Three Quotes From Seth Klarman On The Financial Crisis

I was just reading through Seth Klarman’s 2010 letter to his investors at The Baupost Group and I wanted to share with you three quotes that caught my attention enough to reflect upon:

(1)Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse. 

To deal with this problem, I like to go straight to the Charlie Munger playbook. Instead of crafting a strategy that fears bad things happening, I try to ask myself this question: “If the world gets even messier, what companies will still be making a profit even if everything falls apart?”

When I answer that question, I think of Exxon making $38 billion in profits across 38 countries. I think of Coca-Cola making $10+ billion in profits in all but two countries in the world. I think of Procter & Gamble having a product in 398 out of every 400 American homes. I think of Johnson & Johnson and Nestle with their 2-3 dozen billion-dollar brands. I think of Colgate-Palmolive’s resilient 30% returns on equity and history of paying dividends even through the worst of the Second World War because it turns out that people tend to find money for toothpaste and soap.

Instead of getting scared that the future will be terrible, I try to buy companies that have very strong likelihoods of churning out profits even in the event that these doomsday scenarios turn out to be true.

(2) Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments. 

If you asked the average person on the street which investment is riskier over the next five years—Hershey Chocolate or BP PLC—they would probably think about the strong brand name Hershey and the permanent demand for chocolate bars while simultaneously thinking about the lawsuit hanging over BP’s near-term outlook, and then tell you that BP is the riskier investment.

The problem with that kind of logic is that it does not recognize that the total returns you experience as an investor will always be a function of the price you pay to establish your ownership stake. As of my writing this in mid-August, Hershey trades at just shy of $97 per share. But it is only pumping out $3.20 in annual profits. That means investors are currently willing to pay $30 to lay an ownership claim on each dollar of profit that Hershey generates. The company barely traded in the 20-25x earnings range during the height of the dotcom bubble. When the company experiences a 33% drop in valuation over the long-term, investors shouldn’t be surprised when the total returns significantly lag the earnings per share growth that Hershey experiences over the medium term.

On the other hand, BP is practically being given away because people are discounting the 100+ billion worth of proven reserves that BP has simply because they don’t want to deal with the asset sales following a worst-case scenario court ruling. Right now, the company has a dividend yield over 5% and a P/E ratio between 5 and 7, depending on how you normalize the earnings.

Typically, BP has a dividend around 3% or so and trades at 10x earnings during times of stable commodity prices. A whole lot of things don’t have to go right for BP to be an intelligent investment at $41 per share (heck, even Seth Klarman has disclosed that he’s been buying BP stock for his clients.

(3) You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy. 

Some investors cite adages like “Don’t fight the tape” or “You’re trying to catch a falling knife” to speak out against the practice of buying a stock that is declining in price. What that kind of logic ignores is the fact that the total returns an investor experiences over the long-term is based on the future cash flows generated by a stock in relation to the price paid. If you only buy stocks that are going up, then your investment is gradually losing its margin of safety.

On the other hand, you could have concluded that General Electric was a good buy when it fell to $12 per share during the financial crisis. Sure, it subsequently fell to $6 shortly thereafter, but that does not mean your $12 per share price was stupid. If you held on, you would have doubled your money within four years, and plus there would have been some nice dividends along the way. As long as there is a good likelihood that a company will be generating solid profits per share in relation to the price that you pay for the stock, there is no reason to worry if the price goes down more after your purchase price. If the company’s operational results start to improve, the stock price will eventually follow.

When it comes to investing wisdom, Warren Buffett usually gets most of the attention. That’s because he’s brilliant, can explain complex subjects using straightforward language, and has the unique wit and charm you can appreciate from someone who eats Dairy Queen cheeseburgers and drinks Cherry Cola at black-tie dinners. Oh, and he built a $59 billion fortune just by investing, rather than founding a business or inventing something.

But just because Buffett gets most of the attention does not mean that he is superior to Charlie Munger, Seth Klarman, Peter Lynch, Donald Yacktman, and so on. Once you have millions and millions of dollars, you can step back and think about what you enjoy in life rather than getting caught up trying to get richer. There’s no prize for being richer than the guy sitting next to you in the cemetery. But there is a difference in being able to say you got to do what you wanted with your time while you were here on earth.

I mention this for one reason: I consider the wisdom of someone like Klarman or Munger to be perfectly equal to anything Buffett says. It is a shame for the investing public that Klarman has largely chosen to keep a low profile despite his outsized success. Once you cover the Buffett basics and want to pick up a few more tips, it can make a lot of sense to dig through Seth Klarman’s writings. He’s a gem worth uncovering.