Best of 2010: Profits may be worthless, Klarman says

Speaking at the CFA Institute’s annual conference in Boston, Seth Klarman, founder and president of the Baupost Group, and author of the much-sought-after Margin of Safety, opined that earning money is the easy part, but that ensuring U.S.-dollar denominated profits retain their value may become a challenge.

The following story appeared in our Top Minds special report.

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Global market sentiment has swung between exuberance and despair in recent weeks, as participants churn through the latest data points from Europe and the U.S. Although most investors advocate caution as volatility whipsaws portfolios, they also agree that the global economy is getting back on its feet.

But some remain skeptical.

“I’m more worried about the world than I’ve ever been in my career,” Seth Klarman, president of The Baupost Group, said at the CFA Institute’s 63rd annual conference in Boston in May.

“I have always thought until recently that it was enough to have a good process in our firm. I worry now that there’s a new element in the game which is, in effect, will the dollars we make be worth anything?”

At issue: the U.S. government’s apparent willingness to intervene at the drop of a hat will require vast sums of currency to be “printed.” This will debase the U.S. dollar to the point of worthlessness, he said.

“I worry about the dollar. It’s easy to imagine that over time politicians find it easier to create inflation and debase currency than it is to tackle hard problems. We haven’t tackled a single hard problem, there’s no evidence that we will, and in some sense every can is being kicked further down the road.”

An authentic upswing? He compared the current economic upswing to a Hostess Twinkie: both make people happy, but are made with “totally artificial” ingredients.

“Virtually everything was being manipulated by the government,” he said of the rally that began in March 2009. “There was nothing natural in the markets. Interest rates were close to zero, the government was buying all kinds of securities, mortgage securities, but who knows what else was on the balance sheet?”

He worries about what might happen when the stimulus is removed, and doubts that policy makers in Congress or the Federal Reserve have any idea whether the economy will grow or slip back into recession.

The tragedy of the Great Recession is that government’s intervened too quickly, and that the proper lessons were not learned, he said, pointing out that The Great Depression imprinted the “Depression mentality” on two generations, making a virtue of savings and conservative investment.

“It’s awful to have a depression, but it’s a great thing to have a depression mentality, because it means that we’re not speculating, we’re not living beyond our means,” Klarman said. “There’s something stable about a country, a society, built on that. In some sense we’ve developed a kind of ‘really-bad-couple-of-weeks’ mentality, and that’s not enough to tide us through and avoid future bubbles.”

Lessons learned? A new bubble appears to be inflating in the U.S. Treasury Bond market, as investors bet against the onset of inflation. The belief that the U.S. can never default on its debt is partially true, Klarman noted, as it remains the global reserve currency, and any default would be forestalled by the printing press.

“There were lots and lots of lessons out there,” he said, although many of them have been ignored. “Almost everybody has gotten back in the market, been drinking the Kool-Aid again, and it’s great trouble. We could have another serious collapse and people would again not be prepared for it.”

But an invisible tipping point looms — similar to that experienced by the Greek government, he warns.

“Everything is fine until it’s not fine, and you hold the [Treasury] auction and no-one shows up,” he said. “We’re only AAA if we have valuable assets and good education and great infrastructure and a rule of law, all of which are called into question by our waning infrastructure and the government changing a law whenever they feel like it in financial crises.”

As the editor of the commemorative sixth edition of Graham and Dodd’s Security Analysis, Klarman is never short of a reference to the acknowledged godfather of value investing. But he readily admits investing has evolved to a near unrecognizable enterprise since the first edition was written.

“When Graham was talking about safety of principle, he’s talking in a currency, he wasn’t really thinking about the currency being destroyed. I feel the game historically has been closer to checkers, and now the game is more like chess. It’s almost like it’s in three dimensions, and to ignore that the dollars you make could be worth so much less leads you to think how can I protect myself?”

Typical of his investment strategy, his hedging strategy is designed to make a dollar out of 15 cents.

“We have bought way out-of-the-money puts on bonds, in effect hedging against much higher interest rates,” he explained. “So if rates rise to 5, 6, 7%, we don’t make anything. But if rates go to double digits we can make 10, 15, 20% and if rates went to 20% or 30%, then 50 or 100 times our outlay.”

He admitted that the odds of this happening in the near future are very long, but that such an increase in rates is slightly more likely five years out.

(06/09/10)