There are a lot of ways to invest. Value investing is the most counterintuitive, but that counterintuitiveness, when followed, typically prepares value investors better in seizing opportunities during market drawdowns. It’s also why it’s so hard to follow.
2008 was an extreme example of this. It was, potentially, the worst-case scenario. The crisis had multiple possible outcomes and on October 2nd of 2008, all of it was on the table.
Only a week before, Wachovia and Washington Mutual were “saved” in forced acquisitions and the first attempt at a financial bailout plan failed in a House vote. A week before that, Lehman collapsed. Then the next day, October 3rd, Congress came to its senses, passing the Emergency Economic Stabilization Act — the bailout — which President Bush signed later that day.
That was just in the U.S. It was global and it was only the beginning. The timeline of events is extraordinary.
And my limited description of those few weeks leaves out just how scary it was at the time. There were too many reasons to not invest and get out and too few reasons to stay in and start buying. Yet, some people stayed put and even bought.
The steadfast buy-and-hold crowd suffered through it and emerged better off (than most) in the long run.
But someone still had to buy everything being dumped on the markets. So a few greedy value investors were on the receiving end. Then on October 16th, The New York Times published Buffett’s “Buy America” op-ed, which injected a little more courage for others to step up too. However, none of the buyers would be buying if they weren’t prepared for it in advance.
Of course, I purposely chose October 2nd because, on that day, a Graham and Dodd Symposium was held at Columbia Business School. Leave it to value investors to hold a conference amidst the most chaotic financial episodes in recent history.
I referred to the Symposium once before but failed to put two and two together with the dates. With that as a reference, the Q&A exchanges offer a unique insight into just how counterintuitive value investing is compared to everything else.
One exchange specifically, between Seth Klarman, David Abrams, and Howard Marks, is a great example of how their process of evaluating risk, prepares them for opportunities in the market.
It’s easy to look back on it and say just how lucky they were on their timing. That certainly fits, to a point. But the luck was, in part, due to their risk first approach to their investing process.
Here are their responses to the two questions that stood out the most:
Q: How are you responding to this environment?
Abrams: Today there’s a lot of cheap stuff out there. I mean, it’s kind of eye-popping. I think the biggest area is the debt area. That’s where we’ve been really focusing 100 percent of our time and efforts right now… Everything that we buy goes down every day but you know, we look at the economics of it and the price and I think it’s some of the best opportunities that I’ve ever seen.
I actually was signing a bunch of trade tickets the other day for a few days—I’d been out for a couple days… So it’s making me incredibly excited. Of course in the short term, you know, every tick’s a downtick, and that’s kind of our, my short story of what we’re doing today.
Marks: Well as I said, our money doesn’t migrate the way David describes but we try to adjust our capital… And then at the beginning ’07, we said we think something’s coming so we raised 3-1/2 billion dollars in our Fund 7, which became fully invested around the time of the Bear Sterns meltdown. And then we raised 11 billion for our Fund 7B, which we’re currently investing, and we’re investing that on a steady, gradual pace. If we knew there were better opportunities ahead we wouldn’t invest anything today and if we knew that today was the bottom we wouldn’t invest—have anything left for tomorrow. But we’re not smart enough to know that so we’re investing in a steady, gradual pace.
I think the big difference in this environment is that so much of the opportunity is in the financials. And historically we’ve been an investor in manufacturing, and retail, and transportation/distribution, and not too much in the financials. But I think that the soul of value investing, one of the things at the root, is kind of an attitude of it is what it is. And our number one job is to figure out what’s going on in the market today and what’s the appropriate response. And what’s going on today, of course, is the total lack of confidence, probably overdone, in the financials. And thus securities, as David says, at once in a lifetime prices, which tend to happen every few years…
Financials seem to have higher leverage and inherently lower transparency, and you have to adjust your mindset. But cheapness covers all and I think that’s what we’re seeing today.
Klarman: It feels weird to answer my own question but the one thing I want to say on this point is that every investor should be in a position where they can identify what their edge is. That if you are investing and you don’t have an edge you probably shouldn’t be… So much of the time we have drifted into less liquid or more obscure parts of the universe. It’s why we’re in real estate. We got in when the RTC was formed and the government was selling assets at pretty crazy prices because there were no buyers. And so absence of competition is another key thing for us. That we’d rather not try to outsmart somebody, we’re not sure we could, we’d rather try to hunt where they’re not looking.
