37268558-Seth-Klarman-CFA-Presentation

September/October 2010 AHEAD OF PRINT 1

Financial Analysts JournalVolume 66 Number 5

©2010 CFA Institute

P E R S P E C T I V E S

Opportunities for Patient InvestorsSeth A. Klarman and Jason Zweig

t the CFA Institute 2010 Annual Confer-ence in Boston (held 16–19 May), JasonZweig sat down with legendary investorSeth Klarman to gain insights into Mr.

Klarman’s successful approach to investing.Zweig: The first question I would like to ask

you, Seth, concerns your work at Baupost. Howhave you followed Graham and Dodd, and howhave you deviated from Graham and Dodd?

Klarman: In the spirit of Graham and Dodd,our firm began with an orientation toward valueinvesting. When I think of Graham and Dodd, how-ever, it’s not just in terms of investing but also interms of thinking about investing. In my mind,their work helps create a template for how toapproach markets, how to think about volatility inmarkets as being in your favor rather than as aproblem, and how to think about bargains andwhere they come from. It is easy to be persuadedthat buying bargains is better than buying over-priced instruments.

The work of Graham and Dodd has reallyhelped us think about the sourcing of opportunityas a major part of what we do—identifying wherewe are likely to find bargains. Time is scarce. Wecan’t look at everything.

Where we may have deviated a bit fromGraham and Dodd is, first of all, investing in theinstruments that didn’t exist when Graham andDodd were publishing their work. Today, someof the biggest bargains are in the hairiest, strang-est situations, such as financial distress and liti-gation, and so we drive our approach that way,into areas that Graham and Dodd probablycouldn’t have imagined.

The world is different now than it was in the eraof Graham and Dodd. In their time, business wasprobably less competitive. Consultants and“experts” weren’t driving all businesses to focus ontheir business models and to maximize perfor-mance. The business climate is more volatile now.The chance that you buy very cheap and that it will

revert to the mean, as Graham and Dodd might haveexpected, is probably lower today than in the past.

Also, the financial books of a company may notbe as reliable as they once were. Don’t trust thenumbers. Always look behind them. Graham andDodd provide a template for investing, but notexactly a detailed road map.

Zweig: Seth, you started your career atMutual Shares, working for Max Heine and along-side Mike Price. Can you give us a couple of lessonsyou learned from those gentlemen?

Klarman: What I learned from Mike—and Iworked most closely with him—was the impor-tance of an endless drive to get information andseek value. I remember a specific instance when hefound a mining stock that was inexpensive. Heliterally drew a detailed map—like an organizationchart—of interlocking ownership and affiliates,many of which were also publicly traded. So, iden-tifying one stock led him to a dozen other potentialinvestments. To tirelessly pull threads is the lessonthat I learned from Mike Price.

With Max Heine, I learned a bit of a differentlesson. Max was a great analyst and a brilliantinvestor—and he was a very kind man. I was mosttaken with how he treated people. Whether youwere the youngest analyst at the firm, as I was, orthe receptionist or the head of settlements, healways had a smile and a kind word. He treatedpeople as though they were really important,because to him they were.

Zweig: One of the striking lessons that cameout of the global financial crisis of 2008 and 2009 isthe way traditional value investors got slaugh-tered. What went wrong, and why did so manysmart people get caught by surprise?

Klarman: Historically, there have beenmany periods in which value investing has under-performed. Value investing works over a longperiod of time, outperforming the market by 1 or2 percent a year, on average—a slender margin ina year, but not slender over the course of time,given the power of compounding. Therefore, it isnot surprising that value could underperform in2008 and 2009.

Seth A. Klarman is president of The Baupost Group,LLC, Boston. Jason Zweig is a columnist for the WallStreet Journal, New York City.

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I would make two points. First, pre-2008,nearly all stocks had come to be valued, in a sense,on an invisible template of an LBO model. LBOswere so easy to do. Stocks were never allowed toget really cheap, because people would bid themup, thinking they could always sell them for 20percent higher. It was, of course, not realistic thatevery business would find itself in an LBO situa-tion, but nobody really thought much about that.

Certainly, many of the companies had someelement of value to them, such as consumerbrands or stable businesses, attributes that valueinvestors might be attracted to. But when themodel blew up and LBOs couldn’t be effected, theinvisible template no longer made sense andstocks fell to their own level.

Second, because of the way the world hadchanged, it was no longer sufficient to assume thata bank’s return on book value would always be 12or 15 percent a year. The reality was that instru-ments that were rated triple-A weren’t all the same.Watching home-building stocks may not have beenthe best clue to what was going on in the mortgageand housing markets.

Equity-minded investors probably needed tobe more agile in 2007 and 2008 than they had everneeded to be before. An investor needed to put thepieces together, to recognize that a deterioratingsubprime market could lead to problems in therest of the housing market and, in turn, couldblow up many financial institutions. If an investorwas unable to anticipate that chain of events, thenbank stocks looked cheap and got cheaper andearnings power was moot once the capital basewas destroyed. That’s really what primarily drovethe disaster.

Zweig: With hindsight, it strikes me that aproblem many traditional value investors had wasthat they didn’t have enough on their dashboard.They were accustomed to bubbles forming in theequity market, but the credit bubble was in theperiphery. Equity investors didn’t take the creditbubble seriously enough, because it wasn’t in theircentral field of vision.

Klarman: Another issue that affected allinvestors, not just value investors, was the pressureto be fully invested at all times.

When the markets are fairly ebullient, inves-tors tend to hold the least objectionable securitiesrather than the truly significant bargains. But theinability to hold cash and the pressure to be fullyinvested at all times meant that when the plug waspulled out of the tub, all boats dropped as the waterrushed down the drain.

