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The Klarman before the storm
By John Newsome on 23rd April 2014


For investors, risk and return are Siamese Twins; you can't obtain the latter without the assumption of the former. As a firm, we are occasionally chided (in a friendly way, it should be said) because when it comes to the deployment of capital, we prefer to focus on what might go wrong rather than hope everything will go right. This is a result of our central proposition, which is that we manage clients' capital in exactly the same manner that we manage our own; or, to paraphrase investing greats like Benjamin Graham and Warren Buffett, we want to see a 'margin of safety' with regard to valuation. If we perceive there is one, we'll consider it but if not, we'll happily pass and hold our fire.


Risk, though, can be a very slippery customer. Sometimes, he's obvious but at others, he's invisible. Last year, I went to Afghanistan (for some reason, Mrs Newsome, who keeps muttering about Hawaii, elected to stay at home) because it's a country I have long wished to visit. Risky? Of course, but was it a wonderful adventure? Most certainly. More than a few people questioned my sanity but was it any more dangerous than using Oscar Pistorius' bathroom? In Middlesbrough, police closed the A66 as they searched for the manhood of a gentleman that had, allegedly, been cut off in a dispute over a woman. They failed to find it which wasn't altogether surprising. If a 350 ton Boeing 777 can vanish without trace, the laws of probability were never on this unfortunate man's side. However, the point is that while infidelity might be expected to have consequences, this was somewhat towards the far end of anticipated outcomes.


Which, in a roundabout way, brings me to the thoughts of Seth Klarman, reclusive Wall Street billionaire investor and a man known for his deep value style of investing; he has even been called the Warren Buffett of his generation. In a recent letter to his investors, Klarman made numerous comments which, not for the first time, struck a chord with us.


Many of his thoughts spring from the distortions that naturally result from the Federal Reserve's mammoth bond buying spree, financed out of thin air via Quantitative Easing (QE). This policy has artificially depressed interest rates which, subsequently, has affected the value of all financial assets. Klarman comments "No one can know what the future holds but any year (2013) in which the S & P 500 index jumps 32% while corporate earnings barely increase should be a cause for concern, not further exuberance. It might not look like it now but markets don't exist simply to enrich people."


With regard to the academics responsible for Fed policy, Klarman notes "In short, the Fed captain and crew are proficient in theory but lack real world experience. This is an adventure into unexplored terrain; the Fed has no map because no one has ever been here before." Which brought to mind the Blackadder episode when, prior to attempting a Walter Raleigh style voyage of discovery, Melchett hands Blackadder a parchment produced by the "foremost cartographers in the land". Believing it has been passed to him upside down, Blackadder turns it over only to find it’s blank on both sides. Melchett adds "perhaps you could fill it in for them".


Klarman continues "Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money will not be free. Someday, the economy will turn down again and someday, somewhere, investors will lose money and once again, come to favour capital preservation over speculation." He goes on to say that "it's always a good time to be risk averse because the pain of investment loss is considerably more unpleasant than the pleasure garnered from any pain". Which reminded me of the famous quip by the late US equity strategist Barton Biggs that "bull markets are like sex; it feels best just before it ends."


John Newsome can be contacted on:
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