Not too long ago I wrote about a Baron’s interview with Seth Klarman in 1991. I dug up the article while searching through the digital stacks via the local library. A good chunk of the article covers specific investments at the time and I previously covered the part on his investment strategy.
I wanted to highlight a couple other topics discussed in it because it relates to his process for finding opportunities, which I briefly covered before here and here. (His views didn’t change much from ’91 to ’10.)
What creates opportunities is an interesting question. Often we do best in turbulent times, especially if we are fortunate enough to be holding cash going in. If you think of the stock market as a cauldron of minestrone soup that occasionally somebody sticks a ladle in and stirs up, it takes a while before all the vegetables float back to the level that they were at before…When it gets shaken up, mispricings tend to occur much more than when the market has been at the same level for a long time.
Klarman’s soup analogy fits with Greenblatt’s view on why value investing will continue to work. Investor behavior hasn’t changed in the last century. Decisions are still made regardless of price. And that’s unlikely to change anytime soon.
The institutional investors, being short-term and relative performance oriented, are trying to all beat each other every three months, and hence will react to whichever direction the market is going in. As long as the market is generally flat to rising, they will stay in the market. But if they perceive that the market is going down — in other words, if the market starts to go down — they may all decide to get out at once, none of them wanting to be in longer than anybody else.
There is no question that indexing exacerbated the market movement upward. If we have a bad year or two it is easy to envision that institutions that had money in indexing might pull it out en masse, exacerbating the decline.
Remember this was 1991. The index fund is still in its infancy. Most money is actively managed by institutions. Pensions are a big part of retirement savings, but the 401k is starting to pick up steam. So is the growth in mutual funds. Recently retired Peter Lynch helped the cause after destroying the market.
Still, being different is risky when you’re fighting for fat fees based on last quarter’s returns. So why risk losing money to another institution or fund?
This would later be explained by studies on career risk. Most managers would rather hug their benchmark index than be different and risk losing their job. Their short-term mindset failed them in the end. They never saw the long term risk of losing to index funds.
Of course, index funds offer the same opportunities. Klarman calls it mindless selling. He points out two specific areas:
One thing we want to look for is perhaps a market inefficiency or imperfection. And often these are caused by what we would call institutional constraints. The institutions, first of all, because of their tremendous size, and second of all, because many have gotten away from fundamental investing, tend to be prolific creators of opportunities. An example of this would be when a large company spins off a much smaller subsidiary and distributes the stock free to shareholders. The institutions tend to be natural sellers of the spinoffs…Either they would have to buy an enormous amount to justify a large position, or they sell. And they sell regardless of fundamentals, regardless of the price compared to the value.
Another type of rock we would look under would be when securities get downgraded from investment grade to below investment grade, i.e., distressed. In particular, many funds that own these are not permitted to own other than investment-grade securities. So when the downgrade happens, they have to sell, they have no choice, given the rules that they operate under. That may create a short-term supply/demand imbalance. Another opportunity created by selling that is not dictated by fundamentals.
Since 2008, spinoffs went from an overlooked opportunity to one that is mostly picked clean today. Any strategy that works well invites competition. When that happens, flexibility and patience helps.
So we tend to only make investments when we think there is a compelling opportunity being presented. And often we will hold a third or half in cash or even more, awaiting such opportunities.
Once the opportunities run dry, the competition dries up – most are scavengers looking for a quick buck – renewing the cycle of opportunity again.
The Value Hunter – Barron’s Nov. 4, 1991