Value investing giant, Seth Klarman, issues a warning to all investors
Seth Klarman’s Baupost Group is the world’s 11th largest hedge fund. And Klarman, a renowned value investor, has sometimes been compared to Warren Buffett. So when he offers his analysis, it’s worth reading. Which is why we’re pleased to bring you excerpts from Klarman’s latest investor letter.
“The magnitude and duration of distorted securities pricing resulting from the outsized role of central banks in economic life may be unprecedented. The world is so awash in low cost debt that almost every day in 2016, The Wall Street Journal or the Financial Times routinely reported another market excess. By way of illustration an early October headline proclaimed: “Yield hungry investors snap up 50-year bonds. Hunt for returns outweighs bank fears.” The article explained that the 2.8% yield on these Methuselah bonds was deemed attractive compared to the negative-yielding issues in other jurisdictions. Investors were willing to overlook looming political uncertainty and a slow motion banking crisis in Italy, including the real prospect of a Euro-skeptic political party taking control. Days later, tranches of Saudi Arabian debt, including a 30-year offering at 4.5%, were even more oversubscribed, despite an oil price slump that has devastated the Saudi economy and upended its fiscal situation. And the following week, Austria (Austria!) floated a 70-year issue that was gobbled up despite a paltry 1.5% coupon.
“These top-of-market bond offerings posed numerous risks that investors seemed to be ignoring. First, whenever interest rates return to more normal levels, these bonds are going to trade down in price. Anyone who bet on “lower for longer” will have locked in “inadequate for longer,” an insufficient return not just for a while but for a career, for a lifetime. The market-to-market losses from a mere 50 basis point rise in rates would be equivalent to more than three years of coupon payments for holders of 30-year Treasur[y]s. Second, a pick-up in inflation, or even in expectations of future inflation, would render the meagre yields on these fixed-rate and sometimes very long duration instruments inadequate, causing them to sell off further. Because bonds have been in a 35-year bull market, few investors active today have any experience navigating a sustained secular increase in interest rates and inflation, which from these levels, under the best of circumstances, would make for an exceptionally jolting ride.
“Finally, over the course of time, the credit risk of these priced-to-perfection obligations will almost certainly loom larger, with bondholders again potentially taking it on the chin. Despite minuscule interest rates, a record number of sovereigns were downgraded in 2016. For years, sovereign debt-to-GDP ratios have been increasing in a number of countries. When low-rate sovereigns need to be refinanced, higher rates may savage national budgets, potentially necessitating debt restructurings for marginal issuers. The sheer amount of outstanding debt, $152 trillion worldwide, should have triggered investor concerns. The IMF warned in October, for example, that debt levels posed a mounting threat to the global economy.”
Seth Klarman, The Baupost Group 2016 Year End Letter pg. 3-4
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Mark
:
Hi Roger,
I’ve read several articles here now about the prospect of various asset market declines. As an investor in several of your offerings, this makes me consider whether i have a suitable mix.
I can understand how your local neutral fund ought to withstand market adjustments, and similarly how the long/short montaka might also be shielded by a decline in AUD.
However, my investment in the local long only fund seems at risk of a market-wide knee-jerk correction, despite the funds focus on high quality businesses.
This makes me consider withdrawing to 100% cash, or invest it back into the other funds in order to better protect my capital.
I wonder this, knowing the fund holds a portion of cash already, and that long term the value will eventually shine through. As a patient potential first home buyer, id not like to see a drop in the housing market coincide with a drop in my available capital.
Happy Easter,
Mark
Roger Montgomery
:
Hi Mark, Keep in mind investors tend to do worse than the funds they invest in simply because of ‘switching’. Unlike funds managed elsewhere our long only funds have the ability to hold significant levels of cash (currently rising) and given we are at the coal face, we could be in a better position (and amore conveniently for you) to re-enter the market at an opportune time. Read this blog post Mark: https://rogermontgomery.com/dont-jump-at-shadows-2/
simon oaten
:
an interesting take on “how” CB’s exercise control……
http://bilbo.economicoutlook.net/blog/?p=35303
its “fine” provided you don’t owe externally ……….
as Roger has pointed out “the delta” in PV of lots of Aussie mature stocks is very high to small chg’s in discount rate ……if these co’s have a “miss” …..the price reaction can be amplified
may we live in interesting times !
rgds
sdo
Chris
:
Roger, interest rates within the developed world (US Treasuries as the proxy) are guaranteed within the life of these bonds (50y, 70y) to return to “normal” levels. That’s why I don’t personally hold bonds and especially would not do so now.
It may sound callous, but “more fool them” for buying them and taking the inevitable haircut (and loss of capital)…and outside of a sharemarket correction / crash (which is where my assets are), I don’t see how it would affect me…if anything, bring it on so that I can buy assets more cheaply !
craig.cory.54
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I would imagine these low yield bonds are just the place to temporarily park funds and will be sold down the line to the greater fool (or at marked down capital prices until they do make sense) as rates rise and better options also then become available, the effect of inflation apparently also has it’s part to play but I don’t understand it. Great move for the initiators though – that’s a long, long period of historically very cheap money. Cheers, C.
Euan
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Hi Roger,
I get the money sloshing around from central bank has distorted risk and as such people will be making decisions around investments with less focus on risk… But..the argument from a lot of people I work with (that have 3 to 8 investment properties) is that they have called the RBA’s bluff. i.e. That people now have leveraged so much that the RBA cannot raise rates significantly or it will simply crush the economy, they believe that tightening by the RBA when it needs to be done will be in the form of a 1 or 2%…otherwise Armageddon and why would the RBA do that?
Roger Montgomery
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Wish them well. Rising rates is not the only path to financial stress. Higher vacanices or higher unemployemnt – neither of which the RBA controls – can lead to it too.