Beaten-down markets have been a boon for Baupost, which has become the sixth-largest hedge fund in the United States and a force to be reckoned with. Seth Klarman, president and portfolio manager of 28-year-old Baupost Group, is considered the dean of value investing among hedge fund pros, and such a devotee of Benjamin Graham and David Dodd that he was the lead editor to the reissue of their classic, “Security Analysis,” in 2008.
With his wire-rimmed glasses, graying beard and kindly smile, the 53-year-old Klarman has a gentle, professorial air about him — and a reputation as a cautious investor who is more likely to be found sitting on a mound of cash than taking big risks in frothy markets.
The CIT group controverse
That being the case, it might be surprising to learn that Klarman’s Baupost bested Carl Icahn in the tussle over CIT Group last year and helped wage a successful activist campaign in a merger battle for a small biotech company. But if Baupost has been able to throw its weight around recently, it’s not just because beaten-down markets provided tremendous opportunities for value investors. It’s also because Klarman has been on such an asset-building binge that Baupost has become the sixth-largest hedge fund firm in the United States, with $21 billion under management — three times the $7.4 billion Klarman managed just three years ago. After raising more than $4 billion in early 2008 — the first time in eight years that he had opened his fund to new investors — the founder of once-obscure Baupost has become a hedge fund titan.
To hear Klarman talk about these matters, the success and the deals all flow from the value-investing philosophy he first popularized in his book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” now out of print.
The CIT deal became one of last year’s highest-profile hedge fund trades, but Klarman was way ahead of the crowd. He began to buy distressed credits, especially in the reeling financial sector, during spring 2008, and thought the senior debt of the shaky middle-market lender, looked especially attractive. After all, he remembered that he’d made a successful investment 10 years earlier in another diversified loan company, Finova Group. So Klarman’s team scooped up CIT’s bonds, which were yielding 12% to 14%, for 65 cents to 75 cents on the dollar.
“It had some loan problems, decent quality assets and an equity cushion that would need to be burned through before the bondholders would be impaired, which made for an attractive risk-return,” says Klarman, recalling his initial thinking on the CIT trade on a recent morning in early April at his office on St. James Ave., just a few blocks from Boston Common.
During 2008 the bonds fell to the low 40s, and Baupost bought more all the way down. But by July 2009, CIT was in such poor shape that Baupost and five other hedge funds ended up lending it an additional $3 billion. To help buy some time, the facility was expanded by an additional $4.5 billion.
Klarman says he was confident the deal would offer him a comfortable margin of safety. A first-lien loan, the debt was collateralized by assets worth four times more than the face amount of the debt, and in exchange Baupost got a fat 12% yield. “We don’t usually lend money at par,” concedes Klarman, who for a short period agreed to sit on an unofficial steering committee of CIT’s creditors before it went into bankruptcy. “But how often do you make a loan that is exceptionally safe and you get to make 12%?” Nor did the prospect of bankruptcy worry him. If it were to occur, Baupost calculated that the assets would recover at least 80 cents on the dollar to the unsecured bondholders.
In the late October, as CIT seemed headed for a prepackaged bankruptcy, the deal looked so good to Icahn, who claimed to own $2 billion in CIT bonds, that he opposed it. Icahn called it a sweetheart deal for the large bondholders like Baupost and the other five hedge funds and countered with a $6 billion loan for CIT.
But a week later Icahn backed down, paving the way for CIT to enter into a prepackaged bankruptcy from which it emerged in just 38 days. And Klarman’s analysis turned out to be spot-on: Baupost wound up receiving a package of securities with a market value of about 80 cents on the dollar for its CIT debt.
The Facet Biotech Deal
Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech — a small biotech company spun off in December 2008 from PDL BioPharma — for an average cost of $9 even though it had $17 per share in net cash at the time of the spin off. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”
Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.
Klarman’s high-profile roles last year in both the CIT and Facet Biotech deals helped him generate average returns in 2009 of nearly 27% in the 11 partnerships of Baupost, with the oldest recording a 19% annualized return since inception in 1983. Klarman succeeded by deftly exploiting undervalued markets, whether they are equities, junk bonds, bankruptcies, foreign bonds or real estate. His long-term performance is especially impressive since he is not afraid to place as much as 50% of his assets into riskless cash if he can’t spot a good deal, preferably one with a catalyst.
Klarman: A Student of Benjamin Graham
“Seth is a student of the doctrine of Benjamin Graham, but he is not wedded to it,” says James Grant, editor of Grant’s Interest Rate Observer, who has known Klarman for nearly three decades. “He has a very good understanding of not only what makes an attractive valuation but also what makes an attractive opportunity. Seth looks for value in a 360-degree circle of markets and geographic regions. He is one of the all-time leading opportunists.”
