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Seth Klarman On Value Investing In A Turbulent Market

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.” – Seth Klarman year-end 2015 letter to investors. 2015 was a bad year for Seth Klarman and his Boston-based hedge fund Baupost. The fund lost money for its investors, a rare event – it’s only happened three times since the fund’s founding in 1982. Click to enlarge Off the back of such a terrible performance, Seth Klarman devoted the majority of his year-end letter to investors explaining that value investing isn’t a precise science in his usual calm and philosophical manner. It’s unlikely that Klarman would have been aware what was in store for the markets in the first few months of 2016, but as it turns out, his words couldn’t have come at a better time for value investors seeking reassurance in a turbulent market. Seth Klarman: Take advantage of Mr. Market 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.” – Seth Klarman year-end 2015 letter to investors . To be a successful investor, you must be able to take advantage of Mr. Market’s bipolarity. You must be able to step in and buy shares when Mr. Market offers them to you at a knock-down price, but you need to be able to ignore his calls to sell at lower levels. Klarman writes that the two extremes of human nature, fear and greed drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. Your shares still represent the same fractional ownership in a business as when they traded higher yesterday, however, people are now en masse delivering the verdict that your shares are actually worth less. 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.” — Seth Klarman year-end 2015 letter to investors . Losses can cause people to lose their bearings. It’s natural to want to sell everything after your portfolio has been marked down sharply. Watching your net worth evaporate in front of you as the market falls isn’t a pleasant experience. However, this is the wrong way of thinking about equities. Klarman writes that for an investor to overcome the desire to sell at the bottom and take advantage of Mr. Market’s erratic movements, they must think not about what the market will pay for the securities today, (the stock price) 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. Klarman continues, saying that 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 a 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: 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).” – Seth Klarman year-end 2015 letter to investors . This is why conducting your own rigorous due diligence is essential. The insights gained from due diligence give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market. Seth Klarman: Don’t be greedy Greed works alongside greed to eat away at your confidence and push you to make decisions that are hazardous to your wealth. The angst felt when others are succeeding while you are not can lead you to make poor decisions, on this topic Klarman cities J.P. Morgan, who said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich,” and Gore Vidal who dryly noted, “Whenever a friend succeeds, I die a little.” What’s more, the fear of missing out can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long. 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.” – Seth Klarman year-end 2015 letter to investors . To show just how dangerous (and damaging) fear and greed can be to investors’ returns, Klarman lets the figures do the talking. The data shows that over the 30-year period from 1984 to 2013, the S&P 500 Index returned an annualized 11.1%. However, according to Ashvin Chhabra, head of Euclidean Capital and author of ” The Aspirational Investor ,” the average returns earned by investors in equity mutual funds over the same period was ” a paltry 3.7% per year, about one-third of the index return .” Bond investors were dealt even more pain. While the Barclays Aggregate Bond Index returned an annualized 7.7% over the 30-year period from 1984 to 2013, bond funds produced an annualized return of 0.7%. The underperformance in both cases was a direct result of investors pulling money out of the funds at precisely the wrong times. In short, by letting fear and greed take over their emotions, retail investors have underperformed both the markets and the very funds in which they were invested since 1984. That’s a statistic that’s difficult to ignore. So to conclude: 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 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.” – Seth Klarman year-end 2015 letter to investors. Disclosure: None.

