When Seth Klarman speaks, listen carefully.
Very few hedge-fund managers are as widely and consistently acclaimed as is Klarman, the 56-year-old founder of the Boston-based Baupost Group. The fund has about $27 billion in assets under management -- after returning $4 billion to investors last year. In 2012, LCH Investments NV listed Baupost as the fourth-most successful fund in investment performance. In 2013, Klarman told his investors that he earned them a mid-teens net return, despite having almost half of his portfolio in cash. That’s impressive.
Copies of Klarman’s 1991 classic, "Margin of Safety," a revelatory account of his investing strategy, can be had through Amazon.com, at prices ranging from $1,600 for a used copy to almost $3,600 for a new copy. Klarman solidified his street-cred when, in October 2009, he met privately for 30 minutes with William Dudley, the president of the Federal Reserve Bank of New York, to discuss financial market developments.
So what does Klarman have to say about today's investing climate? The overarching message in his year-end 2013 investor letter, a compendium of wisdom, is that plenty of danger lies ahead, even though most investors are blind to it.
Klarman thinks the stock market these days is akin to a Rorschach test. “What investors see in the inkblots says considerably more about them than it does about the market,” he wrote. “If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stocks probably look attractive, even compelling," he added. He went on to list many reasons that investors may be turning a blind eye: Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. Consumer balance sheets are on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence.
With bonds yielding so little, equities appear to be the only game in town, Klarman continued. The Fed will keep holding interest rates extremely low, leaving investors no choice but to buy stocks, he added. "For now, there are no bubbles, either in sight or over the horizon.”
But for those “with a worry gene,” and who have an understanding that markets can also go down, “there’s more than enough to be concerned about.” Klarman sees artificially high prices everywhere he looks in the stock and bond markets. “A policy of near-zero short-term interest rates continues to distort reality with unknown but worrisome long-term consequences,” he said in the letter. “Even as the Fed begins to taper, the announced plan is so mild and contingent -- one pundit called it ‘taper-lite’ -- that we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences. Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings? Pretty clearly, lower than otherwise.”
He noted that the Nobel-winning economist Robert Shiller has calculated that the stock market’s price-to-earnings ratio is more than 25, “a level exceeded only three times before -- prior to the 1929, 2000 and 2007 market crashes. Indeed, on almost any metric, the U.S. equity market is historically quite expensive.”
What’s more, Klarman wrote, “a skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.” In “an ominous sign,” he said, there are fewer market bears now than at any time since 1987. “A paucity of bears is one of the most reliable reverse indicators of market psychology,” he continued. “In the financial world, things are hunky dory; in the real world, not so much.”
There is also wild speculation in the credit markets, thanks to the Fed’s seemingly endless quantitative easing program. “Even with yields in the cellar, investors snapped up a record $1.1 trillion of high-grade corporate debt in 2013,” Klarman wrote. He pointed out that the issuance of below-investment-grade leveraged loans (bank loans issued to highly leveraged companies) reached $683 billion, topping the 2008 record by almost 15 percent, and that more than half of those were covenant-lite (bank loans with few restrictions on the borrower).
In addition, $63 billion of dividend-recap issues (in which companies float bonds to pay shareholder dividends) also set a record. Junk-bond financings totaled a near-record $324 billion. Bond buyers, desperate for return, bid up junk-bond prices to a record low yield of 4.97 percent, he wrote.
Klarman is eloquent when describing the dangers lurking in the financial markets. He says giddy investors are living a “Truman Show”-like existence, where on the surface everything seems idyllic. In reality, the manufactured calm -- thanks to the “free-money” policies of Ben Bernanke, Janet Yellen and Mario Draghi -- anesthetizes us to the looming trouble.
Morphine is like that, I hear. “Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored,” he wrote. “The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. The artificiality of today’s markets is pure Truman Show.”
It isn't often that Klarman’s investment letters slip through his fund's carefully constructed walls of confidentiality. Because this one did, and it is so uncommonly wise, mere mortals should stop and take note. “Like a few glasses of wine with dinner, the usual short-term performance pressures on most investors to keep up with the market serve to dull their senses, which makes it a bit easier to forget that they are being manipulated,” he concluded. “But what is fake cannot be made real.”
Truer words have rarely been written.
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