In his characteristically understated manner, Klarman simply smiles and says, “I’m not the best, but I am on the all-star team.”
After the debt and equity markets rallied sharply over the past 14 months, Klarman is seeing many fewer good values — and that’s despite the market’s huge sell-off that began in mid-May. He thinks junk bonds are no longer attractive now that spreads have narrowed sharply, and he has selectively sold down his corporate debt holdings over the past year. As a result, Baupost was only up about 3.25% to 6.4% in the partnerships net of fees through April; Baupost now has 30% of its assets in cash, and Klarman expects that number to drift higher. Baupost’s returns this year have been hurt by the huge cash position, but that doesn’t deter him.
Says Klarman: “We are concerned by the high degree of optimism over the past few months.”
Good Times for Baupost
Baupost’s recent growth spurt has come at the same time that more recognizable names — such as Louis Bacon’s Moore Capital Management, Kenneth Griffin’s Citadel Investment Group and Paul Tudor Jones II’s Tudor Investment — have seen assets shrinking from losses or investor withdrawals of capital. By contrast, investors have been clamoring to get into Baupost. “I felt Baupost could handle more money than ever, given the magnitude of opportunities that we were anticipating,” Klarman recalls.
Like John Paulson — whose Paulson & Co. also very quickly became one of the biggest hedge funds — Klarman smelled trouble in the global markets as early as 2006. He thought stock prices were too expensive and that excesses in the credit markets, resulting from heavy borrowing by countries, companies and individuals as lending standards were relaxed, were ominous. “Some things made little sense,” he remembers thinking.
As credit conditions tightened in 2007 and holders of securitized mortgage debt and collateralized debt obligations were forced to take huge write-offs, he noticed that credit spreads had started to widen. At the same time, he realized the housing market was deteriorating and figured trillions of dollars in mortgage-backed securities were not worth par value.
The Difference Between Klarman and Paulson
Klarman’s view was prescient. Paulson and Klarman, however, responded to the impending credit crisis in distinctly different ways. In 2006 Paulson shorted risky pools of CDOs and bought credit-default swaps on mortgage assets on the cheap. His aggressive bets were life changing, as he personally made $3.7 billion in 2007.
The risk-averse Klarman, on the other hand, placed nearly half his assets into cash. Then, as the financial world was imploding, he started scouring the markets for distressed debt. In late 2007 he started putting cash to work, reducing his cache to 25% to 30% by the beginning of 2008. “We were patient,” he recalls.
Klarman reckoned the game changed at the end of February 2008, when London hedge fund firm Peloton Partners was forced to liquidate its $1.8 billion asset-backed fund. “That was like a bell going off for us,” he says. “That was when we made our decision to raise capital. We realized there were a lot of weak holders out there,” he adds, referring to struggling funds that needed to raise cash.
He scooped up some of Peloton’s senior mortgage bonds for about 65 cents to 70 cents on the dollar. Shortly thereafter, their value fell further as the market worsened. But Baupost’s team saw other large sellers and developed relationships with Wall Street, letting various firms know that if anyone was looking to sell, Baupost was interested in loan portfolios, nonperforming debt, toxic assets of any sort, private investments or so-called tier-three assets.
Bargain Hunting: Welcoming New Investors
Sensing so much opportunity, Klarman also decided to open up his funds to new investors for the first time in eight years, raising about $4 billion. He raised the money only from foundations and educational institutions — including the Ivy League — as well as existing investors, all of whom he deemed more likely to stick with Baupost for the long haul regardless of short-term performance swings. Baupost is noted for eschewing fund-of-fund investors, who tend to redeem at the first sign of trouble.
Throughout 2008 Klarman was on the lookout for bargains. And after Lehman filed for bankruptcy and AIG was rescued in September, Baupost made new investments virtually every day, often shelling out $100 million on a single day. Klarman bought the beaten-down securities from others who were reeling from the markets, including many hedge fund managers who were forced to raise cash to meet a surge in redemptions. He didn’t escape unscathed from the carnage: his funds lost between 7% and the low teens during 2008.
But the comeback was worth it. For example, Klarman bought covered bonds of Washington Mutual at an average price of 74 cents on the dollar. He made money on them after JPMorgan assumed the bonds as part of its takeover of WaMu. BY early 2009, yields on some of the depressed paper surged to as high as 25%. His firm also bought distressed corporate debt, including nonbank financials such as CIT and Sallie Mae and mortgage securities, mostly the senior bonds, which were yielding about 12% to 16%. He was able to make double-digit returns on some of this nonequity paper in 2009.