The #1 Secret Behind George Soros’s Investment Success

Although now long retired, the octogenarian George Soros is widely considered the greatest speculator of all time. Other investors such as Ray Dalio may have made more money for their investors than Soros. Activists such as Carl Icahn may have briefly exceeded Soros’s net worth. But Soros will always remain the man who “broke the Bank of England” in 1992, thereby exemplifying a gunslinging style of trading that has been largely confined to the history books. Back in 1987, he wrote a book about his investment philosophy called The Alchemy of Finance , outlining his “Theory of Reflexivity.” Soros admitted he gave his theory such a grand-sounding name so that it would sound like Einstein’s “General Theory of Relativity.” He thought it was that important. Wall Street strategist Barton Biggs called it: “a seminal investment book… it should be read, thought about, underlined page by page, concept-by-idea… (Soros) is the best pure investor ever… probably the finest analyst of our world in our time.” Because of Soros’s stature, The Alchemy of Finance turned out to be one of those books that every Wall Street investor said they had read. But I doubt any of them got through it, let alone understood it. George Soros’s #1 Investment Secret: Tackling ‘The Alchemy Of Finance’ When I was managing my first investment fund over 20 years ago, I decided that I really wanted to get inside Soros’s head. So I took Barton Biggs’s advice and read The Alchemy of Finance . I read it once… I didn’t get it… I read it again… I still didn’t get it… Now, keep in mind that I had been through law school… … So I was used to stirring concrete with my eyelashes… … And getting through more poorly written, turgid prose than most humans should have to endure… But Soros’s writing style made judicial opinions seem like Ernest Hemingway’s lucid prose. Then one day, I ran across a quote from Soros’s own son. It made everything crystal clear, but not in the way that I expected. “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bulls**t, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.” – George Soros’s son, Robert, on his father’s Theory of Reflexivity. Soros himself went on to criticize his own theory in the next edition of the book, admitting that it was essentially incomprehensible. And he was right. George Soros’s #1 Investment Secret: Correcting False Predictions So, if no one has a grand theory to explain the market – not even George Soros – what chance do you have to be a successful trader? It turns out there is a secret to George Soros’s success. But it’s not one that you will find in The Alchemy of Finance . But once you understand and apply this secret, it will make your trading life much easier – and certainly less stressful. The “secret” to Soros’s success is not the ability of his “Theory of Reflexivity” to explain or predict the market. In fact, the secret to his success is quite the opposite. I found it buried in a Soros interview in John Train’s The New Money Masters , in what was almost a throwaway comment: “My approach works not by making valid predictions but by allowing me to correct false ones.” Now, I could get into how this all has to do with Soros’s admiration for the philosopher Karl Popper and the limits of human understanding. But comments from traders who have worked with Soros are more relevant. From James Marquez, a former Soros chief investment officer (CIO): “Soros would be the first one to tell you that sometimes his actions… look like the most rookie, odd-lot, wrong-way kind of thing, selling at the lows, and buying at the highs. But it’s much easier to understand in light of his avowed mission: to be able to come and fight another day. He says: “I don’t want to wake up broke.” And then, Alan Raphael, yet another Soros CIO: “When George is wrong, he gets the hell out. He doesn’t say, ‘I’m right, they’re wrong.’ He says, ‘I’m wrong,’ and he gets out, because if you have a bad position on, it eats you away. All you do is think about it – at night, at your home. It consumes you. Your eye is off the ball completely. This is a tough business. If it were easy, meter maids would be doing it.” Now, contrast that philosophy with how most other people think of trading or investing: We develop an opinion on a stock. We take a position. We convince ourselves that we made the right decision. This is when a bad investment turns into a “long-term investment.” And the “smarter” we are, the worse it is. We “know” we’re right. We “know” our investments will eventually “come back.” Now, let’s examine how Soros would look at the same situation. Here’s my take on what Soros believes: “The secret to my success is that I know that I will be wrong. I consider it a strength to admit my mistakes. That allows me to stay in the game and fight another day.” George Soros’s #1 Investment Secret: How To Apply It In Your Own Trading So, how can you apply this approach in your own trading? Understand that successful trading in the markets has much more to do with having proper exits and position sizing (bet size) than it does the “Theory of Reflexivity” or any other explanation of the market. So the next time you come across a “can’t fail” investment idea, here’s what you should do: Listen carefully and see if it makes sense to you. If you agree with it, then consider taking a position in it. But no matter how terrific-sounding the idea, make sure that you have your exits and position sizing strategies in place. If the position goes against you – which some inevitably will – reframe in your mind the idea that taking a loss is a strength. Make sure you cut your losses. This, I believe, is the key that will keep you from “waking up broke.”

