Seth Klarman - Contrarian Investing, Discipline, and Building Baupost

Welcome to a new edition of the Value Investing with Legends podcast. My name is Michael Mauboussin, and I'm an adjunct professor at Columbia Business School and a faculty member at the Heilbrunn Center for Graham and Dodd Investing. My co-host, Tano Santos, the Robert Heilbrunn Professor of Asset Management Finance at Columbia Business School, and the faculty director at the Heilbrunn Center couldn't join us today, but will be back soon. If you had to pick a time for the birth of what we call value investing, you could do worse than selecting the moment when Ben Graham started teaching advanced security analysis at Columbia about a century ago. Our guest today is not only one of the most successful and visible practitioners of value investing, he's also made major contributions to the field through his writing and commentary, including directly to the Columbia Business School community.

He combines the sensitivity of a great value investor with modern tools and approaches. We are delighted to welcome Seth Klarman. Seth is the chief executive officer and portfolio manager of the Baupost Group, a firm with approximately $22 billion of assets under management. He has overseen the firm's investments since it was founded in 1982. After graduating from Harvard Business School, where he was a Baker Scholar, Seth was brought on at Baupost's inception to manage the wealth of its four founding families. The name Baupost is an amalgam of those family names. Before graduate school, Seth worked as an analyst at Mutual Shares, one of the great value investing firms, founded by Max Heine and eventually run by Michael Price.

He graduated magna cum laude from Cornell University with a degree in economics. His lasting contributions to the value investing community include his book, Margin of Safety, published in 1991 and now offered at Amazon for the bargain price of $2,500, as well as his role as the editor of and contributor to the seventh edition of Graham and Dodd's Security Analysis, published in 2023.

Seth is a member of Harvard Business School's Board of Dean's Advisors and an active philanthropist through the Klarman Family Foundation.

Welcome, Seth. Thank you for joining us today. Lots of topics we're keen to discuss.

Thank you so much, Michael. Thanks for having me.

Let's start at the beginning. You moved to Baltimore, Maryland when you were a little kid and lived not too far from the Pimlico Racecourse, a famous horse racetrack that may come up later in our conversation. What were you like as a little kid, and is there any inkling at that time that you were going to be a budding value investor?

That's a great question. I was always interested in business, starting little businesses. I remember I was a paper boy for the Baltimore Sun afternoons and Sunday. I went into the business of shoveling snow and raking leaves and mowing lawns. I did little carnivals in our yard for neighborhood kids. I remember starting to collect coins. My dad would bring home whatever coins he'd accumulated during the day and I'd go through his change. And over time realized that, for example, we had stopped putting silver in our quarters. I remember taking the bus to high school. It was a public bus, and people had to throw their quarters and dimes into a slot. And I realized that some of those were silver.

Some of those, in fact, were Mercury dimes, which were out of circulation and had gained a premium valuation over the face amount. And I became friends with the bus driver and negotiated for him to pull the rare coins, the collectibles out of the bin at the end of his route. And he would come the next day and say, I could sell you $3 worth of silver half dollars or silver quarters in exchange for $3. And so I had a growing collection in my mother's spice rack of the quarters and dimes that I'd been arbitraging the silver in. So I always had a draw to the opportunities to make money, to understand business better.

That's a beautiful example of arbitrage right there. About as good as it gets. So you go on to Cornell. You have an interest in studying originally mathematics, but end up as an economics major. But as an undergraduate, you secured an internship at the legendary value investing firm Mutual Shares, which you subsequently joined after graduation. How did that come about? And what was it like to work with Max Heine, who's a legend, and Mike Price, who was also a legend? Did it have lasting impressions or imprint on you professionally?

It sure did. I remember it like it was yesterday in many, many ways. First of all, I had no prior work experience except driving a delivery van for a pharmacy. So it was a wonderful opportunity to learn a new field, but a field that I've been interested in since I bought my first stock at age 10. So I was always drawn to the financial markets and had a deep curiosity to just understand how they work. I knew when I bought my first stock, by the way, that I didn't know what I was doing. I bought Johnson & Johnson. I knew I used a lot of Band-Aids. That was about it. So I had a seat right next to Michael Price and right in front of Max Heine. And those guys had grown mutual shares from what had been a $20, $30, $40 million fund of assets under management years before to a couple of $100 million fund over the time that I was there.

