Seth Klarman: Worried About Inflation & the Markets ~ market folly

Wednesday, May 19, 2010

Seth Klarman: Worried About Inflation & the Markets

"I'm more worried about the world broadly than I've ever been in my whole career." ~ Seth Klarman

Those haunting words were uttered yesterday at the CFA Institute's annual conference in Boston according to Reuters' coverage. Are you concerned yet? You probably should be. When the investment manager from Baupost Group speaks, you listen. After all, Baupost Group has averaged 20% annual gains. Klarman went on to say, "Given the recent run-up, I'd be worried that we'll have another 10 years of zero returns." That should inspire some confidence, right?

Reuters had two intriguing articles regarding Klarman's recent remarks here and here. Essentially, Klarman is quite concerned about inflation and has purchased far out of the money puts on bonds. These aren't the type of puts that he'll make money on if interest rates go to 5% either. Nope. Klarman is betting on extreme inflation that would require interest rates of 10% for him to make money on the play... that's how far 'out of the money' he is.

While we can't confirm this, it sounds an awful lot like Julian Robertson's constant maturity swap (CMS) trade he put on a while back (see also our explanation of curve steepener trades). Very loosely speaking, these are somewhat like buying far out of the money puts on long term treasuries. They're likely to expire worthless, but if the scenario does play out, these trades can pay out over 50x. While we can't confirm the exact vehicle he's selected for this play, Klarman is merely seeking insurance should this drastic event occur as he wants to hedge out the potential risk.

In terms of current investment pursuits, the Baupost Group manager is looking at private commercial real estate. He doesn't like publicly traded REITs here because they've rallied too much. This is largely in line from what we've seen out of hedge fund land as many hedgies have been short commercial real estate plays to no avail as everyone seems to think they are overpriced and destined for a correction.

Just a few days ago we detailed the latest portfolio update on Baupost Group and saw that Klarman added a couple of new equity positions. However, the main thing to take away from that update confirms what Klarman recently stated at the conference: Baupost is sitting on a ton of cash. The assets on their 13F filing (mainly US equities) only totaled around $1.7 billion and the firm manages $22 billion. While we know Klarman has also invested in distressed assets, do the math there. Apparently Baupost is sitting on over $6 billion in cash (30% of assets) and don't see many opportunities to put that money to work.

Klarman is notorious for always keeping cash on the sidelines should he find opportunities. However, now is clearly not one of those times as he has debated returning some of the money to investors. A compelling investment landscape from over a year ago is clearly no more. The opportunities seem fewer and farther between and it's very apparent Klarman is concerned given the drastic run-up in equities. Many managers feel we're not out of the proverbial woods yet so now would probably be as good a time as ever to review Seth Klarman's lessons from the financial crisis. While Seth Klarman doesn't speak in public very often, those interested in hearing him will have the opportunity at the upcoming Ira Sohn investment conference.

For our recent coverage of Baupost Group's portfolio, check out their new positions in ADC Telecommunications and Solar Capital. We'll leave you with some closing remarks from Klarman: "We'd rather underperform a huge bull market than get clobbered in a bear market." A true investment manager indeed.

Source: Reuters

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