Street Capitalist: Event Driven Value Investments

Jeremy Grantham has a great essay over at Morningstar which gives us some insights into how he is looking at investing GMO’s funds:

Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future…

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus infl ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

Summer Essays: Finance and Portfolios (Morningstar)

I’ve posted recently that I am also seeing value in large cap stocks many of which seem to have strong exposure to emerging markets and franchises that should be able to withstand tremors in the global economy. Grantham’s point about deflation is interesting. Unlike with inflation — where certain businesses can simply raise prices, deflation creates a downward pressure that is harder to tackle. I’ve noted in the past that Seth Klarman believes in deflationary environments we should seek a wider margin of safety. So if you used to buy at 60 cents on the dollar, maybe you start buying at 40-50 cents.

Sorry about taking so long with the Red Robin post, I am still getting together the charts/models to present.

Today, Charles Stein over at Bloomberg has an excellent article detailing what happened to Seth Klarman’s Baupost Group during the financial crisis:

Seth Klarman almost doubled his hedge fund’s assets to $22 billion in the past two years as the industry shrank by sticking with the off-the-beaten-path investments he’s pursued since starting out in 1983…

While Klarman didn’t post the gains that made Paulson famous, he was able to raise almost $4 billion in 2008 when firms including D.B. Zwirn & Co. and Peloton Partners LLP liquidated funds. Baupost was the ninth-largest hedge-fund firm as of Jan. 1, according to AR magazine, Pensions & Investments magazine and data compiled by Bloomberg. He oversees more money than better-known managers such as Ken Griffin and Steven Cohen.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

I really think Baupost’s performance during the financial crisis was exemplary of value investing at its best — going into the crisis, many fund managers were overly concentrated in long positions. Even the famed long/short funds, which were supposed to use shorting to hedge against market downturns were simply not short enough to make a difference.

Most long-only value funds ran into the same issue. This stems mainly from an unwillingness to take large cash positions when the market gets frothy. That kind of value investing cuts both ways, taking a few concentrated positions will usually allow you to outperform major indices, but it also means that during a downturn your portfolio may get hit with higher than average volatility. As a result, some value funds would actually underperform the S&P 500′s already dreadful performance.

Most people like to knock Baupost’s performance in the 90′s, for not outperforming the S&P but I think that misses the point. What Klarman and his team have put together at Baupost is a fund that can achieve great absolute returns. For some entrepreneurial investors seeking massive John Paulson-like returns, this might not mean much. For college endowments though, having the benefit of limited losses, or actually appreciating in a down year must be a tremendous asset and shows the kind of niche that Baupost can serve.

The other thing that stands out about Baupost is their willingness to travel across all asset classes in search of returns:

A value investor who looks for securities he considers underpriced, Klarman, 53, said he’s best at “complicated” situations where fewer investors compete for assets. Over the years, Baupost has invested in Parisian office buildings, Russian oil companies and real estate that the U.S. government disposed of following the savings and loan crisis of the early 1990s, said Thomas Russo, a partner in the Lancaster, Pennsylvania-based investment firm of Gardner Russo and Gardner…

“He specializes in illiquid, complex assets,” said Russo, who has known Klarman since 1984.

Baupost gained an average of 17 percent annually in the 10 years ended in December, a period in which the Standard & Poor’s 500 Index fell 1 percent a year. The hedge fund has returned 19 percent a year since it was started, even as it held more than 40 percent of its assets in cash at times.

More recently:

Among the money-making bonds Baupost purchased, according to an October 2008 shareholder letter, was debt issued by Washington Mutual Inc., whose bank unit failed in 2008 and was bought by New York-based JPMorgan Chase & Co. Baupost also acquired bonds of CIT Group Inc., a New York-based lender that emerged from bankruptcy in 2009. The fund was part of a group of creditors that made a $3 billion loan to CIT in July 2009.

Klarman, in a May 18 talk to financial advisers in Boston, cited another Baupost purchase during the crisis to illustrate the way he thinks about investing. In a series of “what if” exercises, the firm calculated how much bonds of Ford Motor Credit Co. would be worth under different scenarios, including an economic depression in which loan defaults rose eightfold. The conclusion: the bonds, then selling for about 40 cents on a dollar, would still be worth 60 cents.

