Seth Klarman is the legendary value investor behind the highly successful and secretive Baupost Group. Klarman is also known as the "Oracle of Boston," and his fund has only had three losing years in Baupost's 34-year-long history and has generated annual returns of 16.4%.
Klarman is famously tight-lipped about his investing process. Unlike fellow value-investing giant Warren Buffett, who publishes his annual shareholder letters publicly, Klarman only distributes his thoughts to the limited partners invested in his fund. But for Fool readers, we've managed to snag a copy. A few of Klarman's key thoughts are outlined below.
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A story of "before and after"
Klarman begins his letter by describing 2016 as a story of before and after the presidential election. For the 44 weeks leading up to the election, Klarman describes this time as "a continuation of the prevailing trends: tepid economic growth, absurdly low interest rates, Washington in gridlock, and a long-in-the-tooth bull market characterized by rich valuations and relatively low volatility." This period was "dominated by a continuation of the quantitative easing and near-zero interest rate policies that have been implemented since the 2008-2009 financial crisis."
After the election, Klarman describes a radical change in the market, stating "Optimism over the possibility of a rejuvenated economy drove a protracted post-election stock market rally, with speculators guessing winners and losers based on expected policies of the incoming Trump administration."
Following the surprise Trump victory, "The market rushed to price in the likelihood that Trump would propose sharply lower individual and corporate income tax rates. Ensuing animal spirits drove U.S. stocks to repeated new highs, especially shares of those companies expected to benefit most from lower taxes, expanded infrastructure spending, and deregulation."
However, with regards to the "Trump-bump," Klarman says, "The market's post-election gyrations are emblematic of what markets do: they attempt to forecast he future and reflect it in daily securities prices. But markets are hardly efficient; they frequently overshoot."
Valuation
While Klarman admits that "The new administration will have a decidedly pro-business bent," and that "Corporate profits are likely headed higher on the back of Trump tax cuts and fiscal stimulus," he also warns investors to be cautious. Citing Goldman Sachs, Klarman notes that "the S&P 500, in aggregate, recently traded at the 85th percentile of its historical valuation over the last 40 years, while the median company in the S&P 500 has reached the 98th percentile of valuation."
Klarman furthermore states:
Exuberant investors have focused on the potential benefits of stimulative tax cuts, while mostly ignoring the risks from America-first protectionism and the erection of new trade barriers. President Trump may be able to temporarily hold off the sweep of automation and globalization by cajoling companies to keep jobs at home, but bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces.
Investing in times of uncertainty
As Klarman moves on to describe Baupost's strategy for investing in the era of Trump, he says the firm intends to "stick to the tried-and-true basics: bottom-up, fundamental-based value investing."
Klarman then elaborates:
The market is often a tease. When it's acting well is usually the worst time to invest, and when it acts poorly is usually the best. True investors don't continuously dart in and out of the market, they invest for all seasons.
Although most investors are judged by their returns, Klarman writes that at Baupost, what matters more than outcome is process. Klarman cites famous psychologists Daniel Kahneman and Amos Tversky when he writes, "The job of the decision maker wasn't to be right, but to figure out the odds in any decision and play them well." This somewhat nuanced point is critical for every investor to understand.
A fool's errand
In closing, Klarman remains hopeful regarding Baupost's future success. He writes:
Despite the intense competitive forces outlined earlier, financial markets are still far from efficient. This is, in part, because so many investors have narrow mandates but also because many investors and their investment managers are as short-term oriented as ever (and arguably becoming even more so). Many seem allergic to buying investments in the face of expected bad news -- even when prices have fallen to bargain levels -- if that news seems likely to drive the price still lower. ... Trying to identify the absolute low is a fool's errand.
There are multiple insights to take away from Klarman's letter. For myself, this letter has reinforced the importance of not getting swept up in the "animal spirits" of the market. It has warned for caution and a level head as we adjust to Trump's America. Finally, and most optimistically, Klarman stresses the importance of focusing on process, rather than short-term results. It's a simple, long-term strategy that can work for every investor.
