Seth Klarman, Micron Technologies, and Risk Targeting
When Seth Klarman invests, people pay close attention. As the founder of the Baupost Group, which reportedly manages $28 billion, he has earned his reputation as as an elite value investor.
People are paying attention to his investment in Micron Technology Inc. (NASDAQ: MU), a semiconductor manufacturer. In recent filings, it was disclosed that approximately 28% of Baupost’s publicly disclosed long portfolio was invested in MU.
It looks like things have worked out well for him thus far. What does Klarman see here? Certainly he saw undervaluation when he was buying, and given the size of his position he is pretty confident about that undervaluation.
While Klarman is extremely successful, he is also human. He “puts his pants on one leg at a time,” is capable of mistakes, and is subject to behavioral bias like the rest of us.
In this context, is it possible that Klarman is overconfident about this big position in his long book?
We offer this post on overconfidence from earlier this year for some perspective: http://blog.alphaarchitect.com/2013/02/16/reflections-on-overconfidence/
In Daniel Kahneman’s “Thinking Fast and Slow,” Kahneman suggests applying a “premortem” process when assessing risks and overconfidence in any plan.
Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster.
Thought experiment: What does the premortem look like for MU? A “disastrous” outcome, while perhaps unlikely for MU, seems as though it would be at least within the range of possible outcomes.
In 1991, Klarman published “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” which is now among the most famous books on value investing ever written. Below we highlight a section from his book in which Klarman discusses his approach to risk. It’s a great read, as is almost everything he writes. When we read it, however, we found it difficult to reconcile the statements below with his outsized exposure to MU.
After all, as he puts it, “Bad luck can befall you; mistakes happen.”
The following is excerpted from Chapter 5, “Defining Your Investment Goals”:
If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy…One of the recurrent themes of this book is that the future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.
Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.
Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15 percent a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or how hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.
Targeting investment returns leads investors to focus on upside potential rather than on downside risk. Depending on the level of security prices, investors may have to incur considerable downside risk to have a change of meeting predetermined return objectives. If Treasury bills yield 6 percent, more cannot be achieved from owning them. If thirty-year government bonds yield 8 percent, it is possible, for awhile, to achieve a 15 percent annual return through capital appreciation resulting from a decline in interest rates. If the bonds are held to maturity, however, the return will be 8 percent.
Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond. Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion, but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one’s estimate of future share prices.
In the long run, however, stock prices are also tethered, albeit more loosely than bonds, to the performance of the underlying business. If the prevailing stock prices is not warranted by underlying value, it will eventually fall. Those who bought in at a price that itself reflected overly optimistic assumptions will incur losses.
Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.
Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one I know does: value investing.
Is Mr. Klarman following his own model?
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