Value Investing Forum

Since I've moved a bit further in Klarman's book, I'd like to defend him against criticism (some of which was my own out of ignorance.)

Starting on page 213 (223 of my pdf) he discusses hedging. He actually advocates using hedges that are similar to your investments. So if you own US large cap stocks you can buy puts on the S&P 500 or sell futures contracts, etc. He even says:

In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits. (pg 214).

So I think he would probably agree with my suggestion of buying puts on good short candidates would be a good way to hedge… provided the price is right of course. Options can be over/underpriced and that should be looked at as well.

But on shorting itself, he actually gives at least one instance of a short he does advocate so he can't be completely against the idea of shorting. Starting on page 205 he discusses BNE in which the bonds were undervalued and the stock overvalued:

Opportunistics investors bought the BNE bonds and sold BNE common stock short to lock in an apprarent valuation disparity. [...] Performing these simultaneous transactions appeared to be a low-risk strategy under any conceivable scenario. (page 206).

He then goes on to explain how they would be profitable in different scenarios. Admittedly, this is only one example and would have to be put into context in a broader view on Klarman's style of value investing. At the very least, there is some room for shorting.

I agree with somrh in that writing covered calls is a conservative method for value investors to get some cash flow from their current positions. A value investor can calculate a reasonable price for his security and considering the current catalysts at hand the amount of time he is willing to wait for the intrinsic price to be achieved (and thus to sell his position). Then he can begin selling covered calls at a strike price equal to his price target, or even sell at strike prices below that target for calls with closer expiration dates, which if executed would result in a lower than expected return but in a shorter period of time as well. It's certainly a strategy worth considering as it makes holding for the long term much more palatable as you get paid in cash for holding a security – cash that could be used in times of distressed markets thus mitigating the need for one to "time the market" (e.g. selling long-term holdings just because market is overvalued).

Jae Jun said:

Options can be used to hedge positions, but I've always been interested in how one knows when to hedge?

Markets are completely non predictable and if the options expire worthless, aren't you just throwing away those premiums for the added "security"?

So far from what I've read so far in Klarman is that he acknowledges that markets are unpredictable and we buy flood insurance on our homes since we're risk averse and so why not buy portfolio insurance? Markets are unpredictable so I think he advocates having insurance at all times.

Obviously insurance is a losing game. Your end up paying someone to transfer risk. This aspect doesn't appeal to me at all. I can live with risk provided I understand the risk/reward structure and I can accept that particular risk/reward structure.

The flip side is that short selling carries with it risks that many won't accept. I'm suggesting a compromise between the two.

I'm still of the opinion that Graham would probably consider options to be "speculative" since the time constraint could result in a "permanent loss of capital". But options can  have a decent risk/reward structure. It all depends upon the price and reasons for it the bet.

In Lewis' book (that I mentioned earlier) he follows a couple of investors who ended up buying credit-default swaps on the crappy bonds that wall street was creating. They made most of their money (up till that point) buying out of the money options. Black-scholes models assume returns are normally distriibuted so the tales are unpriced. They would seek out situations in which after some crucial date (earnings announcement, court decision date, etc) and the stock would either go up a lot or go down a lot. The options, they viewed, were cheaply priced. Obviously they lost a lot of money on the bets that lost, but the bets that were right made up for all of those losses. The risk/reward structure worked. But it would have to be looked at on a case by case basis.

What I'm suggesting is a compromise between the two ideas. Find companies that you would short and buy puts on them. That gives your insurance while at the same time can be profitable if you can find overvalued deteriorating companies.

Due to the time element and the potential for loss, I think Graham would think this is "speculative" but I think he would consider it a rational speculation provided you go about it in the right way. If you were disciplined and restricted yourself to, say, 3% of your portfolio as suggested, that would help reduce the addiction element Buffett warns about. But the discipline has to be there.

somrh said:

"You can buy out of the money puts on bond funds to easily insure against

these at reasonable prices, or you can pick certain bonds that you

believe will suffer even more than the broad bond funds."

Why bond funds?

At least as far as recessions go, there is a tendency for interest rates to go down so bond prices will increase.

I finally started reading Klarman's book (I've had it on my computer for a year or two but hadn't gotten around to reading it… now that I have a Kindle, it's that much easier for me to read it) and I haven't gotten to that part yet.

If there's interest (and interest in book club type thing in general) I'll start a thread in the books section and post some of my comments on the book. You can always read along and chime in.

And I guess I'll answer my own question (maybe). Is it because he thinks stock prices are inversely related with interest rates? Personally I'd like to see some evidence.

But if you're willing to buy puts as insurance why not, say, buy puts on a broad market index or even buy puts on stocks that you would have been willing to short. After all, purchasing puts have some advantages over shorting:

1) You don't have to borrow the stock.

2) Your losses are restricted to the premium you paid (instead of "unlimited").

3) For stocks that have options, it's often easier to buy the option then it is to find shares to borrow (many are already "hard to borrow and incur fees for borrowing). (For stocks that don't have options, they may be difficult to short in the first place.)

This way, not only would it be insurance against a significant market downturn, but it also has the potential to be a profitable activity.

http://www.my10000dollars.com/…..of-safety/

this should hold you over til you save up the money :)

I've gone short on stocks before and even scoured obscure brokers looking for available stock that I could go short with. I had one situation where I could not risk anyone knowing what I wanted to short, so I started by calling those obscure firms with offices on the opposite end of the country. In the end, I stopped doing short sales for a number of reasons and wanted to share them for any counter arguments.

1) Market risk vs business risk. With a short position, I take on market risk, because if the stock is bid up enough, I may have no choice but to cover my transaction.

2) If a firm is doing something that Wall St. loves, but is actually a bad activity, all they have to do to push their stock price up is continue this same activity. Yet again, you take on market risk.

3) Buffett says that you can get shorts right 4 out of 5 times, but it's the 1 time that kills you. As value investors, we are taught to invest with conviction. If prices fall, you should be wanting to buy more. In a short, you would think that the opposite should hold too, but you don't know where the top is – the rising stock price and momentum supporting it can go on for a very long time.

4) Seth Klarman is a smart man. Yes, this alone is a good reason for me to not short stocks. He talks about a number of things:

A. Markets naturally lean towards overvaluation – We have circuit breakers to halt trading on the way down, but not the way up, and prices that are too high are just as bad. The regulators only care about the way down though, nothing if prices get too high. Short selling is often banned (financial stocks in 09?), trades have to be executed on down tickets, and so even if there are enough short sellers out there, the odds of them being able to keep prices in line in very tough.

B. Sometimes, the *stock price can dictate business value* – imagine if the intrinsic value, to any buyer in the world, with a 0% cost of capital, is $1 for a stock. It happens to trade at $10 though and so you enter a short sale, hoping that it falls and you can cover the short sale. While the business is only worth $1, the CEO can buy other companies with his overvalued stock, and bring the intrinsic value up. He may be able to raise the intrinsic value to $5 or $6 by doing this, which significantly reduces your perceived "margin of safety" in this short sale. (I would argue that a margin of safety cannot exist for short sales though)

The more I read, the more I *love* the idea of an absolute-return value fund that only takes long positions. I also *love* what Klarman says about portfolio insurance – he spends 1-3% every year insuring against catastrophic events, which for money, represents inflation/deflation/etc. You can buy out of the money puts on bond funds to easily insure against these at reasonable prices, or you can pick certain bonds that you believe will suffer even more than the broad bond funds.

Isn't it funny that we insure our homes against an Earthquake, but we won't insure our retirement portfolio's against tail-risk events?