As in the case of Peloton, Klarman continued to buy up the heavily marked-down senior mortgage securities from collapsing fixed-income funds. Baupost picked up pieces of nonperforming debt and private investments from large sellers. Klarman also bought credit default swaps, but unlike Paulson, he used them sparingly and solely as a hedge against calamity. At the same time, he was lightening his equity load, reducing his stock portfolio from $2 billion in June 2008 to $1.2 billion by year-end.
By October 2008, he drew down the rest of the newly committed money. “As the world blew up in the fall of 2008, it was business as usual for us,” he says with more than a small degree of pride. “It was a fortuitous time because we were conservatively positioned.”
Klarman admits he may have begun buying a little too early, as the returns of 2008 would suggest. However, since March 2008, when he began to take in the new money, he is up more than 30% through April. “Seth has an extraordinary sense of patience and discipline, which not many people have,” says Ray Jacobson, chief investment officer at Davidson College, who made his initial investment in Baupost in January 2009. “He is flexible and opportunistic.”
The Childhood of Seth Klarman
The elder of two boys, Klarman was born in New York City. His family moved to the Mt. Washington section of Baltimore when he was six, but his parents divorced shortly afterward. His father was a professor of health economics at Johns Hopkins University, and his mother taught English in a Baltimore high school before returning to graduate school to earn her master’s degree in social work.
Growing up in the shadows of Pimlico Race Course, he frequently spent his teen years there and developed an interest that would lead him to buy race horses when he became wealthy, enough to do so. And he was always into numbers. Klarman says he loved tracking baseball statistics, and by the age of eight had become fascinated with the stock tables in the back of newspapers. Like so many hedge fund managers, he started investing at an early age. Klarman bought his first stock – Johnson & Johnson – with money he had saved when he was 10. His analysis was simple. Given that he was a big user of the company’s Band-Aids, he figured he could stick to something he knew well. Shortly afterward, the stock split three for one.
When Klarman headed off for college at Cornell University, in Ithaca, N.Y., he initially planned to major in math, the subject in which he had received the best grades. However, after taking a number of economics and history classes, he earned a BA in economics in 1979, graduating magna cum laude.
In the summer of his junior year, Klarman had a fateful experience when his uncle helped get him an internship at New York’s Mutual Shares, the legendary value-driven mutual fund firm founded in 1949 by Max Heine, and also headed by Michael Price, who in his 20s had become a Heine protégé. During a summer working at Mutual Shares, Klarman learned the value philosophy that today is the bedrock of Baupost’s investment principles. “I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom,” he says.
Klarman likes to describe the connection he made to value investing as an inoculation. Either it takes or it doesn’t. “Ultimately, it needs to fit your character,” he explains. “If you are predisposed to be patient, disciplined and psychologically appreciate the idea of buying bargains, then you’re likely to be good at it. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor, and you shouldn’t be one.”
Upon graduation, Klarman returned to Mutual Shares. Price, who now runs his own family office, MFP Investors of New York City, recalls one of the first stocks Klarman bought was a Baltimore meatpacking company called Schluderberg-Kurdle, subsequently renamed Esskay, before it was acquired by Smithfield Foods. Mutual Shares wound up holding the position for several years and made a pretty good profit, Price recalls. “Seth left us a true believer,” says Price.
The Beginning of Baupost
After 18 months Klarman left the firm for Harvard Business School, where he earned his MBA and was named a Baker Scholar, an honor given to the top 5% of the graduating MBA class. There he took a real estate course with professor William Poorvu, who says Klarman was the smartest person in his class. “I realized he was a special guy,” Poorvu recalls.
The decision to go to Harvard – and to take a real estate course – was also fortuitous. One day Poorvu invited his students to lunch with some of the professor’s friends. At lunch Poorvu told Klarman how he had just made a lot of money selling his interest in a local television station to then media giant Metromedia. Poorvu added that he and several friends wanted Klarman to help them invest their considerable sums of money earned from that an other interests, including a computer consulting firm.
In 1982 they created Baupost, an acronym of the names of the four founders of the firm – Poorvu, Howard Stevension, Jordan Baruch and Isaac Auerbach – with initial capital of $27 million. Klarman, who came in later and got left out of the acronym, was initially paid just $35,000 per year, not exactly Wall Street compensation.
