By Rupert Hargreaves. Originally published at ValueWalk.
Seth Klarman’s Market Bubble Warning from many years ago is apt to today
Legendary investor Sir John Templeton is remembered for many things, but perhaps his most memorable investment quote has to be “The four most dangerous words in investing are: ‘this time it’s different’.” Unfortunately, despite Sir John’s reputation, to this day Wall Street analysts and well-known investors continue to use this same to justify high stock valuations and overvalued new issues.
In the words of Mark Twain, “history does not repeat itself, but it does rhyme, ” and by looking back through the letters to investors of hedge funds and investment vehicles over the years, there’s plenty of evidence to support this. One such letter is from Seth Klarman to the investors of his value orientated hedge fund Baupost penned during December 1995.
Seth Klarman’s market bubble warning from the 1990s
Before I get into the letter, I should add some background. Between the end of 1990 and fiscal year-end 1995, a $50,000 investment in the Baupost Fund would be worth $98,430, assuming reinvested dividends and after fees for an annualized return of 14.81% to April 30, 1996. Over the same period, the S&P 500 turned $50,000 into $102,587 assuming the reinvestment of dividends. Looking at these figures,i t would appear that the average investor would have done better to invest in the S&P 500 than with Seth Klarman during the first half of the 90s. Understandably, at the time (similar to today) investors were openly wondering if they would do better to invest in index funds. In response to this, in his year-end letter, Klarman cautioned against this approach:
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“Today, virtually everyone “knows” that over the long-run, stocks will outperform other investment alternatives. Of course, almost no one thought of this as the market made cyclical lows in 1974 and 1982. So after a record-setting thirteen year bull market, proponents of this viewpoint are ignoring the high price they must now pay to purchase equities. Another dangerous notion is that dips in the market always represent buying opportunities.”
The similarities between this quote in the investment environment today (if one wants to coin it is a market bubble warning) are staggering. After nearly a decade of steadily rising stock prices since the financial crisis, investors are abandoning actively managed funds in droves in favor of passive instruments that track an index. The problem with this approach, as Klarman goes on to point out, is not that it is difficult to outperform during bull markets, but that it is impossible to achieve a better result than the rest of the market during bear markets:
“We have said before and will repeat here that you do not really need Baupost to invest your money in bull markets. An index fund could likely perform better. The true investment challenge is to perform well in difficult times. It is unfortunately not possible to reliably predict when those times might be. The cost of performing well in bad times can be relative underperformance in good times. We have always judged that a worthwhile price to pay.”
To outperform during difficult times requires a keen focus on risk, and the acquisition of holdings at a significant discount to intrinsic value. The letter continues:
“We remain surprised by the number of attractive opportunities we continue to find despite generally overextended market conditions. We believe that what we own is exceedingly cheap on an absolute basis, and that these holdings will perform well no matter what the broader market does. A number of our largest holdings at year-end have catalysts for the realization of underlying value, and should come to fruition in the relatively near future.
…
We continue to focus our attention on the avoidance and/or reduction of risk. We believe this can be done without sacrificing good, even excellent, returns over time.”
If indeed this time is not different, investors should heed Klarman’s market bubble warning from around 20 years ago.
The post Seth Klarman: A Bubble Warning From The Past appeared first on ValueWalk.
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