A must read to prepare you for the next market downturn


Seth Klarman, Baupost Group

30 billion dollars under management in one of the most respected hedge funds in the world. 20% CAGR over a three decade long period. Ace value investor. But most importantly, always a keen learner - that's Seth Klarman for you. His book "Margin of Safety" is akin to the Bible for value investors. More importantly for all of us are the insightful lessons and "false lessons" that he penned from his learnings from the 2008 crash. Read them and prepare wisely for the next market downturn, whenever it comes.


Seth Klarman was born in New York in 1957. One can say that economics was in his genes. Early in life he acquired an interest in the subject from his economist father and picked up his first shares at the tender age of ten years. After completing school, he got a degree in economics from Cornell University and went to work at Mutual Shares Corporation. Enriched by the experience, he went on to obtain an MBA from Harvard University in 1982.

That was the year he founded the Boupost group. Today it is a top ranked hedge fund. In 2013 the group had thirty billion dollars in assets under management. The group has kept up a 20% gross return since its founding.

Investment Philosophy

At heart, Seth Klarman is a value investor. He scouts for opportunities in shares, credit instruments, bonds and even real estate, seeking assets that trade under their intrinsic values. In this single minded pursuit for arbitrage, Klarman takes care to build a safety margin to protect from unforeseen downsides. Indeed his bestselling book on investing is titled 'Margin of Safety'. He also does not believe in buying a stock, just because it happens to the popular one amongst investors at that moment. Indeed, to quote Benjamin Graham, he believes; "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." In other words he is no fan of making a quick buck. He looks at stocks as a 'fractional interest in a business and not as a chip in a casino'. (Valuewalk)

Investment Strategy

His world view stems from the fact that like Warren Buffet he believes that markets are inefficient. In his view, it is very difficult for anybody to forecast accurately the movements of prices of stocks, based on performance. His essential idea is to buy cheap, or to put it another way to purchase marked down stock. Another factor in making investments is the time range which investors are willing to give. He is averse to reacting to short term movements in the market. He invests for the long term, with few trades for the short term. "...If someone asked me to invest their money with the goal of turning a quick profit over the next six or twelve months, I'd have no idea how...You might as well go to a casino..."

Investment Style

In the 1997 to 2000 period when the market soared on the back of the dot.com bubble, Klarman's firm Boupost actually underperformed. In 1999 the S&P 500 returned 23.8% while Boupost saw miserable returns of just 8.3%. Yet Klarman kept purchasing shares, even though he believed the market to be volatile. In early 2000 the cash weighting had slid to 4.6% of the assets under management as against the usual mark of 40%. In the year to October 2000, Boupost posted returns of 22.4%. Essentially, Klarman gained from a falling market since the market peaked in September and dropped 13% by December of that year. Wrote Klarman, "...I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone...can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important...it helps you find your bearings when reassuring landmarks are no longer visible..."

He admits that he uses the ideas of Graham and Dodd as templates for developing his own investment strategy. "...When I think of Graham-Dodd, however, it's not just in terms of investing but also in terms of thinking about investing. In my mind, their work helps create a template for how to approach markets, how to think about volatility in markets as being in your favour rather than as a problem, and how to think about bargains and where they come from...The work of Graham and Dodd has really helped us think about the sourcing of opportunity as a major part of what we do-identifying where we are likely to find bargains. Time is scarce. We can't look at everything..."

Yet he feels that in today's scenario that strategy has limitations and cannot be imitated in toto. In particular, abundantly available market information has reduced the opportunity for and quantity of mispriced assets. However, Klarman's average holding period is similar to that set down by Graham-Dodd. "...With the exception of an arbitrage or a necessarily short-term investment, we enter every trade with the idea that we are going to hold to maturity in the case of a bond and for a really long time, potentially forever, in the case of a stock. Again, if you don't do that, you are speculating and not investing..."

Investment lessons

Following the 2008 Crisis, Klarman set his mind to draw the necessary lessons from the debacle. Listed below are these gems of his sharp insight and alsoof what he charmingly calls false lessons. According to Klarman, it requires tremendous discipline and infinite patience to play the role of a contrarian long term investor. One must be completely focussed on risk avoidance, have a sense of history and a grasp of financial market cycles to have a chance for success.


  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.

  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.

  4. 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.

  5. Do not trust financial market risk models. Reality is always too complex to be accurately modelled.

  6. Attention to risk must be a 24/7/365 obsession, with people - not computers - assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioural science, not physical science.

  7. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

  8. The latest trade of a security creates a dangerous illusion that its market price approximates its true value.

  9. A broad and flexible investment approach is essential during a crisis. 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.

  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description.

  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

  12. Be sure that you are well compensated for illiquidity - especially illiquidity without control - because it can create particularly high opportunity costs.

  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

  14. Beware leverage in all its forms. Borrowers - individual, corporate, or government - should always match fund their liabilities against the duration of their assets.

  15. Many LBOs (leveraged buyouts) are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option.

  16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business.

  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

  18. When a government official says a problem has been "contained," pay no attention.

  19. The government - the ultimate short-term-oriented player - cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back-stops and guarantees, whose cost is almost impossible to determine.

  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not wilfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

The False Lessons

  1. There are no long-term lessons - ever.

  2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

  3. There is no amount of bad news that the markets cannot see past.

  4. If you've just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

  5. Excess capacity in people, machines, or property will be quickly absorbed.

  6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

  7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

  8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

  9. The government can indefinitely control both short-term and long-term interest rates.

  10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.") (Valuewalk)

Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.


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