Zweig: A chilling moment in MichaelLewis’s wonderful book The Big Short is whenMichael Burry, a very talented hedge fund man-ager in California, finds himself, in 2007, in thedesperate situation of having to defend his shortpositions in leveraged mortgage securities againsthis own investors, who are just besieging him,screaming at him, why are you doing this? At thevery moment when his temperament is telling himthat he should be doubting his own judgment, hisclients are compelling him to explain to them whyhe has no doubts about his judgment.

How have you organized Baupost to discour-age your clients from putting you in a similarposition?

Klarman: We have great clients. Havinggreat clients is the real key to investment success. Itis probably more important than any other factorin enabling a manager to take a long-term timeframe when the world is putting so much pressureon short-term results.

We have emphasized establishing a client baseof highly knowledgeable families and sophisti-cated institutions, and even during 2008, we couldsee that most of our institutional clients—althoughsome of them had problems—understood whatwas going on.

Zweig: If you were to give one piece ofadvice on how to raise the quality of one’s clientbase, what would it be?

Klarman: In our minds, ideal clients havetwo characteristics. One is that when we thinkwe’ve had a good year, they will agree. It would bea terrible mismatch for us to think we had done welland for them to think we had done poorly. Theother is that when we call to say there is an unprec-edented opportunity set, we would like to knowthat they will at least consider adding capital ratherthan redeeming.

At the worst possible moment, when yourfund is down because cheap things have gottencheaper, you need to have capital, to have clientswho will actually love the phone call and—most ofthe time, if not all the time—add, rather than sub-tract, capital. Having clients with that attitudeallowed us to actively buy securities through thefall of 2008, when other money managers hadredemptions and, in a sense, were forced not onlyto not buy but also to sell their favorite ideas whenthey knew they should be adding to them.

Not only are actual redemptions a problem,but also the fear of redemptions, because the moneymanager’s behavior is the same in both situations.When managers are afraid of redemptions, they getliquid. We all saw how many managers went from

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Opportunities for Patient Investors

leveraged long in 2007 to huge net cash in 2008,when the right thing to do in terms of value wouldhave been to do the opposite.

Zweig: There is an interesting tension in theway Baupost operates. You are organized for thelong term, you invest for the long term, and yet youhave demonstrated that you can be extremelyopportunistic in the short term. For example, in2008, you took distressed debt and residentialmortgage-backed securities from basically zero tomore than a third of the fund in a matter of months.How do you take a firm that thinks long term yetget everyone to turn on a dime and jump on some-thing when it’s cheap?

Klarman: Actually, we increased the positionto about half of the fund by early 2009. There is nosingle answer. First, I have incredible partners. Weshare common aspirations for the business and acommon investment approach. And we are not con-ventionally organized. We don’t have a pharma-ceutical analyst, an oil and gas analyst, a financialsanalyst. Instead, we are organized by opportunity.We have analysts whose focus is on spinoffs ordistressed debt or post-bankrupt equities.

Not only do we not miss too many opportu-nities, but we also do not waste a lot of timekeeping up with the latest quarterly earnings ofcompanies that we are very unlikely to everinvest in. Instead, we spend a lot of our timefocusing on where the misguided selling is,where the redemptions are happening, where theoverleverage is being liquidated—and so we areable to see a flow of instruments and securitiesthat are more likely to be mispriced, and that letsus be nimble. It is fairly easy to say, “Well, this ismuch better than what we own. Let’s move fromthis direction to that direction”—and we aredoing that all the time.

Zweig: In a Forbes article in the summer of1932, Benjamin Graham wrote, “Those with enter-prise haven’t the money, and those with moneyhaven’t the enterprise, to buy stocks when they arecheap.”1 Could you talk a little bit about courage?You make it sound easy. You have great clients andgreat partners. Was it easy to step up and buy in thefourth quarter of 2008 and the first quarter of 2009?

Klarman: You may be skeptical of myanswer, but, yes, it was easy. It is critical for aninvestor to understand that securities aren’t whatmost people think they are. They aren’t pieces ofpaper that trade, blips on a screen up and down,ticker tapes that you follow on CNBC.

Investing is buying a fractional interest in abusiness and buying debt claims on a business. Ifyou are afraid that a bond you bought at 60 might

go to 50 or even 40, you may find it difficult to buymore; but if you know that the bond is covered,with extremely high likelihood, between 80 and paror even above par, the bond becomes more andmore compelling as its price falls.

But you do have to worry about how a bondwill trade and what your clients will think if youdon’t have enough staying power to hold to matu-rity or even beyond maturity in the case of a bank-ruptcy. But if you have the conviction of youranalysis—are sure that your analysis wasn’t opti-mistic or flighty or based on a snapshot of aneconomic environment that cannot tolerate anystress—then you will not panic if the bond’s pricestarts to drop.

Our approach has always been to find compel-ling bargains. We are never fully invested if thereis nothing great to do. We test all our assumptionswith sensitivity analysis. Through stress testing,we gain a high degree of conviction that we areright. We are prepared for things to go slightlywrong because we adhere to a margin-of-safetyprinciple that gives us the necessary courage to goagainst the tide.

Yet, we don’t actually think of it as courage, butmore as arrogance. In investing, whenever you act,you are effectively saying, “I know more than themarket. I am going to buy when everybody else isselling. I am going to sell when everybody else isbuying.” That is arrogant, and we always need totemper it with the humility of knowing we could bewrong—that things can change—and acknowledg-ing that we have a lot of smart competitors. Thus, inworrying about all the things that can go wrong, youcan prepare, you can hedge—and you must remem-ber to sell fully priced securities so that you areunderexposed when things go badly. All these ele-ments give us the courage to follow our convictions.

