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S T R A T E G Y : Seth Klarman




The Forgotten Lessons of 2008
In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis
which, he says, “were either never learned or else were immediately forgotten by most market participants.”

Editors’ Note: As we approach the one-          Twenty Investment Lessons of 2008                   Attention to risk must be a 24/7/365
year anniversary of March 9, 2009, the                                                              obsession, with people – not comput-
day the market hit what we suspect will         1. Things that have never happened                  ers – assessing and reassessing the risk
prove to be a generational low, it’s an            before are bound to occur with some              environment in real time. Despite the
excellent time to reflect on the lessons of        regularity. You must always be pre-              predilection of some analysts to
the market’s collapse and subsequent               pared for the unexpected, including              model the financial markets using
rebound. And who better to provide per-            sudden, sharp downward swings in                 sophisticated mathematics, the mar-
spective than Baupost Group’s Seth                 markets and the economy. Whatever                kets are governed by behavioral sci-
Klarman, who has given us permission to            adverse scenario you can contem-                 ence, not physical science.
publish the following excerpt from his             plate, reality can be far worse.             6. Do not accept principal risk while
new annual letter, in which he describes        2. When excesses such as lax lending                investing short-term cash: the greedy
20 lessons that should have been learned           standards become widespread and                  effort to earn a few extra basis points
from the crisis … as well as 10 wrong les-         persist for some time, people are                of yield inevitably leads to the incur-
sons investors appear to have learned              lulled into a false sense of security,           rence of greater risk, which increases
instead.                                           creating an even more dangerous situ-            the likelihood of losses and severe
                                                   ation. In some cases, excesses migrate           illiquidity at precisely the moment
   One might have expected that the                beyond regional or national borders,             when cash is needed to cover expens-
near-death experience of most investors            raising the ante for investors and gov-          es, to meet commitments, or to make
in 2008 would generate valuable lessons            ernments. These excesses will eventu-            compelling long-term investments.
for the future. We all know about the              ally end, triggering a crisis at least in    7. The latest trade of a security creates a
“depression mentality” of our parents              proportion to the degree of the                  dangerous illusion that its market
and grandparents who lived through the             excesses. Correlations between asset             price approximates its true value.
Great Depression. Memories of tough                classes may be surprisingly high when            This mirage is especially dangerous
times colored their behavior for more              leverage rapidly unwinds.                        during periods of market exuberance.
than a generation, leading to limited risk      3. Nowhere does it say that investors               The concept of "private market
taking and a sustainable base for healthy          should strive to make every last dollar          value" as an anchor to the proper val-
growth. Yet one year after the 2008 col-           of potential profit; consideration of            uation of a business can also be great-
lapse, investors have returned to shock-           risk must never take a backseat to               ly skewed during ebullient times and
ingly speculative behavior. One state              return. Conservative positioning enter-          should always be considered with a
investment board recently adopted a plan           ing a crisis is crucial: it enables one to       healthy degree of skepticism.
to leverage its portfolio – specifically its       maintain long-term oriented, clear           8. A broad and flexible investment
government and high-grade bond hold-               thinking, and to focus on new oppor-             approach is essential during a crisis.
ings – in an amount that could grow to             tunities while others are distracted or          Opportunities can be vast, ephemeral,
20% of its assets over the next three              even forced to sell. Portfolio hedges            and dispersed through various sectors
years. No one who was paying attention             must be in place before a crisis hits.           and markets. Rigid silos can be an
in 2008 would possibly think this is a             One cannot reliably or affordably                enormous disadvantage at such times.
good idea.                                         increase or replace hedges that are          9. You must buy on the way down. There
   Below, we highlight the lessons that we         rolling off during a financial crisis.           is far more volume on the way down
believe could and should have been              4. Risk is not inherent in an investment;           than on the way back up, and far less
learned from the turmoil of 2008. Some             it is always relative to the price paid.         competition among buyers. It is almost
of them are unique to the 2008 melt-               Uncertainty is not the same as risk.             always better to be too early than too
down; others, which could have been                Indeed, when great uncertainty – such            late, but you must be prepared for
drawn from general market observation              as in the fall of 2008 – drives securities       price markdowns on what you buy.
over the past several decades, were cer-           prices to especially low levels, they        10. Financial innovation can be highly
tainly reinforced last year. Shockingly, vir-      often become less risky investments.             dangerous, though almost no one will
tually all of these lessons were either         5. Do not trust financial market risk               tell you this. New financial products
never learned or else were immediately             models. Reality is always too com-               are typically created for sunny days
forgotten by most market participants.             plex to be accurately modeled.                   and are almost never stress-tested for