Stein goes on to outline some of Klarman’s more macro views. His fund is bearish and worried about inflation. Baupost’s US equities weigh in at only $1.7B versus their $22B in AUM, or a about only 7.8%. In addition, like many others, Klarman is apparently a big fan of Jeremy Grantham’s research at GMO:

Klarman’s views on the U.S. stock market echo those of Jeremy Grantham, chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., who recommended investors buy stocks in March 2009 after more than a decade of saying they were overvalued. Grantham’s latest forecast, posted on the firm’s website, predicted U.S. large cap stocks would return 0.3 percent a year, adjusted for inflation, over the next seven years.

Klarman called Grantham “a very smart person” whose forecasts he watches carefully. In an e-mail, Grantham called Klarman “just about the smartest guy around.”

How does Baupost hedge against such possible scenarios?

Klarman buys put options and credit-default swaps, which he calls “cheap insurance,” to protect Baupost against risks such as a steep fall in the stock market or a surge in inflation. He currently has a put, or an option to sell a set amount of a security by a specific date, that will pay off only if interest rates go dramatically higher, he said in his Boston speech. In an October 2008 letter to shareholders the firm said it benefited from credit-default swaps, without saying what the swaps were meant to protect against.

When Klarman can’t find investments he likes, he holds cash. “We prefer the risk of lost opportunity to that of lost capital,” he wrote in his 2004 yearend letter to shareholders. In 2007, Baupost gained more than 50 percent, even as it held more than 40 percent of its assets in cash.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

Using the cheap insurance strategy sounds really sensible to me. Fairfax took the same approach when they purchased credit default swaps to protect against the financial crisis and they paid off handsomely. For more ordinary investors, derivatives like CDSs are probably inaccessible.

There are still some ways of insuring against disaster. One would be using out the money puts on things like the S&P 500. This kind of approach makes it so you are betting on what are initially perceived to be improbable events. Klarman’s fund used this very approach in their early days, against frothy indices like the Nikkei. To learn more about this approach, be sure to read Michael Lewis’ awesome book The Big Short because sections dedicated to Cornwall Capital outline this style of investing.

There are downsides to this approach though. First, you will incur frictional costs whenever your hedges don’t work out. Second, they require you to identify the right kinds of things to hedge against. You end up having to pay attention to whether the market is overvalued or not. This should not be so hard if you are a disciplined investor because you’ll end up seeing your range of opportunities dry up. If you are the kind of investor that keeps making excuses to allow you to buy overvalued stocks, this strategy is not for you.

Seth Klarman and his fund continues to impress me with how they have taken Benjamin Graham’s ideals and adapted them to the modern world. It’s true, for most investors, some of his strategies are out of reach. But some of his ideals – like going to cash when things are overvalued, or taking a real bottoms up approach with your analysis and looking for catalysts in your investments are all things you can incorporate into your process right now.

The Value of Seth Klarman June 2010 – Absolute Return + Alpha

Yesterday, at the CFA Institute conference, Seth Klarman gave a talk on how he sees things today. Reuters was there to report and I thought I’d excerpt the article:

Star hedge fund manager Seth Klarman sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.

“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.

Current market conditions remind Klarman of a Hostess Twinkie snack cake because “everything is being manipulated by the government” and appears “artificial.”

“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.

Klarman has 30 percent of assets at his $22 billion Baupost Group in cash, he said. He started the firm in 1982 with $27 million and has averaged 20 percent annual gains ever since. In 2007, amid the depths of the credit crash, Baupost had its best year, gaining 52 percent.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

One of the key traits you will see Klarman exhibit, year in year out, is his willingness to put a substantial portion of his assets into cash. In Margin of Safety, Klarman sees shorting as flawed because of the potential for unlimited losses. Studying his career, you will see that he also tends to use out-of-the-money options to hedge against risk. He did this in the late 80′s/early 90′s with Nikkei puts and later with gold. In Michael Lewis’ The Big Short, you can read about hedge fund Cornwall Capital’s use of a similar strategy (they did remarkably well).

Here is what Klarman had to say about options:

Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.

The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

Many long-only value managers try to stay fully invested in the market because they are afraid to miss out on upswings in the market. With that kind of attitude, they are almost always crushed more than others with a downturn (concentration juices returns in both directions). But if you study Klarman and Warren Buffett, you will see that there are periods when they put a lot of their assets into cash. Cash allows them to opportunistically invest after the fallout of a market downturn while leaving out the guess-work of picking the right shorts.

