Seth Klarman on investing

Seth Klarman doesn't conduct too many public interviews but I ran across a detailed interview conducted by TIFF Education Foundation (thanks to ValuePlays for referring to it.) A large chunk of the interview dealt with institutional issues, such as picking the right analyst or manager and retaining them, but the latter portion is likely to be useful for small investors. I don't follow Seth Klarman closely—he is not my style and virtually impossible to tell why his fund is purchasing or selling a security—but many value investors consider him to be one of the top investors around. Seth Klarman's record in the 90's is nothing spectacular but many claim he is very risk-averse and has done exceptionally well in the 2000's (I haven't seen anything to confirm this but it is probable that his record, if you include the last 9 years, is quite good.)

I will quote some of his thoughts, while injecting my views, in the rest of this post. Note that the text is not quoted in order and I'm actually going from, what I perceive as, least insightful to most insightful.

(source: Commentary. TIFF Education Foundation. 2009 Edition 2.)


On Holding Cash

Seth Klarman is known for having sizeable cash positions. This is perhaps why is returns in the 90's don't look so good. In any case, I am starting to consider cash management as an essential tactic in investing (I didn't use to think this way.) Young investors, or those whose portfolio is very small compared to the amount of money they contribute every year (i.e. savings), probably can get away with poor cash management; others, however, should think of cash as an asset. A lot of people spend a lot of time thinking about how much to allocate to asset classes such as real estate, emerging market stocks, and so on, but they rarely think of how much cash to hold.

So I wouldn’t want the crowd here to think, “Well, we need to start going to 50% cash sometimes.” I don’t know what everybody should do. I just know that because I sit at a really interesting desk where a lot of really interesting bottom-up ideas cross my plate, I can tell very quickly, do we have no opportunities? Do we have a few sparse opportunities? Do we have a food of opportunities? If we have a flood, we probably want to raise the bar or we’re going to spend every nickel and then wonder what do we do with the next opportunity. There’s also something about the engine of creating opportunities that needs some cash to function. You’d hate to tell a great real estate partner or a great broker, “You know, that’s a really interesting opportunity; I’m glad you have this billion dollars of assets for sale at a ridiculously low price, but I’m sorry, we’re tapped out today.” That’s not a good answer. When you’ve worked really hard to cultivate relationships, you’d like to feed them, so you in some sense always want to have some buying power.

I think anyone who got killed in the current crash, which is almost everyone except short-sellers and certain macro investors (had to be long US Treasuries, Yen, or US$), can probably attest to the fact that valuations became cheap but they were already fully invested. There is going to be huge difference in the next few years between those who have cash versus those that don't. Those with cash can buy securities at much lower prices, while those with cash shortage have to start liquidating (generally with losses) in order to invest.

Of course, the downside to cash is that it is a drag on performance during bull markets. (This doesn't apply to small investors like us but institutional investors also have difficulties sitting on cash due to their business model.)


Warren Buffett is A Role Model

David [questioner]. Do you have a personal role model and a professional role model, if they’re in fact different?

Seth. I’m not used to black-and-white answers on these sorts of questions, but what I came up with on this was Warren Buffett. He has been a wonderful role model even though I know him only a very tiny bit. He was a role model long before I ever met him. What I think he’s done wonderfully, in the tradition of Benjamin Graham, is he is a brilliant investor, and he’s a teacher. He teaches us through his writings, through his interviews, and through his behavior. I think some of the best things that any investor today can read are his early partnership letters. The world is totally different, but there’s wisdom in them for the ages. As he says, an investor needs to be able to confront things they’ve never seen before. I think an investor today could learn a lot by seeing what the environment was like when there was less competition and when securities were of different kinds of companies, and to also understand the cycles of history. Virtually none of the companies that Buffett owned from the ’50’s and ’60’s, the little oddball things, are recognizable today. The eras pass and change but the fundamental principles don’t. Also, he has a thoughtful opinion on almost everything, which is a way of living in the world. It’s a way of asking, what do you want to read? What do you want to know about? What do you want to be an expert on? He seems very balanced in that way.

Warren Buffett is also a role model to me. I'm not a true Buffett fan but I do think he is one of the greatest Americans I have encountered. One of the impressive things about Buffett is that he generally made his money through ethical means. There are many others who became powerful, successful, wealthy, or influential, through dubious methods. Warren Buffett, like all humans, is flawed but he tries to avoid harming others. I am probably impacted more by Buffett's non-investing thoughts, such as his views on social issues, politics, and so forth, than most Buffett fans. Buffett has made me re-think the way I look at certain things in life.

Klarman suggests investors should read Buffet's early partnership letters. I haven't read many of his early letters but plan to do so over the next few years. You can access his early letters from ValueHuntr's resources page (scroll to the middle of the page.) ValueHuntr only seems to list letters starting in 1959 and I'm not sure if he published other letters before 1959.

