2023 Top Episode #1: Seth Klarman – Timeless Value Investing, EP.328

27:48The companies are all gone. They've been merged or liquidated decades ago out of existence. Many of the principles that they talk about are based on laws at the time around prudent man rule or other regulations that no longer apply. But what's still applicable is that despite all the changes, the general principles, which are essentially dependent on humans and their psychological tendencies to get overly exuberant and to get overly depressed and to have constraints on the humans, you must buy a highly rated bond. You can only own a stock that pays a dividend. You cannot own a stock below a certain market cap or below a certain share price.

28:30And those kinds of rules and constraints can lead to inefficiencies. And so while the nature of the exact inefficiencies may have changed a lot in 89 years, the certainty that there will be those, I think, remains high. And I actually am pretty optimistic that they will remain even if computers were replacing people as money managers and were doing all the trading. And that's because the nature of what causes the inefficiency. It's human, but I think the computers will mimic what the humans would do because that's what they're trained to do. And so I think that even AI wouldn't make the markets fully efficient.

29:09There is a degree to which AI, as you get closer to general intelligence, tries to replicate how humans would think. Where do you think as computers on the short end, say of trading and then AI maybe over time replicating thinking will still go wrong relative to human behavior. A caveat that anything to do with technology, you've got the wrong guess. And that I need to know about it. I need to be up to speed. I need to have an opinion about where it might go, but I'm not an early adapter. I don't fool around with it the way some people do. So my opinion may not be as good as some people's. But when I think about it, first of all, my understanding of AI is that it is trained to look at enormous amounts of past data.

29:58I don't fully understand how that is done because, for example, up until 2022, we'd had the longest bull market in history. And so depending on what period one looked at, one might think, well the absence of a bull market maybe we're past that is that right or is it pent up that the absence of a down market the straight up 12 years of bull market that ended in 21 it's like if you're waiting for a bus and the buses as you know from the schedule come every 15 minutes and it's been 45 minutes so either four or five buses are going to come right away or the road is collapsed and no buses are coming.

30:38Which is it? What will the computer tell you? Which is it? Those are hard questions. I don't think humans will always know the answers. I think AI will be amazing at saying, oh, well, when the Suez Canal gets closed by an attack of some sort, here's what happens to oil prices, or here's what happens to GDP around the world in the next quarter, or when there's a war in Europe, here's what happens. Computers will figure that out and humans would have a ton of work to catch up. And maybe computers will see connections that aren't easily seen. But how will a computer figure out the next telecor and electro rent?

31:16Electro rent hasn't been public. There are no published financials yet, although they'll be in the proxy eventually. I don't know how they'd know what telecor shareholders would get or how to think about the contingencies around those kinds of liquidation distributions. And that's not the most complicated thing that could come along. How will they think about what a bankrupt or near bankrupt bond might get into restructuring? Again, I just don't know. To somebody who really is sophisticated in AI, maybe that sounds naive. But to me, I believe that it's likely that the artificial intelligence dealing with a sample size of close to one on a particular oddball transaction may not know what to project.

31:59So in effect, how does Baupost practice value investing? I think that we're set up not on a basis of let's look at the world like other people. We don't have industry analysts per se. We don't focus on a certain equity list of let's know these 200 stocks or let's look at certain kinds of industries because we like their growth prospects. We're set up in a much more opportunistic way. Where are inefficiencies right now and where are they likely to lie? And how do we get them to come into our inbox so we can look at them? We're looking for supply-demand imbalances in the market. Now, if you told me a stock in Turkey is going to be delisted from an exchange, I would tell you that while we don't look at Turkey, we might start to figure out that stock because when it's off the exchange and out of an index, there might be a lot of people that have to sell it.

32:55And there might be a lot of people that quasi-follow that index that don't hold it anymore. And so all of a sudden, you've got a chance that stock price just falls into some kind of black hole. I think a computer could, of course, figure that out. It could say, delisting leads to lower prices, and then maybe make the connection that sometimes that's overshot in some new incarnation. the company gets taken over or can come back into an index. But when you multiply that by all the kinds of things that lead to these mispricings and imbalances, is it a downgrade? Is it bankruptcy filing itself? What about with a private asset that Graham and Dodd didn't write about private assets?

33:37They didn't write about real estate. They didn't write about privately owned companies. yet the same general principles that cause stocks to overshoot can cause business prices to overshoot. Financing becomes less available, so buyers will need to pony up more money as equity, and therefore the price drops. Somebody needs to get a loan that's turning sour off their books by the end of the quarter, a bank or an insurance company, or a real estate fund formed 12 years ago that has one or two more assets and wants the last assets off the books so they can close out the fund and maybe now go raise the next fund or the fund after that.

34:15Tracking that way, sourcing opportunities that way is so different that, again, I don't know what a machine could be trained to do. It's not easy to train humans to do it. Maybe it'll be easier to train machines, but I'm not sure because it really is a lot of sample sizes of one. You see patterns, but patterns don't exactly repeat. That is what we're doing. That is what Bowpost has done for 40 years. We're looking, hunting broad and wide. I like to say we go miles wide to look for opportunity. And then when we think we found it, then we drill miles deep. Maybe the contrast is that other people are going miles deep first.

34:54So they know everything about every industry. They know deeply pharma and auto and finance and whatever else, but they're not as focused on why might any of this be particularly mispriced. And in fact, maybe they're actually oriented towards not going where the mispricings are. The stock's mispriced because management has not done a good job lately. That's hard for people to recommend to their clients or to their bosses. Or maybe the company was involved in something that left them with a degree of stigma, a failed acquisition or a management misstep. And yet those things can cause prices to really get out of whack and lead to opportunity.

35:35So that's the challenge is to find ways to find the bargain. In a sense, you have to be right about less when you don't have to be particularly right about what's the business going to grow into over the next 10 years. Maybe right this second, it's 30 or 40 or 50 % undervalued. Now, the world has changed more in recent years so that because of technological disruption. In Graham's day, he could look at a balance sheet and an income statement and say, look, I'm buying this stock at six times earnings and two thirds of working capital or two thirds of book value, and probably be right about that and realize that the tables will turn, what's out of favor will come back into favor, which is what the quote from Horace, the poet that's at the beginning of Intelligent Investor.