The last point I would make is that your psy-chology as an investor is always important. If youlose your confidence, if you’ve made too manymistakes, if you are down too much, it becomesvery easy to say, “I can’t stand being down morethan this.” Unless you have a bet-the-businessmentality, you would worry about your business,about client redemptions, and about your own networth in the business.

So, by being conservative all the time—bybeing both a highly disciplined buyer to ensure thatyou hold bargains and a highly disciplined seller toensure that you don’t continue to own things at fullprice—you will be in the right frame of mind.Avoiding round trips and short-term devastationenables you to be around for the long term.

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Zweig: I once paraphrased Graham’s won-derful sentence as, An investor needs only twothings: cash and courage. Having only one of themis not enough. And you are saying that courage isnot just a matter of temperament but also a functionof process.

Klarman: Absolutely.Zweig: You were quite critical of indexing in

Margin of Safety: Risk-Averse Value Investing Strate-gies for the Thoughtful Investor,2 which you wrotemany years ago. Have you changed that view?

Klarman: I still think indexing is a horren-dous idea for a number of reasons. That said, theaverage person who spends a very small amountof time on investing doesn’t have a lot of goodchoices out there.

A tremendous disservice is perpetrated by theidea that stocks are for the long run, because youhave to make sure you are around for the long run,that when you have unexpected pain, as manypeople did in 2008, you don’t get out and youactually are a buyer. The prevailing view has beenthat the market will earn a high rate of return if theholding period is long enough, but entry point iswhat really matters.

Stocks trade up when they are put in an index.So, index buyers are overpaying just because a stockis included in an index. I am much more inclined tobuy a stock that has been kicked out of an indexbecause then it may have value characteristics—ithas underperformed. A stock is kicked out of anindex because its market cap has shrunk below thetop 500 or the top 1,000.

We all know that the evidence shows thatwhen you enter at a low price, you will have goodreturns, and when you enter at a high valuation,you will have poor returns. That is why we havehad 10–12 years of zero returns in the market. Andgiven the recent run-up, I am worried that we willhave another 10 years of, if not zero, at least verylow returns from today’s valuations.

The mentality of “I’ll save transaction costs andmanagement fees by indexing” ignores the fact thatthe underlying still needs to produce for you.Indexing usually refers to equities, but the attrac-tive asset class a year ago, on a risk-adjusted basis,was clearly debt, not equity.

Zweig: In one of your recent letters, you dis-cussed what you called the “Hostess Twinkie mar-ket.” First, can you explain what a Hostess Twinkieis? Second, can you explain what you meant whenyou compared markets to a Hostess Twinkie?

Klarman: A Hostess Twinkie is a confectionthat has made many childhoods slightly happier,but it is composed of totally artificial ingredients.

My context, of about 6–12 months ago, was thatvirtually everything was being manipulated by thegovernment. Nothing was natural in the markets.Interest rates were held at zero, the governmentwas buying all kinds of securities—notably, mort-gage securities—and who knows what else hasended up on the Fed’s balance sheet.

We have had lending programs—TroubledAsset Relief Program (TARP), Cash for Clunkers,and even Cash for Caulkers. We just don’t knowthe full extent to which investors have been manip-ulated. But certainly, the government wants peopleto buy equities, to invest so that the market willmove higher, creating a wealth effect or at leasteliminating the negative wealth effect in order tomake people feel better about their situation, torestore a degree of optimism so that the economymight recover.

I am worried to this day about what wouldhappen to the markets, to the economy if, in themidst of all these manipulations, we realized thatthey are, in fact, a Twinkie. I think the answer isthat no one knows, including those in Washington.Will the economy continue to recover and grow ata healthy rate or will we sink into a double-diprecession? As we can all see, the high degree ofgovernment involvement continues.

The European bailout is gargantuan. I doubt itwill work because it kicks the can further down theroad and is yet one more manipulation that encour-ages people to own securities. It is almost as if ourgovernment is in the business of giving people badadvice: “We are going to hold rates at zero. Pleasebuy stocks or junk bonds that will yield [an inade-quate] 5 or 6 percent.” In effect, it forces unsophis-ticated investors to speculate wildly on securitiesthat are too overvalued.

Zweig: It also forces sophisticated investorsto do the same.

Klarman: For a different reason, but abso-lutely.

Zweig: Because the money is free.Klarman: And because they are in a

short-term-performance game where they have tokeep up.

Zweig: Are you concerned about the longer-term consequences of the Fed and the Treasuryhaving essentially turned the whole planet into a“carry trade at zero cost”?

Klarman: I am more worried about theworld, more broadly, than I have ever been inmy career.

Zweig: Why?

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Klarman: Until recently, I thought it wasenough to have a good process at our firm, a cleverapproach, and that by our wits we would findsufficient bargains. I worry now that a new elementhas been introduced into the game, which is, ineffect, Will the dollars we make be worth anything?And if we can print money in unlimited amounts,will the government intervene whenever it deemsit necessary to save the financial system, to prop upthe economy? There are not enough dollars in theworld to do that unless we greatly debase them. It’snot clear that any currency is actually all that trust-worthy, and so I worry about all paper money.

We judge ourselves in dollars. Our clients areall effectively in the United States. We don’t havean offshore fund, and so we hedge everythingback to dollars. Perhaps today is no different fromother crises. Nevertheless, over time, politiciansfind it easier to create inflation and debase cur-rency than to tackle hard problems, and so I worryabout the dollar.

We haven’t tackled a single hard problem.There is no evidence that we will, and in somesense, every can is being kicked further down theroad. So, I am very concerned about that.

I would love to see some sign of energy inWashington that would suggest somebody iswilling—even if it means not being re-elected—totake a tough stand and try to tackle some of theseserious problems, but I don’t see it.

Zweig: Do you think we will eventuallytackle these problems?

