Imagine writing out your investing strategy every year. What would it look like? Would it be consistent? Or would it change every few years?
Now, imagine writing it during the longest bull market in history. Would it change then?
Fund managers do this almost annually to remind clients, partners, or shareholders about the underlying goals of the fund. On some level, it probably acts as self-reminder, offering reassuring confidence that their strategy does work, just not right now. And looking back, it offers a telling tale of whether they stayed consistent, especially during the rough years.
Seth Klarman’s letters are a good example of that consistency. His letters not only show what it takes to stick to your knitting, but what it takes to do it in the face of a massive bubble that makes your strategy look foolish.
The discipline not to deviate in the face of massive relative underperformance seemed insane at the time. After the fact, it looks brilliant and almost too easy. The letters paint a different picture. You can almost feel the emotional toll of falling short of a bubble-driven market and the elation when it bursts.
Sometimes he repeats the strategy almost verbatim from previous letters. Sometimes it’s brief. And other times it’s an extended argument for value investing because of what’s happening in the market. Altogether, the message is consistent:
The Baupost Fund is managed with the intention of earning good absolute returns regardless of how any particular financial market performs. This philosophy is implemented with a bottom-up value investment strategy whereby we hold only those securities that are significantly undervalued, and hold cash when we cannot find better alternatives. Further, we prefer investments, when we can find them at attractive prices, that involve a catalyst for the realization of underlying value. This serves to reduce the volatility of our results and de-emphasizes market movements as the source of our investment returns. Positions with catalysts tend to lag a rapidly rising stock market (like this past year’s) and outperform a lackluster or declining one (like we used to have every few years!).
We will not stray from our rigid value investment discipline. We buy absolute bargains when they become available, and sell when they are no longer bargains. We hold cash when there is nothing better to do, and we hedge against the risk of a dramatic and sustained downturn in the market.
Because of our fundamental, research-driven, absolute-value orientation, we own undervalued securities that we believe will do well regardless of the overall financial environment. In the event of a major market reversal, we believe our market hedges should cushion any serious decline within the portfolio.
We are chagrined that we could have achieved approximately the same returns had we initiated the Baupost Index Fund a year ago. We are pleased, however, that we managed to do so with a vastly lower risk profile.
As we reflect back at fiscal year end, let us reiterate that Baupost’s investment philosophy has remained consistent over time: bottom up, risk averse, absolute value oriented. In making tradeoffs among competing alternatives, we have distinguished ourselves from other professional investors in several ways: our willingness to hold cash balances, sometimes substantial, awaiting opportunities; our preference for investments with a catalyst for the realization of underlying value; our willingness to accept varying degrees of illiquidity in exchange for incremental return; and our flexibility in pursuing opportunities in new areas.
There are several reasons for this relative underperformance: One is our low U.S. stock market exposure (only 31% of net assets at April 30.) Another is our lack of exposure to the expensive large capitalization consumer growth and technology stocks (the new “nifty fifty”) which have been among the best performers in the market. A third is our considerable net cash and cash equivalent position (close to 30% of net assets at April 30.) Finally, we have underperformed this roaring bull market for the same reasons we always do: we remain risk averse value investors and will never own what we perceive to be expensive stocks in the hope that they could somehow rise even higher.
Despite delivering good investment performance over the Fund’s first seven years of operations, I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk. In a stormy market, the value investing discipline becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible. In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts. But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value. And, because you cannot tell what the market is going to do, a value investment discipline is important because it is the only approach that produces consistently good investment results over a complete market cycle.
The portion of our portfolio with a catalyst for the realization of underlying value has increased, hopefully reducing still further our dependence on the level of the equity markets for future results. We intend to persevere in our search for value, and remain confident that our cash balances…are likely to be most valuable just as fewer and fewer investors choose to hold any. We also have substantially increased our position in disaster insurance… We continue to be willing to give up a portion of our upside to protect against serious downside exposure.
