Seth Klarman on Inflation

And the basic job offer I got wasn’t “come run a fund.” It was “come join us and let’s figure out some more things to do with the money.” [14:46] BARRY RITHOLTZ: So eventually you become the lead partner there. [14:50] SETH KLARMAN: I don’t know if CEO is right, Tom. I wasn’t CEO for the first seven or so years, and then I became CEO and effectively got control of the firm — as sort of a handshake deal where we agreed that if I worked hard and did well for the clients, they would recognize that with a stake in the business. So I had no stake the day it was formed and ended up with over half. [15:16] BARRY RITHOLTZ: You ended up with over half. That’s amazing, 40-something years later. [15:20] SETH KLARMAN: Now much less, because I’m a big believer in sharing the pie with my team. [15:25] BARRY RITHOLTZ: It makes a lot of sense. Let’s talk a little bit about the timing. You mentioned there was a lot of turmoil and stagflation. The previous 16 years — I want to say the inflation-adjusted returns were something like down 75%, ’66 to ’82, something along those lines. ’82 was the beginning of a historic bull market. How did that affect how you thought about risk, how you thought about opportunities? What did the markets look and feel like in ’82, when, I imagine, most people were still pretty bearish?

And forced selling — you never want to be a forced seller, and you especially want to be able to buy from forced sellers in any asset class if that comes along. I’m not a mountain climber or a big hiker, but if you’re going to climb a mountain, you want to look bottom-up: is this the right trail, is it safe, do I have my equipment, am I prepared? And then you also want to have the top-down view — what’s the weather? What if it suddenly gets snowy up there, if the wind’s 60 miles an hour, how am I going to handle that? So you kind of want to have in your head the weather forecast. I’m always thinking about, is this environment safe? In today’s market, it feels stretched, but it also feels like we’re on the brink of an unprecedented technology, an era that might be one of very substantial prosperity, but also one of risk to society and great change. So bottom-up still feels like the right way to invest, but you still need your eye on the weather in the financial markets. That means, where’s GDP going, what’s the national debt, where’s inflation going to take us? I always have an eye on that stuff, but we’re not investing our portfolio based on that — the same way we don’t invest based on a macro view that this country would be a good place to invest in. Rather, we notice a security bottom-up and say, wow, that seems egregiously mispriced. I wonder if there are more mispricings. Maybe we should look at that market a little bit closer.

[38:36] BARRY RITHOLTZ: So let’s talk a little bit about cash. I think a lot of investors look at cash as a drag on their performance — the net return is usually zero or close to zero relative to inflation. How do you think of cash? It’s always been such a historically important part of your toolkit. What sort of optionality does it create, versus the career pressure of staying fully invested at all times? [39:06] SETH KLARMAN: You’re nailing it with your question. You’ve covered all the parts of holding cash. Cash can be valuable optionality. Just imagine you have a reasonably concentrated portfolio, and a large position or two comes off the books. Should you put it to work in a nanosecond? Or can you wait until something really interesting comes along? That’s the origin of us holding cash — positions would come off and we’d hold some cash until something great came along. But not just a couple of percent. With concentrated positions, we have 5% and 10% positions in the portfolio. When two or three of them come off, cash goes from next to nothing to 15% or 20%. So that’s the origin, that’s how we got started with the idea that we would hold some cash from time to time. That said, I would accept that I almost certainly made a mistake in holding cash to that extent. There were times when we were 30% cash and even higher, and I viewed it as valuable optionality.

In a momentum market, is that a bad strategy, or are you just adding risk to avoid the cash risk? [41:46] SETH KLARMAN: We think about our benchmark as an absolute return, not a relative return. So we’re not very interested in keeping up with the market. The market’s going to do what it does — and especially a market this concentrated in a handful of names, which it’s really been for a number of years, with the big names that carry the market often, not always, but often expensive, overpriced. We just think that’s not the right way to think about it. We want to earn absolute return. We want to beat inflation by hundreds of basis points. And if we’re doing that, we’re not going to worry about whether that’s ahead of the market or behind. I think over the fullness of time, a good absolute-return strategy is going to beat the market too. [42:28] BARRY RITHOLTZ: So let’s talk about some of the opportunity sets that you look at. You mentioned equities, we talked about distressed debt. You also make real estate investments, other private investments. How do you think about capital allocation across these buckets? Are you using percentage terms, or are you just purely opportunistic? [42:50] SETH KLARMAN: So we came about these through our experiences. We didn’t just wake up one day and say, let’s be in four different areas. Rather, we noticed that over the transom, interesting private investments were coming into the portfolio.

