Baupost’s Seth Klarman has a bone to pick with the media.

The issue Seth Klarman has, according to his year end investor letter, is that his bearish prose is primarily reported. leaving the true measure of his “bullishness” out of most articles and reports.

Stay tuned for more exclusive coverage from Klarmans 2014 letter

He is really more about a balance between being bearish and bullish rather than one or the other. He expresses concern that articles in unnamed blogs don’t present this balanced viewpoint. He says the reporter and audience should be capable of holding more than one viewpoint at the same time, which is a truer measure of his thoughts “than the one-dimensional picture that is often painted of us on our views.”

We understand that some in the media and many bloggers like to sell stories by sensationalizing headlines and content. But they do a disservice to their readers and viewers when they only report a piece of the story. The reporter and audience should be capable of holding multiple ideas at the same time.

He may have a point, but there is more to the issue than presenting multiple opposing viewpoints in an article. Those who follow hedge fund managers are often most interested in their hedging activity – how they manage risk and view troubling issues in the world. What differentiates great minds in the investing community is not just delivering performance in bull markets, but almost more interesting is how they perceive risk.

To be clear: Seth Klarman is value-ish

Seth Klarman is one of the top risk managers of a generation and his views on the economy and world events newsworthy. To certain hedge fund observers what isn’t as newsworthy are endless (and rather boring) bullish statements that one might expect from a long only mutual fund manager. The business news is full of stock market cheerleaders. What makes Seth Klarman so fascinating is his unique world view and risk management approach. Perhaps Klarman’s own statement captures the situation best when he dryly describes the funds outlook: In short, we are neither bullish nor bearish. We are value-ish.”

Seth Klarman 13F data chart via Novus Research

Klarman is undoubtedly rooting for higher stock prices and a robust economy based on the positioning of the Baupost portfolio alone. The nearly $16 billion the fund had invested in 2014 that benefits from a strong economy speaks volumes, but it is the $12 billion he has in cash that speaks to risk management and the ability to convert on opportunity as it presents itself that is where his value-ish comments come into play.

As he noted in his 2014 letter to investors, as the U.S. equity investors were rewarded with one record high after another in the fall of 2014, markets sprinted higher at a rate healthy enough to reward the bulls and punish bears.  As a hedge fund manager with investments primarily tied to a healthy economy, Seth Klarman is hoping. like many, that the stock market avoids bear markets and the economy continues to lavish riches on a great nation. It’s just that he spends much more time discussing risk management issues in his letters than he does parroting bullish happy talk. As just one minor indicator of the focus of Seth Klarmans letter, the word “bull” is mentioned 19 times in his 2014 review document and “bear” is mentioned 28 times. More materially, he spends considerable more time discussing risk issues than he does gloating about potential reward, making an old school hedge fund manager phrase positive returns take care of themselves, but a focus on risk management is the sign of a professional.

In Seth Klarmans letters the real differentiation comes when he discusses risk management issues, and in the 2014 iteration Seth Klarman does not disappoint. “When a bull markets end, a variety of bad things can happen to investors,” Seth Klarman wrote in a protracted piece on risk management titled “Preparing the Team for the Inevitable Bear Market.”

Bear markets are roach motels

Noting that while history doesn’t often repeat, he noted “it certainly rhymes.” During bear markets liquidity can evaporate and “marketable securities can become roach motels – easy to get into, but hard to get out of.” The same is true in debt markets, when a company that could have comfortably refinanced their debt in a bull market suddenly finds, without changes to their individual circumstance, “the liquidity window can suddenly slam shut.”

As a bear market approaches it is easy, if not comforting for an equity investor to immerse themselves I happy bull talk. But risk managers are typically on the lookout for risk to manage, and Seth Klarman notes the bullish blinders.

Amid a severe market decline, you will regret almost anything you thought about selling but didn’t, especially when you realize that you were too nonchalant about acting on negative information. You will also lament how you haggled too much over a small price difference, realizing now that you should have simply hit the bid. In a bear market, you will painfully learn just how easy it is to lose money and just how hard it can be to make it.

Preparing for a protracted bear market does not mean one is hoping it happens

As a convergence of various concerning risk issues could converge this fall, the specter of a protracted bear market is considered. This doesn’t mean Seth Klarman is rooting for a bear market, he and his team are just actively planning for what has been inevitable in market history. He writes:

In a protracted bear market, you will be unique if you aren’t questioning yourself. Everything you thought you knew starts to seem wrong. Everything you bought thinking it was a bargain will appear, at least for the time being, not to have been a bargain at all. Now, at a lower price, the stock may indeed have become a bargain, but do you like it as much as you thought you would now that its price is lower? Or are the facts worse than you thought, the earnings and cash flow eroded, the “compounder” blemished, or are other bargains now simply more appealing? Whereas you once may have said that you would “back up a truck” at such discounted prices, you may find that you imagined wrong, and you have neither the desire nor the capital to add to positions as they hit new lows. Even with market prices scraping bottom, corporate managements that repurchased a company’s stock at higher levels suddenly suspend the program. Expected buildup of corporate cash flow fails to materialize. Debt that seemed inconsequential compared with total enterprise value may now seem large compared with a shrunken market cap that limits recapitalization alternatives.

A key point about bear markets is that instead of somewhat bullish analysts matching wits with even more bullish analysts, Seth Klarman notes that bear market selling takes place on the bloody battlefield of forced or panic selling” as margin calls revert pricing “to more primal ‘sell before it goes lower’ behavior.”

For a value investor such as Seth Klarman the bear market can be a buyers dream – to a limited extent. Values are all around, but the investor’s mental discipline can be severely tested as the core definition of “cheap” becomes relative in a stock market filled with ever more nervous buyers.

Some investments in bear markets become cheaper than you ever thought possible. It will actually seem like more stock or bond certificates have somehow been printed than actually exist. In other words, you won’t believe the prices, but you won’t believe the volumes either. You can buy all you want, but whether you actually want to be a buyer will be tested and re-tested.

Yes, Seth Klarman is a positive person. He likely roots for the economy to grow and prosper as does everyone. But his genius, by his own admission, surrounds his ability to preserve capital. It is his thoughts on risk management that make headlines and are worthy of the attention of sophisticated hedge fund observers.

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