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These are notes taken from a Columbia Business School conference presented on October 2, 2008. Seth Klarman wrote the excellent book called "Margin of Safety." You can find our detailed notes of the book at this link http://rbcpa.com/Notes%20To%20Margin%20of%20Safety.pdf .

I mostly included Klarman's comments, yet James Grant is such a valuable resource. James has a newsletter called Grant's Interest Rate Observer www.grantspub.com , which we find invaluable.

We have studied Klarman for years and find his work to be incredibly valuable. He reminds us that times like these when markets are down 25% or so, that value investing should have its day in the sun again. He pounds the table that competent value investors need to avoid the noise of the day, avoid the investors that are short-term oriented and to stand apart from the crowd.

We hope you enjoy these notes.

Seth Klarman at CIMA Conference 10/2/08


1. Biggest fear was buying too soon and on way down, from up in over-valued levels. Knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.


Q&A


1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman - Unusual amount of forced sellers, via margin calls. This could breed opportunity. Sees a lot of money managers staying on the sideline. He finds this as an opportunity to buy. Buy when others react to news or false news. His experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald - Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant - Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman - He thinks this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges.
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anybody care to guess what is Klarman's inflation hedge?
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This seems a fitting re-read.

Excerpts from Baupost Limited Partnerships 2005 Year-End Letter
January 26, 2006

Today’s Market Environment: The Bad News About Value Investing
Here is the bad news about value investing: value investing itself has never been more popular. Fans of Warren Buffett now fill a sports stadium when they flock to Omaha in May for the Berkshire Hathaway annual meeting. Russell “value” stocks have outperformed Russell “growth” stocks for six consecutive years. Now opportunity is scarce; when we sift through the debt, equity, and real estate markets around the world, we find few bargains. Risks are high, returns low, and markets feel picked over and still expensive. While it receives limited attention, the broadly-based Russell 2000 Index has been making new all-time highs, even as better known indices such as the S&P and Nasdaq remain well below peak levels.

The asset allocation world is an increasingly desperate place. Capital freely sloshes across asset classes to those purporting to have uncovered the tiniest market inefficiency or mispricing. This has the effect of bidding up prices, thereby lowering the expected return and raising the risk on individual securities and classes of securities. Some say this reflects investors’ acceptance of a lower risk premium; we would call it overpaying.

These days, nearly anyone can start a fund to exploit every real or imagined mispricing, and huge sums are routinely allocated to the best performers until they resist new capital entirely, or accept it at the price of being forced to change their style beyond what has made them successful to date. Investors routinely bid increasingly risky and obscure assets to lower and lower returns, with consideration of risk at best an afterthought. Hungry analysts with a computer model searching for a deal are an unusually dangerous breed.

More than ever before, past performance is not a reliable predictor of future results. The half-lives of many formerly stable businesses seem to have shrunk, as competitive forces unleashed by new technology and freely flowing capital erode barriers to entry. An increasingly vast amount of venture, private equity and hedge fund capital flows not into secondary market purchases of securities, but directly into businesses, increasing competition beyond anything heretofore experienced. The bottom line for investors is that if more competitive capital markets don’t get you, more competitive business conditions may.

How do we respond to such an environment? With difficulty and trepidation, would be the short answer. We are not so brazen as to believe that we can perfectly calibrate valuation; determining risk and return for any investment remains an art, not an exact science. Should we accept a lower return than we used to in order to buy a bankrupt bond, corporate spinoff or half-empty office building? If we don’t, we may be forced to sit on a growing pile of cash, perhaps for a very long time, betting that the markets will revert to historical levels of
valuation. If we do, we will be betting that times have changed, that investing to earn a barely adequate return is better than not investing at all.

Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity, accepting a minor diminution in expected return where, and only where, the historic returns have been particularly outsized for the risk. There was never any logic, for example, behind the consensus industry annual return targets of 20% or more on bankrupt bonds or private investments. At times, an expected 15-18% return is ample, given the quality of the underlying assets, the conservative nature of the assumptions made, and the limited spectrum of things that can go wrong. Other times, even a projected 25-30% return might be inadequate, where the quality of the assets is suspect, the return is earned in a risky and unhedgeable currency, and the downside risk is larger than usual. The quality of management must be factored in. The expected duration of an investment may also play a role; a short-duration investment earning inadequate return is over soon, and one can move on to better opportunity. Long-duration mistakes are the gifts that keep on taking, locking you in to low returns, or significant capital losses if you exit early.

Another significant risk faces value investors. Jeremy Grantham at GMO has convincingly demonstrated that all financial bubbles eventually fully correct, and many overshoot to the downside. With valuations still universally high, once markets start dropping, even cautious investors are exposed to the significant risk of getting in too soon. Also, valuation can sometimes involve a degree of circularity – a closed-end fund or holding company trading at a discount, for example – so lower market prices do not always translate into better bargains. If you were clever enough to be out of the stock market in 1929, you might have congratulated yourself as you were picking up the bargains of 1930 30% lower than the year before. But by 1933, you would nonetheless have lost over 70% of your capital. In short, the declines from 100 to 20 and 70 to 20 feel almost exactly the same in terms of the pain experienced, and the debilitating effect on client morale and investor psychology are identical. If we do invest prematurely, as we inevitably will in the next severe bear market, having the correct mindset will be more important than ever. It will take tremendous resolve in the face of extreme markdowns to hold on or even add to positions rather than capitulate along with everyone else.