36:22But what changes now is a business could be doing just fine. But if somebody is working on something in their garage that's going to disrupt that company, five years from now, that company may barely exist or certainly become a lot less profitable. And so an investor has to be thinking about not just cyclical change, like Graham and Dodd were worried about in the depression, but secular change as well. And the combination of that, I think, has made investing harder and value investing harder, that investors can't just crunch a few numbers and say this is mispriced, they need to dig a lot deeper than that.

36:57There's nothing wrong with hard work. And I think the investors who look will continue to find mispricing an opportunity. I'd love to dive into how you apply a lot of this at Baupost. And maybe the first part of that investment process is this idea of sourcing these opportunistic areas that might be ripe for some inefficiency. How do you organize your team to look broadly to try to identify those places where you may then want to dive in deeply? I think the biggest part of it is probably pattern recognition, that you notice that patterns from the past have a way of repeating not exactly, but with some similarity.

37:36You can find a fund that is in the process of liquidating its last asset. The pressures on them are, you better get that asset off the books. We don't want to carry it through another year end. And so all of a sudden, an asset that wouldn't normally be sold now needs to be sold with some degree of urgency. It could be something as simple as realizing that a bond or a loan is about to default or nearing default and might then trade at a steep enough discount or that there's a restructuring opportunity. It might be that the market misperceives litigation and that either thinks the litigation is unimportant or thinks it's more important than it really is.

38:16So most investors are trained to analyze cash flow, but to guess legal probabilities, I don't think anybody's probably good at that. I'm not sure we're good at that, although we try. But I think there are factors that are just more important in the business than they've ever been, such as that. There are many, many of them that add up. And so I think that the combination of that leads to some playing fields that probably have fewer people playing on them that can lead to mispricings, as well as areas that maybe are more likely to be mispriced than others. So I think by following our nose, by looking for patterns, by pulling on threads of similarities, we end up with a pretty good portfolio of investments that are individually likely to be mispriced and collectively or reasonably diversified.

39:05How do you go about communicating with your counterparties so that they start showing you more and more of these idiosyncratic opportunities? I think that's part of the intel inside at Baupost, but it's not as hard as you might think. In the historic days of Baupost, 35, almost 40 years ago, we'd get a phone call, hey, I'm Joe Smith or Jill Smith, and I'm your new coverage for Merrill Lynch, and I'd like to come by and talk about what we can do for you. And time being scarce and just me or a very small group of people, we'd say, look, you don't need to come by, but if you guys ever see on your desk a bond that you've never heard of or a stock you've never heard of or 20 % shareholder in a business that wants to move it quickly, we're your call.

39:55So don't call us with IBM Insights or your new rating of Microsoft. But when you find that secondary partnership interest, or you find that illiquid stake in a private company, call us with that because we'll have a bid for you. And so I think it's seeing those patterns. And then it's a little bit like that quote that when you come to Baupost as a young person, either what we do resonates or it doesn't. I think for the great majority of our people who tend to be quite long-tenured, they come here and it's like they too have been let in on a little secret. And they realize that looking at what everybody else is looking at is probably not that interesting.

40:32If you're going to look at what everybody else looks at, look at it in a highly differentiated way. That's fine. But you're not going to make money by outsmarting people on widely followed stocks with an undifferentiated opinion. But there's a lot out there, right? private markets are arguably as big or bigger than public markets. The real estate market itself is thought to be around the size of global stock markets. And so there's a lot of assets and a lot of transactions and a lot of things that can be bought. The current feedback from the market is you should own the top seven stocks. You should own the stocks that are obvious.

41:10You should move your money into indexes because indexes tend to outperform. If a stock's kicked out of an index, in the short run it underperforms there's a lot of people that have to sell it nobody that has to buy it but i would argue that over a longer period of time it's those stocks that don't make it into the index that are actually the attractive ones because if they stay out of it you're buying the same kind of company at a discount to the ones in the index and god willing if it's ever included in the index now you have significant gain from the step up as well this is not an argument to index or not index.

41:44It's to say that what tends to be in favor tends to be very fully priced. And what tends to be out of favor can become even more out of favor, but tends to offer better investment fundamentals. Literally, if you and I said, look, there are two companies that are identical except one's in the S &P and one's not, and the one that's not trades at a 20 % discount, which is likely to be the better long-term investment? I think we'd say on a valuation basis, it's every time it's the one not in the index. Maybe there's some benefits to being in the index, a lower cost of capital. Maybe it gives the other company some kind of advantage.

42:19But I think a value investor would generally say, give me the one that virtually the same company, but at a much lower entry price, I'm going to have the higher return over time. And of course, looking at returns over a long period of time, measuring them kind of any which way, the better returns come from paying a lower multiple of earnings, a lower multiple of book, a higher dividend yield, whatever it is. So at least that's food for thought. Once you've found one of these opportunities, pattern recognition, canvassing wide, what does a fully vetted process at Balpost look like from seeing the opportunity to doing the deep dive to when you're ready to make an investment?

42:59It can be days and it could be years. That depends on the nature of the opportunity. I like to say that a big enough discount maybe offsets a lack of the deepest possible knowledge. Sometimes there's chaos in the markets and you want to move quickly. On the other hand, anybody that looks at the price and says, wow, that stock has fallen 20 % in the last couple of days, to think that happened for no reason would also be incredibly naive. So I think that investors need to move with a degree of alacrity because opportunities don't last forever, but they also need to do everything with a great deal of humility because the market doesn't just give away free money.

43:42There are a lot of smart people. Sellers might know as much or more than you. They, after all, have owned it for a period of time and you haven't. So you want to really spend enough time to get comfortable to at least make sure you're not the patsy at the table in the way Warren Buffett would describe it. We do a ton of deep work. We dig deep into company financials. We look back a number of years. We always ask ourselves about not just what's the reported number, but what's really going on? What's the free cash flow? What are the margins doing? Have they gotten better? Have they gotten worse?

44:15Is this management doing a good job? Are there missed opportunities? Or are they stretching to put up good numbers that might go away? So we're digging things that have changed over the course of my career. When I started, there were no expert networks to call. You had to figure out your own and maybe figure out who might know something about this business or piece it together, talking to experts on certain part of the business. So I would argue for sure there's way more information available. We all have more information available at no cost or low cost at our fingertips than people in the most serious investment positions had 20 or 30 years ago.

