Seth Klarman's 2011 Investor Letter

I've been trying to catch up on the newsletters of various hedge fund managers that I follow which includes The Baupost Group founder Seth Klarman    I recently featured an interview between Klarman and Charlie Rose [February 19, 2012 Seth Klarman & Charlie Rose] in which they discuss facing history and Klarman's views on philanthropy and investing.


There has been one common theme that has been extremely apparent in these letters and that has been the concern over the US debt levels.  It has also been a focus with John Mauldin's weekly letters see [March 8, 2012 The Cancer of Debt and Deficits] and [March 8, 2012 Tax That Other Guy] and the latest quarterly letter from Jeremy Granthom [March 7, 2012 Jeremy Granthom's GMO Quarterly Letter].


The federal deficit is what makes this one of the most important elections.  Although a president like a football quarterback probably gets too much credit in good times and too much credit in bad times.  What the president does need to do is provide leadership, offer solutions that will address the issues, and try to build consensus among the house and senate.  Honestly, I'm not sure that either Obama or whomever the GOP candidate will be up to this challenge.


You will also see many of the same shared philosophies which Klarman's firm promotes as we focus on here at DWCM which include a long-term focus, taking calculated risk, and focusing on what is best for the client.


Klarman towards the end of his letter goes into detail regarding the work that Daniel Kahneman  psychologist and Nobel laureate writes in his book Thanking, Fast and Slow.  He touches on the role and impact that psychology plays on investing and how you can be helped or hurt by your emotions.

