Quotes from Seth Klarman Interview
Selected Quotes from the Legendary Investor
Given today is a US holiday, our regular weekly newsletter drops tomorrow instead of today.
Before then, we were listening to legendary investor Seth Klarman's interview at Harvard Business School with Das Narayandas last week and thought we should share a few insightful quotes we got from the interview:
1. Step back from the current noise:
"I think it's good to step back from the moment-by-moment noise. Investors sometimes get caught up in the noise, but it's really important to step back….so Daniel Kahneman, my favourite author from Thinking Fast and Slow, wrote a book called Noise and he laid out…an example of somebody taking target practice. Bias is if every shot is up and to the right then there's something. You know my aim is wrong, my gun is wrong or my my eye is wrong. But if all of the shots are scattered around the bullseye that's noise, that it's variability but not predictability and i think that's relevant to investors. Investors just should always want to be thinking about their own thinking…we all know we we deal with enormous amounts of information we need to filter it down to the useful information."
2. The impact of rising rates:
"That is going to test financial institutions who's been writing derivatives they shouldn't write, who's been stepping out to take greater risks in their portfolio because if you can't make it in bonds, people try to make it somewhere else."
3. Watch out for anchoring
"After you buy something you paid for, it doesn't matter. People cling to the idea that at least they should get their money back; maybe there is bad news, and you should sell before it goes lower; maybe put it into something else where you get your money back, but people prefer to make it back where they lost it. People anchor numbers in their heads, and they hold on to them. They have a way of remembering what happened relatively recently. If you recently had a pandemic, you over-worry about the next pandemic even though they don't happen that often. I was certainly guilty of that after 9/11 myself. It seemed obvious that we'd get hit again, and then we didn't for a long time.
4. Best business book:
"We should not expect people to be rational all the time. Daniel Kahneman does a beautiful job in Thinking Fast and Slow. It is in many ways the best business book, the best investing book ever written even though it's not ostensibly about business or investing because it tells us about ourselves”
5. On his philosophy:
"A very significant part of my philosophy has to do with managing your psychology. Markets are about the psychology of others. When are they panicking? When are they greedy? But you have those same flaws or those same potential flaws, and managing your portfolio in a way that doesn't leave you where you're panicking or overexposed to greed. If you can rule those extremes out, you'll navigate the markets well."
6. On finding edge:
"There are lots of ways to develop edge as an investor. One of the ways is deep fundamental knowledge. I have total respect for people who dig incredibly deep in an area where they're doctors and medical researchers. They study biotechs and that's formidable. No one should underestimate that power, but that's not the only kind of inefficiency, as the inefficiency might be informational. Two things happen in markets; right markets are inefficient partly because of human nature, as I mentioned; greed and fear. People get greedy and panic; in some cases, the panic is legitimate. "Oh crap, I leveraged my portfolio, and I'm getting a margin call." or "I have short-term clients, and they can redeem, and I'm getting redeemed, and I have to sell whether I like it or not." There are other constraints on investors that also create inefficiencies. Once in a while, we get a call from someone with one asset in their private equity fund who want to raise the next fund. They want to book a gain on that asset. And so, call it the last asset phenomenon. People literally will sell that more urgently, and maybe they'll favor getting it done over the exact price they get because they want to raise their next fund and move on. They want to book a game and get paid. We live in an imperfect world, and their clients should probably not love that, but maybe their clients would love it. The manager has a lot of things to balance, so that's just one little example. When a bond gets downgraded, there's always an immediate rush to the exits by the investment-grade holders. A bond gets downgraded to junk, say when the bond goes literally from BBB to BB. Many bonds have to get sold; some are probably sold in advance. It's good to know what a company does, its operations, and its worth. It's also interesting to know that there's a very large seller, and the bonds are 20 points lower. With essentially no change in any information, just the rating of a 26 year old at moody's. So those are the kinds of things that can trigger our interest then we do fundamental work”
7. Managing downside:
"Most investors at wall street are tilted to be bullish; almost all research reports are buy reports and not sell reports. Most individuals don't sell short, so there's a bias towards going long. There's nothing wrong with that, except that, at times, it means that people are not thinking about the downside at all. I would recommend a balanced approach. If you don't think about every investment as having a margin of safety, which is a term I blatantly stole from Benjamin Graham- and it's the name of my book the Margin of Safety. This means you buy at a discount and leave room for error, misjudgment, and bad luck because things happen in the world and happen in investing. I think in Warren Buffett's Parlance, he says, "when you build a bridge, you might plan to be driving, you know a certain kind of truck over it, but you build it so it can handle five times as much weight as that just in case," and that's what you should do with investments, so you never lose sight of the downside. When other people buy a very flashy growth stock at a very high multiple, we're probably looking for a more sedate investment that will make less or maybe won't make less and will protect the downside in the heat of the last couple of years that saw stocks rocket to new highs almost every day…We feel our investments are completely solid, so I think that it's not to choose one or the other it's always to remember both getting your capital back and trying to make a return. If I had to choose one of those, I'd always choose to get your capital back because you live to play another day, and losing money is a real challenge because it can be very hard to make it back. If you're a hedge fund manager, this may result in high employee turnover as no one wants to join a fund that's got big losses they have to make back before they get paid. You may get margin calls or other debt coming due, so you always want to be thinking about not blowing up and not getting too far over your skis….When you focus on return at the exclusion of risk, you try to take more risk to get the return; you get the risk but may or may not get the return. If you focus first on the risk and mitigate or avoid or reduce the risk, then you've protected the downside, and then maybe you get the return."