Klarman: People think of me as a pessimist,but I am actually an optimist. When somebody likeSenator Scott Brown of Massachusetts comes alongand says, “I am just going to speak plain English. Iam going to tell what I see is the truth,” that hasappeal, especially in difficult moments when noone else is saying that. I am optimistic that morepoliticians will come along who realize that such astance is actually a path to electoral victory.

Large parts of the country understand thatthere is no free lunch, that we have been lied to, thatall kinds of numbers are distorted and manipu-lated, that inflation is not really zero percent, andthat every adjustment the government makes toany reported data is to make the numbers morefavorable to its agenda.

I am hopeful that people will understand thatwe can’t all just exist on handouts and no taxes,and that we will begin to move in the right direc-tion. But I am not sure whether this crisis is badenough to force us.

I am also troubled that we didn’t get the valueout of this crisis that we should have. The GreatDepression led us to a generation—or even twogenerations—of changed behavior. I grew up hear-ing about how our grandparents had a “depressionmentality.” It’s awful to have a depression, but it’sa great thing to have a depression mentalitybecause it means that we are not speculating, weare not living beyond our means, we don’t quit ourjob to take a big risk because we know we mightnot get another job. There is something stable abouta country, a society built on those values.

In some sense, from the recent crisis we havedeveloped a “really bad couple of weeks” men-tality, and that’s not enough to tide us through,teach us to avoid future bubbles, and ensure astrong recovery.

Zweig: Seth, the simplest way to look at whathas happened in the world over the past three yearsis that the leverage that was taken on by the house-hold, corporate, and financial sectors has beenassumed by governments around the world, withthe United States in the lead. How is this going toplay out, and is there an investment angle on it?

Klarman: I am a bottom-up value investor,and so my partners and I are not experts on top-down investing. But broadly speaking, with sover-eign debt, in a Malcolm Gladwell kind of sense, weare talking about tipping points—we don’t knowhow much debt is too much.

History, of course, is not a perfect guide, andsentiment plays a crucial role. In the 1990s, JimGrant wrote a book about credit called Money of theMind.3 I think sovereign debt is “money of themind.” For example, if we believe that the UnitedStates will repay its debt and inflation will not be abig problem, people will line up to buy U.S. debt.But if we become worried that the U.S. dollar willbe debased, inflation will be high, or the UnitedStates might default—although default isn’t realis-tic because the government can just print moredollars—we will then have the risk of failed auc-tions and much higher interest rates.

A tipping point is invisible, as we just saw inGreece. In most situations, everything appears fineuntil it’s not fine, until, for example, no one showsup at a Treasury auction. In the meantime, we canbe lulled into thinking all is well, that the UnitedStates will always be rated triple-A. Treasury Sec-retary Timothy Geithner speaks as if—at least in hispublic statements—he has been lulled into thinkingthat the United States will always be triple-A. Thatkind of thinking guarantees that someday theUnited States will no longer be triple-A. A sover-eign deserves to be rated triple-A only if it has

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valuable assets, a good education system, a greatinfrastructure, and the rule of law, all of which arecalled into question by an eroding infrastructure, agovernment that changes the law or violates itwhenever there is a crisis, and a legislature thatshows no fiscal responsibility. There is an old say-ing, “How did you go bankrupt?” And the answeris, “Gradually, and then suddenly.” The impend-ing fiscal crisis in the United States will make itsappearance in the same way.

Zweig: In your book, Margin of Safety, yousaid as a general rule that commodities, with thepossible exception of gold, are not investmentsbecause they don’t produce cash flow. Do you regardcommodities as investments in today’s market?

Klarman: No, I don’t. In the book, I wasmostly singling out fine-arts partnerships and rarestamps—addressing the commodities that weretrendy then. Buying anything that is a collectible,has no cash flow, and is based only on a future saleto a greater fool, if you will—even if that purchaseris not a fool—is speculating. The “investment”might work—owing to a limited supply of Monets,for example—but a commodity doesn’t have thesame characteristics as a security, characteristics thatallow for analysis. Other than a recent sale or appre-ciation due to inflation, analyzing the current orfuture worth of a commodity is nearly impossible.

The line I draw in the sand is that if an asset hascash flow or the likelihood of cash flow in the nearterm and is not purely dependent on what a futurebuyer might pay, then it’s an investment. If an asset’svalue is totally dependent on the amount a futurebuyer might pay, then its purchase is speculation.

The hardest commodity-like asset to catego-rize is land, an asset that is valuable to a futurebuyer because it will deliver cash flow, not becauseit will be sold to a future speculator.

Gold is unique because it has the age-oldaspect of being viewed as a store of value. Never-theless, it’s still a commodity and has no tangiblevalue, and so I would say that gold is a speculation.But because of my fear about the potential debasingof paper money and about paper money not beinga store of value, I want some exposure to gold.

Zweig: Benjamin Graham drew a sharp andclassic distinction between investment and specu-lation. I believe his exact words were, “An invest-ment operation is one which, upon thoroughanalysis, promises safety of principal and an ade-quate return. Operations not meeting theserequirements are speculative.”

But Graham sometimes speculated over thecourse of his career. So, maybe regarding commod-ities as speculative doesn’t preclude you from own-ing them, right?

Klarman: I would say that a commodity’sspeculative nature is not what precludes invest-ment. When Graham was talking about safety ofprincipal, he was not referring to currency. Hewasn’t really considering that the currency mightbe destroyed, but we know that can happen, andhas happened, many times in the 20th century.

The investing game has historically been closerto checkers, but now it is more like chess—almostin three dimensions. The possibility that the dollarsyou make could be worth much less in the futureleads an investor to think, How can I protectmyself? Should I be shorting the dollar againstanother currency, and if so, which one?

Zweig: Right. And can you give us an indi-cation of how you are applying that principle toyour portfolio?