The Good News About Value Investing
Not all the news is bad. We live in a world where nearly every professional investor, bull and bear alike, is fully invested, with many more than fully invested through the use of leverage. Most feel enormous pressure to act – in order to justify their management fees and to produce good relative performance. Many have stretched to keep their capital at work. This means that the competition for investments may greatly diminish just when better bargains are at hand.
There is also a limit on the likely population of value investors because value investing involves more patience and discipline than many people can muster. Growth stocks, at least, are interesting; even disciplined value investors are sometimes tempted by the excitement that new technology or a rapidly expanding emerging market seems to promise. Also, many so-called value investors are what we would call value pretenders, “buy-the-dips” specialists who buy what’s down but not necessarily what’s cheap. This trading strategy has worked well for a long time, but will disappoint in the next real bear market.
As we said last year, even with vast amounts of capital and throngs of clever analysts chasing opportunity, the markets remain inefficient. This is not because of a shortage of timely information, a lack of analytical tools, or inadequate capital. Markets are inefficient because of human nature – innate, deep-rooted, permanent. People don’t consciously choose to invest with emotion – they simply can’t help it.
Investors cannot change their stripes and will always exhibit characteristics of greed and fear. They will remain biased toward optimism, interested more in how much they can make rather than how much they might lose. They will be interested in relative, rather than absolute, performance. They will want to get rich quick, lured by short-term trading strategies, hot IPOs, and technical analysis, rather than truly undervalued but long-term opportunities. (This is as true, by the way, for clever hedge funds as it is for unsophisticated individual investors.) Then, when things go awry, investors will again overreact, selling urgently what has caused them pain without regard for value.

Institutional investors continue to experience weighty constraints on good performance, ranging from their own gargantuan size, to short-term performance pressures, to the inability to hold cash. They face restrictions, real or imagined, on investing in financially distressed, litigious or highly complex situations; the prudent man standard can be an albatross. They may have a rigid mandate as to asset classes, geography, and liquidity, and thus be unable to take advantage of some potential opportunities. Value investors can take advantage of these institutional constraints by remaining long term and absolute-performance oriented, by flexibly pursuing opportunity across traditional boundaries, and, in a world where almost no one does it, by holding cash when there is nothing better to do.

Macro Worries
While rising interest rates seem to have cooled the housing market a bit, there is, as of yet, little pain. If conditions continue to deteriorate, as seems likely, there will be significant carnage (and perhaps investment opportunity) as a result of diminished affordability, excess supply, and foolhardy loans made to poor-quality borrowers.

Of greater concern: we increasingly suspect the true rate of inflation to be significantly understated. One factor is the government’s use of “hedonic price adjustments” that attempt to measure the value of “quality improvements” in many goods. In addition, the way the U.S. government measures the cost of many items, such as housing, is based on an odd construct that, not coincidentally, shows the result the government wishes for rather than the one we all can observe in plain sight. Housing costs, in the government’s calculation, are based on
imputed rents, which have not been rising even as housing prices have surged in recent years. When we consider the expenses in peoples’ lives, computers and home electronics are surely becoming cheaper, but almost everything else – food, gasoline, heating oil and natural gas, healthcare, tuition, tickets to theatre, concerts and sporting events, and services from haircuts to lawn care to legal advice are soaring. If the markets wake up, interest rates will surge, housing will deteriorate even more rapidly, and equities will face heady competition from government bond yields.

Finally, as Northern Trust’s Paul Kasriel recently highlighted in the New York Times, household borrowing is out of control, and this debt is clearly propping up the U.S. economy. By way of example, in the third quarter of 2005, households spent a record annual rate of $531 billion more than their after-tax earnings. Historically, consumers regularly earned more than they spent; the recent binge in borrowing for consumption is truly unprecedented. It has (thus far) resulted in consumer spending at a record high 76% share of GDP.

Consumers are using their increasingly valuable homes as quasi-ATMs, extracting $280 billion of cash through home equity borrowings in the second quarter of 2005 alone. This is a surprisingly new phenomenon; in the last three decades of the 1900s, there was virtually no net home equity extraction by consumers. While we cannot predict how these excesses will play out, it seems clear that such trends cannot continue indefinitely, and that a restoration of fiscal sanity will bring with it wrenching, largely unexpected, and painful adjustments.

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. The day of financial reckoning for these and other excesses has been repeatedly put off, creating the illusion that risks are low, when in fact they are enormous and rising. High energy prices, ongoing terrorist threats, and nuclear proliferation add to the vulnerabilities. While we won’t hesitate to take advantage of investment bargains we uncover at any time, we are preparing our team to be well-positioned for the emergence of an expanded opportunity set.
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<<<anybody care to guess what is Klarman's inflation hedge?>>> praytell, what?........Wild guess #1 Timber.....wild guess #2 Commercial real estate..........well, you did ask for a "guess".
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anybody care to guess what is Klarman's inflation hedge?


