Seth Klarman’s YE2018 Letter: Review of 2018 & Portfolio Management for 2019

Smart Money
  • Returned roughly breakeven for the year ended 12/31/18

2018 in Review

  • Major US stock market indices steadily gained ground for the first 3 quarters before plunging in a highly volatile 4th quarter
  • Generally rising share prices moved in tandem with higher corporate earnings, the result of massive fiscal stimulus, large corporate tax cuts, and historically low interest rates
  • In August, the bull market became the longest on record at nearly 3,500 days and counting; but in October, it was as though a trapdoor had opened under global equity markets; widespread optimism instantly yielded to abject pessimism
  • Sometimes, prices decline unrelated to those fundamentals; but at other times, they are anticipatory of fundamental erosion and can ever be reflexively linked: lower share prices can adversely impact the economy in a sort of “reverse wealth effect”; investors feel poorer when the value of their portfolio falls, so they consume less; management may view the share price decline as a potential increase in their cost of equity, causing them to delay capex or expansion plans
  • “Hard data” such as holiday retail sales posted a very healthy 5% increase y-o-y, even as soft survey and sentiment data such as consumer confidence fell from the October highs
  • Equity market plunge accelerated in December, resulting in the worst final month for the major indices since 1931
  • Overall, S&P declined 4% on the year (inclusive of reinvested dividends); NASDAQ officially entered bear market territory, down over 20% from the highs; small cap Russell 2000 index ended the year down 11%; US government bonds rallied significantly, with the yield on the 10-year note declining from 3.24% on 11/8 to 2.68% on 12/31
  • Major European indices posted declines ranging from 8% to 18%; equities in Korea, Mexico, China, and Turkey all posted 2018 losses of 15% or more in local currency terms
  • For the first time in years, FAANG stocks came under a cloud and their share prices experienced significant declines; AAPL sales fell short and its shares fell 38% from their highs; FB slumped as the company disclosed that it would have to spend substantial amounts to address mounting privacy concerns; AMZN and NFLX ended the year down 26% and 36% respectively
  • Most over-extended asset class in 2018 may well have been private equity; fundraising has set records, with estimates of more than a trillion dollar in capital available to be put to work; multiples of leverage extended in PE transactions is approaching previous peaks, as are valuations of such transactions, while the laxity of financing terms is unprecedented
  • Fed raised interest rates 4 times but late in the year it signaled it would slow the pace of rate hikes in 2019; Fed continued the process of reducing its bloated $4.5 trillion balance sheet
  • If lowering interest rates coupled with central bank asset purchases stimulated economic expansion and a bull market in stocks and bonds, will raising rates drive a reversal?
  • Leveraged loan market has been on fire, with a record $788bn of loans issued in 2017 and just below that pace in 2018; almost 80% of the 2018 vintage was issued as “covenant-lite” compared to about 30% in 2007
  • Credit markets were hard hit in November, with yields on US corporate debt reaching an 8.5 year high of 4.38%; GE at one point hit 6.4% from under 3% earlier in the year
  • Ratio of US government debt to GDP has grown from 74% of GDP in 2008 to 105% in 2017; UK surged from 50% to 88%; France from 69% to 98%; Italy from 102% to 132%; Spain from 39% to 98%; Canada from 68% to 90%; China from 27% to 47%
  • In 2018, US budget deficit soared to nearly $900bn and could top $1tn in 2019, a sorry consequence of the 2017 tax cuts that were funded with borrowed money; growing deficits have ballooned the national debt, which by YE hit a record $21.9tn, this while debt costs are suppressed by low interest rate policies
  • USD maintains its de facto reserve currency status – this is a privilege never to be taken for granted
  • There is no way to know how much debt is too much, but America will inevitably reach an inflection point whereupon a suddenly more skeptical debt market will refuse to continue to lend to us at rates we can afford

The Art of Portfolio Management: Balancing Risk Aversion with Risk-Taking

  • Because investors never know when a storm may arise you have no choice but to prepare for the worst; but since the worst doesn’t frequently happen, you cannot let the fear of a monster storm completely paralyze you
  • The way to build a portfolio that will prosper over the long-term, while avoiding irresponsible exposure to the fiercest storms, involves a constant commitment to fact-based decision-making, diversification, an avoidance of recourse leverage, and the analytical imperative of making conservative assumptions
  • Another key element in portfolio management is curtailing the duration through exposure to investments with catalysts for the realization of underlying value; catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events

Baupost Team

  • Jim Mooney, Baupost’s President, oversees the management of our investment team; in his role as head of Public Investments, Jim is assisted by partners Greg Ciongoli, Josh Greenhill, and Rob Bralower, and managing directors Rich Carona, James David, Jianshu Dong, and Ryan Dow
  • Michael Sperling was promoted to partner effective 1/1/19 and Jesse Downing has been promoted to principal
  • Partner Tom Blumenthal leads Private Corporate team of six principals and analysts who diligently source and manage the firm’s PE investments
  • George Rizk oversees US Real Estate and Asset Management and Mark Tsocanos manages International Real Estate (both are partners in the firm); George and Mark are supported by the managing directors on the real estate team: Nick Azrack, Hunt Doering, David Freibaum, JJ Lenhart, Bill Musto, and Brian Zilla
  • Scott Dunn was promoted to managing director and Luca Lelli was promoted to principal

Seth Klarman is the President and co-founder of Baupost Group, one of the largest hedge funds in the world.

The Baupost Group 2018 Letter, January 2019

Image Source: Bloomberg/Getty Images