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Positioning his portfolio

Since the onset of the crisis, Klarman has moved portions of his portfolio into deeply discounted senior corporate and securitized mortgage debt, which he said offer very attractive returns relative to their risk. 

Investors “overreacted” and sold off these securities, he said.  Valuations were further depressed by legal uncertainties – in some cases, companies must go through bankruptcy before investors will earn satisfactory returns. The analytical complexity of evaluating securitized assets, each of which has unique characteristics, also contributed to their being underpriced.

The “contractual repayment of principal is the catalyst for achieving value,” Klarman said.  For corporate bonds, bankruptcy is an acceptable outcome, since senior securities will be first in line to receive payment.  For securitized loans, a par recovery may be doubtful, but that also limits the universe of potential buyers, depressing prices to more attractive levels.

In some cases, the securities he bought declined in value, which he used as an opportunity to increase his holdings.

Klarman sees fewer opportunities today – a “sudden dearth” that “makes us more than a little bit miserable,” he said.  But he recognizes that “money is made when the crop is planted, not when it is harvested,” acknowledging that he expects a strong payoff from the repositioning of his portfolio last fall.

Klarman is intent on optimizing the duration of his portfolio, a concern he says is often overlooked by investors.  Investments become more compelling as the duration lengthens, but last fall he viewed long-duration securities as too risky.  He believed medium-duration debt offered the best risk-adjusted returns, since the yield curve was flat or inverted for the types of investments he was making.

The big questions

Investors face serious questions, the least of which may be whether the recent green shoots that have cropped up are for real.  Klarman said investors must determine the right multiple to pay for companies that benefit from government backing and when government intervention will end. 

Markets will pay a price for government actions, but he is not sure whether that price will be inflation, a loss of faith in the dollar, or both.

Another dilemma is whether Americans would be willing to accept the pain of slower growth, if that turns out to be the only way out of the crisis.

The biggest question in Klarman’s mind concerns moral hazard, and whether the government has created “the mother of all moral hazards” by instilling a belief in investors’ minds that all crises can and will be solved by government actions.  Such a belief, he fears, would skew every investment decision toward unnecessary risk taking.

In the Dr. Seuss book, The Cat in the Hat Comes Back, a house-crashing cat leaves a pink stain around the bathtub after helping himself to some cake.  All attempts to clean the stain fail, as the mess is spread elsewhere – to a dress, a wall, a pair of shoes, and eventually to an entire yard-covering spot.

Klarman fears government actions to deal with the financial crisis are merely repositioning — and expanding — the stain.  “Our over-leveraged, over-consuming population has been living beyond its means,” he said, surviving by borrowing from foreigners.  Many individuals and governments are effectively insolvent, and we are tackling the problem with more debt while keeping incompetent lenders in business.

Klarman did not say whether he believes the government’s actions will work, or whether they will be forever shifting the location of the stain.

Seuss’ tale, incidentally, ends as Little Cat Z takes off his hat and unleashes a “Voom” – perhaps a precursor to the TARP program – which magically cleans up the yard and restores order in the home.

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