So where is Klarman finding opportunities right now? Commercial Real Estate:

One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.

Baupost’s Klarman sees poor outlook for stocks (Reuters)

Now the trick for us small investors is to see if there are any indirect ways to play distressed CRE markets. As Klarman says, REITs have mostly rallied. That means we would have to look at some more creative, less direct investments.

While many investors are questioning whether the current rally in equity markets is sustainable, one area I’m seeing a lot of activity by noted value investors is in the distressed debt market. In general, the best deals here are being made on terms that are simply unavailable to the ordinary investor. Still, I think these are worth studying, they might be useful lessons for future investments.

The CIT deal is particularly interesting because the funds doing the deal are led by some of the best people in the investment business. Bill Gross – PIMCO, Seth Klarman – the Baupost Group, Howard Marks – Oaktree Capital, and Jeff Aronson – Centebridge Partners. In special situations like these, investors are sometimes able to create extremely preferential terms that limit their downside, creating a wide margin of safety.

Here’s a look at CIT’s 8-K:

The Credit Facility has a two and a half year maturity and bears interest at LIBOR plus 10%, with a 3% LIBOR floor, payable monthly. It provides for (i) a commitment fee of 5% of the total advances made thereunder, payable upon the funding of each advance, (ii) an unused line fee with respect to undrawn commitments at the rate of 1% per annum and (iii) a 2% exit fee on amounts prepaid or repaid and the unused portion of any commitment.

The Credit Facility will be secured by a perfected first priority lien on substantially all unencumbered assets of the Guarantors, which shall include 100% of the stock of CIT Aerospace International, and 65% of the voting and 100% of the non-voting stock of other first-tier foreign subsidiaries (other than direct subsidiaries of the Company), in each case owned by a Guarantor.

Borrowings under the Credit Facility will be used for general corporate purposes and working capital needs and to purchase notes accepted for payment in the Offer (as defined below); provided that, except with the consent of a committee of lenders under the Credit Facility (the “Steering Committee”), no portion of the proceeds of the Credit Facility or collateral securing the Credit Facility may be used to pay principal or interest on the August 17 Notes (as defined below), other than pursuant to the Offer (as defined below), or, following the consummation of the Offer, on the maturity date of the August 17 Notes.

The Credit Facility includes a minimum collateral coverage covenant. The covenant requires the ratio of the book value of the collateral securing the Credit Facility to the loans outstanding thereunder to exceed 5:1 as of the end of each fiscal quarter commencing as of the fiscal quarter ending September 30, 2009, and the ratio of the fair value of the collateral securing the Credit Facility to the loans outstanding thereunder to exceed 3:1 as of the end of each fiscal year commencing with the fiscal year ending December 31, 2009. The Credit Facility also contains customary affirmative and negative covenants, including, among other things and subject to certain exceptions, limitations on the ability of Borrowers and subsidiaries to incur additional indebtedness, incur liens, make material non-ordinary course asset sales, make certain restricted payments (including paying any dividends on any of the Company’s preferred or common stock without the consent of a majority in number of the members of the Steering Committee), make investments, engage in certain fundamental changes, engage in sale and leaseback transactions, engage in transactions with affiliates, and prepay certain indebtedness.

CIT Group (8k)

So far, the consensus is that Baupost and others got a steal of a deal.

Caroline Salas and Pierre Paulden of Bloomberg have a great article that stresses the limited downside of the deal:

Pacific Investment Management Co., Centerbridge Partners LP and the four other bondholders that put up $2 billion in financing for CIT Group Inc. made an instant $100 million on an investment analysts say is almost risk free…

Bondholders made $2 billion available immediately and promised another $1 billion by the end of the month. The group received a 5 percent commitment fee on the 2 ½ year loan, amounting to $100 million on the $2 billion already provided. They will receive a 1 percent annual payment on the amount that’s not drawn upon, the company said.

And some choice words by Sean Egan:

The book value of the collateral must be more than five times the amount of the loan and the so-called fair value must be more than triple the debt, the filing said. If CIT wants to retire the loan early, it must pay a 2 percent exit fee in addition to a prepayment premium of 6.5 percent on the amount it wants to reduce, the filing said. The 6.5 percent will decline to zero over 18 months.

Interest will be set at 10 percentage points more than the London interbank offered rate, which will have a floor of 3 percent. Three-month Libor was set at 0.502 percent today.

