Seth Klarman And The Myth Of Wall Street

When Seth Klarman first began value investing for the Baupost Group, he encountered the frequent Wall Street wisdom that value investing would be dead in a short period of time because (1) the rise of computer trading mixed with (2) a significant influx of new investment professionals would lead to a perfectly efficient market where all new information would be instantly known and accurately priced into the stock.

One of the character traits that makes Seth Klarman such a remarkable investor is that he has an uncanny ability to recognize the situations in which news about a company is instantly known but not necessarily accurately priced into the value of the stock. There are two reasons for this—one, frankly, it’s hard to accurately predict the future cash flows for a majority of American companies once you get beyond soda, cereal, toothpaste, and other products that aren’t subject to technological disruption or big shifts in market share among the competitors.

And two, most people do not have the patience to see an investment thesis through if it takes five to ten years to play out. I often get asked, “How can you possibly gain an edge to become a successful investor if there are thousands of individuals and partnerships with million-dollar budgets that are dedicating fifteen hours a day to making opportunistic investments?”

The answer to that question is two-fold. The first part is about recognizing the truth of what Graham said when he pointed out that getting satisfactory returns is easier than most people think, but getting superior returns is harder than most people think. You don’t have to beat the S&P 500 for investing to be worth your while; all you have to do is earn returns that beat inflation to increase your purchasing power.

What’s a blue-chip stock that has disappointed investors by trailing the S&P 500 over the past twenty years, Dupont? The chemical company has trailed the S&P 500 by two percentage points every year, on average for the past twenty years, and you still would have turned every dollar invested into four dollars; a retirement nest egg of $150,000 in Dupont would be worth $600,000 today. Hardly a disaster that defeats the purpose of investing.

And secondly, as Klarman points out, very few managers possess anything resembling long-term patience. The people we associate with Wall Street compete on a short-term, and relative basis—it’s about beating the other guys on a three-month, six-month, and twelve-month period. There’s a barrier to long-term thinking because, if investment selections do not perform well in the short-term, there is no guarantee that you’ll be there in the long term. It’s the same principle that explains why you don’t see NFL coaches and GMs stocking up on 1st round draft picks in 2016, 2017, and 2018 via trades because they know if they don’t win now, they won’t be around later to reap the benefits that come with truly long-term planning and delayed gratification.

In other words, when you’re investing on terms of five, ten, and fifteen year increments, you are playing a game that very others are engaged in. Klarman recognized this when he recognized the long-term appeal of Texaco bonds during their bankruptcy proceedings; he was purchasing debt that was secured by oil assets that were certain to prove lucrative because of their place in the bankruptcy claim order, and therefore, he was willing to tolerate the volatility that came with the uncertainty.

We can learn as much about behavior psychology reading Klarman’s Margin of Safety as we can studying the life works of Charlie Munger.

Klarman recognizes that most people’s understanding of volatility goes out the window—totally defenestrated—once an ownership interest declines 30%, 40%, or 50% in value. Very few people develop such a thorough understanding of business that they can tolerate $100,000 turning into $50,000 at a particular moment of time without feeling some type of negative emotion. The default human wiring associates negative volatility with the loss of security, and the loss of security creates a feeling of vulnerability that diminishes happiness.

You move beyond this, and set yourself up for superior long-term returns, when you thoroughly understand the businesses in which you invest. Ideally, you will make decisions based on long-term earnings power, and oftentimes, current profits can indicate that things are better than other actors in the stock market believe.

There is a reason why BP is such a popular investment holding among the readers of this site, especially compared to the investing public at large. Even after selling assets in preparation for a potential gross negligence payout, BP is still on pace to make $14.4 billion in profits this year. What’s a popular stock in the dividend growth community, Colgate-Palmolive? Well, Colgate has not lowered its dividend payment since the 1890s (and even then, it was the initiation of a dividend payout, rather than a cut, that preceded the streak), and makes a little $2 billion in annual profits today. The readers here understand that, despite all the headlines and headaches that have been associated with BP, and even with the asset sales, it still makes 7x as much total profit as Colgate-Palmolive. This company isn’t going anywhere anytime soon.

Value investors can also get a glimpse of what BP will look like once the oil spill litigation is fully resolved, and the price of the stock increases due to the “established certainty” that people seem to love. Ten years ago, BP was roughly the same size that it is now (it made $15 billion in annual profits then, $14 billion now). Back then, the price of the stock traded in the low $60s. And, in the tradition of John Neff, you get to collect a 5.6% initial dividend yield, which he calls the hors d’oeuvres that precede the main meal (e.g. you get cash while you wait until fair value to sell, at which point, you’d get much more cash). And if you choose to reinvest, you will turbo-charge your returns by automatically gobbling up more shares in the $40 range that you will look upon with a special fondness when the stock trades in the $70s and $80s.

That’s why this “you can’t beat Wall Street guys” stuff is such a myth. It would be like men and women that are marathon runners getting intimidated by the fact that they could never win a forty-yard dash. You’re doing the same activity, but playing a different game.