I was there about a year and a half after I graduated school before I went back to business school. And I remember being drawn to idiosyncratic and special situations. There was a day that Michael threw a prospectus on my lap. I had no idea what was in it. And it announced that a company called Telecor was spinning off a fractional share of Electro Rent for every share of Telecor. Telecor was the distributor and their distribution rights for a Japanese product, I believe, were being shut down. And so the prospectus, the proxy was both for the shares of the spin-off and for what you were likely to get in the liquidation. The liquidation of Telecor was going to generate something, let's call it $7.50 a share.

And Telecor was trading roughly, let's say, at $8 a share. So for half a buck, you could create half a share of Electro Rent. And that meant for a buck, if you bought two shares, you could, for a buck, create a whole share of Electro Rent. Electro Rent's shares were going to throw off something like a dollar of cash flow. So it was an equipment leasing company that Telecor happened to own, and you were going to be buying that at one times cash flow. Now, I had no idea. It's a small company, didn't really know where it would trade. Nobody knows before a spin-off happens exactly where a company will trade. And there weren't a lot of companies like it trading. But what I realized was you had the odds greatly in your favor that it very unlikely traded at under one times cash flow and could well trade at several times cash flow or more.

So we made that a position and it was particularly exciting, I guess, in two ways. One, it was the first thing I ever officially recommended, but it was also a special situation in the purest sense that it didn't involve straightforward looking at a stock that's already trading and saying, 'I have an insight that the market doesn't have for why this is a good investment,' but rather, 'I have an insight that this process is giving me the opportunity to buy something at a ridiculously attractive price.' So I remember that. I also remember Max had a lifelong friend, Hans Jacobson, a gentleman with a very thick German accent, as Max himself had. And Hans was an expert in railroad bonds, of all the things to become an expert in.

And literally, there were hundreds of railroad bonds, usually first-lien bonds of various sorts, many issued decades or even longer before. And you had collateral, in various cases, of the right-of-way or even the assets under the rail line, the track itself, the rails, which had their own theoretical liquidation value. So just listening to the broker, Mr. Jacobson, buying and selling those bonds, listening to the arcane nature, almost like you're getting an American history lesson of Lewis and Clark, who built this railroad and what year and what was this bond issued for? And what's an equipment trust certificate, exactly? And who issues bonds with 100-year maturity, anyway? So there were all these questions and ideas that are running through my head.

And I came to realize that there was value to being an expert. No one probably knew more than Hans Jacobson about the assets behind that. And then in that era, Penn Central, which was a great, large bankruptcy of the mid-1970s, was coming out of bankruptcy and throwing off a lot of securities ranging from debt to preferred to equity, and some of which would be paid off based on the proceeds of liquidating various assets or even air rights above things like Penn Station. So the complexity of that made sense to me that most investors wouldn't be able to play. It wasn't like, "Here's a stock, it's a blue chip, here's the dividend." It wasn't like that at all. It was, "What are these assets worth, and are you going to get paid back, and when, and from what?"

So it just opened me up to the awareness of the kinds of variety of things that can be egregiously mispriced because it's so obscure. It's so different from what everybody else is looking for. It was a revelation. It also helped to pay for business school later.

Well, let me pick up on that because some people do complain that—

The ideas taught at business school, including many of the theories, are somewhat at odds with the principles of value investing. And you came out of a really blue-blood value-investing firm. How did you find the curriculum at business school? And did it actually advance your thinking in terms of being a value investor?

So I really enjoyed business school. I was probably a relatively young 23 when I went there. I enjoyed being in class with so many smart people and intellectually and verbally jousting with them, as is the case method at Harvard. And I would say I was taken aback. You had to learn the Efficient Market Hypothesis. I think my professor was okay that I didn't agree with it. And I would routinely go off on tangents about how this didn't make any sense. And I think, to their credit, they wanted you to understand how to value options in the Black-Scholes model, for example.