February 28, 2010                                  www.valueinvestorinsight.com                                   Value Investor Insight 22
S T R A T E G Y : Seth Klarman




    stormy weather. Securitization is an             ent on absolute yields, yield spreads,      2. Bad things happen, but really bad
    area that almost perfectly fits this             maintaining adequate loan loss                  things do not. Do buy the dips, espe-
    description; markets for securitized             reserves, and the amount of leverage            cially the lowest quality securities
    assets such as subprime mortgages                used. What is the bank's management             when they come under pressure,
    completely collapsed in 2008 and                 to do if it cannot readily get to 20%?          because declines will quickly be
    have not fully recovered. Ironically,            Leverage up? Hold riskier assets?               reversed.
    the government is eager to restore the           Ignore the risk of loss? In some ways,      3. There is no amount of bad news that
    securitization markets back to their             for a major financial institution even          the markets cannot see past.
    pre-collapse stature.                            to have a ROE goal is to court disaster.    4. If you’ve just stared into the abyss,
11. Ratings agencies are highly conflict-        17. Having clients with a long-term ori-            quickly forget it: the lessons of histo-
    ed, unimaginative dupes. They are                entation is crucial. Nothing else is as         ry can only hold you back.
    blissfully unaware of adverse selec-             important to the success of an invest-      5. Excess capacity in people, machines,
    tion and moral hazard. Investors                 ment firm.                                      or property will be quickly absorbed.
    should never trust them.                     18. When a government official says a           6. Markets need not be in sync with one
12. Be sure that you are well compensated            problem has been "contained," pay               another. Simultaneously, the bond
    for illiquidity – especially illiquidity         no attention.                                   market can be priced for sustained
    without control – because it can create      19. The government – the ultimate short-            tough times, the equity market for a
    particularly high opportunity costs.             term-oriented player – cannot with-             strong recovery, and gold for high
13. At equal returns, public investments             stand much pain in the economy or               inflation. Such an apparent discon-
    are generally superior to private                the financial markets. Bailouts and             nect is indefinitely sustainable.
    investments not only because they are            rescues are likely to occur, though not     7. In a crisis, stocks of financial compa-
    more liquid but also because amidst              with sufficient predictability for              nies are great investments, because
    distress, public markets are more like-          investors to comfortably take advan-            the tide is bound to turn. Massive
    ly than private ones to offer attractive         tage. The government will take enor-            losses on bad loans and soured invest-
    opportunities to average down.                   mous risks in such interventions,               ments are irrelevant to value; improv-
14. Beware leverage in all its forms.                especially if the expenses can be con-          ing trends and future prospects are
    Borrowers – individual, corporate, or            veniently deferred to the future. Some          what matter, regardless of whether
    government – should always match                 of the price-tag is in the form of back-        profits will have to be used to cover
    fund their liabilities against the dura-         stops and guarantees, whose cost is             loan losses and equity shortfalls for
    tion of their assets. Borrowers must             almost impossible to determine.                 years to come.
    always remember that capital markets         20. Almost no one will accept responsi-         8. The government can reasonably rely
    can be extremely fickle, and that it is          bility for his or her role in precipitat-       on debt ratings when it forms pro-
    never safe to assume a maturing loan             ing a crisis: not leveraged speculators,        grams to lend money to buyers of oth-
    can be rolled over. Even if you are              not willfully blind leaders of financial        erwise unattractive debt instruments.
    unleveraged, the leverage employed by            institutions, and certainly not regula-     9. The government can indefinitely con-
    others can drive dramatic price and              tors, government officials, ratings             trol both short-term and long-term
    valuation swings; sudden unavailabili-           agencies or politicians.                        interest rates.
    ty of leverage in the economy may                                                            10. The government can always rescue
    trigger an economic downturn.                    Below, we itemize some of the quite             the markets or interfere with contract
15. Many LBOs are man-made disasters.            different lessons investors seem to have            law whenever it deems convenient
    When the price paid is excessive, the        learned as of late 2009 – false lessons, we         with little or no apparent cost.
    equity portion of an LBO is really an        believe. To not only learn but also effec-          (Investors believe this now and, worse
    out-of-the-money call option. Many           tively implement investment lessons                 still, the government believes it as
    fiduciaries placed large amounts of          requires a disciplined, often contrary, and         well. We are probably doomed to a
    the capital under their stewardship          long-term-oriented investment approach.             lasting legacy of government tamper-
    into such options in 2006 and 2007.          It requires a resolute focus on risk aver-          ing with financial markets and the
16. Financial stocks are particularly risky.     sion rather than maximizing immediate               economy, which is likely to create the
    Banking, in particular, is a highly lever-   returns, as well as an understanding of             mother of all moral hazards. The gov-
    aged, extremely competitive, and chal-       history, a sense of financial market cycles,        ernment is blissfully unaware of the
    lenging business. A major European           and, at times, extraordinary patience.              wisdom of Friedrich Hayek: “The
    bank recently announced the goal of                                                              curious task of economics is to
    achieving a 20% return on equity             False Lessons                                       demonstrate to men how little they
    (ROE)       within     several     years.                                                        really know about what they imagine
    Unfortunately, ROE is highly depend-         1. There are no long-term lessons – ever.           they can design.”) VII