8. On value investing
"Warren Buffett never tried to make the most money. He never tried to get rich quickly. He tried to get rich slow, and I feel like that's what value investing is; it's a philosophy that stays away from the hot flashy trendy investments and focuses more on never losing big."
9. On managing risks:
"When you focus on return at the exclusion of risk, you try to take more risk to get the return; you get the risk but may or may not get the return. If you focus first on the risk and mitigate or avoid or reduce the risk, then you've protected the downside, and then maybe you get the return."
10. On making mistakes:
"Today, there's not so much mean reversion. Things may not be mean-reverting because of technological disruption, so I think investors have had to raise their game massively in the last several decades, and I'm not done raising it. I probably haven't raised it as high as it needs to be. It is a great time to be knowledgeable about technology; it was a great time if you could figure out what Amazon was up to. For a value investor, it looked hopelessly risky but for a tech investor, maybe with the right insight into the value of platforms and the value of winner take all business models, that would have been a good thing to have that I didn't have. I pat myself on the back and say, okay, Seth, you were a schmuck twenty years ago and ten years ago for not figuring it out, but you were smart to figure it out five years ago. That's all an investor can do; be intellectually honest, be self-critical we're justified, and keep trying to get better every day. Like Warren Buffett, the best investors study read admit mistakes um always looking to get smarter and wiser because what else can you do as a person."
11. On Post-mortems:
"We spend a lot of time on post-mortems. I am big fan of those because every investment at some point or another feels like a mistake that after you buy it it goes down, after it goes up you didn't own enough and what could you have done differently. Not trying to be perfect but trying to pull what kernels of information you might have for next time. A bull market teaches one kind of lesson, and a bear market teaches very different lessons. I work really hard with the team, many have never seen a bear market because it's been 12 or 13 years to understand that there'll be a day when everything you buy goes down, everything you waited on will seem like a heroically good decision, and everything you buy will seem bad, everything you thought about selling and didn't, you'll feel like you'll also start to lose confidence in yourself because everything you thought now looks wrong, so suck it up and deal with that, but how do you deal with it, and part of it is being prepared by talking about it in advance."
12. What to do when stocks you buy go down:
"One of the most supportive things I do is, if we buy something and it goes down, as any value investor, you look at it, and you check and recheck your work. Then if nothing's different, you should like it more it's a better bargain. If you knew the sweater you bought yesterday is going on sale today, you might be frustrated that you bought it yesterday. What you should do is stock up. We do that with stocks and bonds. One of my colleagues would tell you that I bought this bond in the low 80s; we bought more in the 70s and 60s. We couldn't believe it when it was in the 40s and 50s and bought more; our low print was at 16, and we bought more. He describes it as I never felt; like "Seth was angry or judging me, I felt like Seth was supporting me, and He was looking at it and saying yeah, this is a better deal let's buy more. Buying power is a lifelong imprint for that guy, and that's how you invest and treat the people working for you. I think it made him feel closer to me in the firm because we supported him. I wouldn't have done any of that if I thought he was wrong. I would have said, look, this doesn't seem right; let's get rid of it. I don't yell at people. If you walked into our trading room, it's very low-key; there's no volatility, no emotion; it's not like the movies where you see Wall Street doing hard work. It's like a library.”
13. On where he sees value:
“Looking at the kind of stocks we buy right now, they tend to be relatively higher-quality. Companies may be trading at 11, 12, or 13 times earnings or cash flow, depending on which we think is the better metric. With some solid high single-digit growth that gives you, it makes you know if we'll own those stocks under eight times earnings or under eight times free cash flow in three years. Lightly leverage balance sheets willing to buy back stock when it trades at a reasonable price, so they're also adding value per share by buying the stock when it's undervalued. Knowing the management of good quality, good reputation, not just taking advantage of the shareholders, I think that's as good as anything. We do see inefficiencies in some of the private markets. I wouldn't just hand money to somebody who might not see the same inefficiencies I'm talking about. Still, we're active in four or five areas at all times where we're in public equity and public credit.”
14. Watch out for the silo effect:
“We dig very deep, our approach is,let's look a mile wide, let's look at everything that we can possibly figure out and then we find something that seems like it might be a bargain and inefficient pricing then we go a mile deep. Gillian Ted of the Financial Times wrote a book called The Silo Effect and she talks about the good things and the bad things when that soil you when you just know a certain kind of company or you only know 20 stocks well. The problem is that that's the hammer and nail problem. You know those things really well but you don't know anything about anything else, you have no perspective to say well this is the best of those biotech stocks that I look at but maybe even the best of them is not nearly as good as those stocks over there. The silo effect hamstrings investors. One way to describe how we think about our portfolio is that we look between the silos. We look for cracks and the things leaking out. We look for things that can't be easily siloed, there are fewer competitors in those and if there’s one thing I love it's the lack of competition.”
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