So they never persuaded me. I never persuaded them.

I don't know how my classmates reacted, but I felt like it was a great rounding-out experience that I knew something about how stocks traded and how bonds traded, but I knew relatively little about how business worked. And so the ability to talk about marketing and operations and even organizational behavior was very helpful in understanding the dynamic within companies and eventually meeting people like Michael Porter, writing about the competitive forces that operate on a business. It was a way of thinking that really expanded my horizons.

So after you graduated from Harvard Business School, you joined Baupost.

So how did that come about? So, I had a real estate professor whose name was Bill Poorvu, and he and some friends were in the process of selling Channel 5, which is the ABC affiliate in Boston. And they were coming into, together, a couple of hundred million dollars. And Bill and one of his friends were thinking about, 'What are we going to do with all this sudden liquidity we have? How do we make sure the assets are invested well, they're invested safely? We're taking care not just of the investment side, but the operations side, making sure the coupons are clipped and dividends are collected?' So, their idea was to open an expanded family office that would work for them and their families, but also be open for other families.

Bill's friend Jordan Baruch had a friend, Isaac Auerbach, who was contemporaneously selling his computer consulting and publishing business. And so, between the three of them, they had about $27 million. And they made me the offer to come in and be the investment brains behind the outfit—except there wasn't an outfit—but to apply what I knew, all of my year and a half of experience. And they stayed informally involved and brought in one colleague to help be the day-to-day gray hair and part-time president. So, that's literally what we started. And I had offers to go back to New York to go to Mutual Shares at a big increase in pay and to go do risk arbitrage at another shop in New York. But I decided I liked the idea of, first of all, staying in Boston, and second of all, starting to build something.

And I figured if it didn't work, I wouldn't be too ruined and would be able to re-establish my career somewhere else in a couple of years. And luckily, it was a good time to go into the markets. The markets had been slumping for a while, and I was able to pull it together and begin to invest, initially just domestically and in just bonds and stocks, and over time expanded in a variety of ways that took in new clients. But that was basically the plan. And Bill and Howard Stevenson, who were founders of the firm, and whose last names are the P-O and S-T of Baupost, are still around today and serve on our advisory board. So, it's been a remarkable run for over four decades.

Let's shift a bit to investment philosophy. As you write in the preface to the seventh edition of Security Analysis, value investing is a flexible approach grounded in basic principles. Can you discuss some of those principles, as well as how the world has changed since the original version of that book came out, now close to a century ago?

I think the basic principles, people could differ, but I think basically markets are inefficient, and markets are inefficient because human beings are involved, and humans, they react emotionally. They get greedy and they get fearful. Markets are also inefficient—I think some of this is probably what I added to Graham and Dodd—but they're also inefficient because people put constraints on their behavior. They have things like a 'prudent man' rule, that you want to only own stocks that have been profitable for the last five years, or you want to only own stocks above a certain market cap, or you only want to own bonds above a certain investment rating. And that means that whatever doesn't fit nicely into those guardrails can be excluded and can really be attractive for mispricing.

So the fundamental message, I think, from Graham and Dodd is: do fundamental analysis. Many stocks will be fairly priced much of the time, and bonds, but periodically something will happen that will either cause great exuberance or great despair, and they'll get either really overvalued or incredibly undervalued. And the market can be your friend on both sides of that, giving you great opportunities to get in at bargain levels and also to trade out at very full or even excessive levels. So the challenge is, in some ways, the discipline to wait patiently until those bargains emerge, and then the temerity to stand there when it's going down in your face, the market's telling you you're wrong, but you're holding on because you've done the work and you have the conviction that it's even a better bargain today as it falls in price.

