columbia klarmanl

8/3/2019 Columbia Klarmanl

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A friend sent me a video of a speech given by Seth Klarman at the Columbia Business School.

Klarmans hedge fund the Baupost Group has done over 20% a year since he founded the firm in

1983 with only one down year. Also, Seth Klarmans book Margin of Safety: Risk-Averse Value

Investing Strategies for the Thoughtful Investor is also one of the best books Ive read on value

investing. Its currently out of print and selling for about $1,600 but I got a copy through my

librarys intra library loan program.

Of all the articles/speeches/interviews of value investment managers this is one of the best

speeches Ive ever watched. Klarman discusses how he made over 5 times his money investing

in Enron debt, what his investment principles are, his thoughts on the investment manegment

industry, why he doesn't go short and why he uses derivitives.

This speech is not posted any where else on the internet. Here is my summary:

Thoughts on Investment Manegment Industry

The investment Manegment industry is not set up to achieve market beating returns.

Instead they are incentivized to get big and act like asset gatherers. At the same time

there is little incentive to take risk and deviate from the mean because if they strike

out and underperform for even a short period clients will be lost quickly. Its an

enforced mediocrity (if you want to get big just do what everyone else is doing and

settle for average results).

Klarman said he would rather hold treasury bills then invest in many of the hedge funds

out there. If stocks do 10% going forward and a hedge fund that charges 2 and 20 takes

3% of your money in fees youve only got 7% left, plus its leveraged, holds illiquid

securities, etc. He would much rather get 4.5% risk free.

Tweedy Brown is todays manifestation of Benjamin Graham

Value investing is risk aversion

Baupost charges a 1 percent management fee plus 20 percent of profits.

How Baupost Invests

Rule #1: Dont lose money. Rule #2: Never forgot Rule #1.

Baupost always looks for catalysts in its investments. If you find a stock trading for 50%

of what you think its worth you want there to be something that will trigger it to

reach fair value.

Baupost will always sell an investment as soon as it near their estimate of fair value.

Baupost has analysts focused around the type of opportunity; Baupost has a spinoff


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analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst

and an analyst looking at companies that are depressed because of a bad earnings

announcement).

Baupost invest in: Both public and private distressed debt, Real estate (Baupost has

done over 200 real estate deals including biding on RTC auctions), U.S. and foreignequities, LBOs and Derivatives.

The portfolio is 45% cash, 20% equities, around 17% distressed debt, 11% real estate, 7%

private investments (distressed debt, small LBOs, financial restructurings), 6% in South

Korean equities and a small % in hedges.

Baupost looks at every merger, rights offering, privatization of government business,

spin off, major share repurchase, dutch auction tender, thrift conversions or anything

else that could cause mispricings.

Post bankruptcy situations are a good place to look for bargains because people avoid

them and dont understand them. A lot of good things can happen in bankruptcy such

as terminate overpriced contracts or leases, shed extraneous business units or, deal

with union problems or settle contingent liabilities; all under the protection of

bankruptcy court. Then all the debt holders have equity and they will want to sell.

Baupost opened over 1,000 savings accounts across the country to take advantage

of thrift conversions

Baupost doesnt go short because unlike going long when you can take advantage of a

drop in the value of an undervalued security by just buying more, if your short even

though you may be right that its worth less then the trading price you can still go

broke. Its way more risky and you can lose infinity. Think tech stocks if you shortedthem in 97, 98 or even 99 you would have been killed. It works for a while and then the

market goes berserk and you get killed.

Baupost uses hedges to reduce risk. For example they use derivatives to hedge the

interest rate risk in their real estate holdings. They hold credit default swaps on the

government debt of countries they have investments in (S. Korea). They also hold

credit default swaps in a bunch of European countries not necessarily because they

have holdings there but because it reduces risk and they were very cheap ($60, 000 a

year for $100 million in insurance).

Baupost does best when there is high uncertainty and little information. When they

research a company they do what ever they can to find information; they talk to every

one to get information including, manegment, industry people, former executives,
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customers, suppliers, they sometimes hire consultants and talk to analysts on buy and

sell side.

They constantly reassess to find new information, if theyve overlooked something or if

something has changed.

Employees own second largest position in Baupost.

Bauposts 3 investment principles:

1. Focus on risk before return. This is why Baupost has so much cash, currently 45% of the fund

is in cash. If they could find undervalued investments they would put all their money to work

tomorrow. If they had to they would have no problem holding 100% cash. People fail to have

sell discipline because they cant hold cash.

2. Focus on absolute returns. Institutions focus on relative returns but Baupost doesnt because

Klarman cant imagine writing a letter to clients saying "we performed well during the year,

the market was down 25% and we were down only 20%" also clients will pull money out at the

wrong time and it has a strong psychological effect.

3. Only focuses on bottom up investing. He has views on the macro but doesnt think he has an

edge in that type of investing. Klarman said that its really hard to turn a macro idea into an

investment.

Klarman's 5 fold investment in Enron debt

Baupost invested in Enrons senior debt and he said that would be an example of his

favorite type of investment. The situation had a lot of complexity, hard to analyze, alot of litigation, uncertainty and no one wanted to be associated with anything Enron

creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It

comes down to assessing assets minus liabilities. After a few years most of Enrons

assets were cash $16-18 billion but the liabilities were extremely complicated, with

over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years

and try to figure out its liabilities and how much they would get back on the bonds.

Baupost believed that the people liquidating Enron were low balling what they would

get back on the bonds. The people liquidating Enron were very pessimistic and they

originally estimated that the bonds would get back 17 cents on the dollar at the same

time the debt traded for 14-15 cents, Baupost estimated that the debt would recover

30-40 cents and as of now they believe it will be more then 50 cents.

Investments like Enron debt are possible because the market doesnt assess risk

correctly by relying on volatility (beta).
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