Seth Klarman 2016 year-end letter

I have access to the 2016 year-end letter that Seth Klarman has shared with Limited Partners and stuff.

How important is Trump’s presidency that Seth divided the year between “Before” (44 weeks) and “After” Trump to share his view of the year. The first one was dominated by tepid economic growth, low-interest rate, rich valuations and relatively low volatility. Also, quantitative easing, QE-infinity and negative rate (quite nonrational IMHO).

The election was an inflexion point, “after“, post-election rally, winners and losers (of course, those in most influence Trump’s point of view will win more that the others).

Seth quote the last summer article called “It’s Getting Scarily Quiet in the Stock Market”, this article warned the complacency about the central banking, Seth’s point of view is that the central banks, with their policies, have increased the financial assets. Examples such as The market and Methuselah, Saudis bonds and Austria. The debt expansion was huge in 2016, IMF said last October that world debt is a real thread for 2017. A really good point is that last 35 years the modern world has been living in a bull market, low-interest rates and right now inflation is going up and interest will raise and not much of active managers have experience in this type of market. Seth is critical with this topic:

  1. Whenever interest rates return to more normal levels, these bonds will trade below price
  2. Inflation, if this comeback, these instruments will sell off further.

After

Animal spirits drove US stocks, election benefited infrastructure companies.  News highs, especially shares of those companies expected to benefit most from lower taxes, expanded infrastructure spending, and deregulation. Post-election, interest rates jumped and bonds slumped in anticipation of policy changes and an acceleration in economic growth. As Trump promised, tax cuts and fiscal stimulus will cause higher corporate profits. Also, a relaxation of regulations is expected to boost the banking industry.

“Goldman Sachs notes that the S&P 500, in aggregate, recently traded at 85th percentile of its historical valuation over the last 40 years, while the median company in the S&P 500 had reached the 98th percentile of valuation”

The main point about Trump economy is that “may be able to temporarily hold off the sweep of automation and globalization, keeping jobs at home, bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces[…] the U.S long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off”.

For businesses and investors predictability it really importance to make assumptions, model performance and finds decisions. Elections matter, Trump will create investment opportunities and high uncertainty.

“A value investing approach is defensive by nature, emphasising preservation of capital through the purchase of investments with a margin of safety”.

In my opinion, the best part of the letter is the last one, when Seth explain that the key approach is to maintain conservative in weak markets. In top-down approach, you need to be right in the magnitude, path and timing.

The market is in bull market mode as we can see below.

S&P500 sicne 2005

Notes Chapter 3: Margin of Safety

  • 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.
  • [Taking about institutional investors] Hundreds of billions of other people’s hard-earned dollars are routinely whipped from investment to investment based on little or no in-deph research or analysis.
  • You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking.
  • Selling is difficult for money managers for three additional reasons:
    • 1) Many investments are illiquid, and disposing of institutional-sixed positions depends on more than simply the desire todo so.
    • 2) Selling creates additional work as sale proceeds must be reinvested in a subsequent purchase. Retaining current holdings is much easier.
    • 3) SEC, the governmental agency with regulatory responsibility for mutual funds, regards portfolio turnover unfavorably. Mutual fund managers thus have yet another reason to avoid selling
  • Institutional investors are caught in a vicious circle. The more money they manage, the more they earn. However, there are diseconomies of scale in the returns earned on increasingly large sums of money under management.
  • Allocating money into rigid categories simplifies investment decision making but only at the potential cost of lower returns.
  • Window dressing is the practice of making a portfolio look good for quarterly reporting purposes.
  • As depressed issues drop further in price, attractive opportunities may be created for value investors.
  • Unfortunately the appropriate relationship between bond yields and stock prices cannot be incorporated into a computer program. There are simply too many variables to allow investors to determine a relationship today that will apply under every future scenario.
  • Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities.
  • Investing without understanding the behavior of institutional investors is like driving in a foreign land without a map.

Notes Chapter 2: Margin of Safety

 

  • What is good for Wall Street is not necessarily good for investors, and vice versa.
  • Wall Street firms perform important functions for our economy: they raise capital for expanding businesses and (sometimes) provide liquidty to markets.
  • Up-front fees clearly create a bias toward frequent, and not necessarily profitable, transactions.
  • Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting.
  • Investors must never forget that Wall Street has a strong bullish bias, which coincides with its self-interest. Wall Street firms can complete more security underwritings in good markets than in bad.
  • Some people work on Wall Street solely to earn high incomes, expecting to depart after a few years.
  • A few Wall Street partnerships have done a particularly good job of motivating their employees to think past the current transaction.
  • The bullish bias of Wall Street manifests itself in many ways. Wall Street research is strongly oriented toward buy rather than sell recommendations.
  • Although high stock prices cannot be legislated, regulation can cause overvaluation to persist by making it easier to occur and more difficult to correct.
  • 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.
  • [Talking about new type of securities] There is something – lower risk, higher return, greater liquidity, an imbedded put or call option to the holder or issuer, or some other wrinkle – that makes it appear superior (new and improved, if you will) to anything that came before.
  • The value of a company selling a trendy product, such as television shopping, depends on the profitability of the product, the product life cycle, competitive barriers, and the ability of the company to replicate its current success.
  • All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the down ward slide ensues.

Notes: Margin of Safety

Seth Klarman is one of the best-known value investor. He run a company called The Baupost Group for 33 years. In this list published last January the assets under management are $27 bn.

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I started his book, “Margin of Safety”, and I wanna to share my notes here, just to re-read it in the future.

Chapter 1: Speculators and Unseccessful Investors.

  • Stocks represent fractional ownership of underlying business and bonds are loans to those businesses.
  • Investors in a stock thus expect to profit in at least one of three possible ways:
    • From FCF generated by the underlying business, reflected in a higher share price or distributed as dividends.
    • From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share prices.
    • By a narrowing of the gap between share price and underlying business value.
  • Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Many speculatores attempt to predict the market direction by using technical analysis as a guide.
  • Market participants do not wear badges that identify them as investors or specculators.
  • Value investors pay attention to financial reality in making their investment decisions. Speculators have no such thether.
  • Assets and securities can often be characterized as either investments or speculations. Difference: investments throw off cash flow for the benefit of the owners.
  • Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judment, they respond to market forces not with blind emotion but with calculated reason.
  • Two markets view: efficient markets and inefficient priced. The last one, create opportunities for investors to profit with low risk. Mr. Market by Benjamin Graham.
  • Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell. Frequently, however, he becomes irrational.
  • Value investors, who buy at discount from underlying value, are in a position to take advantege of Mr. Market´s irrationality.
  • The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value.
  • You cannot ignore the market but you must think for yourself and not allow the market to direct you.we
  • Unsuccessful investors: dominated by emotion.
  • There are countless examples of investor greed in recent financial history.
  • Given the complexitities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success.