Klarman: We try to protect against tail risk:the risk of unlikely but possible events that couldbe catastrophic. Such an event would lead to muchhigher inflation. There are ways to hedge againstinflation, including specific bets on the reportedinflation rate. What we don’t like about thosehedges is that the government is the party thatdetermines the official rate of inflation.

And it seems to me that we have much higherinflation today—and have had for most of the last20 years—than the government admits to. Webelieve it is likely that the bond market vigilanteswill call the government on inflation before theactual inflation shows up in the government’saccounting. Therefore, we have bought way-out-of-the-money puts on bonds as a hedge againstmuch higher interest rates. If rates reach 5–7 per-cent, we won’t make anything on the hedge. But ifrates go to double digits, we can make anywherefrom 10 to 20 times over money, and if rates go to20 or 30 percent, we can make 50 or 100 times ouroutlay. The puts are one kind of disaster insurance.

I think the odds are low that such high infla-tion will happen in the near future, but lookingahead five years, it becomes more likely, althoughcertainly not a 50/50 chance. With a very limitedinitial outlay, I think a hedge like ours is a reason-able protection.

Zweig: So, it’s cheap insurance.Klarman: Yes, it’s cheap insurance in the

same sense that if you have a $400,000 home andhomeowner’s insurance costs $2,500 a year, you’llbuy the insurance. But if homeowner’s insurancecosts $150,000 a year, you’ll say, “I am going to bemore careful with matches.”

Zweig: If clients should give you moremoney when things are undervalued, do you giveit back when markets are overvalued?

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Klarman: Great question. That is probablynumber one in my mind most of the time—how tothink about firm size and assets under management.

Throughout my entire career, I have alwaysthought size was a negative. Large size means smallideas can’t move the needle as much. You may beless nimble because you have larger positions.Today, we have $22 billion in assets under manage-ment, but 20 years ago we were at $200 million.

As we entered the chaotic period of 2008, weanticipated that things would start to get prettywild. And so, around February 2008, for the firsttime in eight years, we went to our wait list becausewe recognized that the opportunities were likely tobe both plentiful and large—and lumpy and arriv-ing unpredictably.

We believed that having more money undermanagement might let us take advantage of oppor-tunities that otherwise we would have had to passon because we didn’t have enough buyingpower—and that proved to be right.

We certainly didn’t foresee the events ofSeptember 2008, but we were ready for them. Wegot a lot of interesting phone calls from people whoneeded to move merchandise in a hurry—some ofit highly illiquid, and most of it, in one way oranother, fairly illiquid. So, to have a greateramount of capital available proved to be a goodmove. If we had waited until the crisis hit to raisecash, we would probably have been much lesssuccessful in doing so.

Today, we are trying to walk a tightrope. Evenas we are trying to build our firm to manage thecapital we have, we are also—psychologically andin other ways—readying ourselves to return it.

One of the nice things about our investmentapproach is that we always have cash available totake advantage of bargains—we now have about30 percent cash across our partnerships—and so ifclients ever feel uncomfortable with our approach,they can just take their cash back.

We have a lockup on a portion of our capitalthat is running off at the end of 2010. After that, wehave lengthy notice periods but no real lockup.Thus, clients can have their cash back if and whenthey’d like it. In addition, we are discussing whetherwe should return cash. If our cash position rosematerially higher than it is today, we would sendsome cash back—and we’ve told our clients this.Our clients appear not to like to hear that and wouldthus far like us to keep it. But I think returning cashis probably one of the keys to our future success inthat it lets us calibrate our firm size so that we aremanaging the right amount of money, which isn’tnecessarily the current amount of money.

Zweig: How do you decide whether you havethe right amount of assets under management?

Klarman: Our capacity level is absolutelymarket dependent. We don’t want to be adistressed-debt firm that suddenly buys bonds atpar. We want to buy bargains, and our only goalas a firm is excellence. I really don’t care if our firmhas $5 billion or $25 billion in assets. And I don’tcare to ever go public, to sell out, which would, Ithink, ruin our firm.

If my partners and I can go to bed every nightand retire at the end of a long career feeling that wehave done right by our clients, that we have putthem first, that we have always thought about theirinterests before our own, that we haven’t gougedthem and haven’t proliferated products, I am goingto feel great, even if I have made a small fraction ofwhat I could have made, because that’s not, in mymind, what any of this is about. What my partnersand I do every day is about the sacred trust ofmanaging clients’ money, not about how we canmake more for ourselves.

Zweig: Seth, that’s a great segue into the nextquestion. Please discuss the change in the moralfabric and ethics of Wall Street since the time ofGraham and Dodd.

Klarman: Wall Street exists to make money,and I don’t think it has ever been otherwise. Theperception of Wall Street as a horribly evil place is,from my perspective, misguided.

With new-fangled securities and with propri-etary trading, there may be more inherent conflictsof interest today than in the era of Graham andDodd. For instance, our firm is in contact withmaybe 10–15 different desks at each of the majorfirms. How each of the firms manages potentialconflicts of interest is open to question.

I know that Wall Street is always trying to ripour eyeballs out, but I never know on which trade.Anybody who thinks they can do business withWall Street without their eyes being wideopen—without caveat emptor applying—is takingunnecessary risks. Wall Street certainly has aresponsibility not to lie, but they owe us no fidu-ciary responsibility on a trade. They are a counter-party or a market maker connecting us with a seller.

The idea of a Wall Street broker betting againsta customer on a transaction is a little bit different,but even there, it is highly complicated. The situa-tion could be that the customer wants to buy amortgage security, whereas the firm that sells itwants to hedge its exposure, which should not bea concern. In my opinion, we should celebrateGoldman Sachs for not blowing up, rather thanwishing they had blown up like their peers monthsearlier by not hedging.

