Video conference with Seth Klarman discussing value investing, investment strategies and advice for success.
Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?
Exclusive: York Capital to wind down European funds, spin out Asian funds
York Capital Management has decided to focus on longer-duration assets like private equity, private debt and collateralized loan obligations. The firm also plans to wind down its European hedge funds and spin out its Asian fund. Q3 2020 hedge fund letters, conferences and more York announces structural and operational changes York Chairman and CEO Jamie Read More
Seth Klarman: Value Investing, Investment Strategies And Advice For Success
I thought I would talk for a while about our approach about how we're thinking about the world right now how we're seeing opportunities and what we're doing and then leave some time for questions at the end if that's okay. OK. So I graduated from business school as was said in 1982. And the world in 92 was extremely different than many years after that. In 1982 we had very high interest rates U.S. Treasury securities were yielding about 12 percent of their way to peaking out around 14 percent. The prime interest rate shortly after we started the firm got to over 20 percent. The stock market a little bit like today was down in the dumps. You had a market that was true the Dow was trading in the hundreds. It had done nothing for the past 18 years. So a little bit like Japan actually down market over a very long period of time. No one was graduating business school to go into Wall Street. The I've often thought that people's temper of it in the business is colored by the day they come into the into the business. So if you started in 2005 or 2006 you probably were influenced by the optimism of those of those markets if you came in 1982 or perhaps in 2009 you were influenced by the pessimism of those markets. And it does affect you if you remember how cheap things can get. You don't easily forget that lesson. So my background was I had worked for a couple of years at Mutual Shares Mutual shares was run at that point by Max Heine who was one of the founders.
Klarman 2017 letter on
- the danger of Chinese leverage
- Discipline while value investing in bubby times
- Value investing is not dead
- Radicalization of politics
- Dangerous FAANG valuations
Many many years before and when I started it was a 40 million dollar no load mutual fund applied value investing principles. What I left a couple of years later it was two hundred million. And ultimately when Max's successor Michael Price sold the firm about ten years ago it was around 30 billion dollars under management. I learned an enormous amount. There are probably more that I learned in my in my subsequent two years of business school and the real really important thing that I learned was right value investing is a risk averse approach. Value investing is one of the series of principles and a way of thinking about investing that tells you to first focus on risk before you focus on a return. I think ultimately all people are risk averse. That is a human tendency in a sense to be risk averse that if I offered anyone in your class or anyone I ran into today the chance to double or nothing. Their net worth on the cup toss of a coin. They would all turned me down. Everybody would turn me down and it's not because people would like to double their net worth but it's because at the margin the incremental value of more money is not as high as the pain from losing what you have. So given that the value investing principles make sense that approach that causes you to protect on the downside which is where the real pain is for people is more important than an approach that causes you to make a lot but runs enormous risk.
You can actually see that in action today that people that are down 30 percent 40 percent 50 percent or more are in excruciating financial pain it being down that much actually causes your thinking to blurry it causes you to stare into the abyss and wonder if you've lost half how hard would it be to lose the rest. And most people are prepared to start over. So we see actually as a dysfunction where people who were committed to investing in the markets all of a sudden are now retrenching they're pulling back they're holding cash. Endowments are rethinking whether they should be invested anywhere near the way they were invested before and so are individuals is actually a fair amount of Pettitt going on. And I think that that could spread if things don't get better in fairly short order. We started our firm. I love it. Let me say first of all you know Benjamin Graham is really the intellectual father of value investing. He had the opportunity to work in the markets or the 1920s 1930s very much like Buffett after him. And in some ways like are we getting a small amount of capital rummaging around for really miss price situation situations where there was a reason for mispricing Catalyst something that would cause you to make money. Z the classic principle that Graham espoused is the net net working capital test where he said that if you can buy a stock for less than two thirds of its net worth capital which is working capital minus all liabilities that that would be a real bargain. And the reason it's a bargain is you're basically buying that business for less than you could liquidate for. And that's critically important principle was it didn't mean actually liquidate the business.
But it meant that if you wanted to liquidate the business if someone else wanted to come along and look at the business that you essentially a risk free opportunity to invest in a company that you could get out with a profit and that if the business turned around or the market perceived that it was about to turn around you would then make money without actually ever needing to take control or to cause it to liquidate. That principle was very relevant in the 1930s when there were a lot of stocks during that awful period in the economy trading down below liquidation value then for most of the time in the last 75 years. There weren't so many periods where that actually was applicable if you applied that test as a simply through two or three years ago you would have thought almost nothing that fit. And now once again there their stocks trading down towards cash per share a lower capital per share. So again that test might be applicable. Now I'm not in favor of a paint by numbers approach to value investing where you just follow a few simple mathematical rules to start buying. But my my understanding of value investing from reading a lot about the studies that have been done is that value investing adds 1 to 2 percent a year. So if you just mathematically bought the cheaper half of the market and avoided the more expensive half under under whatever metrics you wanted underpriced earnings précis cashflow dividend yield price to book that you would get a percent or two a year.
But I also thought why would you ever trust a dumb blind formula when you perhaps could do better with your own analysis and investigation. So I always thought you could help that some situations that look superficially cheap are that cheap. The inventories are obsolete. The receivables are uncollectible their bad assets on the books is off balance sheet liabilities like environmental problems or litigation. So the thought for my first perspective was that we'd always follow value principles but try to improve on them through in-depth fundamental analysis and detailed research. The other thing that we try to focus on in a sense. Our approach is built on three underlying pillars. One is that as Graham says you want to focus on risk before you focus on returns. Some of that comes from the worrying that George described in his introduction. A lot of it is focused on multiple scenarios what can go wrong. How much can you lose. You know we don't think of risk in an academic sense of Beta which doesn't make any sense to us at all. Volatility is that risk relativities volatility volatility creates opportunities and isn't necessarily risky at all unless you have some lewdly to sell up to date. The price was very low. Rather risk is the probability of losing and how much you can lose if you lose. So we focus on a risk before we focus her or her and that's obviously very different from Wall Street where they still even after pressure right a huge percentage of research reports that are bullish. Very few that are bearish and even when they do think about other scenarios they tend to think they tend oversold while a single point estimates rather than a range of possible outcomes.
And in other words inevitably you are focused mostly on what you can make and with the spurious precision that the second ROI principle that we think about is the world is oriented towards relative performance. It's one of the giant weaknesses in the investment world. Of all the big mutual funds are focused on competing against each other competing against the market. So they're looking at relative numbers. If if the market's up 20 they want to be 21 if the market is down 20 they want to be down 19. The reason for that. By and large is everybody's an asset gatherer and get their assets. If you perform in the top half of performance or if you point out in court performance you almost certainly never get fired. You don't lose clients and your firm is very profitable and successful. So like Cuttriss we think wealthy individuals and establishes intuitions because of the risk aversion are actually interested in absolute returns that you know other words. If you're focused on absolute returns the idea of losing people's money becomes fairly abhorrent and if you focus on relative returns you're happy with losses as long as you lose less than everybody else.