And that's what I love about it, that every day is something new. You don't know what new thing you're going to learn or what new environment you're going to experience. And bargains continue to show up. Markets are different over the 100 years, for sure. There's so many more companies. There's ubiquitous information. Technology makes it available constantly at everybody's fingertips for free. So that's the difference. You have regulatory changes in very significant ways. And in many ways, the U.S. is such a great market because we do have regulation and we do police the markets and make sure that the little guy has a fair chance, although not always. And things can fall through the cracks there, too.

The other thing about the changes over time is that Wall Street has become a very different, vast place. There's both a buy-side and a sell-side. The buy-side are giant mutual funds and ETFs and now index funds. The sell-side are brokers and, in many cases now, online brokers and other ways to transact. And very few of those parties are all that interested that you do well. They're interested in themselves doing well. So the challenge as an investor is to have an expansive reach to be able to get up to speed on any kind of potential investment opportunity. And those can look very, very different over time—new types of debt securities, new hybrid vehicles. There's all kinds of ways to participate.

So it's significantly different. But the fundamental principles of mispricing and inefficiency continue to be true.

I love this point about the universality of inefficiencies because of human nature. But I'd love to just dive a bit deeper into what's happened to market structure. You mentioned some of this: the rise of indexing, the multi-strategy funds, the ETFs. Have those in their wake left opportunities for other people who are not doing those types of things?

I think that they have created the possibility of inefficiency, but I'm not sure how inefficient it is. So, one example is people are indexing for intelligent reasons. People index to reduce or minimize transaction costs and to not underperform the market, although they're giving up the possibility of outperforming the market. When a stock is added to an index, all this money needs to pour into that stock. Now, people have a sense of the kinds of stocks that the S&P might add to it or other indices. But nevertheless, those stocks can surge on the day of an inclusion. So, in theory, somebody could spend a lot of time saying, 'What might be included, and what might those stocks do? How thinly traded are they?'

How tightly held are they? And you can, within some amount of reasonable estimate, guess what stocks are going to be included. This isn't something we do. Similarly, in the reverse, when a stock is kicked out of an index, it can get dumped. Why would a stock get kicked out of an index? Well, it may have suffered and fallen in price to where it's no longer S&P 499 or 500, but it's S&P 1300, and that doesn't belong in the S&P 500. And when another company comes along of more substantial size, they'll replace one with the other. So when people come in to dump those shares, which is often at the end of trading at four o'clock on a Friday, that might not be very well bid. So it's not something that you should focus on buying.

But I think it's a place to look: 'I wonder how that stock might trade Friday afternoon.' And maybe there's no merit to that company. Maybe it's a near-bankrupt retailer headed for bad times, headed for worse times. But maybe it's actually a viable business at a price. So I think mostly we think about inefficiencies not as telling you what to do, but as suggesting places to look.

So in that spirit, one of the longstanding debates in the value investing community is the benefit of specialists. And you had that delightful story about your railroad bond—specialists versus generalists. For example, our colleague Bruce Greenwald argues for specialization. And where do you come down on this? And how has Baupost structured its analytical efforts over the years to balance that specialist versus generalist idea?

It's a great question. I would say that probably both have their merit, but Baupost comes down on the side of generalists. We are opportunistic. And if you're specialized, you're going to know a whole lot about a few things. And there might be moments, there are times when that's in the sun, when there's so much to do within that area of specialization. But there are probably a lot of times when it's just not interesting. So you know a whole lot, but there's nothing actionable. What we like is when we get a phone call, somebody's got to sell this by Friday afternoon. It could be a building. It could be a portfolio of condos that were built two years ago. It could be some lien on an asset you never heard of or participation in litigation.

So you need to move quickly. It's hard to appraise. And there might not be big competition because it's not the kind of thing that trades every day. So we like being able to pivot to have ready buying power and be able to move into whatever new opportunity shows up. The one thing, though, is then you need to be able to go a mile deep. So at the end of the day, you need to be a generalist to seize the opportunity to notice it, to figure out what to work on, to prioritize your time. And then you've got to drill down really deep, like you want to be a specialist in that, even if you might only be a specialist for two days. Now, of course, once you do that, once you're a specialist in that obscure type of instrument or asset, now you know it.