The initial plan was for Klarman to serve as portfolio manager, while Stevenson, who taught an entrepreneurial management course, served as part-time president. He is now co-chairman of the advisory board. They also planned to farm out the money to other money managers, creating an expanded family office. However, after meeting with several, they had a change of heart.
The Baupost founders were turned off by what they deemed to be a big disconnect between how the prospective money management firms were investing their clients’ money and how they were dealing with their own money. They also frowned on the herd behavior they saw, as most of the managers generally invested in the same stocks. Meanwhile, Poorvu and his friends were impressed with the kinds of questions Klarman was asking. So they decided he was the best person to manage their money. “They were taking a big risk on a relatively inexperienced person,” Klarman says.
Different than the Rest
Poorvu and his friends didn’t think so. Poorvu recalls how he was drawn to Klarman’s curiosity and desire to explore things in depth. Klarman, he saw, was not afraid to challenge anyone. “He was fearless,” Poorvu adds. “He had strong opinions. There were discussions more than arguments. It was an enthusiasm for what he was doing. We realized he was on a different level than they were.”
Those attributes have not disappeared. Grant describes Klarman as ferociously smart, notoriously prickly and not one to engage in a lot of soft preliminaries in a business context. “His intellect can be hugely intimidating,” he elaborates, stressing that Klarman has earned a great deal of respect in the investment community. “He comes out and says what is on his mind and expects you to be blunt and direct as well.”
Grant recalls how, years ago, Klarman would aggressively press Goldman Sachs salesmen on their investment ideas with a flurry of detailed questions. He was so fierce, Grant muses, that the Goldman guys were afraid to answer the phone if they saw it was someone from Baupost calling.
Investing with a Margin of Safety
When Baupost was created, Klarman determined that one of the best ways to make money is to avoid buying stocks that are widely covered on Wall Street and owned by many managers. In general, he tries to buy everything at a big discount. “What you are buying is a margin of safety,” he explains, invoking the name of his book written in 1991, which laid out his value philosophy. The book has found its own secondary market, and currently can be purchased for $1,700 new or $775 use on Amazon.
Managing risk and determining the margin of safety are the backbone of Klarman’s investment process. He and his team look at what could go wrong in a company, the economy, how some event or issue could affect the company or the security. “You can like a company but not find opportunity in its securities, or not like a company but find opportunities in the securities,” he says.
Ultimately, he says, money managers must pick their poison. They are going to be wrong sometimes. The question is, what are they going to be wrong about? They can take a risk and then possibly lose their client’s money, or the client could see their money remain intact but wind up not liking you because you missed a great opportunity. “Our bias is to buy when we have a high degree of conviction and wait patiently when we don’t,” he stresses. “That’s the core of our approach, which has kept us out of trouble.”
The Disciplined Investor
In other words, he prefers being wrong by missing opportunities rather than losing money chasing them. This is why Baupost, on average, has 30% of its assets in cash, and it is not unusual for Klarman to sit on 40% or 50% cash, as was the case in 2006 and 2007. This makes the fact that he outperformed the S&P 500 virtually every year in the past decade even more remarkable. In 2006 Baupost was up 22% compared with 15.8% for the benchmark, despite holding a huge amount of cash. The following year it had an explosive 54% return, compared with just 5.49% for the S&P, again with nearly half its portfolio in cash.
But Klarman has never felt pressure to put money to work, especially during the late 1990s, when Internet and tech stocks were surging out of control and critics were asserting that Warren Buffett was a relic unable to adapt to new markets. Klarman’s willingness to underperform over short periods of time when he does not see value also explains why he refuses to take money from funds of funds. He prefers educational and philanthropic groups.”If making money right away is important to you, please take your money out,” he says.
“When he doesn’t see things he likes, he doesn’t buy,” says Price admiringly. “He sits on cash. He is very disciplined.”
When mulling a specific investment, Klarman says, he looks at an anticipated return, although he won’t cite a specific level because Baupost’s required return depends on the perceived risk.
How to Pick Stocks
Klarman tries to figure out what something is worth, drawing in part on the usual metrics treasured by traditional value managers: price-to-book-value, price-to-cash-flow, price-to-earnings, dividend yield and replacement cost. Unlike most value investors, however, he does not put heavy weight on these measures. For example, if a stock is trading at a deep discount to book value or some other standard, he does not automatically buy it, since there is no guarantee the stock will go back to that level and no way of knowing how long it would take to reach that level. It could go to a deeper discount before it narrows again, or the value itself could change. “Book value is not a good proxy if the inventory is subject to obsolescence,” he adds.
And unlike many value managers, he does not look at what a private buyer might pay for something because that deal might never materialize.