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The ethical issue is tough. I regard as highlyethical virtually every buy-side manager I know. Iwould put my money with them and trust them todeal with my affairs in my absence. I would alsogive those on the sell side fairly high marks in termsof personal integrity and character and in realizingthat life isn’t just about making every last nickel,but with the understanding that some people willtake advantage in the short run to get a bonus or tolook good in front of their boss.

Zweig: Are there any particular reformsyou would like to see or not see coming out ofWashington?

Klarman: We don’t engage in any activitiesthat would be regulated away or would likely beaffected by new regulation. We don’t borrowmoney. We don’t use margin. Any requirementsregarding disclosure or limits of leverage would befine with us.

I would love for proprietary trading to goaway, however, so that we have fewer competi-tors. I believe that proprietary trading creates aconflict for brokerage firms that can’t give us thebest service if their desks are aware of our ordersand are front-running them, which we thinkhappens—but again, we don’t blame thembecause we know it goes on.

Systemic risk regulators will not be effectivebecause the pressure on them will be so great.People like it when stock prices are up, when theeconomy is strong. It’s human nature. A systemicrisk regulator will have to pull away the punchbowl when the party has barely started and likelywould be called before Congress to explain why.Regulating risk in that way is almost impossible.

Bank capital requirements should be higher.The potentially growing bank rescue fund also hasits problems. In effect, we are saying to JamieDimon, “When your less successful, less capablecompetitors screw up, it’s your problem. Friendsdon’t let friends drive drunk. So, Jamie, you arereally running Bank of America and Citigroup andall the other banks.” That’s craziness. It’s not fair.In no other business would we penalize the suc-cessful firm for not instructing its less astute com-petitors on how to run their businesses better. ButI don’t really know how to fix that.

Broadly speaking, there are ways to prevent afinancial crisis. If we could make it so that theequity is wiped out of failing financial firms and thesubordinated debt converts automatically toequity, we wouldn’t need government capital injec-tions. We’ve seen a lot of firms get bailed out unnec-essarily, such as the AIG holding company’screditors, who are getting par as debt matures forno reason that I can fathom. We could have rescuedthe subsidiary without rescuing the parent.

Zweig: At Baupost, how do you avoidgroupthink?

Klarman: That’s a fabulous question. At ourrecent investment team retreat, virtually everyspeaker—many of the leading thinkers in the mar-kets and in business—was of the opinion that terri-ble problems await in terms of paper money andthat gold is an asset investors should seriouslyconsider. Also, the prevailing opinion was that theEuropean Monetary Union is likely to break up. Allof our partners instinctively said, “Wow! That’sgroupthink. We better be really careful beforeassuming that because everyone thinks that, it isdefinitely going to happen.”

I think we are very good at intellectual honesty.We actually hire for intellectual honesty. In aninterview, we work hard to see whether people canadmit mistakes. We hold our people accountable tothat standard. Everybody is going to make mis-takes, but we like to know that people will acceptthat they have made them, figure out what theyhave learned from them, and move on.

We are aware of our biases, which are proba-bly to be worried and to be pessimistic about themarkets and the economy, but they help us inbeing thorough so we can be right. We are awareof the risks of being unduly biased in either direc-tion. Investors need to pick their poison: Eithermake more money when times are good and havea really ugly year every so often, or protect on thedownside and don’t be at the party so long whenthings are good.

At Baupost, we are all clearly in the samecamp. We have all our own money invested in thefirm, and so we are very conservative. We havepicked our poison. We would rather underper-form in a huge bull market than get clobbered in areally bad bear market.

Zweig: How do you hire for intellectualhonesty? How do you screen for that? How do youfind it?

Klarman: We dwell a lot on past experiences.We ask people, What is the biggest mistake you’veever made? It’s a very open-ended question becauseit’s not solely an investment question, althoughprospective hires often answer as if it were.

We ask a lot of ethics-related questions togauge their response to morally ambiguous situa-tions. We care that they can identify a tough calland a conflict of interest.

We also look for ideational fluency, which essen-tially means that someone is an idea person. Inresponse to an issue, do they immediately have 10or 15 different ideas about how they would want toanalyze it—threads they would want to pull á la

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Michael Price—or are they surprised by the ques-tion? We don’t want them to be sitting at their desksnot knowing how to pursue the next opportunitywhen it comes along. We throw out a lot of differentthings in interviews, but we are looking for peoplewho have it all: ethics, smarts, work ethic, intellec-tual honesty, and high integrity.

Zweig: Does short selling by hedge fundsamount to the biggest market manipulation outthere?

Klarman: I would be surprised to find outthat that is true.

We don’t sell short at Baupost, but my experi-ence is that short sellers do far better analysis thanlong buyers because they have to. The market isbiased upward over time—as the saying goes,stocks are for the long run. And just by the natureof what they do, the street is biased toward thebullish side, and so there is more low-hanging fruiton the short side.

Short sellers are the market’s police officers. Ifshort selling were to go away, the market wouldlevitate even more than it currently does. In myopinion, it would not be in the country’s best inter-est to have short selling prohibited. There would bemore scams, more potential for the little guy to rackup painful losses because securities would beallowed to rise unchecked. The act of selling some-thing short, of voting that it’s overvalued, is a pos-itive for the system.

The one exception is when short sellers, ineffect, yell “Fire!” in a crowded theater in anattempt to create fear or spread malicious rumors.

A potential market manipulation is the pur-chase of credit default swaps by those who wantcompanies to file for bankruptcy rather thanrecover. That activity has a problematic aspect to it.

Zweig: Can you think of any possible mech-anism that would limit the kind of short selling thatfeeds on self-fulfilling rumor while permittingmore “fundamental” short selling?