So the next time something comes along, you can look at it again. But the search should begin more broadly. I'd like to describe our search as a mile wide and then a mile deep.

So in that context, how do you guys think about valuation, especially given that you are operating at different parts of the capital structure, different asset classes, and you get sometimes these unusual things across your desk?

The whole Graham and Dodd idea of value investing is that you're buying with a margin of safety. You're buying an asset at a discount and you're happy to sell at a smaller discount. You don't even need it to go to full value to do well. Valuation is always at the crux of any investment decision for a value investor. You don't want to be paying more than something's worth. You also want to be investing with an eye on the downside, with a margin of safety, if you will, so that there's room for things to go wrong and you'll still come out okay. So we think about valuation mostly in terms of expected return. And the way we do that is to equilibrate across a variety of asset classes that we focus on. We focus on four, maybe five asset classes, and they are basically places that we do or have found inefficiencies over time.

So we focus on public equities, we focus on private equity, we focus on public credit, we focus on private credit, and we focus on real estate. Those are mostly opportunistic. We don't have to be in any of it at any one time. And the allocation to these various sectors, these various segments of the portfolio will change a lot over time. We can go from 5% in credit when it's uninteresting to 50% in credit when it is, and back to 10% when it's less interesting again. A year ago, our credit book was about 25% of our assets. Today, it's 15. And each of them goes up and down based on the opportunity. We don't buy anything if we don't think we're going to make a reasonably safe 15% return. And that's for what we would consider reasonably safe credit.

And that would be for performing credit or a very safe bankruptcy-type of investment. And the returns go up from there. For a public equity, it would be higher teens. For anything illiquid, whether that would be real estate or private equity or private credit, you'd now be pushing high teens out into the mid-20s. And it's simply a way of calibrating and saying, is this equity better than this building? How do you know? You've basically got to use the same kind of what you believe are conservative assumptions, reasonable timeframes, stress testing the outcomes, and thinking about downside in a similar way, and then saying, okay, I need to get an illiquidity premium for tying up my money in this illiquid asset.

Although it's worth noting that some liquid assets, they're technically liquid, but if you own 11% of a company, it's not the most liquid stake. Some stocks trade by appointment. They're not the most liquid vehicles. Certain bonds may only be held by a handful of owners. And so you're always trading off varying degrees of illiquidity as part of the calculation.

So, Seth, one of your lines, which I love to repeat to my students, and you shared this in a talk to Columbia Business School to the community in 2008, and you repeated it in the new preface to Security Analysis. And here's the line. You say, 'Value investing is, at its core, the marriage of a contrarian streak and a calculator.' So can you break that down just a bit? Why isn't it enough just to be a contrarian, being on the other side of the trade? What do those two pieces mean to you and why'd you say it that way?

I think it's a quip, so it's a clever way of saying something that basically is you should be a value investor. A value investor needs a calculator to be able to assess value, and a value investor maybe needs to get their bearings by asking themselves, 'Am I going against the grain here?' I don't think every investment needs to go against the grain, but I think you should ask yourself, 'If I'm not against the grain, if I'm part of the herd, what edge do I have?' And asking yourself, 'What's my edge?' turns out to be a really positive question. Again, sometimes the edge is, it's too big for the arbitrageurs to close the spread, so I'm getting paid generously. Or there's so much uncertainty around the outcome of this bankruptcy that even though a lot of people are looking at it or own it, it still might have significant alpha left in the price.

But broadly, the world has evolved. I think being contrarian was enough in Ben Graham's time. Ben Graham looked at companies trading below liquidation value because the bad news in the depression was cyclical. We were in a downturn. The Fed didn't behave the way it does today, nor did Congress. So people were rushing in to save the economy or reliquify things or go into deficit spending in vast ways. And so when you had downturns, they were mostly cyclical. When stocks were trading at a discount to net working capital, it was mostly because there was no customer demand to shop at that retailer or to buy that product. Over time, you've got more things going on in the economy. And I'd say it's really technological disruption that has changed things where more companies are under attack.