February 28, 2010                                   www.valueinvestorinsight.com                                   Value Investor Insight 23

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Seth Klarman: The Forgotten Lessons Of 2008

  • 1. S T R A T E G Y : Seth Klarman The Forgotten Lessons of 2008 In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.” Editors’ Note: As we approach the one- Twenty Investment Lessons of 2008 Attention to risk must be a 24/7/365 year anniversary of March 9, 2009, the obsession, with people – not comput- day the market hit what we suspect will 1. Things that have never happened ers – assessing and reassessing the risk prove to be a generational low, it’s an before are bound to occur with some environment in real time. Despite the excellent time to reflect on the lessons of regularity. You must always be pre- predilection of some analysts to the market’s collapse and subsequent pared for the unexpected, including model the financial markets using rebound. And who better to provide per- sudden, sharp downward swings in sophisticated mathematics, the mar- spective than Baupost Group’s Seth markets and the economy. Whatever kets are governed by behavioral sci- Klarman, who has given us permission to adverse scenario you can contem- ence, not physical science. publish the following excerpt from his plate, reality can be far worse. 6. Do not accept principal risk while new annual letter, in which he describes 2. When excesses such as lax lending investing short-term cash: the greedy 20 lessons that should have been learned standards become widespread and effort to earn a few extra basis points from the crisis … as well as 10 wrong les- persist for some time, people are of yield inevitably leads to the incur- sons investors appear to have learned lulled into a false sense of security, rence of greater risk, which increases instead. creating an even more dangerous situ- the likelihood of losses and severe ation. In some cases, excesses migrate illiquidity at precisely the moment One might have expected that the beyond regional or national borders, when cash is needed to cover expens- near-death experience of most investors raising the ante for investors and gov- es, to meet commitments, or to make in 2008 would generate valuable lessons ernments. These excesses will eventu- compelling long-term investments. for the future. We all know about the ally end, triggering a crisis at least in 7. The latest trade of a security creates a “depression mentality” of our parents proportion to the degree of the dangerous illusion that its market and grandparents who lived through the excesses. Correlations between asset price approximates its true value. Great Depression. Memories of tough classes may be surprisingly high when This mirage is especially dangerous times colored their behavior for more leverage rapidly unwinds. during periods of market exuberance. than a generation, leading to limited risk 3. Nowhere does it say that investors The concept of "private market taking and a sustainable base for healthy should strive to make every last dollar value" as an anchor to the proper val- growth. Yet one year after the 2008 col- of potential profit; consideration of uation of a business can also be great- lapse, investors have returned to shock- risk must never take a backseat to ly skewed during ebullient times and ingly speculative behavior. One state return. Conservative positioning enter- should always be considered with a investment board recently adopted a plan ing a crisis is crucial: it enables one to healthy degree of skepticism. to leverage its portfolio – specifically its maintain long-term oriented, clear 8. A broad and flexible investment government and high-grade bond hold- thinking, and to focus on new oppor- approach is essential during a crisis. ings – in an amount that could grow to tunities while others are distracted or Opportunities can be vast, ephemeral, 20% of its assets over the next three even forced to sell. Portfolio hedges and dispersed through various sectors years. No one who was paying attention must be in place before a crisis hits. and markets. Rigid silos can be an in 2008 would possibly think this is a One cannot reliably or affordably enormous disadvantage at such times. good idea. increase or replace hedges that are 9. You must buy on the way down. There Below, we highlight the lessons that we rolling off during a financial crisis. is far more volume on the way down believe could and should have been 4. Risk is not inherent in an investment; than on the way back up, and far less learned from the turmoil of 2008. Some it is always relative to the price paid. competition among buyers. It is almost of them are unique to the 2008 melt- Uncertainty is not the same as risk. always better to be too early than too down; others, which could have been Indeed, when great uncertainty – such late, but you must be prepared for drawn from general market observation as in the fall of 2008 – drives securities price markdowns on what you buy. over the past several decades, were cer- prices to especially low levels, they 10. Financial innovation can be highly tainly reinforced last year. Shockingly, vir- often become less risky investments. dangerous, though almost no one will tually all of these lessons were either 5. Do not trust financial market risk tell you this. New financial products never learned or else were immediately models. Reality is always too com- are typically created for sunny days forgotten by most market participants. plex to be accurately modeled. and are almost never stress-tested for February 28, 2010 www.valueinvestorinsight.com Value Investor Insight 22