44:52But that said, information is only so valuable also because it's what you do with it. It's having a differentiated view about it. We have then active internal debates. The teams meet as pods, which tends to be a partner and a more senior and a more junior analyst altogether. That's an approximation, but that's what it looks like. when they're ready to make a recommendation, they may run it by another pod just to say, hey, does this sound crazy? We have our analysts meet once a week at lunch. Anybody who's around and wants to meet, the partners don't attend that. So it's a free space for analysts to be running things by each other and not feel like partner's going to hear them or they might judge them for being naive or having a silly idea.

45:36So I think that's really important for people's development. When the team's ready to pitch the idea, they run it by me. They run it by our president, Jim Mooney, as well, usually at once in the same meeting. If it's a public idea, we have our traders in the room who can shed insight into how the thing is trading or any particular thoughts about what's going on in the market at the moment on that name. We reach a decision often in an hour. Sometimes we don't reach a decision and we agree to reconvene or we agree that it's interesting, but not at the current price. Other times we'll meet, we'll agree, we'll buy it.

46:08And then in days we're meeting again because the prices dropped further and it's now an even better bargain. And do we want to own more? Part of my nature is these things churn in my head. So sometimes I'll wake up after a meeting the next morning and think, I forgot to ask one question or there's a risk I hadn't thought about that now I'm thinking about. And so we'll reconvene. It probably drives my people a little crazy, but I always think protecting the client's capital is more important than whether I drive somebody a little crazy. So we are constantly reconvening if it moves closer to our price target.

46:41Is this a good sale? When should we get out? Do we sell part of it? How should we think about that? If it falls, should we buy more? How big should it be? If something else gets more interesting, should we keep holding it or is this new thing even more attractive? There are two things that are limited in investing, two constraints on every investor. One is capital and the other is time. And they're both really important. So if something you own falls, sometimes you'll trade out of it, even though you don't like it any less than you did. You just like something new that came along more. Those kinds of conversations, I think, are extraordinarily helpful in optimizing a portfolio.

47:19How have you gone about evolving that decision-making process as Baupost has grown in number of people over the years? I would tell you I've done it poorly. I continue to have final say in the portfolio. So the way I wield that power is I have final say, but I defer a great deal to my team. So I give the team rope. If it's a senior partner who's produced a lot of profit for the clients over the years, and they want to do something that I'm not sure about, I tend to give them room to do that. I think that's valuable and probably career extending for them. It makes them feel appreciated, gives them satisfaction that they're getting to make decisions.

48:01But I also, in some sense, I'm deciding on investments, but I'm also deciding on people. Who do I trust when they say they've done the work? What does that mean? Have they done good work? And for our best people, which we have a lot of really great people, long tenured people, trusting them has been exactly the right thing to do for a very long period of time. The final say, a portfolio manager still needs to sit on top of the structure, and it's because we slosh money into and out of areas. So we might have loaded up on corporate credit over the last six months, but if tomorrow there's something better to do in a private investment or in real estate, we may be reducing positions we like to buy something even better.

48:42The organizational key is somehow to have people that are team-oriented enough to say, oh, I get it. I worked hard on this idea. I'm glad we own it. But if we can own something better that's going to make more for the clients, I trust that's also in my best interest. And we try to pay people not just on their own bottom line, but on a firm-wide bottom line for that exact reason. How do you think about position sizing? Sizing has been one of the strengths of Baupost over its history. I've run into people with unusual views about sizing. So I've come across a number of funds that have a view that the goal in investing is to limit how much you can lose on any idea.

49:22So the key is to have 200 ideas in your fund, none of them more than half a percent. You don't understand that. If you can establish that an idea is good versus one that's bad, then why can't you understand that there might be one that's great rather than just good? and why would that not be bigger? I also think a portfolio can absorb more than a tenth or two tenths of 1 % of loss. So we prefer to identify over time through continued work, through price decline, that a good idea has now become a great idea or through an event, through a company announcement that the following is going to happen.

50:01And maybe you've studied the company long enough that you understand or can appreciate right away what that news means, where somebody else might think it's directionally not the direction to go or at least not understand the impact of it. So we obviously stay very far away from any line of inside information, but we want to capitalize on our insights and patience that our long-term oriented clients give us. We have made our big dollar profits over the years, usually on ideas that have gone against us at first, and we average down. And when they are catalyzed, which means some event is going to happen that will cause us to make money.

50:38We're not just dependent on somebody waking up tomorrow and liking it more than they did today, but rather the company will in fact complete a reorganization plan or will complete a liquidation plan or a merger will close with high probability or an asset will get sold out of their corporate portfolio and they will buy back stock with a lot of the proceeds, whatever it might be. Those are the kinds of catalysts we look for. The presence of a catalyst makes us comfortable having a bigger position. The hardest thing about value investing without catalysts is you can own something that's out of favor for an incredibly long time.

51:17And over five or 10 or longer year period, being early and being wrong look exactly the same. And you can start to get confused and your people can start to get confused and your clients can start to get confused. And so I don't know anybody other than maybe Warren Buffett who could underperform for a decade or more and feel like everybody's just dandy with that because they have confidence it's going to work out. And of course, every investor should also be asking themselves those questions that if you own a stock that just goes down and down and down, might you have been wrong? or at least maybe you could have figured some things out earlier and not owned it from the highest price you paid.

51:59One of the things about Bowpost also, because we know we don't know everything, we know we know so little in the scheme of how much there is to know, that we spend a great deal of time trying to learn lessons. And so we spend time learning both from our successes and from our failures because they both contain valuable learnings. those learnings aren't always available the first day. It may take quite a while to reflect back. I remember reading years ago in an interview, they asked a head of a mutual fund, tell me about your best idea over the years. And they said, well, I found the stock at$5 and it went to 50.

52:34And when I looked up that stock, guess what? It had gone from five to 50, but it was back to five. So was that a great idea or was that a lucky trade? I don't know the answer. How do you think about risk management? Bailpost was founded on the principle of protecting the capital first and foremost of the families that founded it. And so I would describe us as having a risk-averse approach. We try to think about downside in every individual investment. We roll that into a portfolio, not in some fancy math formula, but intellectually. where are our correlations? Do we have exposure as a portfolio that's as bad as the individual investments?

