[From The Archives] Seth Klarman: The Value Of Not Being Sure

This article first appeared at ValueWalk.com

In February 2009, Seth Klarman wrote a piece for the Value Investor Insight publication entitled, The Value Of Not Being Sure.

The piece, written during the midst of the financial crisis, laid out Seth Klarman:’s trading strategy for the period of turbulence. And the article offered advice as to how investors should deal with the volatility. This information is relevant for today’s market as much as it was at the time.

Erratic Mr. Market

The first paragraph was titled: Erratic Mr. Market. Seth Klarman noted that at the time, the short-termism of the market had overwhelmed many market participants. As a result, trading had become erratic as investors’ time horizons dropped to days, rather than years:

“Time horizons have shortened even more than usual, to the point where the market’s 4:00 p.m. close seems to many like a long-term commitment. To maintain a truly long-term view, investors must be willing to experience significant short-term losses; without the possibility of near-term pain, there can be no long-term gain.”

Even today this is a relevant observation. As Seth Klarman goes on to note in his piece, for the value investor to remain committed, it necessary for him or her to take a long-term view and not become a day trader. What’s more, Seth Klarman cautions that market volatility is not the investor’s key enemy, in fact, it is the underlying economic situation.

“The greatest challenge of investing in this environment is neither the punishing price declines nor the extraordinary volatility. Rather, it is the sharply declining economy, which makes analysis of company fundamentals extremely difficult. When securities decline, it is crucial to distinguish, as possible causes, legitimate reaction to fundamental developments from extreme overreaction.”

The trouble of finding opportunities

Seth Klarman’s article was written around the time of the market’s lowest point in 2009. And there were plenty of opportunities for Seth Klarman and his hedge fund, Baupost to take advantage of.

However, the difficulty was finding the best opportunities, those companies that wouldn’t suffer from deteriorating economic fundamentals and the knock-on effect of falling security prices.

“In today’s market, however, where almost everything is down sharply, distinguishing legitimate reaction from emotional overreaction is much more difficult. This is because there is a vicious circle in effect (the reverse of the taken-for granted virtuous circle that buoyed the markets and economy in good times). This vicious circle results from the feedback effects on the economy of lower securities and home prices and a severe credit contraction, and, in turn, effects of a plunging economy on credit availability and securities and home prices.”

With the US economy in tatters, many households would feel the pinch and consequently, not all bargains were created equal. Still, as Seth Karlman goes on, many investors became forced sellers in a falling market, which in some cases inadvertently helped them achieved better outcomes than the value-oriented bargain hunters who bought from them. That said:

“Buying early on the way down looks a great deal like being wrong, but it isn’t. It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in. AsBenjamin Graham and David Dodd taught us, financial markets are manic and best thought of as an erratic counterparty…f you look to “Mr. Market” for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of the emotional extremes, then you are very likely to succeed over time…if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations.”

Baupost vs S&P Seth Klarman

Timing Mr. Market

Seth Klarman’s viewpoint throughout the article is that the market will recover over time, no matter how severe the downturn.

Baupost actually started buying distressed securities during 2008, fully expecting things to get worse before they improved:

“While it is always tempting to try to time the market and wait for the bottom to be reached…such a strategy has proven over the years to be deeply flawed…Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

In an uncertain environment — like that of 2008/09 — money managers must keep firmly in mind that the only things they can really control are their investment philosophy, investment process, and the nature of their client base. Therefore, a tight grip over investment process is required.

“Controlling your process is absolutely crucial to long-term investment success in any market environment.”

“When an investment manager focuses on what a client will think rather than what they themselves think, the process is bad…When the manager’s time horizon becomes overly short-term, the process is compromised. When tempers flare, recriminations abound, and second guessing proliferates, the process cannot work properly.”

Value investing is contrarian by its very nature and when taking a contrary approach, “one has to be able to stand one’s ground, be unwavering when others vacillate, and take advantage of others’ fear and panic to pick up bargains.”

Seth Klarman: The value of not being sure

Successful investing requires flexibility and open-mindedness. You can never be sure what the future holds for the economy or for your investments.

“Successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong…Those who reflect and hesitate make far less in a bull market, but those who never question themselves get obliterated when the bear market comes.”

And this is the value of not being sure. As Seth Klarman highlights, successful investors should always be ready to doubt themselves and admit that they were wrong. It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Being overly certain in an uncertain, unpredictable, and ultimately unknowable world is hazardous for investors.

“To be sure, uncertainty breeds doubt, which can be paralyzing. But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction. Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments.”

As a result, uncertainty helps you to become a better investor, pushing you to work harder and to be endlessly vigilant.

1 Comment

  • This article of Seth Klarman was written in the previous crisis in 2009 when stock prices were hitting lows, leading to great opportunities for stock investors. Today, thoughts are emerging as for the stock prices to be too high, anticipating a possible market downturn. His advice will be worth reminding in the next few months or years to come, and I try to continually remind me of that: To focus on my investing process, no matter what. This actually helps to stay away of the market movements.

    Always great information from Seth Klarman.

    Thanks for the post.

    Samir KABA

    https://ivmoats.wordpress.com/

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