Even if CIT fails, the bondholder group will probably make money because of the collateral, according to Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. The lenders have “virtually 100 percent assurance” they’d be able to recoup all their money in a bankruptcy, said Sameer Gokhale, an analyst with Keefe Bruyette & Woods Inc. in New York.

‘Don Corleone Financing’

“This is called Don Corleone financing,” Egan said, referring to the patriarch in the organized-crime family depicted in the 1972 film, “The Godfather.” “You can’t lose money on this deal.”

Outside of the “urban underworld,” Egan, 52, said he couldn’t recall seeing a loan backed by as much collateral that paid interest rates so high. “These terms would make a pawn- shop operator blush.”

CIT Hit With Interest Rate More Than 25 Times Libor (Update2)

Deals like this, while unavailable to ordinary investors will likely serve as lessons for what happens when an over leveraged company faces problems with financing. Liquidity crunches seem to be creating a number of great opportunities for investors who are willing to remain rational. Often, as management is threatened by bankruptcy, they’re more than willing to bend over backwards to cede terms in order to secure the capital that they desperately need.

Jeffrey Goldberg of The Atlantic has this great article which asks what the average investor is supposed to do right now. I often discuss investing with everyone I meet, it’s a passion — but I’m often shocked by the preconceptions that people have about it. The ordinary investor has really been misinformed which unfortunately leads to bad decisions and negative returns. Goldberg’s article sets a lot of things straight and would be good reading for anyone you know who is interested in investing but knows little about it. What I liked most about Goldberg’s article was the quotes from Seth Klarman:

Klarman is an acolyte of Ben Graham, the original value investor. Value investors—Warren Buffett is the most famous—seek out distressed, underappreciated assets, buy them, and wait until the rest of the world realizes that they’re worth something.

“The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent,” Klarman said over lunch one day in an empty Boston restaurant. “Successful investors like stocks better when they’re going down. When you go to a department store or a supermarket, you like to buy merchandise on sale, but it doesn’t work that way in the stock market. In the stock market, people panic when stocks are going down, so they like them less when they should like them more. When prices go down, you shouldn’t panic, but it’s hard to control your emotions when you’re overextended, when you see your net worth drop in half and you worry that you won’t have enough money to pay for your kids’ college.”

One theme of Margin of Safety is that people like me aren’t equipped to be investors. “No one knows what he’s doing unless he’s a full-time professional,” he said. “As in many professions, full-time experts have an enormous advantage. Investing is highly sophisticated and nuanced. The average person would have an incredibly hard time competing.”

On the troubles of the small investor:

He agreed with Robert Soros that the financial-services industry treats the small investor not as a client but as a source of ready cash. “The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”

After 15 years of pabulum, I was enjoying, in a perverse sort of way, receiving straight talk from masters of finance.

“Everybody these days is a just-in-time investor. People say, ‘I’m going to leave my money in the market as long as possible, and then pull it out of the market just before I have to write the tuition check.’ But I think we’re seeing that the day you need to pull it out of the market, the market might be down 50 percent. It’s critical not to be greedy. Avoid leverage and don’t invest money that you can’t stand to lose.”

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged. Why are you keeping your money in the market?”

“Because—”

“It’s because you think you’re going to make more money in the market than you’re paying in interest on your mortgage.”

“Yup.”

“Well, are you?”

“Uhh, no. But I’m getting the mortgage-interest deduction.”

“Yes, the interest is deductible. But if you had capital gains in the market, you’d pay taxes on those. In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”

“But if I dump my portfolio now, I make my losses real.”

“How are you going to feel if the market drops another 50 percent?”

Klarman brings up an interesting argument. I feel like when people decide they want to invest, they do not properly weigh their actions in the context of their overall financial situation. I have a feeling that many people invest simply to say that they’re invested. As a result, they usually make poor or mediocre decisions. At the very least, they end up investing money in the market when they may have been better suited by paying down debt. The kind of arbitrage practiced, where someone takes out a mortgage but invests in the market is highly risky. But I don’t think many people weigh investing in the market versus their mortgage.

Finally, Klarman’s question to ask anyone who is interested in investing:

“Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”

Be sure to read the entire article, there are excellent insights from Bill Ackman and Robert Soros among others.

