Will Baupost Follow Its Own “North Star” Amid Challenging Quarter?

For those investing in hedge funds, timing their allocation on a drawdown has always been a difficult if even controversial topic among allocators. Tiiming the investment after the point at which a hedge fund has exhibited significant mean reversion has practical execution hurdles as well requiring nerves of steel. Hedge funds, too, have similar issues in investing after a market has experienced significant losses, as a recent Baupost letter to investors reviewed by ValueWalk illustrates.

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The question that remains un-answered after Baupost's reported negative year to date performance is: Did the potential king of finding value in drawdowns, the value investor that has a history of delivering annualized average performance in the mid teens while keeping significant cash on the sidelines -- did this hedge fund follow its investing "North Star" and invest on a drawdown in October? That answer remains elusive, one perhaps answered in a short period of time that might point to the "emperor of drawdown value investing" to rival the "bond king." The answer was not provided, but the question was set up in a recent Baupost letter to investors reviewed by ValueWalk. Although it is all theoretical since Seth Klarman's Baupost Group remains closed to investors.

Baupost's Brian Spector addresses the “chutzpah” required to invest in an irrational stock market

A retiring Brian Spector, as reported by Julia La Roche of Business Insider, writing the October 15 Baupost letter to investors, noted the “chutzpah” it takes to invest in a falling and rising tide market. It is often a skill that is more easily discussed than actually executed. For instance, on a mathematical basis, investing in activist Bill Ackman would be advised. One year from now with the comfort of hindsight the investment in Ackman’s hedge fund when all the chips are down the decision would seem clear. But in the moment, the uncertain present, the decision to invest in a hedge fund, a general market or a stock can seem uncertain at best in crisis if not the equivalent of diving off a cliff in the middle of the night without visibility into what lies below. To effectively invest on a drawdown, investors “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,” Spector wrote.

From one perspective investing when the “tide goes out” in the stock market is easier than investing in a hedge fund where the investor capital went out. Why is this? Investing in a hedge fund on a drawdown requires understanding human emotion guiding decisions in which that being invested. Unlike a general market, which has no individual emotion that can become a statistical outlier, investing in a hedge fund after they have experienced significant loss requires confidence that the individual fund management, often reflected in one individual at the top, won’t lose confidence, change their approach or adjust the strategy during periods of stress. After the tide goes out for a hedge fund manager, that is the worst time to tweak a strategy as emotions are likely to creep into individual perspectives. General markets can be driven by emotion, to be sure, but that emotion reflects the wisdom of crowds -- or more appropriately the lack of wisdom, which creates a value dispersion opportunity. The individual human factor does not play as big a role as it does when investing in a hedge fund on a drawdown.

What's amazing about Baupost is how they delivered annualized returns in the teens with significant dry powder on the sidelines

Spector, when trying to explain how Baupost, now with $27 billion under management, has succeeded over time at delivering a notable 17 percent annualized return since exception, addressed a common strategy point, a guiding light that does not change, a “North Star which guides everything we do.” For a fund to have a guiding principle that they can turn to in good and bad times keeps the portfolio managers, the institutional investment managers and entire staff focused during the bad times, which 2015 might be categorized as such.

Baupost was down -6.6 percent through the end of September,  Sabrina Willmer of Bloomberg reported. The date of that reporting is important, because Baupost’s recovery performance will tell a lot about how closely the fund sticks to its own "North Star.” Those privy to Baupost’s monthly performance in October and November – both the performance and the investment letters are a guarded secret – will be able to determine two key questions: the degree to which healthcare dragged down the entire fund portfolio but almost more importantly investors can determine, to a degree, if Baupost stuck to their core investment value philosophy.

Did Baupost invest in the market, use that legendary "dry powder," during the September sell-off?

Spector addresses the core that, in hindsight, should have kicked in during the nasty third quarter of 2015. “Rather than adjust our investing style to keep pace with the markets, we strive to maintain our philosophy, way of thinking, and process, regardless of market conditions,” he wrote.  Spector wrote that occasionally a general market environments becomes significantly dislocated from common reality, as normal market conditions disappear and fear, panic pervades as participants rusn for a small exit that increasingly becomes smaller as more people search for it. This point might be considered “a tide market” where “distressed sellers, illiquid securities, huge redemptions, and an excess of paranoia and fear” grip investment decisions.

This is common, a feature of human nature. What can make certain investment managers elite is how they handle panic, fear and despair. “We quickly find a number of interesting opportunities, deploying our significant cash balances as we trade our precious liquidity for mispriced securities,” Spector wrote. Baupost is noted not just for its strong investment returns in both traditional and non-traditional value investments, but also its high cash balances that it uses to deploy when a market environment temporarily jumps off the rails. It is difficult to nail the exact bottom in investing in a hedge fund manager or a general stock market after a drawdown.

Nailing the exact market bottom is celebrated but lucky, the real skill is consistently executing on a disciplined strategy

While buying at or even near the statistical bottom of a market is the highly praised tactic, hitting the exact point of a drawdown’s exhaustion is really more an exercise in luck. What really matters – and goes generally unnoticed in the mainstream – is how consistently a hedge fund investor invests during market dislocations. “We may lose money in the short term, as we add to our portfolio while prices are dropping,” as Spector outlines the risks in such a strategy. “But when markets turn, we expect multiple years of strong profitability.”

Is this what occurred during September and October?

From one perspective the most recent market sell-off was a difficult drawdown to play due to the double bottoming in the stock market in general. Adding to the confusion to those with general healthcare overweight exposure was the breaking into new lows in the healthcare sector. Baupost, who was exposed to the “Valeant effect,” a negative shadow cast on the entire healthcare arena, might have looked at the break to new lows in healthcare and emotionally thought it was a turn in the entire market. Did Baupost pick apart the "bad boys" in the healthcare industry while finding values such as Horizon Pharmaceutical, which is up significantly -- near 15 percent -- since ValueWalk wrote about a hedge fund manager investing in the industry "good guys."

“We work furiously to understand the drivers of the investment,” Spector wrote. That’s interesting. Did he understand that healthcare was generally down due to what has been perceived as the actions of a few bad apples in a generally good bunch? If this was the case, an investment in the general healthcare sector minus the bad boys might have taken place in October. Or did Baupost think the entire market was headed lower?

“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?'" Did Baupost apply this stated logic to the most recent drawdown?

For Baupost investors, the hedge fund that is arguably among the elite at investing on a drawdown market – if not the very emperor – had an opportunity to put on display this rather unique talent for discipline under immense pressure in October. In fact, the “Margin of Safety” investment theory, written about in a rare book written by Baupost founder Seth Klarman known as the “North Star” of Baupost that now sells for nearly $1,500 per copy, might be visible to investors in the October and November performance of the fund. We’ll have to watch.

Baupost did not reply to a request for comment.

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