Klarman: I really don’t have a problem withmost rumors. It’s yelling “Fire!” in the theater andcausing problems for a company that needs to rollits debt that I am worried about. But I would alsosay there should be some burden on companies thatcontinue to be dependent on rolling over debtregardless of the market environment.

For example, what General Electric did goinginto the financial crisis was irresponsible. GEassumed that the markets would be the same asthey had been for decades and that it could alwaysroll commercial paper—and when it couldn’t, thegovernment rescued it. In my view, GE had aresponsibility to extend the maturity on its debt soas not to be dependent on access to the capitalmarkets at all times.

If short sellers are wrong on fundamentals—ifthey want to short a stock at 10 that I know isworth 20 and they want to drive it to 8 and 6—Iam going to buy and they are eventually going tobe wiped out.

I don’t understand the worry about computersselling stocks at a penny, other than it creates a falsesense of calm in investors’ minds that the marketswon’t be volatile, which would be a false sense ofwell-being because markets are, and should some-times be, volatile. If someone wants to sell me astock worth 50 bucks for a penny, it doesn’t botherme at all. I don’t think it should bother any of us.

Zweig: What about the problem of individ-ual investors who had market orders in and just gotcrushed?

Klarman: Nobody should ever put in a mar-ket order. It doesn’t make sense because the marketcan change rapidly.

Zweig: What are your top investment assetclasses for the next decade?

Klarman: My answer is that we are highlyopportunistic, and I will be buying what otherpeople are selling, what is out of favor, what isloathed and despised, where there is financial dis-tress, litigation—basically, where there is trouble.That is how we direct our search. We don’t have acrystal ball, and so we don’t know what those assetclasses will be.

Zweig: All right. The next question is the sis-ter of the last question. I can’t resist asking itbecause I know it will drive you crazy. The questionis, how are you making money?

Klarman: Typically, we make money whenwe buy things. We count the profits later, but weknow we have captured them when we buy thebargain.

Right now, we are buying, or trying to buy,private commercial real estate because the stressesin that market are creating bargains. The privatemarket in commercial real estate, especially theprivate market for anything less than center cityClass A office or malls, has terrible fundamentals,and the likelihood that they will get better soon isnot good. Yet the government has propped themarket up with TARP money and Public-PrivateInvestment Program money and also, essentially,by winking at the banks. I think the Federal DepositInsurance Corporation has told banks, “Don’t be ina hurry to sell your commercial real estate. We willbear with you.” Servicers of commercial real estatesecurities and mortgage securities have also beenslow to sell and eager to restructure.

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In contrast to the private markets, the publicmarket in real estate has rallied enormously. ManyREITs are yielding 5 or 6 percent, which reflectsvastly higher prices and less attractive yields thanthe private market offers.

Nevertheless, we are not making any money inreal estate right now. We are putting money towork in private commercial real estate when wecan, very selectively, because those investmentswill yield a good return over time, unlike the publicpart of real estate that is quite unattractive.

We are making money on the distressed debtwe bought two years ago, which has gone from 40or 50 or 60 to 90 or par, and on other similar secu-rities that have been grinding along, throwing offcash, mostly rising in price or going through aprocess that will ultimately deliver a profit to us.

Zweig: How does Baupost define a valuecompany, and what is your average holding period?

Klarman: With the exception of an arbitrageor a necessarily short-term investment, we enterevery trade with the idea that we are going to holdto maturity in the case of a bond and for a reallylong time, potentially forever, in the case of a stock.Again, if you don’t do that, you are speculating andnot investing. We may, however, turn over posi-tions more often.

If we buy a bond at 50 and think it’s worth parin three years but it goes to 90 the year we boughtit, we will sell it because the upside/downside hastotally changed. The remaining return is not attrac-tive compared with the risk of continuing to hold.

In our view, there is no such thing as a valuecompany. Price is the essential determinant inevery investment equation. At some price, everycompany is a buy; at some price, every company isa hold; and at a still higher price, every company isa sell. We do not really recognize the concept of avalue company.

Zweig: Regarding the way-out-of-the-moneyputs on bonds that you mentioned earlier, are youconcerned about counterparty risk down the road?

Klarman: Yes. We worry about counter-party risk in everything we do, including the puts.We diversify counterparties. We try to choose onlythe best-run, most solvent, best-capitalized coun-terparties. As often as possible, we make sure thatthey post collateral; so, if the trade goes our way,we have valid collateral that we can collect if theyhave trouble.

Even if we run into trouble with counterpar-ties, it doesn’t mean we will lose all our money. Itmay be that we would collect, down the road, 50cents instead of a dollar, but that still might bebetter than not having the protection.

Some investors missed some very importanthedges over the last few years because they wereunduly worried about their counterparties, whichisn’t to say we shouldn’t have that concern. We verymuch do, but we live in a world where you have tomake tough decisions. Sometimes, we choose agood enough counterparty over doing nothing.

Zweig: You spoke of deploying capital andbeing fully invested in 2008 and 2009. Can yougive an example of a situation that justifieddeploying your capital in the midst of a decline ofthat magnitude?

Klarman: We began by asking, Is there any-thing we can buy and still be fine in the midst of adepression? Our answer was yes—the bonds of thecaptive auto finance companies, which were trad-ing as low as 40 cents on the dollar. Ford MotorCredit was particularly attractive because Fordseemed to be the best positioned of the Big Three,the most likely to survive.

If Ford’s loan losses went from the existing runrate to eight times the run rate, 40 percent of thecompany’s entire loan portfolio would be totallywiped out. But the bonds we were interested in,which we could buy at 40 cents on the dollar, wouldstill be worth 60 cents on the dollar. That, to me, isa depression-proof investment.