53:13Or might there be much less exposure because we have offsetting investments? If this one does well, that one's likely to do less well. Or if this one does poorly, that one's likely to be a grand slam home run. Are there ways to mitigate risk just with offsets in the portfolio? Then you can also mitigate with catalysts. Catalysts shorten your duration. They make you less dependent on the overall level of the market in the future. And we know, Warren Buffett wrote in the 73-74 timeframe, unfortunately, that no one should own common stocks who's not comfortable with a 50 % drop in the market. I could tell you almost nobody's comfortable with a 50 % drop in the market, yet Americans own more stocks than ever before.

53:53And so I think people have forgotten that kind of admonition. I think that's really important too. So it's why I don't just want pure beta equity long, diversifying into other asset classes, into credit, for example, shorten your duration, give you a senior position in a capital structure where you're likely to get paid back even if the equity struggles mightily. Or if you don't get all your money back, you get 80 cents on the dollar back. A lot of things diversify away from full market risk. It's position diversification. It's hedging at the portfolio level. We tend to overlay macro hedges and commodity-type hedges, interest rate hedges, as appropriate based on each individual investment.

54:36And there may be a layer of portfolio hedges that look like essentially puts on the market. And the reason for that is that the average long-term multiple of the market's about 17 times, but you have moments. Today, it's 20 times. You have moments it's hit closer to 30 times, and other times it gets to 10 times. At times when the market is more expensive than historic averages, you are exposed like crazy to just the multiple coming down to the long-term returns winning out. And you can lose a lot just from that kind of mean reversion. So we try to protect against that too. I will hold cash in the absence of immediate opportunity.

55:17That's not a terribly big number these days, but the combination of those hedges, those mitigants do provide a significant degree of downside protection. And when we do have downside, it tends to be quite limited. So Baupost has only lost money in five of its 41 years. All but two of those have been in the mid-single-digit range or less. So protecting capital to that extent over four decades, I think, is the name of the game for what Baupost tries to do, what value investors hope to accomplish. When you're investing in private securities compared to public securities, How do you think about pricing in liquidity?

55:53I think you have to get paid for illiquidity. I think that there is a cost to giving up control over getting in and getting out, but there are offsets. And so one of the offsets is you'd think if you bought a building, it's illiquid. But if you own the whole building, you get to decide when to sell it. Whereas if you own 100 shares of stock or a million shares of stock of a company, management could do something extraordinarily dumb that you wouldn't have done. And so there are puts and takes. And so I want to make sure I get paid for giving up the right to change my mind. But just because an asset is in illiquid form doesn't mean it's purely illiquid.

56:32Buildings get sold all the time. Whole companies get sold all the time. Whereas 9.9 % of the shares of a$400 million company might be a very illiquid block. And so liquidity may not be what everybody seems to think. There's been, I think, a great misunderstanding in recent years among some people who run money that illiquidity itself delivers degree of return, that if you take the illiquidity, you automatically get the return. I don't think anything could be weirder than that idea, that the reason you make money from illiquidity is when you have people on the other side of the trade who have an illiquid asset and they suddenly need to monetize it.

57:12They want it off the books. that may cause it to trade at a discounted price and the discounted price provides the higher return the liquidity itself doesn't generally when clients ask this i say you want to make several hundred basis points i don't know if that's 200 or 500 basis points but giving up the liquidity the right to change your mind is worth a lot on the other hand just as a thought experiment let's take the most liquid of all instruments and let's say i found a five-year treasury bonds at a time when treasuries yield 4%. And I had a way that you could create that at a 10 % yield, but you couldn't trade it for five years.

57:48There's a price on liquidity. Would anybody do that? Well, I would argue that anybody that's going to buy treasury bonds and would likely keep holding them for five years ought to be first in line to do that trade. And that exists. I can't describe all the ways it exists, but we are trading off things like that all the time. Maybe the cash is in a liquidating trust and will only get paid out slowly. Maybe there is something cash-like or treasury bill-like where the cash is held. And so it's not exactly a treasury bill, but it's like a treasury bill. And yet the yield is way, way disproportionately more than you'd ever get on a treasury.

58:24So we're on the eternal hunt for things like that. And sometimes we actually find them. What have you found about differential risk premium in international markets compared to the U.S.? We invest internationally. We have stocks in Europe. We have debt in Europe that we sometimes buy. We own real estate globally, although mostly it's U. And Western Europe. Our mandate is broad and flexible. Our mandate is broad and flexible. We have stocks in Europe. We have debt in Europe. We own real estate in Europe. for decades. It was in favor. Everybody was lining up to go there. I knew that they have a pretty authoritarian system of governance and didn't want to be on the wrong side of that.

59:10We stay away from most markets like that as a pretty regular rule. Yet, the stocks were starting to discount such a significant degree of China risk that we felt like for the first time ever that you're actually getting well paid. We found a company whose stock was beaten down 90 % and thought that was attractive and so far so good, but it's not a large percentage of our capital. But it was a very intrepid idea by one of our analysts. I don't have a view about emergent markets, about the frontier markets. We're humble enough and cautious enough to know that if you don't live in a country, if you don't have people that are active in that country, you're at a real disadvantage.

59:52And so I have no idea what the premium should be for buying equities in Africa or equities in Asia. But when I find a stock trading at 25 cents on the dollar, I know that those things tend to work out. So that's how we've applied it. But the vast majority of our investments are US and Western Europe. And I don't know that Western Europe needs particularly significant risk premium over the US. Obviously, for clients who live in the US or with exchange rate risk, you may have some considerations there. That wouldn't be a big discount from our perspective. We just take each individual investment as it is, try to understand what the risks and opportunities are in it and make our determination then.

1:00:33As the economic environment's been changing with rates rising and inflation, particularly in the U.S. over the last year and a half, two years, where is your antenna up in that pattern recognition for the types of opportunities you suspect will come over the next few years? This is to me one of the weirdest times since I've been in the investment business for over 40 years, that you had a bubble. It was really a credit bubble that became an everything bubble. Super low interest rates, at times zero rates, made capital easily available and incredibly cheap. And that led to startup manias and SPACs and meme stocks and crypto, all kinds of speculative activity.

1:01:14I'm not convinced that we've even begun to sort out that bubble. Now, that bubble did a pretty good job of collapsing in 2022, but the market has rallied back so much this year. We're now in a bull market, no longer in a bear market by that at least arbitrary definition of 20%. I think that the damage that was done over a 12-year bond bubble, and of course, don't forget, it's been a 35-year bond bull market up till 2022, that what were financial institutions supposed to do during that timeframe? They couldn't get paid by taking credit risk. It still wasn't much. They couldn't get paid by going out in duration.