I haven't read much of Buffet's writing—I would say I have read less than 20% of his shareholder letters and 100% of his newspaper/magazine articles—but, with my limited knowledge of his writing, I would say the best item Buffett has ever written is How Inflation Swindles the Equity Investor for Fortune in 1977. The PDF contained at Valuehuntr is very poor quality and hard to read but you can also access the article from ValueInvesting.DE. I don't know about his early partnership letters but this article is a must-read for investors. Even if you are macro-oriented, I highly recommend this article because it contains so many insightful ideas (as an example, I like how he says in one section that public shareholders own class D shares of companies, while governments own class A, B, and C shares.)


Is Investing an Art, Science, or Craft?

David [questioner]. The next question is one that I’ve asked other folks who’ve appeared on this stage over the years. I get asked the question a lot when I go out and talk to groups of college students or graduate students. They ask, “Is investing an art or a science or a craft?”, where craftsmanship is defned as the ability and willingness to come to work every day and do the same thing over and over again. How would you answer this question as it applies to what you do professionally? Art, science, craft: what’s the balance among the three?

Seth. I would say art first and foremost, craft second, science third. To me, the science of valuing things and of identifying when things sell at a discount is as straightforward as could be. It’s almost a commodity these days; when you hire business school kids, they all know how to do that. There are nuances and places they might make mistakes, but I think that’s the easiest part, albeit for a layperson it might seem like the hardest part. I think there is a big element of craft in showing up, especially for a value investor where part of the game is discipline. It’s like Warren Buffett says, you are in a game with no umpire and no called strikes so you can keep the bat on your shoulder for a long time. So the craft of showing up and saying, “Nope, nothing interesting today. Nope, still nothing interesting,” is really important. There are other parts that are also like a craft, such as hiring, which is tedious, as you know. One year we interviewed over 50 people and made no offers, so it was like waiting for a cheap stock. You’re waiting for something, and unless you have a massive hole that you have to fll, you have no urgency, so it forces you to have that long-term, craft-like perspective. I think, ultimately, the nuances I was talking about — the ability to distill two or three major themes out of an investment and get right to the heart of the matter — is truly an art. Some of our best analysts can get up to speed in a day or two on something they’ve never heard of before. This is a world where many people have chosen to specialize, to have silos, to have narrow areas of extreme expertise. That’s a legitimate choice, and many of the best long-short funds, for example, have their pharmaceutical analyst and their oil and gas analyst and their financial analyst. We respect that, but we think more value is added by being generalists and seeing opportunities from a broader perspective. If you have silos, you’re going to own things only within those silos. If you have the broader perspective, you can say, “I don’t even like stocks, I’m working on distressed debt,” or something like that.

An important question and an important answer. I wonder how someone like Charlie Munger or even Warren Buffett would answer the question.

I suspect what Seth Klarman says goes against what I, or many other newbies and amateurs, feel. I suspect most amateurs feel that the science part—determining the number, the value—is the hardest (Klarman even alludes to this possibility of amateurs and newbies having difficulty with this.) Many, including me, spend an inordinate amount of time on the science part. However, Klarman says that investing is, foremost an art, followed by the craft aspect.

I haven't given this question much thought and I'm not sure if I agree with his answer fully. I think the science part plays a bigger role than he implies—it might even be above the craft aspect. For instance, even the best & smartest on Wall Street were completely wrong with the valuation they placed on many securities in the last few years (particularly mortgage bonds and credit default swaps on almost anything—I'm not talking about fradulent mortgages; I'm referring to truly erroneous valuations.) In any case, there is some truth to what Klarman is saying.

The science part probably has the lowest barrier although it takes some minimal study (perhaps the amateurs have difficulties getting past the minimum barrier.) This is why professionals will likely beat the vast majority of newbies and amateurs. Even the below-average professional who spends 9 to 5 everyday on investing will likely have a better grasp of the science aspect of investing than above-average amateurs who have full-time jobs doing something else and can't learn anything to the same degree.

The craft aspect, which I think is less important than what Klarman thinks, actually gives a small edge to amateur investors. This has nothing to do with knowledge and is more of what you, as an investor actually chooses to do. For professionals, they are often forced to do something—anything—even if one should just stand still.

As far as the art of investing is concerned, I completely agree with Klarman. Investing really is an art. This is why you can't read books x, y, and z; work on it for n years; and become a successful investor. But the art aspect is probably the only area where an amateur investor may be able to develop a big edge over professionals. There really isn't any automatic advantage possessed by professional investors if you look at investing as an art. Because it is an art, there is no methodology or some system you can learn and become successful. I see many newbies trying to perfect a 'system' but there really isn't any; they would be better off trying to get a sense of what they are actually investing in, and how that fits into the world. If you look at many of the successful investments by Warren Buffett, you will notice that it has little to do with quantitive aspects and more to do with understanding the essence of a business and what it is trying to do in this world.

I'm not saying there is only one way to invest but it is useful to think about what investing is, and what you, as an investor, is trying to master.