Auto loans did not show the same signs ofoverreaching by lenders as did subprime and otherhousing loans, yet many people were extrapolatingthe problems associated with housing to autos. Aswe saw it, the same deterioration in credit stan-dards, broadly speaking, that plagued subprimehousing loans was not apparent in the loan portfo-lios of the Big Three auto companies.

In addition, current erosion was not a problem.Although housing delinquencies and defaults wentthrough the roof in late 2006 and 2007, nothing sim-ilar occurred in auto loans. And into 2008, no majoruptick in delinquencies and defaults materialized.Even assuming a much worse default rate than wewere seeing at the time, Ford bonds had an amazingupside under almost any scenario—if default ratesonly quadrupled (rather than octupled, as weassumed) to 20 percent, the bonds were worthpar—and thus appeared to have a depression-proofdownside. We all agreed to make those investments.

Zweig: Is there any situation like that outthere today?

Klarman: No. The rally may very well beoverblown. It’s certainly overblown on the creditside because risks remain real in the world, yetbonds are starting to be priced for close to perfec-tion, especially in the junk-bond market, wherepay-in-kind (PIK) bonds and dividend recap bondsare appearing once again.

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Essentially, the problem is that governmentintervention interfered with the lessons investorsneeded to learn. Those who stared into the meta-phorical abyss are right back at it, with the possibleexception of college endowments, for whom thepain has been long lasting because of their spendrate. Almost everybody else is drinking the Kool-Aid again, and it is very troubling. We could haveanother serious collapse, and people would againnot be prepared for it.

Zweig: How are you protecting your clientsagainst unanticipated inflation and a decline inthe dollar?

Klarman: Our goal is not necessarily to makemoney so much as to do everything we can toprotect client purchasing power and to offset, asmuch as possible, a large decline in market value inthe event of another severe global financial crisis.We not only care about the intrinsic underlyingvalue of our clients’ investments, but we also wantto avoid the psychological problem of being down30 or 40 percent and then being paralyzed.

At this juncture, there are just too many scenar-ios to enumerate. We have thought about scenariosin which the dollar remains the reserve currencyand those in which it doesn’t; those in which goldgoes berserk on the upside and those in which itstays flat and then falls, because gold is currentlyat a record high. All scenarios are worth contem-plating. This type of analysis is really very much artand not science.

Zweig: Can you recommend a few booksother than those by Graham and Dodd that ouraudience might enjoy?

Klarman: Certainly. First, however, let mesay that Graham’s The Intelligent Investor,4 whichyou recently revised, is probably more accessiblethan Graham and Dodd’s Security Analysis,5

although the nifty thing about the sixth edition ofSecurity Analysis is the updated comments.

Joel Greenblatt’s You Can Be a Stock MarketGenius6 is tactical and includes some very specific

and interesting strategies, and The Aggressive Con-servative Investor,7 by Marty Whitman and MartinShubik, is also very interesting.

Anything Jim Grant writes is wonderful. Evenif he’s not always right on his predictions, he isamong the best thinkers and financial historians.Michael Lewis has never written a bad book.Moneyball8 is about value investing. Looking back20 years from now, The Big Short9 may be the defin-itive book about this era. It is about a microcosm,but the microcosm explains everything. AndrewRoss Sorkin’s Too Big to Fail10 is fabulous, as isRoger Lowenstein’s The End of Wall Street.11 In fact,all of Roger Lowenstein’s books are excellent, andso we should read everything Roger has written.

Never stop reading. History doesn’t repeat,but it does rhyme. Jim Grant has a wonderfulexpression: In science, progress is cumulative, andin finance, progress is cyclical. Fads will come andgo, and people will think we are on to a new thingin finance or investing; but the reality is that it isprobably not really new, and if we have seen themovie or read the book, maybe we know how itturns out.

Zweig: By the way, I would recommend afew more books that I have no financial interest in.One is called How to Lie with Statistics,12 by DarrellHuff. It was first published in 1954 and has nevergone out of print. You could read it on a singlesubway or bus ride. It’s a terrific book.

I would also recommend any book by RichardFeynman, the Nobel Prize–winning physicist,because I think if you pick up any of his books, youwill learn more about how to think in the time ittakes you to read that book than you could learn injust about any other way.

Seth, unfortunately, we are out of time, and Iam the most disappointed person in the room.

Thank you.

This article qualifies for 0.5 CE credit.

Notes1. Benjamin Graham, “Are Corporations Milking Their

Owners?” Forbes (1 June 1932). 2. Seth A. Klarman, Margin of Safety: Risk-Averse Value Invest-

ing Strategies for the Thoughtful Investor (New York:HarperCollins, 1991).

3. James Grant, Money of the Mind: Borrowing and Lending inAmerica from the Civil War to Michael Milken (New York:Farrar Straus Giroux, 1992).

4. Benjamin Graham, The Intelligent Investor, edited by JasonZweig (New York: HarperCollins, 2003).

5. Benjamin Graham and David L. Dodd, Security Analysis,6th ed. (New York: McGraw-Hill, 2009).

6. Joel Greenblatt, You Can Be a Stock Market Genius (NewYork: Simon & Schuster, 1997).

7. Martin J. Whitman and Martin Shubik, The Aggressive Con-servative Investor (Hoboken, NJ: John Wiley & Sons, 2006).

8. Michael Lewis, Moneyball: The Art of Winning an UnfairGame (New York: W.W. Norton, 2003).

9. Michael Lewis, The Big Short: Inside the Doomsday Machine(New York: W.W. Norton, 2010).

10. Andrew Ross Sorkin, Too Big to Fail (New York: Viking, 2009). 11. Roger Lowenstein, The End of Wall Street (New York:

Penguin, 2010). 12. Darrell Huff, How to Lie with Statistics (New York: W.W.

Norton, 1993).

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