Seth Klarman Year Ended Letter 2015

When somebody criticizes the stock I hold should I don the lawyer hat and defend it?. Lots of questions arise within me. Are they willing to learn from facts or am I just defending my ego ?. Are they trying to be genuinely friendly to me and trying to protect me ? Are all their stocks doing so well and only mine doing poorly ? Are their stocks in the ruins and they are trying to massage their egos by finding out there is a bigger fool out there ?

Ah whatever the reasons are , I feel that my energy is misdirected. I should not be spending energy on the defence of the stock or to refute the know-it-alls by being another know-it-all. I should rather spend my energy on researching the stock more, If I made a mistake, should sell it and look to live another day. If my process is right I should sit tight. I think Seth Klarman letter of 2015 is like a bible in the above scenario

Src : http://consensus-inc.com/002001i/knay1537/fin-com/0217fm-03.pdf

BAUPOST LIMITED PARTNERSHIPS 

2015 YEAR-END LETTER

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” -- Bertrand Russell

Did we ever mention that investing is hard work – painstaking, relentless, and at times confounding? Separating relevant signal from noise can be especially difficult. Endless patience, great discipline, and steely resolve are required. Nothing you do will guarantee success, though you can tilt the odds significantly in your favor by having the right philosophy, mindset, process, team, clients, and culture. Getting those six things right is just about everything. 

Complicating matters further, a successful investor must possess a number of seemingly contradictory qualities. These include the arrogance to act, and act decisively, and the humility to know that you could be wrong. The acuity, flexibility, and willingness to change your mind when you realize you are wrong, and the stubbornness to refuse to do so when you remain justifiably confident in your thesis. The conviction to concentrate your portfolio in your very best ideas, and the common sense to nevertheless diversify your holdings. A healthy skepticism, but not blind contrarianism. A deep respect for the lessons of history balanced by the knowledge that things regularly happen that have never before occurred. And, finally, the integrity to admit mistakes, the fortitude to risk making more of them, and the intellectual honesty not to confuse luck with skill.

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Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight. They move in unpredictable cycles, with investors stampeding this way and that. Businesses quickly come in and out of favor, and the same business can be valued by the market very differently in a matter of days, sometimes on the basis of new facts, but often because of mercurial investor perceptions or simply money flows

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It is critical for any investment firm to be built to take a pounding – structurally, financially, and psychologically. Investors must have a patient client base that allows for persistence during a bad year (or years), and an approach that limits risk while maintaining an appropriate balance between greed and fear. Greedily throwing caution to the wind is eventually disastrous, but fear-induced paralysis is not a recipe for success either. Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.

While value investing is a demonstrated strategy for long-term investment success, it isn’t like being handed a treasure map. Rather, the value approach teaches you how to make your own map. And even then, the map doesn’t tell you precisely where to dig for treasure: it just points you in the proper direction.

Several years ago, a friend outside the industry asked me to mentor him in Graham and Dodd, and I provided voluminous reading material and coaching. He was intrigued and energized, he said, and declared himself a value investor. Three months later, he informed me that he was giving up. It didn’t work, he had determined. It turns out that not everyone has the patience and discipline to follow the one approach that has been demonstrated to deliver excess returns with limited risk over the long run.

Value investors gain clarity by thinking about their investments not as quoted stocks whose prices whip around on a daily basis, but rather as fractional ownership of the underlying businesses. In Benjamin Graham’s construct, Mr. Market sometimes becomes greedy, overpaying for your shares, and other times fearful, selling you his shares at bargain levels. Successful investors must possess the mindset to take advantage of Mr. Market’s bipolarity, and even come to appreciate it.

Two extremes of human nature, greed and fear, perpetually drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. While your shares today still represent fractional ownership of exactly the same business as when they traded higher yesterday, people en masse are delivering the verdict that your shares are worth less. It is natural to panic at the possibility of further markdowns. But crucially, you have to find a way not to care or even to relish this eventuality. Warren Buffett has written that one should not invest in stocks at all if uncomfortable with the possibility of a 50% drawdown. The mistake some investors make is to accept the market’s immediate verdict as fact and not opinion, and become disappointed, even frustrated. For investment professionals, trepidation over poor performance can morph into fear of job loss. Career risk thus plays a role in their ultimate, and usually untimely, capitulation; even those who wish to be patient may worry that their employer or client will not share their resolve.

Paper losses can cause people to lose their bearings. When your portfolio is marked down sharply, it’s natural to fear losing the rest. Thinking about your net worth based on the latest stock quotes may superficially seem appropriate, because if you sold your shares today that’s all you would get. But investors must adopt more complex thinking. What you’re really worth is not what the market will pay today (that’s the erroneous assumption behind the efficient market hypothesis), but rather the true value of the securities you own based on such attributes of the underlying businesses as free cash flows, private market values, liquidation values, downside protection, and growth prospects. This is what Graham and Dodd taught and what we believe at Baupost.

When the market, in the absence of adverse corporate developments, drives an undervalued security down in price to become an even better bargain, that’s not reason for panic or even for mild concern but rather for excitement at the prospect of adding to an already great buy. When tempted to sell into a decline, investors must think not only about what they would be getting (the end of pain that accompanies the certainty of cash), but also what they’re giving up (a significantly undervalued security which, emotion aside, may be a far better buy than a sell at today’s market price). This is why relentless and thorough due diligence and deep fundamental analysis are so important. They give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market.

