Baupost

A letter gives a rare glimpse into one of the world's most secretive — and most successful — hedge funds


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There are two types of investing, according to the departing partner of hugely successful and secretive hedge fund Baupost Group: "needle in a haystack investing" and "tide comes in and tide goes out investing."

One type takes rigorous work as you search for a small number of opportunities. The other, "chutzpah."

The partner, Brian Spector, made those comments in a letter to investors in the $27 billion hedge fund.

The letter, included with Baupost's quarterly update, provides a rare glimpse into the Boston-based fund, which is led by iconic value investor Seth Klarman.

Spector, a senior member of the fund's public investment group, will retire at the end of the year after 17 years at the fund to focus on his family and philanthropy, according to the third-quarter update, dated October 15 and obtained by Business Insider.

Klarman, the author of the famed book on value investing "Margin of Safety," described Spector as "an outstanding investor, collaborator, and mentor."

Klarman also asked Spector to write directly to investors.

"Because of his unique perspective and insights, I asked Brian to draft a letter to you that accompanies this letter. He alone determined the content. I hope you find that it furthers your understanding of Baupost," Klarman wrote.

As of the end of last year, Baupost Group had achieved net gains (after fees) of $23.4 billion since its inception in 1982, placing it amongst the top-performing funds in the world, according to data from LCH Investments.

In more than three decades, it has had only two down years. Right now, the fund is on track for its third annual loss, suffering a "mid-single-digit year-to-date decline" after what Klarman described as a "painful" third quarter.

Dot-com bubble

Spector was 25 when he joined Baupost in May 1998 during the "heart" of the dot-com bubble. It was a tough time to be a value investor — broadly defined as finding stocks that are undervalued by the market and poised to rise.

Back then, some thought that the glory days of value investing had passed.

"Traditional metrics like cash flow and asset values were being blatantly disregarded by the market in favor of newfound metrics such as eyeballs and clicks. High-tech companies were the darlings in a rapidly rising market while less-sexy value stocks significantly lagged," Spector wrote in the letter.

Baupost finished the year down over 12%.

Two years later, though, the dot-com bubble burst, presenting an opportunity for Baupost.

While others were selling off their positions, Baupost continued to buy tech stocks at "remarkable prices."

It wasn't easy. Spector wrote that there were many sleepless nights watching investments they made at bargain prices continue to fall:

The bear market picked up steam and we found a number of stocks trading near or even below their net cash value. We bought baskets of formerly hot technology stocks that were getting pummeled, despite having good businesses with contracted revenues. Although many of these companies were experiencing negative cash flow, their management teams were shrinking headcount to align to the new economic reality and were successfully lowering or eliminating cash burn. It seemed like shooting fish in a barrel. We were buying cash at a discount with an option that the underlying businesses had real value. All we had to do was wait for that underlying value to be recognized. What could be easier than buying cash at a discount?

It turns out buying a dollar for 50 cents is a lot harder than it seems. Every day we added to these positions, thinking we were getting an even better bargain than the day before, only to wake up and watch prices drop further. Other respected investors would often comment about how 'value tech' was a 'value trap,' best to be avoided. It was as if the market was having a 'going out of business' sale and we happened to be the only customer who showed up. While both exhilarating and painful at the same time, what I remember most vividly is exhaustion. After countless late nights at the office, I would head home, collapse on my couch and stare at the ceiling. I was unable to read, watch television, or fall asleep. All I could do was worry about what we might have missed in our analysis.

Ultimately, Baupost was right in its thesis. The market turned, and the stocks they had bought shot up.

What's more, moments like that don't come up too often in the market. It was a "tide comes in and tide goes out" opportunity.

"Most of the time we are in periods of haystack investing," he explained. "We sift through lots of investment ideas to find a few decent opportunities. We sell more securities than we buy and our cash reserves begin to build."

Then, once or twice a decade, the markets "become significantly dislocated" and the tides change. That's when it's time to get in, and it takes nerve.

From the letter:

We see distressed sellers, illiquid securities, huge redemptions, and an excess of paranoia and fear. We quickly find a number of interesting opportunities, deploying our significant cash balances as we trade our precious liquidity for mispriced securities. We may lose money in the short term, as we add to our portfolio while prices are dropping. But when markets turn, we expect multiple years of strong profitability.

