Seth Klarman: focusing on value stocks will pay off

Value stocks are very much out of favour , says Seth Klarman, chief executive of hedge fund Baupost. But that won't always be the case.

Seth Klarman, CEO of The Baupost Group
(Image credit: © 2018 Bloomberg Finance LP)

“Today’s trend-following environment has left Baupost looking flat-footed,” says Seth Klarman, the co-founder of the $29bn hedge fund, in his latest letter to investors. Baupost returned less than 10% in 2019, compared to a gain of 30% for the S&P 500 index.

The shortfall was largely due to its focus on value stocks, which are out of favour to an extent that is exceptional by historical standards. “The relative underperfomance of small cap value has been only more extreme twice in history – in 1929, right before the Great Depression, and in 1999, at the height of the tech bubble.” Klarman blames this in part on the growing influence of passive investing and index funds, and the way that they draw money into a narrow set of companies. “Stocks not included in prominent indices relentlessly lag, while the beneficiaries of such inflows move more or less in tandem, sometimes regardless of diverging fundamentals.”

Yet Baupost has “utter confidence” that a focus on value will pay off, “knowing that the rocket fuel that propelled markets in 2019 will run out”. When it does, the reckoning will be grim for “high-flying and often profitless upstarts” such as Netflix, Uber and Tesla. The failed initial public offering and subsequent bailout of WeWork is a reminder of how abrupt this might be. “Investing is not a sprint but a marathon. Over the long run, major mispricings are eventually corrected ... because short-term illusions are pierced and enduring characteristics become more apparent.”

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