Sorry for the thin posting recently, I’ve been going through final exams. This morning I had a chance to watch Charlie Rose’s interview with Nassim Taleb. Like always with Charlie Rose, the interview was top notch:

One of the things that struck me as interesting in the interview was the fact that the prospect of deflation. Nassim Taleb seems to think that that’s where our economy is heading:

CHARLIE ROSE: But let me go — you mentioned Nouriel Roubini, who has been here and who has become well-known as someone who has predicted this and saw it coming, and scares the hell out of people when he comes and sits where you do, because he sees it as getting worse, and even suggests sometimes it may mark the decline of America. How bad do you think…

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I — I had the same story, haven’t changed my story since — and what convinced me of this is that we switched from an environment of inflation, hyperinflation, where people are afraid of commodity prices rising, to a total deflation in no time. Look at inflation bonds…

… I know that we are going have massive deflation. The overhang of debt, massive deflation. Debt needs to be reduced. And I think Paulson seems to be doing a good job, particularly that they were part of the cause of what happened, you know, it is quite commendable.

That got me wondering – what is the best way to invest when you think that deflation is coming? When we, as value investors, invest we look for margins of safety. But if asset prices are falling, the margin of safety quickly contracts. So what are we to do?

Seth Klarman of the Baupost Group touches of this in his book, Margin of Safety. We’re lucky because the book was written only a few years after the junk bond craze, these kinds of topics were on the mind of investors. Here is what Klarman had to say on deflation:

In a deflationary environment assets tend to decline in value. Buying a dollar at 50 cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial “hidden assets,” such as an overfunded pension, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst a broad-based decline in business and asset values, however, some hidden assets become less value and in case may become hidden liabilities. A decline in the stock market will reduce the value of pension fund assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at a historical cost, may no longer be undervalued. Overlooked subsidiaries that were once hidden jewels may lose their luster…

The possibility of sustained decreases in business value is a dagger in the heart of value investing (and is not a barrel of laughs for the other investment approaches either).

Which is really the heart of the problem with deflation, especially for value investors. We have to be cautious and not forget the fact that underlying values can indeed decline. This may have been one of the mistakes that some fund managers made when investing in banks while using book value to approximate business value. Book value was simply written down each quarter, ruining whatever margin of safety existed.

Klarman gives us three ways to invest if we think that business value may decline:

First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or hold current positions. This means that normally selected investors would probably let even more pitches than usual go by.

Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or not you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause to diminish become moot.

These rules are telling us that we need to be even more conservative if we wish to protect against deflation. That means increasing our margin of safety to compensate, and sticking with areas we’re more certain about. Sometimes value investors like to relax their standards so that they can join in the action of the market. They end up buying dollars for 70 or 80 cents and dip their toes in industries outside of their circle of competence. Maybe they’ll invest an an industry where the asset values are much harder to determine, they may make the error of overestimating and skewing their valuations as a whole. So we must become more conservative as the market becomes more turbulent.

With respect to the third factor, I really see this from a special situations perspective. Workouts like risk arbitrage, odd-lot tenders, and so on may be helpful because the price changes should be independent of the market’s precise movements and determined more by the transaction itself usually with a fixed time interval. This gives you the luxury of figuring out when the transaction will be completed so that you can compare it against what the market is doing.

Maybe you’re thinking about investing in an arbitrage situation but you think that asset values will decline over the course of the year. This could affect debt covenants or trigger a material adverse clause and kill the transaction. So you have to keep time in mind. The longer a transaction is supposed to take, the more you risk your capital, especially if you think the value of businesses will be declining.

Investing with macro issues in mind is always a tough thing, especially because its practically impossible to predict exactly what the economy will do. I don’t think that we need to study or spend too much time focusing on the economy though. We simply need to stick close to our principles and maybe exercise more caution that usual. If we do this, our returns should reward us well.

I mentioned Seth Klarman and inflation hedging previously in my post about his talk at the CIMA conference. Here is another quote, this time from a recent article on MarketWatch:

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be “vicious and protracted.”
“The financial market collapse and bailout makes us sick,” he wrote. “There is likely more carnage to come.”

The U.S. dollar will likely weaken and its reign as the world’s reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.

The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.

I still haven’t figured out what his inflation hedge might be, but it’s something worth thinking about. Here’s a line from his book Margin of Safety, which hints a bit at inflation hedges:

…value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar.

What might he be looking at? Timberland? Oil and gas properties? Or maybe land itself, domestically or abroad.