Seth Klarman is More Worried than at Any Time in his Career

Seth Klarman

The concern that the dollars he earns for his clients will lose their purchasing power is always on hedge fund manager Seth Klarman’s mind.   The possibility that the government will continue to print money to solve our economic problems has left him more worried than at any time in his career.

“There are not enough dollars in the world to do that, unless we greatly debase them,” he said.

Klarman has enjoyed one of the most illustrious careers in the investment industry.  As founder and president of the Boston-based Baupost Group, he has compiled a track record of 20% annual returns over the last 28 years.  Most remarkably, in only one year has he lost money.

He spoke at last week’s CFA Institute annual conference, where he participated in an hour-long question-and-answer session with author and Wall Street Journal columnist Jason Zweig.

This article is longer than usual, since we are providing comprehensive coverage of Klarman’s remarks, from start to finish, on topics including how Baupost is organized, market valuation levels, the investment industry and how he is protecting his clients against a potential decline in the value of the dollar. 

Hostess Twinkies

“A Hostess Twinkie is something that has made many childhoods slightly happier with totally artificial ingredients,” Klarman said. 

That metaphor explains the prevailing environment in the US over the last year, he said, when virtually every market condition was maintained by the government, which kept interest rates at zero, bought up mortgage-backed securities, and installed far-reaching lending programs.

“We don’t know the full extent to which we were manipulated,” he said. “The government wanted people to buy equities, to invest so that the market would go higher, to build the wealth effect so that people would feel better, and to restore a degree of optimism so that the economy might recover.”

He is still worried about what would happen to the economy and the market if those artificial ingredients are removed and “we realize it was in effect a Twinkie.”

That high degree of government involvement continues, he said, with the “gargantuan” European bailout program, which he said is not likely to work and merely “kicks the can down the road,” serving as the latest example.  “It is one more manipulation tempting people to own things.”

“It’s almost like the government was in the business of giving people bad advice.  ‘We’re going to hold rates at zero, so please buy stocks or junk bonds that will yield at least five or six percent so you might make something.’  In effect, it is forcing unsophisticated investors to speculate wildly on things that are fully too overvalued,” he said.

Sophisticated investors are similarly tempted, he said, mostly because they are engaged in a short-term performance race.

The new element in the game

Government involvement is why Klarman is more fearful now than at any previous point in his career.  He said he always thought, until recently, that he could do well by having a good process and a clever approach, and his wits would enable him to find good bargains.

Now, however, he said a new question affects his outlook: will the dollar be worth anything?

His clients are US-based investors, his results are measured in dollars, and he hedges his positions back to dollars.  While he conceded that this crisis might not be different from other crises – and we might successfully recover from it – he is worried that the solution to every problem is to push the problem further down the road. 

Politicians find it easier to “create inflation” than to tackle the serious problems, he said.  He cited newly elected Massachusetts senator Scott Brown as someone with the right attitude and the ability to communicate clearly, and he said we need more politicians like Brown to address those problems.

Klarman said most Americans understand that there is no “free lunch” and that and we cannot indefinitely forestall problems such as budget deficits, but he is unsure whether the current crisis will force us to act in the right manner.

“We didn’t get the value we should have from this crisis,” he said, contrasting the recent woes with the Great Depression, which spurred one or two whole generations to change their values – Americans in the decades after the Depression believed in saving and not borrowing to the point of overextending themselves.  Though the Depression itself was terrible, Klarman said, “it was a great thing to have a Depression mentality.”  

Instead, we’ve had a “really bad couple of weeks” mentality, he said, and that’s not enough to help us avoid future bubbles.