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Seth Klarman: Embrace Your Contrarian Convictions

The recent market plunge has lessons for value investors

 

The Covid-19 virus-induced market tremor has tested the mettle of many investors. After a decade of investment bliss, watching the continuously record-setting S&P 500 come down precipitously then pivot swiftly into bear market territory caused many investors to flee the crowded theater, now on fire.

Given the tremendous uncertainty surrounding the trajectory of the coronavirus and the economic carnage it may leave in its wake, many investors viewed the post-plunge market bloodletting as far too insalubrious an environment to consider purchasing stocks of any kind — no matter how low the price.

The short-term sequence of tumultuous events, from late February to early March, provide an instructional backdrop that illuminates the wisdom of indomitable value investor, Seth Klarman.

What would Klarman have to say about investor psychology on display during the coronavirus contagion? Was the panic of the herd an unforeseen and unorthodox reaction, or from the perspective of true value investors, was it predictable?

Klarman instructs us that these periods of market disquiet, which induce panic-selling and irrational behavior, can present auspicious opportunities for purchasing financially sound companies at prices below their “intrinsic value.” In his book, Margin of Safety, Klarman said that in these situations risk does not disappear, but rather enables a value investor to balance the calculated risk against the margin of safety the distressed share price provides. He wrote:

“There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”

Klarman reminded us that, as Benjamin Graham noted in 1934, intelligent investors, “look to the market not as a guide for what to do, but as a creator of opportunity. The excessive exuberance and panic of others generates mispricing’s that can be exploited by those who are able to keep their wits about them.”

Klarman firmly believes, as did Graham, that human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favorable and adverse—indefinitely into the future. He wrote:

“Then, there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher return. The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk. When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down.”

In 2004, Louis Lowenstein, a Columbia Law School professor, corporate finance expert and market critic, wrote an academic paper which examined investor behavior, which was titled “Searching for Rational Investors in a Perfect Storm.” The following year, Klarman submitted a written response in which he argued that the impulses of greed and fear are too ingrained in human nature to render the market 100% efficient or rational. Klarman astutely noted that even if

“the entire country became security analysts, memorized Ben Graham’s Intelligent Investor, and regularly attended Warren Buffett ’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads.”

Klarman understands and has embraced a central tenet of intelligent investing that is immutable: the inability of most people to buy during spasms of panic selling and to refrain from purchasing when the herd believes the upwards trajectory of the market will continue indefinitely. The guru wrote:

“Markets are inefficient because of human nature—innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions— they simply cannot help it.”

Klarman noted that market cycles will always bring these behavioral extremes to the fore, regardless of an investor’s experience or education:

“People would, in short, still be attracted to short-term, get-rich-quick schemes. People would notice which of their friends and neighbors were becoming rich—and they would quickly find out how. When others did well (if only temporarily), people would find it irksome not to be participating and begin to copy whatever was working today. There is no salve for the hungry investor like the immediate positive reinforcement that comes from making money instantaneously.”

The investor’s words seem almost prescient today and provide a good backdrop for viewing the impulsive reactions of many investors during the recent market meltdown. Klarman suggests that during distressed periods, it is predictable that many investors will always act in the same manner. He wrote:

“A country of security analysts would still overreact. They would shun stigmatized companies, those experiencing financial distress, or those experiencing accounting problems. They would still liquidate money-losing positions as they were making new lows.”

However, it takes fortitude and insight to act on the opportunities available in down markets. Courage is needed to deal with the short-term, at times ephemeral, volatility of the market while remaining steadfast. As difficult as it can be for even the most ardent value investors, Klarman argued that intelligent investors should stay true to their convictions in uncertain times and pursue their contrarian strategy.

In Margin of Safety, Klarman acknowledged the difficulty a committed value investor will encounter under challenging market conditions. It takes a certain temperament and fortitude to have faith in swimming against the prevailing Wall Street tide:

“Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses.

By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.”

The sudden market drop induced indiscriminate investor selling, sending the share prices of many financially sound companies nearly off the charts. Many blue-chip companies pummeled by the market are now selling far below their fair values as going concerns. Some are selling at or below their book values.

Undoubtedly, Klarman would agree that the list of viable potential candidates for purchase during this fire sale is bountiful and worthy of serious review.

John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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