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Seth Klarman On Mr. Market And The Market Environment

By Rupert Hargreaves. Originally published at ValueWalk.

The parable of Mr. Market forms the basis of any value investors’ understanding of the stock market environment at different times and securities prices. Originally devised by the godfather of value investing, Benjamin Graham, Mr. Market has since been used by all of Graham’s followers, and many more, to describe the stock market environment and how investors should react during periods of turbulence.

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Seth Klarman

Stock Market Environment in 2000

In December 2000, Seth Klarman to the investors of his hedge fund, Baupost just as the dot-com bubble had started to burst and describe the stock market environment, he leaned upon Graham’s Mr. Market analogy. “A manic fellow, Mr. Market will sometimes become exuberant, other times depressed,” he wrote. “Investors who look to Mr. Market for advice will inevitably do the wrong thing at the wrong time.

Investors who attempt to profit from Mr. Market’s manic depressive nature will be successful over the long run. These days, Mr. Market has run completely amuck, often manifesting manic and depressive behavior at the same time in different securities,” the letter opines. “Investors should prepare themselves for a greater degree of portfolio volatility because it is impossible to tell how wild Mr. Market’s mood swings may become.

It is of paramount importance that investors brace themselves for a stern test of their investment will. Avoiding overpriced speculations and maintaining a strict value discipline is more important than ever because the overpricings are so egregious and the bargains so pronounced,” Klarman concludes the section on Mr. Market.  At the time, this advice was highly relevant. Many highflying tech stocks have seen their share prices plummet amid the wider market rout and many investors (both value and growth) suffered.

Seth Klarman Stock Market Environment

Seth Klarman has produced a return of more than 20% per annum for his investors since Baupost’s inception. Baupost is closed to new investors but if you’re interested in small-cap value stocks you need to check out ValueWalk’s exclusive magazine Hidden Value Stocks. Released quarterly, in each issue we talk to two value-orientated hedge fund mangers and cover four stocks that have little or no other coverage. To the end of the second quarter, stock picks profiled returned 27% overall. Click here to find out more.

The parallels between the dot-com bubble and the tech mania that has taken over  the stock market environment today are uncanny. Reading through Klarman’s letters of the time, you could quite easily switch over the dates, and it would make no difference. For example, in the December 2000 letter he writes:

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“At this time, attractive valuation is not considered a good story. A slow growth or no growth company trading at one half or one third of its underlying value attracts no important constituency of investors. I sometimes joke about the new market valuation rules of thumb: stocks that fail to meet earnings expectations all seem to trade at 10 times reduced earnings, while formerly profitable companies that report losses all seem to trade at five dollars per share. Many investors avoid these stocks precisely because others are staying away. Why would those kind of stocks ever go up, they wonder.”

“In today’s environment, money flows rule, trumping all other factors in determining security prices. From any starting point, money flowing into one category and away from another can wreak havoc with accustomed levels of valuation and can cause egregious mispricings, both too high and too low.”

This is not just a letter from the past, it is, in fact, a warning from one of the greatest value investors of all time. The late 1990s was a period dominated by high-flying growth stocks that could do no wrong. Tech stocks lead the charge as momentum drove share prices higher and investors’ seem to forget all about valuation.

A similar stock market environment persists today, and while there are some differences between now and the dot-com crash, investors’ desire to chase growth at any price remains a common factor. As low volatility fund investors recently found out when low vol funds bought tech stocks because the algorithms told them to, a lack of fundamental analysis can lead to losses in the real world, something Klarman has warned about for decades:

“The fantasy of a near-term Dow 36000, of holding stocks for the long run regardless of valuation, plays well in classrooms, computer models, and editorials. It fares less well in the real world, where earnings disappointments are met with share price demolition, and where corporate managements massage and manipulate results for gullible compliant investors until the untidy reality inevitably peeks through. Like a couch potato clicking the remote control, real-world growth investors are continually switching their capital from areas of disappointment to areas of perceived opportunity, oddly unaware that all of the channels are showing reruns. Each alluring new area is the “before” photo, each broken growth stock “the after,” but no amount of adversity seems to dissuade growth stock investors from the hunt.”

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