  • 2. S T R A T E G Y : Seth Klarman stormy weather. Securitization is an ent on absolute yields, yield spreads, 2. Bad things happen, but really bad area that almost perfectly fits this maintaining adequate loan loss things do not. Do buy the dips, espe- description; markets for securitized reserves, and the amount of leverage cially the lowest quality securities assets such as subprime mortgages used. What is the bank's management when they come under pressure, completely collapsed in 2008 and to do if it cannot readily get to 20%? because declines will quickly be have not fully recovered. Ironically, Leverage up? Hold riskier assets? reversed. the government is eager to restore the Ignore the risk of loss? In some ways, 3. There is no amount of bad news that securitization markets back to their for a major financial institution even the markets cannot see past. pre-collapse stature. to have a ROE goal is to court disaster. 4. If you’ve just stared into the abyss, 11. Ratings agencies are highly conflict- 17. Having clients with a long-term ori- quickly forget it: the lessons of histo- ed, unimaginative dupes. They are entation is crucial. Nothing else is as ry can only hold you back. blissfully unaware of adverse selec- important to the success of an invest- 5. Excess capacity in people, machines, tion and moral hazard. Investors ment firm. or property will be quickly absorbed. should never trust them. 18. When a government official says a 6. Markets need not be in sync with one 12. Be sure that you are well compensated problem has been "contained," pay another. Simultaneously, the bond for illiquidity – especially illiquidity no attention. market can be priced for sustained without control – because it can create 19. The government – the ultimate short- tough times, the equity market for a particularly high opportunity costs. term-oriented player – cannot with- strong recovery, and gold for high 13. At equal returns, public investments stand much pain in the economy or inflation. Such an apparent discon- are generally superior to private the financial markets. Bailouts and nect is indefinitely sustainable. investments not only because they are rescues are likely to occur, though not 7. In a crisis, stocks of financial compa- more liquid but also because amidst with sufficient predictability for nies are great investments, because distress, public markets are more like- investors to comfortably take advan- the tide is bound to turn. Massive ly than private ones to offer attractive tage. The government will take enor- losses on bad loans and soured invest- opportunities to average down. mous risks in such interventions, ments are irrelevant to value; improv- 14. Beware leverage in all its forms. especially if the expenses can be con- ing trends and future prospects are Borrowers – individual, corporate, or veniently deferred to the future. Some what matter, regardless of whether government – should always match of the price-tag is in the form of back- profits will have to be used to cover fund their liabilities against the dura- stops and guarantees, whose cost is loan losses and equity shortfalls for tion of their assets. Borrowers must almost impossible to determine. years to come. always remember that capital markets 20. Almost no one will accept responsi- 8. The government can reasonably rely can be extremely fickle, and that it is bility for his or her role in precipitat- on debt ratings when it forms pro- never safe to assume a maturing loan ing a crisis: not leveraged speculators, grams to lend money to buyers of oth- can be rolled over. Even if you are not willfully blind leaders of financial erwise unattractive debt instruments. unleveraged, the leverage employed by institutions, and certainly not regula- 9. The government can indefinitely con- others can drive dramatic price and tors, government officials, ratings trol both short-term and long-term valuation swings; sudden unavailabili- agencies or politicians. interest rates. ty of leverage in the economy may 10. The government can always rescue trigger an economic downturn. Below, we itemize some of the quite the markets or interfere with contract 15. Many LBOs are man-made disasters. different lessons investors seem to have law whenever it deems convenient When the price paid is excessive, the learned as of late 2009 – false lessons, we with little or no apparent cost. equity portion of an LBO is really an believe. To not only learn but also effec- (Investors believe this now and, worse out-of-the-money call option. Many tively implement investment lessons still, the government believes it as fiduciaries placed large amounts of requires a disciplined, often contrary, and well. We are probably doomed to a the capital under their stewardship long-term-oriented investment approach. lasting legacy of government tamper- into such options in 2006 and 2007. It requires a resolute focus on risk aver- ing with financial markets and the 16. Financial stocks are particularly risky. sion rather than maximizing immediate economy, which is likely to create the Banking, in particular, is a highly lever- returns, as well as an understanding of mother of all moral hazards. The gov- aged, extremely competitive, and chal- history, a sense of financial market cycles, ernment is blissfully unaware of the lenging business. A major European and, at times, extraordinary patience. wisdom of Friedrich Hayek: “The bank recently announced the goal of curious task of economics is to achieving a 20% return on equity False Lessons demonstrate to men how little they (ROE) within several years. really know about what they imagine Unfortunately, ROE is highly depend- 1. There are no long-term lessons – ever. they can design.”) VII February 28, 2010 www.valueinvestorinsight.com Value Investor Insight 23