There's always somebody attacking or somebody building something in their garage that's that much better. That's like how you think about technology. If you're not figuring out how to use it or making it, you're probably going to get destroyed by it. So it might have been enough to be a contrarian in Graham's day and say, 'Someday the shoppers will be back. This retailer is going to go back up in price when they make some money.' Today, it might be pushed off the edge of the cliff by Amazon. So it's the disruption that threatens business models. People used to talk on Wall Street, 'Oh, this is a melting ice cube. It's a pager company, but they have a long runoff business and all these manufacturing plants, and drug dealers will need pagers.'

'So there'll always be demand.' Well, no, these days when things get that way, the ice cubes melt. I call it financial climate change. The ice cubes melt faster than ever before. So it's not enough to be a contrarian. It's good to have a contrarian instinct, but then you need to ask yourself, 'Am I being blindly contrarian? And do I really want to touch the situation? It seems like it really could go to zero.' So you always need that judgment, which is why it's not enough to just be contrarian.

So Ben Graham famously didn't feel that it was important to meet with management. While his protégé, Warren Buffett, valued that interaction, how does the role of management fit into your decisions? And is it important to you as an organization to spend time with managers before you make an investment?

I think it's increasingly important. And I would say in many ways, it's because if you were just buying the balance sheet, you're buying the assets that are there today. It might be enough to know that the accounting firm that blessed the balance sheet, that blessed the financials, said these assets are really there. But there's parables about value investors buying cash at a discount, for example, in the worst downturns of biotech stocks. The problem is the cash isn't going to be there. They're spending the cash to defend the market position, to grow the business, to make an unrelated acquisition, whatever it might be. So we're adamant that you need to talk to them to understand intention. Do they care about shareholders?

How will the shareholder benefit from what they're doing? Are they making good decisions? What's their judgment around why are they doing X or Y? And can we assess that that's not just to feather their nest or build a bigger platform or to take a time horizon that's just beyond the time horizon that investors can typically stomach? So we basically think that talking to management is not a perfect art. Management talks about what management wants to talk about, and they have sometimes their own agenda. But I think you can get a lot from the conversation around what's the likely direction, both of where they're taking the assets, what new bets are they going to make, and how much do they care about shareholder return?

One of my favorite questions for a lot of the stocks we look at that haven't done much in the market lately is, 'Why should we or anybody buy the stock here? What's the plan for how you're going to deliver value for your shareholders, especially because the last couple of years your stock really has lagged?' And I think, again, you don't have to agree with the answer, but hearing it shows you something about the caliber and the character of management.

A topic that all investors who manage money for others recognize, and I still don't think it gets the attention it deserves, is the role of the investors you serve. You've said before that having patient and long-term-oriented clients is really crucial to success. How does an investment organization achieve that goal, and how deleterious is it to have money coming and going willy-nilly?

I've always felt like the most important thing as an investor is to feel the freedom to go to where the opportunities are. So a flexible mandate and the imprimatur of your clients to say, 'You're a steward of my capital and I want you to do what you think is right. Don't do what's popular. Don't do what everybody else would do. Do what you think is right.' So sometimes to be successful, you've got to stand against the crowd. You've got to go against the grain. You're buying what everybody else is selling. You're developing a differentiated view based on that. So from my perspective, the maybe most important thing about finding the right client base is twofold. One is get to know the clients before you bring them in.

You don't need to take everybody that wants to give you money. And I'm positive that taking the wrong clients, especially as a young manager, will put you in a terrible place. I know somebody who has actually started a firm, was building a good record maybe for a year and a half, and he was up. And the client started demanding why wasn't he up more and that he act differently. And by not having matched the clients and built an expectation, in a way, you almost want to build an expectation of, 'I want to know that if I think I had a good year, you'll also think it's a good year.' That's hard to know that in advance, but it's why you get to know people. It's in everybody's interest to create that alignment and identify if it's present.

