Brian Spector Leaving Baupost Letter - Business Insider

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11/5/2015 Brian Spector leaving Baupost letter - Business Insider

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Seth Klarman, the president and CEO of The Baupost Group.

A letter gives a rare glimpse into oneof the world's most secretive andmost successful hedge funds

JULIA LA ROCHE

NOV. 4, 2015, 3:31 PM

There are twotypes of investing,according to thedeparting partnerof hugelysuccessful andsecretive hedgefund BaupostGroup: "needle ina haystackinvesting" and

"tide comes in andtide goes outinvesting."

One type takesrigorous work as

you search for asmall number ofopportunities. Theother, "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 yearafter 17 years at the fund to focus on his family and philanthropy, according to the third-quarterupdate, dated October 15 and obtained by Business Insider.

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

Klarman also asked Spector to write directly to investors.
http://www.businessinsider.com/author/julia-la-rochehttp://www.businessinsider.com/author/julia-la-rochehttp://www.businessinsider.com/author/julia-la-rochehttp://www.businessinsider.com/author/julia-la-roche


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

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

In more than three decades, it has had only two down years. Right now, the fund is on track forits third annual loss, suffering a "mid-single-digit year-to-date decline" after what Klarmandescribed 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. Itwas a tough time to be a value investor broadly defined as finding stocks that are undervaluedby 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 thedarlings in a rapidly rising market while less-sexy value stocks significantly lagged," Spectorwrote 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 theymade at bargain prices continue to fall:

The bear market picked up steam and we found a number of stocks trading near or evenbelow their net cash value. We bought baskets of formerly hot technology stocks that weregetting pummeled, despite having good businesses with contracted revenues. Althoughmany of these companies were experiencing negative cash flow, their management teams

were shrinking headcount to align to the new economic reality and were successfullylowering or eliminating cash burn. It seemed like shooting fish in a barrel. We were buyingcash at a discount with an option that the underlying businesses had real value. All we hadto do was wait for that underlying value to be recognized. What could be easier than buyingcash at a discount?

It turns out buying a dollar for 50 cents is a lot harder than it seems. Every day we added tothese 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 commentabout how 'value tech' was a 'value trap,' best to be avoided. It was as if the market washaving a 'going out of business' sale and we happened to be the only customer who showedup. While both exhilarating and painful at the same time, what I remember most vividly isexhaustion. After countless late nights at the office, I would head home, collapse on mycouch and stare at the ceiling. I was unable to read, watch television, or fall asleep. All Icould 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 boughtshot up.

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


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and tide goes out" opportunity.

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

Then, once or twice a decade, the markets "become significantly dislocated" and the tideschange. 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 paranoiaand fear. We quickly find a number of interesting opportunities, deploying our significantcash balances as we trade our precious liquidity for mispriced securities. We may losemoney in the short term, as we add to our portfolio while prices are dropping. But whenmarkets 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 ofpublic opinion, you have to fight normal human emotions, and you have to be prepared todouble down on your bets when your conviction is most in question. As Benjamin Grahamonce 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 succeeda 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 doenough work on the offerings to make sure we arent missing anything and often go homefeeling 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 enormousamount of time focused on the downside and the risk of permanent capital loss. We also tryto 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 aninvestment may be interesting, we start down the path of trying to confirm or reject ouroriginal thesis. Depending on complexity and price, this process may take days, weeks, oreven months. Oftentimes we place investment ideas back on the shelf and wait for a lowerprice. 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 workhard 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 dont find interesting ideas, we donothing and hold cash. For this reason, Ive often joked that Im 97% unproductive. Whilethis means I better be damn productive the other 3% of the time, it also means exercisingpatience 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, andmake a decision. Our portfolio decision process must be incredibly efficient, as we recognizethat good ideas are scarce and may prove fleeting.

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

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 wehave generated good risk-adjusted returns despite holding cash. Most insiders, on the otherhand, believe we have generated those returns BECAUSE of that cash. Without that cash, it


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would be impossible to deploy capital when we enter a tide market and great opportunitiesbecome widespread. Seth has said on a number of occasions in both types of markets, 'If youhave great ideas, you will have capital to deploy.' This is incredibly motivating to ourinvestment team.

Aside from discussing how the firm uses the fundamentals of value investing, Spector alsodelved into the culture of Baupost. Unlike some funds where the environment is supercompetitive, Spector said that Baupost has a culture revolving around teamwork and confidencein one another.

When a team member finds a good idea, we discuss who should work on it and how itcompares to other ideas we are currently finding (as well as other past ideas). This is acomplicated management issue. Good ideas are scarce and most investors like to pursueinvestments 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 thancooperating and maximizing investment returns for the firm, they are often incentivized todo 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 exceptionaland cant be fully understood from the outside. People work together to maximize thereturns 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 andthe team, they comfortably make hand-offs, root for one another, and try to help in any waypossible. This means reviewing investments, exchanging impactful information andopinions, as well as mentoring one another.

It is a running joke in our industry that portfolio managers look enviously at the teams oftheir competitors, always assuming the other groups are better. Not here. At Baupost, Ivenever thought that I would want to go into 'investment battle' with anyone else. Our team isexcellent and I believe it has improved as we have grown. (Quite frankly, I wonder if I wouldeven have the opportunity to interview at todays Baupost!) We get along, share ideas,support one another, mentor younger analysts, and have a good time together. I know thepart 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'strading floor:

We try to maintain a calm working environment. In order to really understand a firm and itsdecision-making process, one needs to comprehend how it acts in a period of uncertaintyand stress. Are people calm or yelling at each other? Does it feel like business as usual or iseveryone paralyzed by all the red on their screens? At Baupost, if you were in our tradingroom, you would not know if the market was up 5% or down 5%. This is by design. It ismuch easier to make reasoned decisions without someone screaming at you or secondguessing your judgment. Its 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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