Excerpts from Seth Klarman’s 2010 Letter to Limited Partners

Readers of this blog know that I believe Seth Klarman, portfolio manager at the hedge fund Baupost Group, is one of the greatest investors of our generation. We share so many of the same views as Klarman that I consider us the “Poor Man’s Baupost.” Baupost is rarely open to new investment, their investors typically spend years on a waiting list before an opportunity arises, and those that endure need to commit tens of millions in capital. So by “poor” I am referring to the fact that investors can actually invest with us. If I could make it over Baupost’s hurdles, I would invest in Baupost funds in a heartbeat.

Excerpts from Klarman’s 2010 annual letter to his limited partners have made their way to several investing websites. See, e.g.:


The following excerpt of the excerpt summarizes his analysis of current macroeconomic conditions in the US:

Benjamin Graham’s margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won’t derail an investment – is applicable to the economy as a whole. Bridges intended for ten-ton trucks are overbuilt by engineers to hold vehicles of 30 tons. Responsible investors assume their best judgments will sometimes go awry and insist on bargain purchases that allow room for error. Likewise, an economy built with no margin of safety will eventually implode. Governments that run huge deficits, promise entitlements that will be next-to impossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse – perhaps not imminently but eventually, as Greece and Ireland have recently discovered.

It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. A friend recently posited that adversity is valuable not for what it teaches but for what it reveals. The current episode of financial adversity reveals some unpleasant truths about the character and will of our country and its leaders, and offers an unpleasant picture of the future that awaits, unless we quickly find a way to change course.

That our current predicament will end badly is not usually debated. Most think it is only a matter of degree. There are three ways out of the mess: We can either make permanent draconian spending cuts at all levels of government (federal, state and local), raise taxes dramatically, or we can pay back our debts with cheaper dollars by printing money and subjecting the country to serious inflation. Obviously, a combination of these three is possible.

At the margin, a fourth option would help: Allow massive immigration and naturalization of the world’s best and brightest who also possess capital. The US is still Reagan’s shining city for most foreigners and that will be true as long as most of the world’s governments believe that countries like Libya deserve a seat on the UN’s Human Rights Council. For example, how much of the housing bust would have been mitigated if we placed at the top of the immigration list those with capital to purchase houses, expedited the naturalization of those immigrants, and made it a requirement that they owned their homes for at least ten years? And, that says nothing about the productive contributions that those immigrants could make as entrepreneurs or employees of entrepreneurs.

My view is that the least painful way out (certainly not pain free) is through draconian spending cuts. I am in Hayek’s camp, not Keynes’s. The backbone of the US economy is its entrepreneurs. The only long-term solution will be one that unleashes entrepreneurs and provides the incentive for them to take risks, create jobs, and once again be the beacon for the world’s best and brightest. It will mean massive cuts in regulation, harsh cuts in entitlement spending, massive layoffs of bureaucrats, and pain for many in the private- and non-profit sectors who have been feeding at the public trough for decades–everyone from community organizers to trial lawyers to public school teachers. In other words, it will mean that any politician who wishes to be re-elected will attempt to kick the can down the road, so expect serious inflation instead.

If entrepreneurs were unleashed, if they were encouraged to get rich, they would create wealth and jobs and they and their employees would pay taxes—lots and lots of taxes. They would pay those taxes even without an increase in tax rates but especially if those rates were cut and made less “progressive” because more jobs would be created under a flatter tax system than a progressive one. By focuing on ways to grow the pie and ignoring whether the pieces were cut evenly, the pie would grow. Flatter and lower tax rates, cuts in regulation, and massive cuts in government spending would be a starting gun for US entrepreneurs.

On the other hand, higher taxes as a means of getting us out of the mess will likely lead to higher government spending, not deficit reduction. Therefore, higher taxes are not a solution. The pols cannot help themselves, and we should not be their enablers.

Finally, since Reagan’s election we have enjoyed the longest bond boom in history as interest rates worldwide plummeted thanks largely to rapid increases in productivity and lower inflation. So, although many of us are too young to remember the ravages of late 1970s inflation, there is a lot of pain in allowing the figurative printing presses to run un-impeded at the Federal Reserve, especially for retirees. Despite all of that, the “no-fault,” do-nothing option will likely be the most appealing path for most politicians and it is likely that the long, bond bull market is over. Politicians are setting Bernanke up for the fall in the history books.

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