Distressed Debt Investing_ Wisdom From Seth Klarman - Part 4

6/27/2015 Distressed Debt Investing: Wisdom from Seth Klarman - Part 4

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DISTRESSED DEBT INVESTINGThis blog will try to dissect distressed debt investing, up and down the capital structure. We will look at current distressed debtsituations, try to explain the ins and outs of how decisions are made in the distressed debt world, probably rant a few times aboutpositions that are working against me, and hopefully enlighten some readers.

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Wisdom from Seth Klarman - Part 4

If y ou are new to the blog, here is part 1-3 from our "Wisdom from Seth

Klarm an" series.




In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get

to it, thank y ou to Andy for his donation (for those so inclined, a donation link is on

the right rail, lower in the page). More donations = the better.

In 2006, Baupost's v arious funds ended the y ear up between ~21.4 to 22.8%. This is

in comparison to the S&P which was up 15.8% that y ear. Gains were made from a

number of categories with approximately 7 % of absolute gain coming from

performing and non performing debt - with the largest gain coming from "unnamed

non-performing debt" which I speculated in last post was a position in Enron. These

results are ev en more impressiv e giv en that cash/cash equiv alents were 48% of the

fund at y ear end. ROE therefore was ov er 40% during the y ear.

After discussing the party that was 2006, Klarman writes:

"We maintained our discipline throughout the year: disciplined

buying when bargains emerged, and disciplined selling when prices

approached full value. Despite fairly expensive markets, robust

competition, and a near complete dearth of distressed debt

opportunity, our tireless, highly capable, and experience team was

able to fairly regularly uncover new opportunities. Considerable

fundamental progress in many of our holdings, along with our

strong selling discipline, triggered realizations during the year that

were approximately equal to new purchases, resulting in relatively

flat cash balances that masked substantial underlying activity.

One adverse in evidence during the year is that the markets

proffered fewer extreme mispricings, and a relatively greater

number of moderate ones. Beneficially, the velocity of the correction

of these mispricings accelerated. In other words, fewer investments

become really inexpensive, more become somewhat inexpensive,

and the correction of these smaller mispricings happened faster than

usual, enabling a particularly favorable overall result for us and for

many value-oriented investors. It is impossible to know if this

paradigm will continue, although the proliferation of ever-vigilant

and opportunistic hedge funds and increasingly private equity pool

suggest that it could.

The old saw reminds us never to confuse genius with a bull market.

Anyone can become "expert" at buying the dips, and recent market

conditions have amply rewarded dip-buyers with quick gains. It will

not always be so easy; slight bargains don't always compliantly

rally. Sometime minor bargains become major ones, and sometimes

great bargains turn out to be not as cheap as you thought. Eras of

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quite low volatility and general prosperity are often followed by

periods of disturbingly high volatility and economic woe.

Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly

into "buy anything"; a rising tide that is lifting all boats often proves

irresistible."

This guy must hav e a cry stal ball. Remember he wrote this in January 2007 . He is

also somewhat pointing the finger (I am sure unintentionally ) to many of the v alue

inv estors that kept buy ing and buy ing all throughout 2nd quarter of 2007 - 2008. I

remember reading an interv iew with a prominent v alue inv estor say ing that

Freddie Mac was one of the cheapest stocks he had ev er seen - and he just kept

buy ing and buy ing it.

After talking about the sheer magnitude of capital flowing into alternativ e

inv estments (hedge funds, v enture capital, and priv ate equity ), fueled by demand

from institutions and pensions:

"Many of today's institutional asset allocators are not evidently

worried about the enormous amounts of capital surging into

alternative investments. They are now asking the relevant bottoms-

up question: Where are today's bargains? They are not following

that thread to build, investment by investment, or one carefully

chosen fund at a time, a diversified portfolio of undervalued

investments. Instead, they are typically focused on the answer to

three questions, each of which demonstrates a reluctance to think

for themselves:

1 . What has worked lately?

2. How can I diversify my way to investment success?

3. How can I invest like the institutional thought leader of this era;

in other words, like Y ale?

Here's why these questions range from remarkably foolish to largely

irrelevant.

Investing is mean reverting. What has outperformed lately will not,

and cannot, grow to the sky. Sustained out performance in any

particular sector of the markets is eventually borrowed from the

future, to be given back either slowly through sustained under

performance or quickly through price declines. What has worked

lately is popular, widely owned, and bid up in price, and therefore

generally anathema to good future results. But human nature makes

it extremely difficult for people to embrace what has recently fared

poorly."

And further down the letter...

"The idea that you should own a little bit of everything is a concept

rooted in market efficiency. If the markets are efficient, you cannot

outperform anyway, so by owning a bit of everything in just the

right proportions, you stand to reduce portfolio volatility, what at

least avoiding under performance. This is the best that you can hope

to do in an efficient market.

For any fundamental-based investor, this is complete hogwash.

Investment come in the following varieties: undervalued, fairly

valued, and overvalued. Price is everything, and every investment is

undervalued at one price, fairly valued at a higher price, and

overvalued at some still higher price. You buy the first, avoid the

second, and sell the third. Having a goal of diversification, rather

than owning value, causes investors to take their eye off the ball. It

is a refuge of investment wimps, owning a little bit of everything to

avoid being wrong, but thereby ensuring never being really right

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either."

I lov e it. Too many times, each of us get caught up try ing to look at some many

things that our heads spin. A number of v alue inv estors suffer from a problem I

fondly dub "Ev ery thing is cheap sy ndrome" ... after y ou study Buffet, Graham, and

Klarman y ou start looking at ev ery thing, and lots of the things y ou look at y ou think

are cheap. Any inv estor can rationalize a price target for any asset. The goal is to be

patient and swing at those once in a lifetime opportunities, and then not dilute

those returns with mediocre v alue traps.

"Given how hard it is to accumulate capital and how easy it can be

to lose it, it is astonishing how many investors almost single-

mindedly focus on return, with a nary of thought about risk. Lured

into their slumber by the 'Greenspan-now Bernake-put', an

investment mandate of relative and not absolute returns, as well as

a four-year period of generally favorable market conditions,

investors seem to be largely oblivious to off the radar events and

worst-case scenarios. History suggests that a reordering of

priorities lies in the not too distant future."

The first rule of inv esting is to not lose money . And the second rule is to not forget

the first rule. When approaching situations, alway s look to the possibility and

magnitude of permanent capital loss. I remember watching Alice Schroeder (author

of The Snowball) at an ev ent a y ear or so ago and she mentioned that Warren Buffett

will not inv est in a situation where there is ev en a remote chance of permanent

capital loss.

Stay tuned later in the week when Distressed Debt Inv esting finishes its analy sis of

the 2006 Baupost Annual Letter.

Posted by Hunter

Labels: distressed debt investing concepts, Seth Klarman

1 COMMENTS:

Anonymous, 10/06/2009

Hi - good post and good blog. Where could one find the more recent (after

~2001) Baupost letters? Thanks.

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hunter [at] distressed-debt-investing [dot] com I have spent the majority of my career as a value

investor. For the past 8 years, I have worked on

the buy side as a distressed debt and high yield

investor.

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Distressed Debt Investing_ Wisdom From Seth Klarman - Part 4