1:01:52The yield curve was decently flat, at least part of the time. We've seen some financial institutions do what Silicon Valley Bank did and end up with significant mismatches of assets to deposits. but I'm not convinced we know where all the bodies are buried. I think here and there you read an article that says this bank has a hundred billion dollars of bonds below market or whatever, but I'm just not convinced. I'm not saying there's anything more. I don't know anything, but I'd be nervous because markets cause behaviors. And when people have to put money to work, have to run a matchbook, have to run a large balance sheet, they're going to do something with the money.

1:02:30We haven't seen a lot of bodies float up. I don't know what that means, but I'd be worried. I think that we've become incredibly dependent on the government rescuing everything. The irony of this moment is that while you had a Greenspan put and a Bernanke put and a Yellen put, now Powell is breaking it. I don't know if he can break it and provide the put right afterwards. On the other hand, with SVB, we did. We changed all the rules around deposit insurance in order to not let them splatter. And so these are really complicated questions. I don't feel like I know the answer for sure. But I think the moral hazard is very high.

1:03:08I think people's memories are short. I think people would be really wise to pay attention to history, to think back to an era where everything didn't get rescued, to try to imagine a bear market that didn't immediately just lead to a buying opportunity. You don't have to look that far back. People could look back to 74.5 or 73.4, many, many stocks trading at single-digit earnings multiples that weren't going out of business, but people needed to sell stocks to pay the bills and to meet their commitments, you had a genuine liquidation. You really haven't had much of that for a really long time.

1:03:44You had a lot of hiccups around between 98 and 01. And then the great financial crisis was a really ugly 12 months or so. I'm just not sure why you couldn't have more trouble, especially because you had enormous capital flows. You had entire buildup of a private credit industry and disintermediation from banks. Maybe that'll all go smoothly. Maybe it won't. It's not been tested. The nature of most Wall Street innovation is it's never stress tested for a rainy day because that wouldn't be any fun. It's fun to sell a lot of bonds, sell a lot of stocks, sell a lot of partnerships and rake in the investment banking fees.

1:04:24But when the rainy day comes, mortgage-backed securities can blow up and it wouldn't surprise me to see pockets of private credit blow up. Private equity funds has been rescued historically. So in the 08-09 period, I always thought there should be an asterisk on private equity because those guys got rescued by the Fed rushing in, cutting rates, and Congress's stimulus plans as well, which a lot of private equity debt was trading down to 50 cents on the dollar, and yet all those deals ended up working out. Had that rescue not happened when it did, you might see very, very different numbers out of private equity.

1:05:01Now, there might be an argument that private equity is always going to be on the beneficiary side of that. That might be true, but it also might not get rescued in some further period, especially with the imbalances in our society and with moms and pops wondering why they're rescuing wealthy Wall Street financiers. So there's just a lot of uncertainty in my mind about that. I just think in general, if I had to give one piece of advice to people, I'd just remind them, study financial history. That Jim Grant likes to say, science progresses secularly, but finance progresses cyclically. And that most ideas have been around before, and we repeat the same mistakes and there's a lot to learn from studying past periods.

1:05:44Obviously, I didn't live in the Great Depression, but I feel like even studying that has prepared me for bad markets. It's prepared me to make really tough decisions. It's informed me of how bad things could get and yet also emboldened me to understand that if it's not the Great Depression, maybe down 40 or 50 percent is actually a pretty steep decline. So I think the history helps center us on what a reasonable range of outcomes might be while we never lose sight of what the extremes of history might dictate. When you combine that study of history and this very uncertain and in some ways unprecedented time, how does that translate into how you're positioning the portfolio relative to how you have in the past?

1:06:29We've been yield starved like everybody else for the last 12 years until rates started to move up a year ago. We like credit. Credit often is misunderstood, lends itself to inefficiencies. When a bond gets downgraded below investment grade, there can be a natural constituency of holders who want to churn out of that, and that can lead to pricing inefficiencies as well. So we like to look at credit. We like distressed credit. We like bankrupt debt. We're not rooting for it to happen, but it's a playing ground. We can hunt through when those markets exist. When there's hardly any distressed credit, that post has to look elsewhere.

1:07:08So in the 2010 to 2012 to 2021 period, we focused more on some private markets and private inefficiencies, real estate for one, private equity for another, but it doesn't look a lot like other people's private equity. It looks like more one-off hairy deals of some sort. that are mispriced for a particular reason. Now, we've rebalanced into credit. Everything we do is bottom-up. It's not top-down asset allocation, but we found enough debt to make that about 15 % of our portfolio, and that's been pretty steadily growing. This is not anything like peak opportunity, but I think could continue to increase depending on what happens with inflation and what happens with the economy.

1:07:51You could even have an economy where interest rates go down, inflation gets tamed, but that's accompanied by an economic downturn and that could lead to more financial distress. A lot of companies have taken on way more debt than probably would be that prudent. So that's probably the biggest change in the portfolio. We are pretty well hedged. We don't try to hedge every ounce of risk. We never have. We're not a zero beta fund or anything like that, but we're protected meaningfully against some pretty extreme scenarios. It wouldn't surprise us to encounter those, that we don't really understand the degree of exuberance in the market.

1:08:28There were certainly individual stocks that were oversold in the downdraft of 22, but the overall market did not really reach bargain levels. Maybe it reached fairly price levels and now has rebounded again to overpriced levels. I'm not making a market prediction, but I do think there's vulnerability. While our credit exposure has gone up or equity exposure has gone down somewhat, and we're trying to focus a greater percentage of the equity book on positions with catalysts. I'd love to take a step back and talk a little bit about the business of Baupost. For a long time in the early years, you didn't have any clients except for the family.

1:09:06And then I guess, I don't know, 15, 20 years ago now, you did bring some institutions, but you've been very careful about who is an investor. What's your perspective on the importance of that alignment between what you're trying to do and who your investors are? We took families by word of mouth in the early years of Baupost. So maybe we'd add a family or two a year. But even with that, our assets were still in the couple of hundred million dollar range 10 years in. And we took our first institutions in 98. So we're probably coming up to our 25th anniversary of that. And they've been great partners because they're aligned.