Buying BRK ??

I mean, some of the BRK portfolio (PG, Gilette, Coke, MidAmerican, etc) seem to supply quite basic products and services, that would likely survive inflation for an extended period.
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<<<anybody care to guess what is Klarman's inflation hedge?>>> praytell, what?........Wild guess #1 Timber.....wild guess #2 Commercial real estate..........well, you did ask for a "guess".

Definately not timber and not real estate. I'd guess short US Treasuries.
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BGMan,
Just curious if you could elaborate on the quotes below. Do you think Seth is talking about the past three years in terms of his biggest fear of buying too soon? Was he/is he talking about being extremely cautious now about the next three years?


Biggest fear was buying too soon and on way down, from up in over-valued levels. Knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.


Here are a few excerpts from his January letter to investors if that helps to further frame the discussion.
Best
Ish

Virtuous circles have formed in many areas of the financial markets, driven, in part, by a
strong economy, a benevolent Fed, and investor ebullience. Consumer, corporate, and
commercial real estate lending have burgeoned in ways similar to residential lending. We
believe there have been remarkable excesses in each of these areas, exacerbated by the
moral untethering enabled by securitization, the greed of lenders chasing returns, and the
painfully short memories of everyone concerned. Succinctly, we don’t expect the
subprime mortgage debacle and housing contraction to be isolated events but more likely
the first failure in a broader reckoning. The overstretched consumer seems unlikely to be
a more reliable debtor when it comes to servicing a car or credit card loan than they
proved to be as mortgagees. The equity of highly leveraged companies, in many cases
purchased by private equity firms at fantastic valuations that could not be justified today,
has increasingly become an out-of-the-money call option on the hope that things
somehow work out.
The 2000’s bull market in commercial property was driven by a precipitous drop in
capitalization rates (the required yield demanded by investors). By 2007, this left many
properties carrying more debt than these same properties were worth only a few years
prior. Commercial mortgages and securitizations will certainly experience their share of
difficulties now that financing spreads have widened, property prices have stalled out,
and vacancies in certain asset classes are starting to rise.
The stock market is another area where favorable tailwinds have turned into headwinds.
Rather incredibly, the credit crunch, which clearly has an impact on the cost of corporate
financing, the general availability of credit, and the value of companies to a leveraged
buyer, did not prevent most of the broad stock market indices from rising in 2007.
Neither did the skyrocketing price of a barrel of oil, which jumped almost 60% during the
year. While no one can forecast the stock market, and while the weak dollar does make
U.S. shares look inexpensive to foreign buyers, we would not be surprised if the incipient
economic slowdown and continued credit deterioration contribute to stock market
weakness as 2008 unfolds.
One of the ongoing complexities of security analysis is that you can never satisfactorily
determine where you are in a cycle. How long might a bull or bear market last? Had you
avoided the upward frenzy of 1929 and missed the great crash only to jump into the
market in early 1930, the pain you would have felt by 1933 would hardly have been
different from the agony of those who had invested at the 1929 peak. We will not be
certain until much later whether the so-called bargains of January 2008 were truly
undervalued or merely dangerous temptations to value-starved investors.
Other reckonings are under way as well. Managers of money market funds are clearly reexamining
the wisdom of incurring any credit risk whatsoever, since the brunt of
investment losses often ends up being borne by their management companies rather than
their funds. Investors in money market and bond funds are certainly scrutinizing their
holdings with a newfound seriousness. The world has turned nearly upside down for state
and local treasurers, who, with the solvency of all the incumbent municipal bond insurers
now suspect, are actually able to issue uninsured debt at interest rates no higher than
insured debt. These same treasurers are getting an on-the-job primer in the management
of pooled debt vehicles and retirement funds, beginning with a tutorial on the dangers of
trusting the ratings of any debt instrument.
No one can know what the future holds, but a further revulsion against risk in all its
forms would not surprise us. Higher borrowing costs, tighter lending standards, and more
cautious investor behavior could further slow economic activity, with a resultant fall in
securities prices. This is a scenario that we do not consider remote, one that we fear, and
one that we, no matter how well positioned, will need all of our experience,
resourcefulness, caution, and acumen to survive reasonably intact
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Hello

I have created a compilation on Seth Klarman here

>> http://www.valuestockplus.net/seth-klarman

I hope "fool" boarders like it :)

- Toughiee
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No. of Recommendations: 13
Looks like this guy copied my work, word for word, and took credit as his own.

http://victoriacontrarianinvesting.blogspot.com/2008/10/seth...
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No. of Recommendations: 1
Looks like this guy copied my work, word for word, and took credit as his own.


Porayko is a really sad, pathetic, slimy weasel!! (If I had a Blogger account, that's what I would have posted )


Hohum
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