Greed, too, is deeply rooted within people. It is expressed through the drive to acquire more and more and the related angst felt when others are succeeding while you are not. This is what J.P. Morgan meant when he said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.” Or as Gore Vidal dryly noted, “Whenever a friend succeeds, I die a little.” The positive reinforcement from repeated stock market success can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long. A recent article in Vanity Fair about a looming bubble in Silicon Valley noted, “Collectively these start-ups have helped promote a culture of FOMO – or ‘fear of missing out,’ in Valley parlance – in which few [venture capitalists], who have their own investors to answer to, can afford to ignore the next big thing.”

Fear of missing out, of course, is not fear at all but unbridled greed. The key is to hold your emotions in check with reason, something few are able to do. The markets are often a tease, falsely reinforcing one’s confidence as prices rise, and undermining it as they fall. Pundits often speak of the psychology of markets, but in investing it is one’s own psychology that can be most dangerous and tenuous.

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Discipline isn’t something an investor should be turning on and off. There’s no point in being disciplined most of the time, only to toss the fruits away in a weak, distracted, or greedy moment. And there’s no such thing as being almost disciplined – even one moment of weakness can invite the wolves in, and it can also send a message. If you expect the members of a team to be disciplined, then letting down one’s guard on occasion is at first confusing, and then demoralizing, as the benefits from prior discipline are squandered. If excessive risk-taking is rewarded even once, there will quickly be no discipline at all

In the moment, public market investors have no ability to control investment outcomes, but they can control and improve their own processes. We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk. We do our utmost not to allow this to happen. We believe that by remaining focused on following a well-conceived process, we will make good risk-adjusted, long-term investments. And we know that if we do that, we will indeed earn good returns over time.

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While operating within the constraints of value investing principles, we are determined to look far and wide for opportunity, building our competencies over time based on learning and experience. We must neither be confined by a narrow mindset of what may or may not be undervalued, nor become so aggressive in pursuing opportunity that we deviate far beyond our circles of competence. I tell our team that we wouldn’t be doing our jobs if we remained locked in the past, buying only the melting ice cubes of previously good businesses now in decline as though technological change weren’t accelerating the obsolescence of entire industries. We would also be remiss if we failed to take advantage of new analytical tools and resources. We must consider new ways of thinking. We must continuously ask ourselves whether any investment under consideration is just too hard to properly assess: Is the fruit too high-hanging? In investing, there are no style points awarded for degree of difficulty. However, the complexity and opacity that may cause others to discard potential opportunities as “too hard” can drive market inefficiencies that result in opportunity for us. In 2015, we took a close look at “big data” technology as a research tool and potential “edge” for Baupost. While there are a number of applications that may be interesting over time, we continue to strongly believe that our investment success will ultimately depend not so much on big data as on big judgment.

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As with Pavlov’s dogs, in a bull market investors find certain actions repeatedly rewarded; their behavior thus becomes deeply ingrained. Amidst a relentless rally, almost anything you come close to buying but ultimately pass on goes higher, inducing you to be more aggressive. Similarly, anything you sold you probably sold too soon, even if it had met your price objective. In a bull market, focus on downside risk ceases to be shrewd discipline and instead becomes an albatross. Many are seduced into raising their appraisals, because doing so is rewarded. As if missing out on returns weren’t itself painful enough for “Type-A” money managers, it also causes underperformance that can frustrate clients and raise career risk. Bull markets don’t typically end until most have capitulated, at which point there is almost no one new left to buy.

Bear markets, of course, offer their own false “lessons,” but in the opposite direction. As prices fall, anything you previously sold turns out to have been a good sale; anything you bought was premature accumulation. When securities become “value-ish,” they at once become too tempting for the value-starved to avoid, yet still potentially toxic to one’s financial health. It takes a great deal of fortitude to set the bar at the consistently right place in all market environments. A bar that fluctuates with the tide is, in effect, no bar at all. Trading losses in a down market can turn investors into Mark Twain’s proverbial cat who once jumped on a hot stove: to this feline, all future stoves are also assumed to be worth avoiding. We haven’t been in a broad-based bear market since early 2009, although numerous sectors now seem to have entered one. We believe that value investing principles, great patience and discipline, a flexible mandate, a time-tested process, and the ability to hold cash, as well as decades of experience in a multitude of market environments, should serve us well in navigating through.

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It’s obviously far better to be alive today than 50 or 100 years ago. But optimism isn’t an investment strategy. Growth isn’t always profitable growth, and the returns from investments are typically determined more by the price paid than the growth rate. Whether any of these favorable trends are fruitfully investable is unclear. While we may all be better off decades from now, it’s reasonable, in light of the numerous concerns discussed earlier, to expect a bumpy ride.

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A fiduciary should think more about the safety of an entire portfolio than about any individual holding. Is Baupost willing to make an investment that has a meaningful, even significant probability of loss, if the expected value – the weighted amount and probability of gain and loss – is hugely positive? The answer is yes. All positions involve a degree of risk; any investment can go sour, and any probability assessment can be wrong. We manage the risk of loss in any single position by sizing appropriately based on historical experience as well as by striving for prudent diversification. Every day, businesses we own are making countless decisions they believe will offer positive expected value to shareholders in excess of their firms’ cost of capital. It doesn’t make sense to own businesses which do that, yet be unwilling to do it ourselves.

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