1:09:39Every type of client has its solidity. We love individuals because we can explain what we do. Our founders were individuals. individuals tend to think about protecting on the downside at least as much if not more than institutions who maybe can take a longer-term view, who are in competition with each other in a way that individuals aren't necessarily. But both types have made fantastic clients. We've been very careful to avoid hot money-type clients, short-term thinking-type clients. The alignment is one of the most important success factors for any investor. If you don't of long-term oriented clients, you can't make long-term investments.

1:10:19And since I have no idea how to make short-term investments that work, I don't know how people without long-term money can invest. So it's very important to have a courtship period where you meet with clients. Literally, I've had people offer us money and I've said, I won't take your money until you read this annual letter and you read the last five years and you understand what we do and you really appreciate because we don't want to be out of alignment where we think we had a pretty darn good year and you don't. So let's talk about what we are trying to achieve, what's attainable and what's not.

1:10:52And I think those kinds of things have served us a really good stead because it has led to a much greater overall alignment. I think the endowment world especially matches well for us. The endowment world following your and my mentor's wisdom, Dave Swenson, over a lot of years has worked hard to form long-term partnerships with managers. And those long-term partnerships are ones of trust and trust being concretized through actions and performance, teams getting to know each other, not top person to top person, but deeply enmeshed throughout organizations. And I think from the institution's perspective, the ability to follow a manager through thick and thin that you can read a brochure, you can talk to somebody for an hour, but you don't really know how they're going to handle adversity.

1:11:43You don't know character. And so it takes a long time to see that play out. And the same thing from the manager perspective, that it helps to see how the client behaves and will they be a good long-term partner? Will the capital be there when you need it the most? And so I think that alignment is perhaps one of the biggest keys to investment success over a long period of time. How have you thought about the legacy of Baupost? Let's say you do this another 40 years, but at some point in time, you may not be doing this. I'm very cognizant that I can't and shouldn't be doing this forever. I think Warren and Charlie are great exemplars that you can still be doing this into your 90s, but I don't think I should be running Baupost more than another 15 or so years.

1:12:30Maybe I'll still be involved in some capacity. People have done a good job in some cases of stepping back, still playing a role. And I'd like to think as long as I'm sharp, that the investment skill set actually is cumulative additive thing where you may be not familiar with the latest change in technology in the world, but you have a large amount of perspective on what are good entry points and exit points and where risks might lie. So I'd like to think Baupost will succeed past my tenure. The reason I think it is. We've been a great thing for our clients. The clients have made a lot of money with very little drawdown in the bad years.

1:13:09And the team at Baupost has prospered and we've got a 250 plus person firm. And a lot of people have made their entire careers here. We're very proud to say we have people that have been here not just five or 10 years, but many people, 20, 25, 30 year anniversaries, which we enthusiastically celebrate. A good thing that serves interest of employees and clients ought to be around. I will need to pull back. I will need to continue to delegate like I've been doing and find more things to delegate. And I continue to do that. I continue to push people to take on more responsibility, give people promotion opportunities.

1:13:46And truly, I think right now, we not only have a deeper partner group than we've ever had and as talented as ever, but we also have a very, very deep middle of people that have joined the firm in the past three, five, seven, 10 years who have tremendous potential already contributing at a high level. So I'm really excited at what the future can bring. But I know a lot rests on my willingness to give up responsibility and my ability to do it cleverly so that it takes hold. So the impetus for you doing this was your editing of the seventh edition of Graham Dodd Security Analysis. I'd love to hear any reflections you have on value investing of some of the contributors that you brought in to the book to write new chapters on different investment disciplines?

1:14:33I was a co-editor of the sixth edition, and we had the idea in that edition that none of us were going to take the fifth edition or an earlier edition and strip it down and provide fresh examples. It would have taken five or 10 years. Certainly nobody with a day job like mine could do that. So we wrote covers over each of the important sections. So we wrote about a historical perspective. Jim Grant provided that. Jim's such a brilliant historian. Roger Lowenstein provided a perspective on what the market had been up to since the prior edition. And so they both did a reprise of that for this edition.

1:15:13Jim's piece is fabulous. I didn't think he could top himself, but he wrote again about what the world was like in Graham's day and how an investor ought to think about that today, the importance of financial history, as I emphasize. Roger wrote about the last 15 years. Frankly, it was very helpful for me because living through it still isn't the same as like a play-by-play in your ear, but remembering all of the fads and bubbly aspects of the last 15 years and how long and painful that's been for value investors because money has tended to flow into growth and out of value, some of which, by the way, justifiably, because disruption and a lot of businesses have had their long-term prospects damaged.

1:15:56But nevertheless, I think in many ways, a big overshoot as people have become less patient and less willing to hold any investment through thick and thin. The most important thing I think we realized is that Graham and Dodd wrote about equities. They wrote about credit. They did not write about international. And so we have a section on international investing and what's different about it. They did not write about private asset classes, which are really important. They're really important about post. I think they're really important in general as a way to think about where value is. The David Abrams section on the lessons of investing in both public and private assets and how they hand in hand can make you better at each, which is what Warren Buffett says, that I'm a better businessman because I'm an investor and I'm a better investor because I'm a businessman.

1:16:46And then Seth Alexander, who's another wonderful protege of Dave Swenson and somebody you and I both know and appreciate, wrote about endowment management. And I wanted that because I wanted the perspective, not just of somebody who's picking stocks or bonds, but somebody who's actually in the business of giving out money to money managers. Somebody who's thinking about stewarding a large pile of assets over a very long term period and doing it in a unique way that is differentiated from what everybody else in the field is doing. and I know I got the best example of that out of current endowment management.

1:17:23What a great thinker Seth is and a wonderful guy. And he jumped on the chance to do this, which I wasn't sure I'd be able to get him. But truly, it's a broad group of contributors. I mean, we have Todd Combs, who is one of the right-hand men of Warren Buffett. He doesn't talk much in public, but he has a great section about bottom-up fundamental analysis and how important that is to him and his approach. We have somebody who's not been heard from that much, Dominique Miel, but she wrote a beautiful book about her investing called Damsel in Distressed. She was focused on distressed debt when she was at Canyon Partners.

1:17:58She's funny and a wonderful writer. Dominique has a great section. Nancy Zimmerman has a really important section on arbitrage in investing and how to think about that in terms of market inefficiency and value investing. but I could go on and on. It's a really strong group, a variety of different approaches, and I think it holds together really well. I didn't say it, but I wrote the preface. That was meant to be, as good as I know how, what has changed in the last 15 years and what has changed in the last 89 years. So when you take Graham and Dodd and you say, this is the Bible, this is what they wrote, what part of it still applies?

