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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.

A Shopping List For Bargain Hunters

The old saying that “things can always get worse” seems to be an apt description for markets so far this year. A poor start to the year has snowballed into an environment in which investors are being paid to “sell the rallies.” Year-to-date global equity markets are down roughly 10 percent in dollar terms, as measured by Bloomberg performance data for the MSCI ACWI Index (NASDAQ: ACWI ). While a few markets, notably Canada and Mexico, are flat to nominally higher, several market segments, including U.S. biotech, China and Italy are down more than 20 percent since the start of the year, according to Bloomberg data for the Nasdaq Biotechnology index and the respective MSCI country indices. Against this backdrop, bargain-hunting investors are asking whether there may be opportunities. My take: Given that the sell-off is occurring in the aftermath of a multi-year bull market, stocks overall still aren’t cheap. That said, it’s not too early to begin compiling a shopping list of potential bargains that may be worth considering . While the selling has returned some value to equities, the best that can be said is that most markets now look reasonable. According to a BlackRock analysis using Bloomberg data, a global benchmark ( ACWI ) is trading at around 16.5x trailing earnings , down around 7.5 percent from last summer’s peak but roughly in-line with the 10-year valuation average. Global stocks look cheaper on a price-to-book ( P/B ) basis, but with the exception of emerging markets equities, they are only trading at a small discount to their 10-year average. If valuation is unlikely to put a floor under markets, there are two other scenarios that could help establish a bottom: signs of economic stabilization or a more aggressive, coordinated response from central banks. As I don’t view either as imminent , markets are likely to remain volatile in the near term. There’s value to be found if you know where to look However, for investors looking to bargain hunt, there are certain segments of the market that are trading at a significant discount. While it may still be too early to pull the purchase trigger, these two segments in particular are worth a closer look. 1. Emerging Markets. After underperforming for the better part of the past five years, emerging market stocks, as measured by the MSCI Emerging Markets Index, are one of the few, genuinely cheap asset classes. At roughly 1.25x trailing book value, emerging market equities are trading at a level last seen at their trough in early 2009. On a relative basis, using the MSCI World Index as a proxy for developed markets, EM stocks trade at nearly a 35 percent discount to developed markets, the largest such discount since the market bottom in 2003, according to an analysis of data accessible via Bloomberg. 2. Energy stocks . The other universally unloved asset class is energy. While assessing ” fair value ” is always an elusive exercise when discussing commodities, the recent plunge in oil prices seems to have created value in energy-related companies . With energy firms’ earnings still plunging, their price-to-earnings ( P/E ) ratios don’t look very appealing. However, based on P/B measurements, the sector, as represented by the S&P 500 GIC Energy Sector, is trading at the lowest level of the past twenty years and at about a 45 percent discount to the broader U.S. equity market. Even assuming future write-downs, the current discount looks large. Emerging markets and energy have another argument in their favor: Over the past several months, rising volatility has begun to chip away at the momentum trade. Long positions in biotech and tech darlings have already been hit. Downside momentum plays continue to work, but being underweight, or short, energy or emerging market stocks have become very crowded trades. Similar to what has happened to long-side momentum plays , such downside momentum trades are likely to violently reverse at some point. When that occurs, these two segments appear well positioned to benefit. This post originally appeared on the BlackRock Blog.

Income Investors In Risky, Energy-Related Products Get Creamed

Brokers who pitched energy based structured products during the recent oil boom to conservative clients will be flooded with phone calls from angry clients. As the price of oil has crashed from $100 a barrel less than two years ago to below $30 on Thursday, investors who bought structured products looking to generate income have been crushed. The pain felt by investors in the futures market, energy partnerships, high-yield corporate bonds and the shares of oil and gas companies is well known, noted Wall Street Journal columnist Jason Zweig last weekend. But the plummeting price of oil is also “wreaking havoc” on opaque and complex structured products tied to the price of oil, Zweig reported. In 2015, the biggest names on Wall Street, including Bank of America (NYSE: BAC ), Morgan Stanley (NYSE: MS ) and Goldman Sachs (NYSE: GS ), issued at least 300 so-called “structured notes,” which are short-term borrowings with returns linked to the price of oil or other energy-related assets. Remember those heady days, just a year ago? It was a perfect time for Wall Street to pump out high-risk products and sell them to Mom and Pop investors. The stock market had gone up in almost a straight line since March 2009, the depths of the credit crisis. The demand for commodities seemed vast, and the U.S. energy industry, with the boom in fracking, looked invincible even though oil prices had started to slide. Those structured securities issued last year total at least $1.3 billion, with most maturing later this year. Investors have a bit of time for oil to bounce back, however, if that bounce doesn’t happen, expect a flood of investor complaints to be filed against the brokers and broker-dealers who sold the structured notes. The allure of the notes and structured products is that investors can make a lot of money if oil goes up just a smidge, with some notes tripling gains at a capped rate. But in some cases there is no protection on the downside, so investors will see “dollar for dollar losses, without limit,” if the fund goes down, noted Zweig. But getting back to even will not be easy, noted one analyst cited by Zweig. “They vast majority of them are underwater,” said the analyst. “And a lot are materially underwater. On many of them, you’d need a 50% to 100% jump in the price of oil from today’s levels to get to break-even.” “This is not really an investment strategy so much as a wager on which way oil prices are going,” another analyst told Zweig. “And some of the risks and costs of that wager are masked by the complexity of it.” Hidden risks and costs, a complicated investment structure based on derivatives – readers, these are red flags in any market. “Many people who thought they were buying black gold on the cheap appear to own a black hole instead, with limited means of escape,” concludes Zweig. We couldn’t agree more. Zamansky LLC are securities and investment fraud attorneys representing investors in federal and state litigation against financial institutions. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.