Investing in tide markets takes chutzpah. To do so effectively, you need to fly in the face of public opinion, you have to fight normal human emotions, and you have to be prepared to double down on your bets when your conviction is most in question. As Benjamin Graham once said, 'The investor's chief problem and even his worst enemy is likely to be himself.' But most importantly, you have to be at a place that empowers you to succeed—a place that is uniquely situated to take advantage of these market conditions. A place like Baupost.

A typical day at Baupost involves the team sifting through possible investment ideas:

On most days, it offers a menu full of bland, unhealthy, and fully-priced choices. We do enough work on the offerings to make sure we aren't missing anything and often go home feeling unsatisfied and unproductive.

Then, they find something that's compelling and focus their energy on it:

We work furiously to understand the drivers of the investment. We spend an enormous amount of time focused on the downside and the risk of permanent capital loss. We also try to understand potential optionality and upside. We ask ourselves, 'How and when will the market eventually see the situation differently?' Once we have a hypothesis about why an investment may be interesting, we start down the path of trying to confirm or reject our original thesis. Depending on complexity and price, this process may take days, weeks, or even months. Oftentimes we place investment ideas back on the shelf and wait for a lower price. Only when the investing stars line up will we add the position to our portfolio.

We can do this successfully because we have a culture of patience. Even though we work hard every day trying to uncover the next great investment, we only deploy our capital when we have real conviction that we have found one. When we don't find interesting ideas, we do nothing and hold cash. For this reason, I've often joked that I'm 97% unproductive. While this means I better be damn productive the other 3% of the time, it also means exercising patience often and waiting for great opportunities. On the flip side, when an idea has been analyzed and is fully baked, we drop whatever else we are doing, discuss the investment, and make a decision. Our portfolio decision process must be incredibly efficient, as we recognize that good ideas are scarce and may prove fleeting.

Warren Buffett said, 'Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble.' When a great opportunity comes around, it is imperative to size it correctly.

One key reason the fund is able to invest in those big ideas is it keeps cash on hand:

One of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk-adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when we enter a tide market and great opportunities become widespread. Seth has said on a number of occasions in both types of markets, 'If you have great ideas, you will have capital to deploy.' This is incredibly motivating to our investment team.

Aside from discussing how the firm uses the fundamentals of value investing, Spector also delved into the culture of Baupost. Unlike some funds where the environment is super competitive, Spector said that Baupost has a culture revolving around teamwork and confidence in one another.

When a team member finds a good idea, we discuss who should work on it and how it compares to other ideas we are currently finding (as well as other past ideas). This is a complicated management issue. Good ideas are scarce and most investors like to pursue investments they have sourced. At most investment firms, analysts operate as free agents. Their pay is based primarily on the performance of their individual "book." Rather than cooperating and maximizing investment returns for the firm, they are often incentivized to do the converse. This may breed a culture of mistrust and misplaced motivations.

At Baupost, it is just the opposite. This is an area that I believe makes Baupost exceptional and can't be fully understood from the outside. People work together to maximize the returns for our clients, partly because they are incentivized to do so, but also because they believe in one another. No one would want to hand off a good idea and watch another analyst drop the ball. But, since our investment staff is accountable to both the partners and the team, they comfortably make hand-offs, root for one another, and try to help in any way possible. This means reviewing investments, exchanging impactful information and opinions, as well as mentoring one another.

It is a running joke in our industry that portfolio managers look enviously at the teams of their competitors, always assuming the other groups are better. Not here. At Baupost, I've never thought that I would want to go into 'investment battle' with anyone else. Our team is excellent and I believe it has improved as we have grown. (Quite frankly, I wonder if I would even have the opportunity to interview at today's Baupost!) We get along, share ideas, support one another, mentor younger analysts, and have a good time together. I know the part I will miss most about Baupost is the daily interaction with my smart, ethical, hard-working, and funny (some intentionally) colleagues.

He noted that you'd never know what the market is doing based on the atmosphere of the fund's trading floor:

We try to maintain a calm working environment. In order to really understand a firm and its decision-making process, one needs to comprehend how it acts in a period of uncertainty and stress. Are people calm or yelling at each other? Does it feel like business as usual or is everyone paralyzed by all the red on their screens? At Baupost, if you were in our trading room, you would not know if the market was up 5% or down 5%. This is by design. It is much easier to make reasoned decisions without someone screaming at you or second guessing your judgment. It's not always easy, but we try to maintain the same atmosphere and investment process in all markets.

Spector concluded that Baupost's successful long-term track record isn't due to a "silver bullet" of "formula," but rather the 215 people who make up the firm.

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