Like the majority of Baupost's investor correspondence over the years, Baupost's 1994 year-end letter contains some valuable insights. However, the year-end letter is difficult to get hold of in full, although ValueWalk has a copy and some analysis. The 1994 letter is also a gem and we recently saw a copy for the first time.
The market of 1994 has many parallels with today's market environment.
1994 saw a surprise rate hike by the Federal Reserve and the following panic hammered hedge funds, credit funds and foreign exchange traders. The suddenness of the move caught many investors by surprise, unprepared and dangerously exposed. This drove forced selling across the credit markets, and bond prices collapsed. The effects of this reverberated around the world and into developing markets. The Mexican peso fell as much as 40% within one week before coming to rest.
This crash was preceded by a warning from Klarman in his book, Margin of Safety. The concept of the 'yield pig' became a term for investors who were susceptible to any investment product that promised a high current rate of return, without properly assessing the risk that the product carried. Seth Klarman uses Margin of Safety to try and prevent investors from becoming yield pigs, warning that if high yield assets were indeed low risk, they wouldn’t be offering a high yield in the first place.
Seth Klarman wrote the following statement during February 1992:
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“…These days, however, I don’t believe investors are being compensated sufficiently to venture beyond risk-free instruments…”
Klarman's decision to stay away from the credit markets in the run up to 1994 allowed Baupost to take advantage of the credit market turmoil that ensued throughout 1994.
Baupost 1994: Positive returns
After warning about yield pigs, Klarman avoided much of the carnage following the 1994 surprise rate hike and his partnerships all posted positive returns for the year, beating the Dow and S&P 500. This outperformance was a result of Klarman's conservative investment strategy, high cash weighing and a strict discipline to only buy value.
Even in 1994, six years before the dot-com bubble burst, Klarman was reporting that the market in general was overvalued, although he was still able to find bargains.
"Our assessment of the stock market today remains virtually the same as it has been for the past few years: the market has entered a state of near-chronic overvaluation, driven predominantly by enormous cash flows of investment funds into equities rather than any identifiable fundamental development at could justify today's prices… Fortunately we invest in individual securities and assets not markets. Even in the most overvalued of markets some investments become quite undervalued… Since overly optimistic assumptions take time to be proven wrong, no near-term correction is likely…" -- Seth Klarman 1994 annual letter to investors.
Once again, there are many similarities here between the market in 1994 and 2015. Klarman's hunting ground moved from distressed equities, towards distressed debt. Both publicly traded and bank debt instruments that provided the potential for a high return, with lower than average risk.
"At year end, the largest position of each of the partnerships is a stake n the bank debt and a much smaller investment in the bonds of Maxwell Communications. We have also recently taken a position in the bank debt of a Canadian holding company that is selling off its subsidiaries over time. In November our large position in the bank debt of Integrated Resources was exchanged for cash and shares in Presidio, a liquidating entity which holds Integrated's remaining assets. At this time, we are in the process of analyzing a number of other distressed bank credits for possible purchase…"-- Seth Klarman 1994 annual letter to investors.
Other distressed debt situations acquired by Baupost included distressed real estate loans -- pools of loans on various types of property, which in many cases were non-performing. Due to Baupost's size and its talent pool, the fund was able to assess the risk/reward ratio more effectively than other investors:
"…We have found that distressed real estate investments offer Baupost three advantages compared to marketable securities. First, we are able to gather and analyze superior information with which to make a more informed investment decision. Second, we have been able to identify a number of transactions that were priced to involve both less risk and higher return. Finally, direct investments generally have several formidable analysts or the realization of underlying value that publicly traded securities do not…"-- Seth Klarman 1994 annual letter to investors.
An example:
"Colony Land Fund
This is a pool of California and Arizona land loans purchased from the RTC in the late summer of 1993. This pool was acquired at the bottom of the real estate market; we effectively bought finished building lots at raw land prices. It appears that the internal rate of return on this investment could exceed 40%. Baupost regrettably has only a minor interest this transaction." -- Seth Klarman 1994 annual letter to investors.
Baupost 1994: Physical property
Baupost also made several "one-off" property investments during this time. These included four multi-family properties in the Atlanta area for a total of $12 million. One of these properties was sold for an 80% return within a year, and the other three were, at the time of the 1994 letter, producing cash yields for Baupost in the mid-to-high teens. Other property investments were made on similar terms with many of the physical properties acquired through distressed debt trading at significant discounts to the guarantee property's underlying value. There were more than twenty of these single-property investments made at the time.
These debt investments and illiquid instruments made up 54.4% of the Baupost Partnerships assets at year-end 1994 as Klarman looked outside the equity markets for value.
With cash amounting to 13.6% of assets, publicly traded equities and fixed income securities totaled 29.3% of Baupost's portfolio at the end of 1994 and the best performers for the year were as follows.
Crossland Federal common, Brooklyn-based thrift that had been bailed out by the government only a few years before. Carson Pirie Scott & Co, a department store company that had come to the market only a year before and was struggling to live up to lofty growth expectations. The rest of the equity portfolio was populated with the common stock of beaten down communications shares, as well as Klarman's favorite; thrift conversions. C
ompanies in the portfolio included; Cellular Communications, Coherent Communications, Viacom warrants, Paramount Communications, Maxwell Communications, New Dartmouth Bancorp, Grant Street National Bank, Lehman Bros. common stock and Bay Ridge Bancorp common stock. Klarman also held a large number of S&P 500 put options, which came back to haunt him as the market charged higher throughout the rest of the decade.
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