1:18:36What's the intel inside? Where's the beef and what has changed, and to do both of those with an attempt to have this be that if nobody updated this for the next 50 or 100 years, there'd still be a lot of beef here for future readers, which I think we've accomplished, but we'll find out. Seth, somehow we've gone an hour and a half without mentioning the phrase margin of safety. So I feel like I have to ask you about the one book that you wrote and whether you have any reflections on margin of safety that you wrote 30 years ago now, and whether you're thinking about an update to that high-priced, scarce book, only available on eBay.

1:19:15It truly has gone out of print. Maybe at some point I'll bring it back. I have an idea in my head of what might be a companion edition that could make sense of bringing it back in some way. When this project came up, I knew that I could only do one, or at least one at a time. So I thought this thing deserved to be updated. A lot of change in the world in 15 years. I thought I knew a good group of contributors. And when I called them to see if they'd be willing, and they all said yes, I felt like now I had to go forward. But I got a great team. There's some ample reason that I could redo or new addition of margin of safety.

1:19:48I would talk more about process. I talk about culture at an investment firm. I talk about the flexibility of approach in that you don't need it to look exactly the same as it looked last year or five years ago, that the markets evolve, the kinds of securities that exist evolve. I would talk much more about private investments and the applicability of Graham and Dodd principles to private investments. I did some of that in my preface, but I would greatly elaborate on that. And look, the other thing about margin of safety is it's 30 years old. And I think part of it was meant to be just an intellectual continuation of intelligent investor.

1:20:23And I think I achieved some of that. There are some things in it I wouldn't write today. Some things I think are just wrong. I didn't really do a good job on understanding the value of intangible assets, for example. The world of distressed debt still applies and is still really interesting, but there'd be whole new sections on that because the game has changed and for the worse probably. So there's a lot to be said. There's an old saying somebody told me after I wrote that book. The saying is, it's good to have written a book. It is good to have written a book. It's not good to be writing a book.

1:20:56And especially when you've got a day job. It was hard enough when I wrote that book that I had two small kids. So my hands are full, but it's not impossible that I would bring it back in some way. I still love that I stole the title blatantly from Intelligent Investor because it's such a great expression and it really captures what a value investor tries to do. You need to leave room because you might be wrong. Markets might go against you. But if you're patient, you can find a margin of safety. And having one means you're likely not to be in tears when a lot of other investors are. I'd love to circle all the way back to the beginning with your studying of baseball stats.

1:21:35And I want to ask you about two personal investments, which may not at all fit into your value investing framework. So one, which you've been involved with for a long time, the Boston Red Sox. How did you think about that as an investment when your day job is so focused on the analytics of value investing. So as a lifelong baseball fan, as a Moneyball fan, as a Red Sox fan after I transplanted up here, the story behind it is somebody had approached me to buy into the Celtics when that franchise changed hands something like 20 years ago. And I thought about it. I thought hard, but I passed because I felt like my true love was baseball.

1:22:18And I said to the sports agent who was marketing it, look, I'm going to pass, but if you ever see a slice of the Red Sox, give me a call. And four or five years later, he called. He was a former Patriot, actually. He was a wide receiver for the Patriots, Randy Vitaha. And he called and I bought somebody else's steak. I didn't know if it would be a good investment. It was probably 30 times current cash flow. What I thought was it would be fun. And I said to my wife. I said, this might be crazy. It's not money we absolutely have to have. And it might be a good investment, but it's bound to be fun.

1:22:52It turned out to be a way better investment than I would have thought, as good as any investment one could have made. There was a fractional interest in the team. And those were trading probably relatively inexpensive compared to where the team would have traded. And the team has done a brilliant job under the operational leadership of Sam Kennedy, who's the best COO of anything in the whole sports world, which I think most people would actually agree with. And they've grown the value of the business enormously. John Henry and Tom Warner have also built a huge amount of value in their activities and their leadership.

1:23:22So it's been great. And it turned out to be a value investment. I didn't know it was, but the real return has still been the fun. It's just been enormously fun to be part of it, to go to meetings and express a few thoughts here and there. And my wife and I go more than we ever did. And that also So it's been fun, not only for me, but for her as well. So the other one circling back to stats and sports and maybe even Baltimore, you've been involved in horses. Yep. And I think twice had a horse win the Preakness at Pumaco. Yep. We'd love to have you share a little bit about that experience and horse handicapping as it relates to investing.

1:24:00So when I was a kid, we used to go to the races after school, literally junior high school. We'd run home, throw our books down, head up to the track. They'd let you in free 10 minutes before the eighth race. And you'd bum a program and a racing form off some old guy who was leaving. And you'd handicap quickly and put down a few dollars. Or sometimes you get an old guy to bet for you as well, since you were too young legally to do it. Then I'd go home and do my homework. So I just love the analytical experience of handicapping. It's not the same as investing, but it has commonality. You take in enormous amounts of information.

1:24:38It's highly disparate. You need to factor in so many different considerations of the horse and the trainer and the jockey and the track condition and the distance and who else is in the race and likely pace scenario of the race. You need to factor in a lot. And I love that analysis. At some point, a friend from childhood said, why don't we buy a horse together, which probably happens a lot and it's always a terrible idea. It was a terrible idea in terms of making money. It was a fun idea, and that led me to stay involved. And so I have horses and have been incredibly fortunate in the last couple of decades to win the Preakness twice.

1:25:20It's a race that, for me, it's as good as winning the Derby. It's the middle jewel of the Triple Crown. Well, it's not the Kentucky Derby. It's really special. And to do it on my home field three blocks from where I grew up is very special. So that's been a lot of fun. I know that you don't often do this when it's not tied to philanthropy. So I wanted to make sure I had a chance to take the opportunity to get your thoughts on philanthropy. Just to touch on this, one thought about philanthropy relates to this book because I pledged all the proceeds and royalties from this book and as well as a masterclass I recently did to increase diversity in the investment field.