The Altman Z-Score In Edward Altman’s Own Words

By Larry Cao, CFA The Altman Z-score is a famous formula for measuring a company’s financial worthiness devised by Edward Altman . I sat down with Altman in Hong Kong recently to discuss the Z-score, its original inspiration, evolution over the years, use and misuse, as well as the current credit situation around the world. In this first installment, Altman discusses how the model was initially developed and what has changed since then. For the rest of our conversation, please stay tuned for additional installments in the weeks ahead. Larry Cao, CFA: Can you start by giving us some background on how you came across the problem and how you developed the formula as a solution? Edward Altman: When I was a graduate student at UCLA in the mid-1960s, one of my mentors, Professor J. Fred Weston, knew that I was looking for a topic for research, and he wrote me a one-word note one day: “bankruptcy.” In those days, bankruptcy was not a very popular research area, although there had been some work done using individual measures to look at the financial risk of companies. I decided I had to look at the subject of predicting financial distress of companies using a multivariate approach. You know, sometimes breakthroughs are not so much a function of the brilliance of the people but the timing and the luck. And I was very lucky to be a Ph.D student at the right time in the right place. If I had thought about this subject two years earlier, I would not have had the computer firepower that was just beginning to come on campuses in the United States. If I had been on the scene two years later, someone else would have already done the work. I combined a number of financial indicators with a technique for statistical classification known as discriminant analysis to predict bankruptcy. That was written in 1967, published in 1968, [and] known as the Z-score model or the Altman Z-score. And this model originally was built and still is mainly relevant for manufacturing companies. I had no idea that, almost 50 years later, people would still be using it and, indeed, using it more than ever. In your paper, you used five categories of variables – liquidity, profitability, leverage, solvency, and activity – to predict insolvency. How did you end up choosing the specific variables in the model? At that time, there were a lot of variables in the literature that you could choose to predict insolvency. But I decided there are two variables that were potentially very powerful but had not been used yet. One was the retained earnings: The argument there being a firm that has grown its assets mainly by reinvesting earnings is healthier than a firm that has grown the assets by using “other people’s money.” Retained earnings is also a measure of the age of the company and leverage. So that one measure combined leverage, profitability over the life of the company minus dividends, and also the age or experience of the company. You would think it makes a lot of sense because it does go back to the history of the companies and says, “Hey, how much money have you made and how much of that have you reinvested rather than paid out to your owners?” Yet you don’t come across models that use retained earnings very much these days. That’s true. It’s funny. Retained earnings/total assets is so powerful in my model, but you don’t find them very much taught in the classroom or found in the literature. I found it extremely important and helpful in almost every model I built over the years, for different industries and countries. What’s the other new variable you identified? The other new variable then – even though now it’s quite commonly understood – was the market value of the equity relative to the book value of the debt, as opposed to the book value of equity. It was the first study that – even before the Merton model, which was 1973, 1974 on risky debt – anticipated the importance of market equity relative to book debt as a very important indicator where it represents the ability of the company to raise money from the capital markets to pay down the debt or to expand the company. So market equity is now a fundamental part of many so-called structural models provided by Merton, KMV, and a number of other providers. So Z-score is a statistical model, with all the parameters driven by the particular sample. [Exactly] For a different sample, should users get new estimates for the parameters? The original sample was manufacturers. Rather than updating the original model for, say, more recent bankruptcies, which we can do, what we prefer to do is build new models. I developed the Z”-score model in 1995 mainly for emerging market and non-manufacturing industrial companies. We also decided to take out the fifth variable, sales to assets. And we re-estimated the coefficients. So you took out an activity ratio? Exactly. It was very sensitive to the industry and, to some extent, the country. There was a new breed of corporate debt coming from emerging markets in the mid-90s, such as from Mexican, Brazilian, and Argentinian companies. And we tried to get a model which was more appropriate for that segment of the world and for manufacturers and non-manufacturers. We find that Z” is far more robust across sector and countries than Z-score, although both do a good job in classifying companies as to their bankruptcy potential with the same further modifications. How did the five variables rank in terms of importance? We look at the relative contribution and its statistical test. It turns out return on assets is number one. Retained earnings to total assets is number two. Market equity to total liabilities, three. Sales to assets, four. And the least important one, surprisingly, is the liquidity ratio, net working capital to total sales. Has the ranking changed from Z to Z”? No, it has not changed, except that sales/total assets is no longer a factor in the revised Z-score model. Fascinating. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.