by Frederik Vanhaverbeke
In the latest of a new series for SBM Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
A country of security analysts would still over react. In short, even the best-trained investors would make the same mistakes that investors have been making forever, and for the same immutable reason – that they cannot help it.
—-Seth Klarman
When Warren Buffett says that there are few hedge fund managers he would entrust his money to, but that Seth Klarman is an exception, we should take a closer look.
As we will see Klarman has a unique track record that illustrates extremely well the need for a long-term focus. He is also famous because he pursues a low profile. He is media shy. He doesn’t want his letters to shareholders to be published on the Internet. And he hasn’t authorized a reprint of his famous book Margin of Safety despite overwhelming demand for it.
Trying to stay under the radar is actually not uncommon among top investors. It illustrates their modesty about their investment operations. It fends off undesired competition from copycats. And it avoids the pressure to stick with positions (in order not to lose face) about which one has talked in public. Furthermore, to avoid pressure from clients Klarman carefully selects the investors in his hedge fund. He makes it very clear that people who are looking for the quick buck, who bail when the market is going down, or who are not willing to put up extra funds to invest in the midst of a crisis should not apply.
In the first article of my series on top investors that are featured in my book Excess Returns: a comparative study of the methods of the world’s greatest investors we explained through the operations of Prem Watsa that intelligent investors have tolerance for losses or underperformance in contrarian positions. Seth Klarman is probably an even better example. While he beat the market by more than 6% a year between 1983 and 1990, the 1990s were hard on him.
The chart below compares the performance of Seth Klarman in the 1990s with that of the Nasdaq composite and the S&P 500 (with dividends reinvested), all rebased to 100 on December 14, 1990. Between 1990 and 1997 Klarman barely managed to keep up with the S&P 500.
Chart: Seth Klarman versus the Nasdaq Composite and the S&P 500 in the 1990s.
The results had much to do with his defensive positioning.
As stock valuations were constantly on the rise, Klarman felt uncomfortable chasing the market. In 1998, Klarman suffered a major setback caused by the crisis in emerging markets. Moreover, he became very concerned about the valuations of large caps and technology stocks. And because he had parked a large chunk of his portfolio in cash and in cheap small- to medium- sized stocks that lagged the market substantially in the late 1990s, he lost even more ground to the market in 1999 when the Nasdaq and the S&P 500 almost reached their pinnacle. In October 1999, Klarman lagged the S&P 500 (with dividends reinvested) by almost 1.5% a year since 1983. That kind of underperformance over a period of almost 17 years is enough reason for most people to bail out of their manager.
Needless to say, Klarman’s appreciation of the stock market in the late 1990’s was spot-on. When the market collapsed between 2000 and 2003, Klarman roared back with a vengeance. By the end of 2003, he had reestablished his excellent track record, beating the S&P 500 by almost 4% a year since 1983. And the best was still to come. Similar to Prem Watsa, Klarman began to prepare himself for a possible financial crisis around the mid 2000s. His approach, though, was somewhat different from Watsa’s.
In 2006, Klarman had half of his portfolio in cash. Late in 2007 he put some of that cash to work as the first housing problems lead to a number of bargains. In the first months of 2008 he started to buy distressed debt. Because he anticipated huge opportunities in toxic assets, stocks, and loan portfolios, he also raised cash with his investors. This way, he had a lot of firepower at his disposal when the market crashed after the collapse of Lehman Brothers.
Throughout the market plunge in the autumn of 2008, Klarman bought bargains every day. By the end of 2008 the investors in his hedge fund that had been with him since 1983 had enjoyed annual compound returns of 16.5% after fees and expenses. That was more than 6.5% better than the annual return of the S&P 500 (with dividends reinvested) over that same period.
Seth Klarman
Critics may say that Klarman turned bullish too early as the market touched bottom some months later (in March, 2009), causing a modest loss of about 8% in his portfolio over 2008. But Klarman was definitely not the only top investor to be early. We saw in the article about Prem Watsa that he also removed his equity hedges in the autumn of 2008. And around that same time Warren Buffett openly pleaded in favour of stocks amidst the market mayhem.
As a matter of fact, Seth Klarman describes the attitude of intelligent investors excellently when he states that “investors must have the courage to buy on the way down, realizing that what one buys will probably go down even more after the purchase.” That’s completely in line with what most top investors proclaim: since market timing is impossible one must buy gradually on the way down (of a particular stock or of the market), and sell gradually on the way up.
What we can learn from Seth Klarman’s track record is that the interpretation of track records is tricky. An exceptional investor may underperform over a long period of time exactly because he or she does the right thing. Intelligent investors stick with their guns in spite of (overwhelming) pressure to change tack.
Next up is Shelby Davis, a private investor who made it to the Forbes 400.