In this environment what’s so unique is you’re not buying from really sophisticated sellers, you’re buying from panicked, out of their mind, margin called, desperate people. It’s sad that things have come that way. You’re buying from some of the smartest trading desks on Wall Street who have a mandate from above, reduce leverage, get out of it, I don’t care. And so even as you’re taking advantage of opportunities using the same analysis you’ve always used but with a much higher batting average because unlike most of the time you look at 100 things and find one or two, now you look at ten things and find three or four. But the competition seems to have gone away because uniquely at this moment, unless you’re Howard with a large pool of money or David with having prepared for this kind of environment, and versatile, and able to maneuver around, a lot of people came into this leveraged, a lot of people are now down well into the double digits and are worried about redemptions, they don’t have quality clients, they have short-term money. And so the combination of pressures on people cause an awful lot of smart people to be on the sidelines right now or facing actual redemptions and forced to sell things they’d actually rather be buying. So I think that’s another thing about the current environment that, in a way, you don’t even have to be as smart as before. You just have to be in the game, have money, not be in terrible trouble as an investor.
Q: How has the current environment surprised you? In what ways were you prepared for it? What do you wish you had done differently if anything?
Marks: Well I wish I had shorted subprime. I mean, I think we prepared pretty well. We sold the vast majority of our assets and we raised small funds in the high risk low return years, and we have essentially no leverage, and we locked up a lot of money for a long time, and the only thing we didn’t do is go short. And you know, I feel okay about how we prepared. Now all we have to do is execute…
When I think about preparing, and think about what’s unfolding, and listen to David, what I realize is that I didn’t predict one thing that’s happening this year. What I did predict is something bad would happen and when I say it is what it is I believe that it’s our job to look in the environment and say what’s going on? How are our investors behaving? What actions have they taken? What structures can now be done that shouldn’t be done? And that kind of thing, and respond. You know, if you went back a year and a half ago, what you see in the paper is global wall of liquidity. That’s all we heard about. There’s this money coming, and it’s coming, and it can’t stop, and it’s infinite, and it will always take every asset higher and higher. And when you hear that stuff you know there’s something wrong and you don’t know how it’s going to end but you know it can’t go on and– Who was it, Herb Stein, who said anything that can’t continue will end? And when behavior is ridiculous and risk is ignored it will stop, and the end will be ugly. And the more ridiculous the excesses on the up side the uglier the unwind.
Klarman: Yeah, I love that point, Howard, that Jim Grant called liquidity and credit money of the mind and it’s there and then it’s not there, it’s amorphous, you can’t see it, it’s not real. And in a way to me, anybody that ever says how can the market go down, there’s a wall of liquidity? Or there are structural imbalances. As long as I’ve been alive there have been structural imbalances. Most of the time they don’t matter. Once in a while they really matter. That’s what’s hard, that if you run your portfolio to be fine in an upward market, if you’re in the game, you will have exposures that you wish you didn’t have in a worse market. In terms of our firm I tried so hard to learn the lessons, to me, of ’98 in particular, which were don’t be unprepared for something out of the blue that’s really bad. To some extent we were prepared but you’re never prepared enough. We had a lot of macro protection in terms of credit default protection on bonds we didn’t own, just betting that credit spreads would widen. That’s been incredibly helpful. But we got really tired of buying market puts or anything like that because they inevitably are expensive and expire worthless. And so you always, as an investor, have terrible tradeoffs. Do you overpay for insurance or do you go uninsured? And it’s just one of those dilemmas that there’s no perfect answer to.
My surprises of this environment are, you know, when Warren Buffet put out his job description for—I’m sure there’s several in the room that applied—to replace him someday, he said that one of the criteria that he was looking for was somebody who could deal with things and even anticipate things that had never happened before. And that was prophetic and incredibly important for investors. That all of us every day, every week, every month, have to deal with things that we’ve never seen before. In any previous downturn in my investment career some things would be getting killed while other things would be recovering. In this environment it’s been straight down for everything. We’ve had almost no respite so the idea that you’d be able to recycle money out of one bargain that then recovered into another one has just not happened. You need to be prepared for that. That anybody that says that they see five and ten standard deviation events every couple of years is obviously not thinking correctly about probabilities. So things happen and we need to be ready.
The Graham and Dodd Luncheon Symposium 2008
Marks and Klarman on Lessons from Big Mistakes