (three different editors) while others think that Klarman was a relatively unknown hedge fund manager in 1991 (Baupost only had $400 million in assets) so there wasn't much interest. Still others are of the mindset that Value investing was on the outs at the time since many Value managers had suffered during the recession. Whatever the case, Margin of Safety remained an obscure tome for many years and, unfortunately, the Baupost performance for the next decade didn't help much with its popularity. Value investing fell increasingly out of favor during the 1990’s bull market leading up to the Tech Bubble and Crash. Now many people would have been quite pleased to compound capital over the next ten years at nearly 13% (taking the $400 million to $1.3 billion just on performance). Alas, the S&P 500 had one of the most spectacular decades in its history over that period and compounded at more than 15%, and no one wanted to talk about Value in 2000. At Baupost, the last two years of that period were the most challenging with losses in the low teens in 1998 and a single digit return in 1999 and Klarman concluded his year-end letter by saying, “The last two years have been difficult ones for The Baupost Fund. We are disappointed but not disillusioned, and remain confident that a fundamentally-driven, disciplined value investment approach will deliver good results with limited risk over time. We appreciate your patience and support and look forward to a period of improved performance.”
Just how great was the aversion toward Value in 2000? A story might help illustrate. Klarman is a disciple of another legendary Value investor, Jeremy Grantham, much as we are at MCCM. I was CIO at UNC at the time and was making the case to the Investment Committee in early 2000 that we should be rotating away from Growth (which had wildly outperformed in recent years) and move some capital toward Value (which had underperformed). In fact, the recommendation was to give money to GMO, Jeremy’s firm, for their Value product. Jeremy is famous for the incredible accuracy of his forecasts for asset class returns, but they tend to be very contrarian (by their nature since they are based on mean reversion), and my Chairman didn't want to hear any more about Value strategies. He particularly didn't want to hear any more about Jeremy’s prediction that the S&P would have a negative return for the next decade, and said, “Mark, you are not allowed to use the letters, G, M, or O in a sentence in this room again.” As it turns out, Jeremy was precisely right, the S&P 500 compounded at a stunning rate of negative (1%) from 2000 to 2010 (let that sink in, a decade of negative returns from the US. equity market). What you probably don't know is that Klarman compounded at an astonishing 17% for the same period (remember that the decade from 2000 to 2010 included two declines greater than 50%). Suddenly everyone wanted to hear about Value. Margin of Safety became a not-so-instant classic. Klarman became a more widely known hedge fund manager, and Baupost’s assets swelled to $22 billion. Keep in mind that over that period some legendary hedge funds were forced to close up shop (some in 2000-2002 and more in 20082009). All the while Baupost grew at an astonishing rate, tripling assets from 2002 to 2008 and doubled assets again from 2008 to 2010 (they actually raised $4B in 2008 while other marquee names shuttered). With a little math here one might realize that compounding at 17% for a decade means you end the period with nearly five times as much money as you started with, so most of the increase in AUM was organic growth. As of the end of 2015, Baupost has generated the 4th largest amount of gains for investors of all hedge funds at $22.6 billion (behind only Dalio, Soros and Tepper). One last element of the discipline that Klarman follows at Baupost is their propensity to return money to investors if they believe that the investing environment is unfavorable. They have returned capital on numerous occasions, with the latest being a $4 billion distribution in 2013.
