Wednesday, January 4, 2012

Seth Klarman and contrarianism

I just read through a collection of Seth Klarman’s letters to shareholders in his fund – the Baupost Group. Klarman is a value investor and wrote the out of print “Margin of Safety”, now selling for over $1000 on Amazon. The Baupost Group has achieved an average annual return of 19% since 1983 for its three partnership funds. The particular letters I read were for a smaller fund that he set up in 1990.

One thing that struck me reading through his letters is his contrarian streak. I think it’s incredibly hard to confidently go against the grain when everyone around you seems like they’re printing money. That’s why Klarman’s letters are so refreshing.

In the letters between 1995 to 2000, he calls the internet bubble several times. You can feel the frustration in his letters as his funds lag various indices by substantial amounts. At one stage (April 1999) $50 000 invested in the particular partnership at its inception (December 1990) would have turned into $139 277. That’s not bad, but $50 000 in the S&P 500 passive index would have returned $250 971! That sort of persistent and dramatic underperformance has got to feel pretty bad.

Klarman makes passing mention of the internet fad in his 1995, 1996, and 1997 letters, but rips into it in 1998:

The U.S. stock market has been propelled by investors falling all over themselves to buy large-capitalization growth stocks like Microsoft, Coca Cola, and even General Electric. At least they are, more or less, good companies. Occasionally, periods of unbelievable excess occur, where near-worthless enterprises are propelled into the stratosphere. Such a period is now upon us.

It is bad enough that the shares of small growth companies announcing stock splits surge skyward as if something value enhancing has actually taken place. Now, suddenly, the siren song of the internet has become even more irresistible for hordes of growth investors.

Consider the case of K-Tel International, the company best known for selling music CDs and tapes on late night television. After hovering in a narrow trading range around $7 a share(for its 4.1 million outstanding shares) since January, the announcement that K-Tel plans to sell its music on the internet caused its shares to skyrocket from $7 to $45 in just one week and to $80 a week later with daily volume exceeding 100% of the freely tradeable shares outstanding. "You put 'dotcom' behind it and they'll buy it", said one analyst commenting on the behavior of internet-obsessed investors. In a similar vein, Market Guide, a provider of financial data, rallied from 3 to 29½ in three trading days after announcing a partnership with America Online. At 29½, the company had a market capitalization of almost $150 million yet it boasts current annual revenue of only $5 million. Watch out below!

And in 1999:

The $200 billion market capitalization of America Online recently exceeded that of IBM. Charles Schwab was recently valued 50% more highly than Merrill Lynch. Priceline, the Internet company that sells airline tickets, was valued more highly than the three largest airlines, combined! eToys came public and immediately jumped to a valuation well above that of the well established Toys "R" Us. The prevailing casino atmosphere must certainly put a damper on trips to Las Vegas or Atlantic City, where there are more losers than winners. In Internet-land, there have been no real losers as of yet; the illusion of a positive-sum casino is an attractive lure for the gambler. Recent exuberance notwithstanding, at today's valuations it is clear that Wall Street is certain to continue issuing shares of new Internet companies until the supply of shares overwhelms the resources of the buyers.

It’s obvious now and in hindsight that he was absolutely, 100% right. He ended up making up all his lagged performance (and then some) in 2000 and later. But at the time it must have been maddening.

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