Going forward, we will seek to focus on low risk investments while emphasizing capital preservation. Although emerging markets are bargain priced by historical standards, we will maintain a much more limited exposure to them in the future, including, as much as possible, an emphasis on situations with catalysts for the realization of underlying value. Until the developed stock markets retreat from record levels of valuation, we expect to have less portfolio exposure to equities going forward and more exposure to event driven situations such as liquidations and reorganizations that are not so dependent on the vicissitudes of the stock market for their investment return. Also, we will demand more compelling undervaluation than before to incur market risk. In the absence of appropriate opportunities, we will hold increased levels of cash. Finally, while we still expect to hedge against extreme conditions, the aforementioned combination of greater undervaluation, catalysts, potentially higher cash balances, and hopefully better aligned hedges should result in much improved performance.
Simply put, we continue to face an unprecedented market environment with extreme volatility. In the face of very high prices, affordable and appropriate hedging is next to impossible. In our assessment, significant caution is called for at this time, and this is how we are positioned. While everyone else on Wall Street motors ahead at a frenetic pace, we are intentionally going slowly, unafraid of missing out on speculative gains and intent on protecting capital. This is an extremely challenging and dangerous environment, and we would rather be overly cautious and forego some profit than overly optimistic and potentially much poorer.
We are continuing to balance on the tightrope between investment opportunity and risk aversion, taking advantage of the most compelling opportunities while maintaining a very cautious posture in an environment where most securities are priced for perfection and then some. The preservation of your capital remains our foremost goal…
Simply put, we are navigating through an unprecedented market environment, where fundamental analysis is thrown out the window and logic is turned on its head. We underperformed in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market.
As we emphasized in our Semi-Annual Letter to Shareholders, our goal is to generate good absolute returns with limited downside risk over time. A portfolio of deeply undervalued, carefully chosen securities, many with catalysts in place for the realization of underlying value, is the most reliable way we know of to achieve this goal.
We are disappointed but not disillusioned, and remain confident that a fundamentally-driven, disciplined value investment approach will deliver good results with limited risk over time.
The Fund seeks to achieve its objective by profiting from market inefficiencies using a value-oriented and, often, an event driven approach. We are not seeking to keep up with any particular market index or benchmark. Rather, we are attempting to achieve good risk-adjusted investment results over time through the successful implementation of our investment philosophy.
We continue to believe strongly in a value investment approach, attempting to buy assets or businesses at a considerable discount to underlying value. Bargains exist because the financial markets are inefficient, yet many investors lack the requisite patience and discipline to take advantage of them. A value approach may outperform or underperform the overall market at various times because of changing investor sentiment, but we believe that a value philosophy never goes out of style. When sentiment towards undervalued sectors of the market is at its nadir, it is the best time to be buying value.
Clearly, the Internet bubble has burst. Nearly all publicly traded Internet stocks have come up snake-eyes, and there is considerable doubt about whether there is or ever was a “new economy.” No longer can you add “dot com” to a word, sell shares to the public, and join the Forbes 400. No longer can entrepreneurs count on investors to fund enormous and protracted operating losses. Although the carnage thus far is extensive, the economic fallout from the end of this speculative mania has yet to be fully felt.
The point of investing, after all, is not to have a great story to tell; the point of investing is to make money with limited risk. At some point, investors will drop their Pulitzer prize winning story stocks and revisit their attention on the old classics, stocks that make you money because their undervaluation creates a compelling imbalance between risk and return.
In effect, the lessons of the technology stock bubble have only partly been learned. The correct lessons — price matters, trees don’t grow to the sky, high risk does not necessarily correlate with high return, sometimes it is better to be risk-averse — have begun to be applied to technology stocks but not to most of the rest of the market. As we have said before, it appears likely that considerable pain must be incurred over a protracted period for investors to fully absorb these unavoidable lessons.
Baupost Letters 1995 to 2001