Circling back to Margin of Safety, there are many good reviews/analyses of the book available so we will not recreate the wheel here by diving too deeply into the contents of the manuscript itself. We will rather follow our traditional format of integrating quotes from Klarman assembled from various sources that will tell a story of how this great investor thinks about the philosophy of investing, the investment business and the current market landscape. However, we do want to start off by establishing the core concept of margin of safety as the cornerstone for Value investing as we make our case for The Value of Value given today’s challenging investment environment. Klarman begins the book acknowledging that “Value investing is not being discussed here for the first time” and, in fact, the original concept for margin of safety belongs to Benjamin Graham and David Dodd (considered by many to be the founding fathers of Value Investing) who wrote the seminal work on Value Investing, Security Analysis, in 1934 (original copies sell for nearly ten times as much as Margin of Safety). As illustrated in the graphic above, Price and Value are two very different things. The Price of something is what a buyer is willing to pay a seller, while Value is the intrinsic worth of that item. In the markets, investors should only buy stocks, bonds, or other assets when the Price is meaningfully lower than the Value. "the difference between the two is the Margin of Safety, and limiting yourself to only buying assets when there is adequate margin of safety is how you protect yourself from the cardinal sin of investing, losing money. Klarman said he wanted the book to be a manual for investors, not on how to invest, but rather how to think about investing. He wanted to elucidate a thoughtful approach to selecting the best securities across the capital structure (both stocks and bonds) in a risk-averse framework that will ensure long-term compounding of wealth to help investors avoid the disastrous results experienced by following an undisciplined approach.
When asked why he would give away his investing secrets in a book, Klarman quipped that the Value investing legends like Graham and Buffett had articulated their brilliant Value philosophies for years and if investors would not heed their wisdom, they were unlikely to listen to him. In talking about his expectations for the limited impact of his book, Klarman went on to say, “Warren Bufiett once wrote that value investing is like an inoculation, it either takes or it doesn't, and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don 't. Value investing is not a concept that can be learned and gradually applied over time. It is absorbed and adopted at once, or it is never truly learned.” The other challenge is that the investment business is set up to promulgate the exact opposite approach to investing, encouraging lots of activity (more commissions), discouraging the use of cash (which generates less fees) and the industry spends a lot of money to create the image that sitting around waiting for securities to go on sale is a fool’s errand. Klarman further explains how giving away all his ideas would not lead to less opportunity for him and Baupost clients in his quote, “Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.” Hard work, discipline and patience are indeed virtues, but we can all cite plenty of examples in our lives where we know what is good for us (eating right, exercising, building relationships) yet we can’t consistently muster up these virtues to achieve success. After a very challenging 2015 Klarman summed this challenge up again in his year-end letter by writing, “Did we ever mention that investing is hard work, painstaking, relentless, and at times confounding? Separating relevant signal from noise can be especially difficult. Endless patience, great discipline, and steely resolve are required. Nothing you do will guarantee success, though you can tilt the odds significantly in your favor by having the right Philosophy, Mindset, Process, Team, Clients, and Culture. Getting those six things right is just about everything.” Let us explore those elements to discover The Value of Value.
Klarman on Philosophy
Investing has been called the last liberal art, so talking about Philosophy seems an apt way to begin our discovery process. One of the things I really appreciate about Klarman’s approach is summed up in his quote, “The real secret to investing is that there is no secret to investing.” Value investing is not some deep, dark secret available to only a privileged few, but rather a broadly available and easily accessible construct that anyone can attempt to practice. We use the term “attempt” intentionally here because “Value investing is simple to understand but difficult to implement.” As we mentioned above, there are plenty of pursuits in life that are simple in concept but challenging to continuously commit to over time. Furthermore, Klarman advises those that have now checked the boxes on understanding and commitment and are working their way down to returns that “while some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.” And if anyone has scratched returns off their list, put a little star around patience in all capital letters, and now checked comprehensive philosophy, there still might be a more fundamental requirement. Klarman is of the mindset that you might have to be born with the capacity to accept the philosophy entirely. “It turns out that value investing is something that is in your blood. There are people who just don't have the patience and discipline to do it, and there are people who do. So it leads me to think it's genetic.” In other words, no matter how many times you read books on the subject, no matter how many great Value investors’ habits you study and seek to emulate, no matter how much you want to be a Value investor, it may not matter. While this is a fairly strong statement and my first reaction is to say that anything can be learned (nurture beats nature), admittedly throughout my career it has been rather easy to pick out true Value investors, as they do tend to be different than other investors. My own personal experience is that I have always been a Value investor at my core, and whenever I have tried to alter my approach (like trying to buy growth stocks at triple digit multiples) the experience has been uncomfortable and quite challenging.
Read the full letter below.