Rather, Klarman tries to figure out what he could be willing to pay for the business today if it had to be liquidated or if the various parts of the business were sold. He says this does not mean the future is not important. “A dirt parcel in the middle of Boston is worth more than a dirt parcel in the middle of the desert,” Klarman says. But it is difficult to navigate between the present — for example, valuing current cash flow — and the future, such as projecting future subscribers for a cell phone company. “We would have a hard time making optimistic bets about the future,” he says. “You have to worry about your margin of safety, which value investors always want.”
In general, Klarman runs what he calls a sensitivity analysis. He likes to determine the best possible scenario, the worst case, and the base to find that margin of safety.
How far does he take it? Pretty far, or so it seems. Grant muses that shortly after he launched his newsletter in 1980s, Klarman requested a meeting to determine whether to commit $200 for an annual subscription. “He grilled me to see if it was a good investment for his fund,” Grant says, laughing, stressing that Klarman has been a subscriber ever since.
Baupost’s investment team consists of about 40 people — including six other partners — who investigate different asset classes, geographies and securities types. They are all generalists, except for the commercial real estate specialists. Although Klarman does not make every investment decision, he does make a point of saying he approves the concept of what they are doing.
Klarman, who spends most of the time sitting on the trading desk or in conference room meetings with his other investment professionals rather than in his office, must approve every trade, although he does not personally execute them. “If I am hard to reach on vacation, they can take a position,” adds Klarman, stressing that most of his key people have been with the firm for a number of years.
Bonds Instead of Stocks
Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.
Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management.
Serious Problems down the Line
These days Klarman is not very bullish. One of his concerns is the record dollar amount of junk bonds that were sold in March and April — $69.8 billion during that eight-week period. And that comes right after a record year for junk bond issuance in 2009, when $185.9 billion was sold.
Klarman is also concerned that the leverage that has weakened the consumer and corporations in recent years has now been added to the government, whose debt has been skyrocketing over the past decade. Meanwhile, interest rates are close to zero percent. “I don”t know how we wean ourselves off that,” he warns. “It is time for caution.”
As spreads on the debt have narrowed, he has been selling. Over the past year, Baupost has sold corporate debt at or near par after buying it for 40 cents or 50 cents on the dollar. He’s still selling, stressing that he’s waiting to buy when he can be adequately paid to take risk.
The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses.
Baupost is 30% in cash now, its long-term average. Klarman stresses that the cash position is residual — the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”
And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.
For Klarman, the overriding concern is valuation in individual investments, not the macro state of the market. And given today’s turmoil and financial distress, one might have expected more opportunities. “But, the opportunity set has been diminished by all of the government intervention,” he adds, referring to the current 0% interest rates, TARP and TALF. If financial institutions started selling these assets, opportunities would open up, he says.
Baseball, Race Horses and Charity
Another high-profile investment he has made in the past year was in the Boston Red Sox, buying the minority stake of advertising mogul Ed Eskandarian for an undisclosed sum. “It’s a tiny little sliver,” insists Klarman. “It’s been fund. The other owners have been incredibly gracious in welcoming me.” His biggest perk: better access to extra seats at hometown ball games.
Living next to Pimlico as a child may have been the impetus for a great career in finance, but ironically it seems Klarman’s worst investment has been in race horses. He bought his first one in the early 1990s, and in 1993 he started Klaravich Stables with longtime friend Jess Ravich, a West coast investment banker. Klarman’s crowning achievement came in 2004, when Read the Footnores, his horse, ran in the Kentucky Derby. One of the worst moments was when he finished seventh. Horse ownership, he acknowledges, is “almost certainly a negative present value situation.”
In 2008, Breederscup.com estimates Klaravich Stables earned less than $34,000. That’s a far cry from the roughly $275 million to $300 million Klarman probably earned last year as a hedge fund manager, a topic he won’t comment on.
Klarman will say that he gives away most of his money to the Klarman Family Foundation, which his wife Beth runs, or to individual charities, except for an undisclosed sum squirreled away for his three children. His foundation gives out considerably more than the standard 5% each year, focusing on alleviating poverty and improving education in the inner city. He also gives money to health care and science causes; he has created an eating disorders center and a funding program for scientific grants in the field of eating disorders. Klarman, who is Jewish, gives money to causes such as Boston’s Combined Jewish Philanthropies.
“It’s easy to write checks,” he says. “It’s hard to be thoughtful philanthropists. My wife Beth and I try to make our money go a long way. ” What else would you expect from the dean of value investing?
[This article first appeared June 2010 in Institutional Investor’s Alpha. Its author is Stephen Taub.]