1:25:59So I'm giving all of the money to three organizations, SEO, something called Lighted Pathways, and Girls Who Invest, all of whom are bringing people that are underrepresented in the investment business into the business. This summer, Girls Who Invest, for example, has 207 scholars who are rising college juniors who have found out about the program, applied to it, it's selective, and are going to be scattered out at different investment firms and endowment offices and other related types of enterprises and getting exposure. They get trained at Wharton for five or six weeks, and then they do their summer job for the next six weeks.

1:26:41Not everybody will love it, but a lot of people have their eyes opened. This summer, Bowpost will have three girls who invest, but about a dozen interns total spread out across the organization from IT and HR and communications. We have interns pretty much up and down the organization, and we feel great about it. It's good for our team to be doing that. We actually have long been convinced that having a more diverse team makes us better as a firm. Diversity of thought, diversity of experiences, challenging existing thinking, it just has to make us better. And so we want to always be part of that.

1:27:19This was an example of philanthropy to further an end. My wife and I formed a foundation over 30 years ago when I first started to make real money. We joined the Giving Pledge a number of years ago. We've already given away over half and continue to make that a priority. It's a lot of fun. It's a challenge. Philanthropy focuses on the world's problems, and they're called problems for a reason. If they had easy solutions, they wouldn't be called problems. We work on some things in biomedicine and healthcare. We are doing some really interesting things in Israel, both in medical research, but also So with the Arab population, trying to bring people into the 21st century in terms of diversifying their workforce and creating opportunity for kids of all backgrounds in Israel to get a great science education and then to have career opportunities and working with companies to be more welcoming to people to end up with more diverse workforces.

1:28:17And it's actually taking off. It's actually starting to work. And we feel like that's one of the really important things we're doing. We do a lot in the local Boston community and beyond the Massachusetts community. Probably the single biggest area right now is democracy funding because you know about how threatened American democracy is in terms of what happened in 2020, but also in terms of kicking people off the voter rolls and gerrymandering and making voting harder in general. This is not what a healthy democracy does. and of all the things I want for my kids, obviously I want good health, but I also want them and their kids and their grandkids to live in a democracy.

1:28:59Democracy has been the most important thing in my life that I can't imagine what my life would have been like if I didn't grow up in the United States or Britain or Canada or somewhere. I don't want that for them. And a lot of the trends are disturbing and we're in a very difficult, fraught time for America. I obviously want the country to come back together, but I especially need it to come back as a democracy. So that's become a very large area of funding. We're focused on organizations that protect the vote, organizations that defend against litigation, organizations that are fighting gerrymandering, that are innovating in types of election structures that might lead to better outcomes, maybe more centrist candidates.

1:29:40Well, Seth, I don't want to let you go without asking a couple of fun closing questions. So what's your favorite hobby or activity outside of work and family? I'm a Red Sox fan. I love going to the Red Sox. I love thinking about their next move and imagining what the GM job might be like, because it's, I think, not that different from a PM job, only much harder. What's your biggest pet peeve? I think as an individual, I don't like people who take each other for granted. I think that it's easy to get busy. It's easy to go on autopilot. But I think it's really important to stop and ask the extra question, especially care about the people that you care about and live that way.

1:30:20In investing, I get frustrated at the short-term orientation. I think it's so pernicious. It's easy to fall into that trap. And to have investment success, you have to fight that successfully. I also get stuck on the idea that stocks can be valued to the penny, that I believe in the concept of a range of value, that there's no exact price for a business. When you read Wall Street reports, they see our price target is 50 to 50. Why don't we say between 50 and 60? But if you buy it at 35, you're okay. I think that would be for the best. What investment mistake have you made that you'll never make again?

1:30:59This isn't a profound one, but it's my first one. And I don't know that anybody knows about it. I've never talked about it. But in the earliest days of Baupost, we had this great idea There was a closed-end publicly traded mutual fund that had omitted some dividends, and it was in arrears. And as you know, they have to clean those up before they can pay common dividends. And this company had announced that they were going to be cleaning them up and paying a giant dividend. And the stock went up a lot to what I thought was full value. So I sold it. And then I realized I was two weeks away from going long-term.

1:31:34So giant mistake just from sloppiness. Now I have an operations team that would never let that happen. Back then, I didn't. I knew it, but I didn't stop and check. So it just made me realize, again, how you have to check every detail. Which two people have had the biggest impact on your professional life? I think there are three, but they're in different categories. The two are Max Heine and Michael Price for mutual shares. From Max, I learned to be kind to people. and from Mike, I learned to never stop pulling threads. But the third is my wife, who's been so supportive that without her and everything she did to organize our family and take care of the kids when I was unavailable writing my book or working or on a business trip, I couldn't have done it.

1:32:22So it would be those three. What's the best advice you ever received and in what context did it come to you? Max Heine told me that I ought to take a Dale Carnegie course on public speaking. And I didn't know what was behind that. But when I reflect back, being able to communicate your ideas, being good public speaker, being comfortable with that are just so important. Max saw in me that was an area that wasn't as strong as it could be. And so almost 40 years ago, I give him enormous credit. I'm glad that I took his advice. It was so spot on. What teaching from your parents has most stayed with you?

1:33:04Philanthropy. Mom and dad got divorced when I was young, but each of them wrote checks to their colleges, wrote checks to various organizations that were on their near and dear list. And I found that motivational and inspiring that I realized that it's also important to me the same way to give back, to repay organizations that have benefited you in your life. All right, Seth, last one. What life lesson have you learned that you wish you knew a lot earlier in life? Something a famous investor said to me once, which is to never be afraid to bet on yourself. Obviously, my career path was a bet on myself, but I also probably would have done even better if I had had more confidence about the uniqueness of the kinds of opportunities I was finding earlier in my career.

1:33:53I never want to look back. I never want to whine and complain about coulda, woulda, shoulda, maybe I could have made a few more dollars. But I think the advice that don't be afraid to bet on yourself is really important. It's advice I give to young people all the time. I don't tell them to go start a fund. But once you're out there, once you feel ready, don't sell your business, apply yourself, make your business as good as it can be. So that applies to me too. We each bring whatever qualities we have and whatever dreams we have to everything we do. I was just fortunate that I had the opportunities I did.

1:34:28And I think part of that advice essentially is make the most of the opportunities that are made available to you. Seth, thanks so much for this rare opportunity to take so much time and share your great wisdom and experience. Thank you. It was a lot of fun as you predicted. Thanks for listening to the show. If you like what you heard, hop on our website at CapitalAllocators.com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time.