Via Klarman's Letter

• Our greatest success for 2011 was not the profit we earned, though we are always happy to report a gain. Rather, our major accomplishments in 2011 involved the avoidance of substantial loss
• As noted recently in Grant's Interest Rate Observer, the U.S. has 3.3 times more Treasury debt outstanding than a decade ago, yet the yield demanded by the market has fallen by two-thirds, from 6.1% to 2%. The market won't always be so accommodating. Someday, when the market demands higher interest rates or, worse still, refuses to buy new debt at any price, our situation will quickly get out of hand
• While we insist on investing based on what we see, many seem determined to commit capital based on the muscle memory of what things used to be like or on the undying hope for a full-bore recovery that never seems to arrive. The knee-jerk response of many investors to each successive crisis has been to anticipate a quick fix and buy the stock market's dips. Stocks that have declined 10% or 20% may be cheap--certainly they are cheaper than they were--but it is much harder to know if they are cheap enough: cheap enough to withstand an economic double dip and the resultant poor earnings; cheap enough to hold their valuation should corporate profit margins revert to their historic mean, or worse; and cheap enough to still be glad you bought them after they trade a lot lower
• We must strive to learn the lessons that led to unprecedented American prosperity for the great majority of our 235 years. Certainly, investment in education, technology, infrastructure, and scientific advancement should be at the top of the to-do list. Higher energy taxes, which would wean us off fossil fuels while encouraging the development of alternatives, are a "no-brainer," especially when the externalities of carbon emissions and national security are factored in. Ensuring that every American has the opportunity to succeed is crucial. Our politicians need to soberly assess the country's precarious situation, deliver some tough messages that politicians hate to deliver and voters don't like to hear, and call on all of us--and we, collectively, need to meet the call--for hard work, community service, shared sacrifice, and a commitment to pull together to restore national greatness
• In the words of New York Times columnist Charles M. Blow, "We have to stop snuggling up to nostalgia, acknowledge that we have allowed a mighty country to be brought low and set a course to restitution. And that course is through hard work and tough choices. You choose greatness; it doesn't choose you...." "We must look out at the world with clear eyes and sober minds and do the difficult work as we've done time and time again. That's how a city shines upon a hill."
• Elie Wiesel once said, "God gave Adam a secret--and that secret was not how to begin, but how to begin again." America in 2012 needs to begin again. Our nation's greatness has always derived from the core principles upon which it was founded--justice, personal freedoms, rule of law, social and economic mobility, opportunity for all It comes from the people--courageous, sturdy, self-reliant, fair-minded, charitable, entrepreneurial, and hard working. With a re-emphasis on these roots, we can, like Adam, begin again. With the intellectual honesty to accurately assess our problems and identify the shortcomings of our current system, it is not too late to turn this situation around. Time is running out, but with strong leadership, a determined effort, and selfless attitude, we can get through our troubles, restore our economy and our lost confidence, and regain our national greatness and leadership position in the world.
• I added that our ability to maintain a long-term, absolute performance discipline in a short-term oriented world obsessed with relative performance is crucial, as is our determination to concentrate capital in our best ideas. Finally, our willingness to hold cash at times when great opportunities are scarce allows us to take advantage of opportunity amidst turmoil that could handcuff a competitor who is always fully invested.
• Upon reflection, I believe this perfectly sums up what we try to do at Baupost. We are always long-term oriented. We never attempt to gauge near-term market movements; we have no edge there. We strive to make long-term investments that have truly compelling risk-reward characteristics., We are never afraid to stand apart from the crowd. We stick to our game plan, and focus on areas where we are skilled and experienced. We are resolute in resisting the short-term performance pressures and herd behaviors that plague the investment business. 
• We don't try to be anyone's best performing manager in a given year because such an attempt would almost certainly fail. It would distract us from our focus on risk-aversion and the pursuit of excellent long-term results, while shifting our attention toward quick gains, short-term trades and market momentum. We doubt anyone with such a focus could excel, and are certain that attempting to do so would involve heightened risk and diminished long-term returns. In frothy markets, we would rather disappoint clients by being underinvested than try to keep up While incurring the risk of large losses.
• From the day we started managing capital for clients in 1982, we have always focused singularly on one thing: what is the right thing to do with the capital we oversee. With the employees of Baupost being, collectively, the firm's largest client, we, too, are benefiting from this approach. There is a valuable investment lesson in knowing that by not trying to be a client's best manager in any given year, we have strengthened their confidence in us. Certainly, I left the conversation more determined than ever to maintain a long-term orientation, unafraid to stand apart from the crowd.
• Investors are frequently guilty of "narrow framing," whereby they demonstrate a preference for selling stocks where they have gains, while holding on to losers3. A rational decision-maker would only be interested in the future consequences of current investments; the price they paid is obviously irrelevant. Yet most decision-makers irrationally prefer to lock in gains and hate taking losses. In financial markets, with literally thousands of data points and opportunities for successful or failed judgment, it should be no surprise that even the most sophisticated, knowledgeable, and experienced investors still make irrational decisions.
• Kahneman tells us about economist Howard Kunreuther, who observed that protective actions, whether by individuals or governments, tend to be designed to prevent a recurrence of the worst such disaster actually experienced. Societies track the high-water mark of rivers and prepare accordingly, apparently assuming that floods will not exceed that level. Images of a worse disaster do not come easily to mind. This is one example of the "availability bias," where our expectations about future events are distorted by past experience. This is particularly dangerous in the current financial market environment, where unprecedented things are happening with surprising regularity. Similarly, the memories of disaster dim over time, as do worry and diligence, leading to complacency. This is as true for our beliefs around and preparations for financial disaster as for any other kind4.
• Outcome bias is demonstrated where actions that seemed prudent in foresight look horribly negligent in hindsight.6 When the outcomes are bad, clients can blame their agents (baseball managers, CEOs, investment advisors) for not seeing the "handwriting on the wall." We have talked about how a sound investment process likely leads to a good investment result. A good result, though, says nothing about whether the process involved was a good one and, thus, whether or not the success might be replicable. One of the many reasons we regularly review our investment process with you is that the merits of our approach can only be judged over the long term. An unchecked outcome bias could cause you to become disillusioned in the short run, either because we failed to predict the future with precision or because other managers appeared to.
• One of the places that Kahneman arguably falls short is in his discussion of investment management. He regards the investment industry as having been built on an illusion of apparent skill because the number of investors who reliably outperform the market is a small one.8 Ironically, Kahneman fails to recognize that it is precisely because of the biases in our thinking and the constraints and pressures placed on people in the industry that recurrent mispricings and inefficiencies exist for those who are able to resist the pressures of conformity and short-term performance measurement, and who know where to look for mispricings.
• Understanding how our brains work--our limitations, endless mental shortcuts, and deeply ingrained biases--is one of the keys to successful investing. A Baupost, we believe that it is sometimes easier to predict how investors will behave in certain situations than it is to predict a company's bottom line. At times of market extremes, by avoiding emotional overreaction and remaining aware of our biases, it may be possible to know market participants better than they can know themselves.
• Investing lies at the intersection of economics and psychology, the place where net present value meets greed and fear. It is important to know the numbers—but that is not sufficient. And it is important to know how people think-but that, too, is not enough. Both matter; it is, of course, good to buy investment bargains, but it is far better if you know why they are bargain-priced.
• We have regularly communicated the critical need for an investment firm to operate with a sound investment process. This is easier said than done. The first steps involve identifying the proper goal identifying the means to achieve it, and eliminating factors that stand in the way. The goal of an investment firm, as we see it, is to deliver good risk-adjusted investment returns for olients over the long run. While we can endlessly debate how to measure risk or what constitutes a good risk-adjusted return, that is not our purpose here. We recognize that many things stand in the way of achieving even this simple-sounding goal.