3 Key Takeaways from Seth Klarman’s 2013 Letter


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Seth Klarman of Baupost is clearly skeptical of two big themes today. (Check out notes from his 2013 annual letter here and here.)

  1. The bull market in the U.S.
  2. The opportunity mindset in Europe.

Remember that his approach and views are freakishly spot on.

Two obvious ones include avoiding the Internet bubble in 1999 and the 2008 crisis.

Before I continue on about Klarman, please click on the image below to download a PDF version of this article.

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Klarman isn’t just a smooth talker though. He walks the walk.

During the “lost decade”, Baupost obliterated the averages, returning 14.8% and 15.9% for the 5 and 10-year periods ending December 31st versus -2.2% and -1.4%, respectively, for the S&P. – Outstanding Investor Digest

While everyone was freaking out during the 2008 crisis, this is what Klarman did.

During the crisis in 2008, Baupost lost “between 7% and the low teens.” Still though, he certainly outperformed the market indices and much of his investment management brethren in a time of panic. – MarketFolly

When Klarman talks, you should listen.

So based on the latest annual letter, here are 3 key takeaways you should know and the implications involved.

Key Takeaway #1

“If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about”

Brilliant.

This is related to what Bruce Greenwald means when talking about earnings power value.

If a business is unable to generate more cash than what it needs to operate (or reproduction cost), then it’s just earning enough cash to sustain itself.

This is a tricky comparison.

According to simple metrics, such as return ON capital, the company may be making a killing. But this difference is going to make many investors pour money into overvalued assets and taking on unnecessary risks.

Key Takeaway #2

“Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to play on juiced corporate earnings?”

Warren Buffett said that “probably the best single measure of where valuations stand at any given moment” is  the Wilshire Total Market Capitalization divided by the US GDP.

As of March 12th, the total market cap highlights a significant overvaluation at  about 117.2% of the last reported GDP.

This implies a 1.6% return a year going forward.

Total Market Cap to US GDP

Total Market Cap to US GDP

Another frequently used tool is the Shiller P/E.

Right now, the Shiller PE reflects a value that is 54.5% higher than the historical mean, also implying a return of 1% for next year.

Shiller PE

The Shiller PE

So what is the right multiple to play on juiced corporate earnings?

The question that Seth Klarman poses is one to reflect upon. As investors look at all the profits taken in recent years, their mouths could be watering. Is the expensive price justified to enter now at the market?

Key Takeaway #3

“On almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix , Inc. and Tesla Motors Inc.”

Look at the yield spreads between high yield bonds and the Treasury spot curve at the moment.

We’re really close to historical low digits, and the spread is 7.25%.

Without question, QE has initiated a search for yield that impacted nearly every market available to investors.

3

Now look at what this environment is doing to the valuation of actual companies.

Klarman called out two specific companies and grouped them as “nosebleed stock market valuations”

  1. Netflix (NFLX)
  2. Tesla (TSLA)

Check out the valuation numbers for NFLX and TSLA which is only going to exemplify Klarman’s example. I’ll come up with a raw estimate of its intrinsic value. Numbers are from the OSV Stock Analyzer Software.

The numbers I’m about to show you are raw numbers without adjustments for predicting “future” growth.Even slight adjustments don’t help these two companies to justify their current price.

Netflix (NFLX) Intrinsic Value and Valuation Ratios

NFLX Intrinsic Value Ranges

NFLX Intrinsic Value Ranges

NFLX Overvalued Valuation Ratios

NFLX Overvalued Valuation Ratios | Click to Enlarge

Tesla (TSLA) Intrinsic Value and Valuation Ratios

Now check out Tesla.

TSLA Intrinsic Value

TSLA Intrinsic Value – Overvalued

TSLA overvalued valuation ratios

How much “future” growth are you really paying for? | Click to Enlarge

The Trend is Your Friend Until it Isn’t

Check the numbers above again. Klarman isn’t exaggerating.

The old adage “the trend is your friend until it isn’t”, is closer than any given point in the past 5 years.

As a value investor, take the market’s optimism with a grain of salt. Use common sense, patience and diligence to protect your capital while achieving satisfactory returns.

Not the other way around.

Howard Marks wrote in one of his memos;

We must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into action or panic selling, we should become aggressive.

What about you? Where are we at now?

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3 responses to “3 Key Takeaways from Seth Klarman’s 2013 Letter”

  1. Carl says:

    I don’t understand the 3rd graph. What’s the 7.25 % spread ?

  2. Hermann says:

    Good article. I’ve been moving towards about a 50-60% cash position over the past 3 months or so and am also looking to focus on much more “traditional” and simple value measures… low price to book, low debt, free cash flow. I also think it’s worth avoiding yield pig syndrome so while I normally like looking for high dividends I think the low interest rate environment is causing some companies to raise dividends for yield chasers. Thus I may favor stock buybacks since that is less visible… though only if the price is low of course :).

    The problem is it may take 2-3 years for a correction and even though “everyone knows” the market is overpriced pulling back a bit and taking losses by virtue of underperformeding now vs. Getting crushed later will not prove psychologically easy in the short run (short being 1-3 years… yikes).

    That’s why people like Klarman outperform. They can get out when it’s good and get in when it’s bad. Its so easy, right. I mean they are TELLING us how they do it… and yet… man its hard to hit that sell button:)!

    Thanks to the Internet we get to watch in real time and have a historical record… not that it will change behavior much.

  3. “pulling back a bit and taking losses by virtue of underperformeding now vs. Getting crushed later will not prove psychologically easy in the short run”

    You bet. So hard to sell when you think your stocks aren’t that expensive as well..

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