The past is the past, but moving forward, it looks like they’re going to have real ramp for rents and for occupancy. We’re seeing opportunity here and there to add to a portfolio of assisted living. Similarly, we like certain parts of the real estate office market, especially some outside the major cities, in a few select markets though. And we’re seeing more in other submarkets within real estate. Real estate, as you know, is a giant market — it’s probably got a market cap around as big as the public equity market — but it has a very different capital structure in terms of who the players are and how much capital they can tap, and the opportunity set. So real estate’s interesting. We like looking at it, and we have a team that’s agile and could deploy capital quickly when something comes along. In private investments, it’s opportunistic, and there have been some things to do lately as capital’s pulled back from private investments. For example, in energy and midstream, that’s led to some things that have trickled down to us that we’ve been very excited about — very high return and well-hedged, so downside-protected. So we’re just opportunistic investors. I would say, though, using my top-down lens that you mentioned, we are certainly nervous. We’re in a bit of an economic boom, possibly an inflationary boom. Who knows what’s going to happen with the Strait of Hormuz, and the result of that. And the demand for AI and AI-related investments is so all-encompassing.

If we can’t make an argument for why it’s turned around in the next year or two, it might be nice that it’s trading at a five-year low, but that doesn’t mean it’s not going to be at a seven-year low and a ten-year low. Our time horizon is not that long. We can’t just hold things that don’t perform for five or ten years. Very few people can do it today, and that’s not holding our feet to the fire. All organizations need to demand accountability from the teams. So we always are asking ourselves a different question about what is going to drive the success of this investment, rather than just letting cheap be enough. It’s not enough. [50:18] BARRY RITHOLTZ: Very interesting. Coming up, we continue our conversation with Seth Klarman, CEO and portfolio manager at the Baupost Group, discussing the state of investing in today’s environment. I’m Barry Ritholtz, you’re listening to Masters in Business on Bloomberg Radio. [SEGMENT BREAK] [51:12] BARRY RITHOLTZ: My extra special guest today is Seth Klarman. He is the CEO and portfolio manager of value investing legend the Baupost Group. The firm manages about $22 billion in client assets. So we’ve touched briefly on things affecting today’s environment — the price of oil and inflation. We have a Middle East war. We’re still dealing with a new set of tariffs. It seems like every week there’s a different macro headache. How do you think about the current environment?

We read again this morning that 10% or 15% of some endowments’ entire endowment is in the one name SpaceX. So they’re going to want to sell. Employees are going to want to monetize and go from being wealthy on paper to wealthy in a bank deposit. So that’s a lot of stock for sale. And we have to sell that stock while apparently Google and Facebook need more money, and OpenAI and Anthropic need more money, and utilities need more money for power, and chip companies need to build new factories in America. There’s so much demand for money. I think we’re in a vulnerable place, where ultimately supply and demand for money determines the cost of capital. That’s true in the bond market, and it’s in effect in the stock market. So we might be looking at some supply-demand excess where prices soften just because there’s so much supply of securities and the need to monetize is so great by these private companies. [58:18] BARRY RITHOLTZ: So let’s talk about another imbalance between supply and demand through history, because Baupost has been around for over four decades. You’ve traded and invested through and survived all sorts of different market regimes — inflation, disinflation, the dot-com bubble, the financial crisis, QE and ZIRP, COVID, and more recently the return to, let’s just call it, normalized interest rates. Has anything changed since 1982? Is it just the same screaming from one crisis to another? Or do things eventually sort of moderate, do we learn from these experiences?

What’s the same, what’s different? [59:11] SETH KLARMAN: I think all investors should be students of history, as we talked about. Over the course of history, there are cycles. You’re going to have a cycle where you’re at war, and then another cycle where people are tired of war and you have peace for a while. At some point you have peace long enough that people forget how bad war is, and you end up in another war. You have those similar cycles whether it’s government spending, inflation and deflation, that sort of thing. Even the nature of debt — debt feels great when nobody’s asking you to pay it back, or interest rates are low. At some point that becomes pernicious and a giant problem. So we’re likely to always see those cycles, at least as long as humans are in charge of markets. How do you navigate it? You navigate it by realizing that you may not see the cycle with clarity while you’re in it, but you know there are cycles, you know that what seems to be true today for all time probably won’t be true for all time, and you hold on to that. So again, it goes to the idea of holding inconsistent ideas in your head at the same time: this is both true, and likely at some point to become less true or untrue, and you don’t know exactly how. So how do you hold the portfolio? You diversify. When things are up a lot and become more expensive and the go-forward return is low, you take profits, you trade out.

In his 2023 investor letter, Klarman blamed the Federal Reserve's easy-money response to 2008 for more than a decade of distorted asset prices. He argued that the central bank's suppression of interest rates had driven investors up the risk curve, into leverage, and into lower-quality assets in a search for yield that the policy itself had made impossible to find safely. His critique was structural rather than cyclical. The Fed had not merely lowered rates but had committed, implicitly, to preventing large losses in financial assets. That commitment changed the behavior of every other actor in the system: corporates leaned on cheap debt to buy back stock, private equity bid up asset prices using leverage that depended on low rates forever, and retail investors learned to buy every dip. Klarman's conclusion was that the unwinding of this regime would not be orderly. As rates normalized, the entire scaffolding of leverage built on the assumption of permanently free money would have to be repriced. He framed 2022 as the first installment of that repricing, not as a one-off shock, and warned that the second-order effects - bankruptcies, distressed sales, redemption pressure at leveraged funds - would compound over several years rather than resolve in a single quarter.