📰Inside the Mind of Young Seth Klarman (1991 Interview)
“I get more stressed when the market is running up than when it is running down.”
In the wake of the COVID bear market, Seth Klarman was raising capital for Baupost Group, then a $29.5 billion fund. Some investors balked (‘I Can’t Believe I’m Saying This, But I’m Passing on Seth Klarman’). They had three complaints: Baupost held too much cash, had drifted into private assets, and performance had been lackluster (“Baupost has delivered double-digit gains just once since 2010”).
All of these issues were foreshadowed in a lengthy interview with Klarman in 1991, only 10 years into his career.
“Seth is running Baupost more like a wealthy person might run their personal money than like the aggressive hedge fund manager that he’s been over the years,” the investor says.” ‘I Can’t Believe I’m Saying This, But I’m Passing on Seth Klarman’
Well. This is exactly how Baupost was formed: as a family partnership with an emphasis on downside protection. Klarman was hired to manage it.
“Investing with the firm means allowing Klarman’s team to do mostly whatever it wants with the money. Since the financial crisis, that’s often meant buying private assets, such as real estate.”
Again, this has always been in Klarman’s DNA. And with a lack of distress in public markets, his pivot to private markets was not surprising.
“The most controversial thing that Baupost does with its wide-open investment mandate is nothing at all. Cash amounts to about one third of the portfolio on average, or about $10 billion.”
Even back in 1991, Klarman carried a remarkably high cash balance. It took a market crash to get him very close to being fully invested.
A: [The cash balance] has probably averaged between 40% and 50% for the year. We were fortunate to be well-positioned at the beginning of the year with a few major positions in distressed securities that worked out quite well.
Q: What was the lowest cash position you have had in the eight-plus years you have been doing this?
A: We came very close to being fully invested shortly after the ’87 Crash.
Incredible. The main difference of course is that back then Baupost posted strong returns regardless (“20-25%” after fees). Because Klarman did so well while carrying cash, he was never forced or motivated to change.
Ten years into his career, we can see the young Klarman operate a nimble Baupost during the golden age of value and distressed investing — a much less competitive market with regularly occurring credit cycles. “We want to stay small because it is more fun,” he said. Then added that “the last thing I want to be is manager of a staff of a dozen analysts and portfolio managers.”
There are many lessons in this interview. The most important may be that even the smartest investors can neither predict the market nor their own behavior if the incentives are strong enough.
If you’re a serious or professional investor, I think you will learn a lot from studying Klarman precisely because his firm has lagged in recent years. Because his mindset was shaped by his mentors, and their mentors. Because of the issues that came with scale, with a change in the opportunity set. And because the value investor’s mindset can be both tremendously useful and treacherous.
If you’re just a casual observer or free subscriber, keep in mind just a few key ideas:
Don’t mistake investors like Klarman for stock pickers. Their publicly disclosed stock portfolios don’t tell you much about what the overall portfolio looks like. Nor are stocks necessarily their bread and butter. Their guiding north star is “value” and they often find it in other parts of the capital structure.
Baupost was formed to invest “as if it was our own money”. It was incubated by a small group of wealthy clients looking to protect their wealth rather than maximize returns. They were comfortable holding a lot of cash. And the market tended to regularly offer opportunities to put the cash to work during times of stress. It’s obvious how this model could become a challenge for institutional clients (who care about annual returns), at greater scale (locked out of smaller opportunities that occur with some regularity), and in an environment in which recessions and credit cycles occur with less frequency.
Holding a lot of cash can also create “wishful thinking” regarding the market. The investor hopes that the market will decline and cash can be put to work. One has to be very careful not to permanently adopt this mindset.
Klarman was bearish at the time and pointed out how “people are conditioned to buy on any decline, on any bad news. It might take a while for people to be weaned away by the punishment of having the market not rebound. That helps to explain why, when things are as bad in the economy as we perceive it, the market hangs in there.” How familiar does that sound after the last two years? Then again, the 90’s turned out to be a terrific time to buy every dip. The next few years? I doubt it. But I’m sitting on some cash and that could well be shaping my thinking…
How Klarman got started and Baupost’s unconventional origins
“We have historically done very well in down markets. Our general predisposition is that we ought to run our money as if it is our own.”
Blessed with great clients
“We are blessed with a client base that is not short-term-oriented. I don’t think any money manager knows how deep the reservoir of client goodwill is.”
Klarman's deep value mindset
Where to look for opportunities
“We look for a market inefficiency or imperfection. And often these are caused by what we would call institutional constraints.”
Macro and the cash-rich investor’s mental trap
“We would love for the market to go down so we can take advantage of lower prices.”
Can nobody resist the siren call of higher AUM?
Distorted prices: who is the marginal buyer?
More competition? Bring it!
Notes on the investments he discussed