So we never just take a phone call and have somebody wire money. We take a meeting and we get to know them. We flood them with our materials. And if they say, 'You know, that's all too much,' fine, then it's not a good match. And the other thing we do is, once somebody's in as a client, they can't always anticipate how they're going to feel at different points in their life based on different kinds of investment results. So we try to educate them further as a client. So it's one of the reasons we write reasonably lengthy letters many times a year, keeping them informed of what we're doing. And we're helping, I would say, condition them to be the clients that we need them to be so we can do a great job for them.

Investment firms are rife with behavioral biases—is something you've acknowledged before. So how important do you think is temperament among the people, for example, you hire? And how do you try to manage or mitigate biases in decision-making at Baupost?

You can't always know what somebody's temperament is going to be like until you work together for a long time. But I think you could see behavioral biases in the way people react to situations. I think the thing I've always feared is being in a place where I had a great opportunity set. I was very excited about what we're seeing. And I felt like maybe one of my colleagues is freezing up. I analogize it to the baseball pitcher that gave up the winning home run last night, causing the Red Sox to lose the game. And if they're still thinking about that, and they're not applying their best process, and they're putting their best foot forward, then they might blow it today again, maybe not by giving up the game-winning home run, maybe they're...

not going to buy a stock because yesterday a stock fell 10 points after they bought it and they're scared and they're afraid. Like if you fall off a horse, that metaphor of getting back on is apt. And so I want not just the character of my people, but I want the nature of the team to be, 'Hey, we've got your back. Everybody has stocks that go down after you buy them before they go up. Nobody's giving you a hard time.' And one of the things I do is I literally go team member to team member and say, 'I have so much confidence in you. I had lots of stocks in my career that have gone down before they've gone up, and not all of them work. So what I don't want you to do now that the market's down a lot in 2021, for example, don't hesitate to make that recommendation.'

Anything you like today is probably better than it was before the market fell a lot. So keep coming with ideas. And it's why we work as a team. I have a different vantage point than you do. You're the analyst. I'm the portfolio manager. Together, we can make the best possible decision. I can encourage you, but you can also remind me that you've spent 30 hours or 100 hours with that company, and I've heard it for 45 minutes from you. So together, we're going to get to the best place. So use my experience and my hopefully cold-blooded nature to not panic, to not develop fear from a temporary decline, but rather to almost be emboldened by it. Like Warren Buffett always told us how he was skipping to work in 1974, his NAV was down, but the opportunity set was so great.

He knew every time he bought something, he was expanding his net worth. It wasn't contracting, even though it looked like it on the surface.

So let's step back a bit and talk about what's going on in investment trends. You mentioned five asset classes broadly that you look at. How do you feel about the opportunities? And let's say public versus private equity, public versus private credit, and real estate. Does anything stand out? You mentioned changing a little bit position in credit. Anything stand out these days in terms of what you see going forward?

I think at the moment, it's a four out of 10 opportunity set. Markets are historically expensive. Markets just hit an all-time high. At least the S&P did, not the Russell. And there's very little despair. There's very little panic. There was a lot more in the spring with the tariff announcements. And I think that could all come back. The markets seem oddly certain that the president that announced unexpected tariff changes would never do anything like that again. Well, we know he very well might. He's a very impulsive guy and he likes what he likes and he doesn't like what he doesn't like. So I think there's also unsound fundamentals in the macro economy. We're running enormous deficits during strong economic period.

We may or may not be on the verge of approving a new bill that extends those even further and farther into the future. And it continues the tax cuts for the very rich while taking away food, medicine for the poor. It's a very strange moment. And none of us know how it's going to play out. In some ways, I think we're at the mercy of foreign creditors. Well, yes, we can just print more money. Although that is denominated in dollars, it feels like an unstable situation that may be getting closer to a day of reckoning. So my answer is, we see probably more to do in some areas than others. Credit has become uninteresting with the rally in credit. Spreads have narrowed. Bond yields are down a little bit.

The Fed may cut. Who knows what that'll trigger? But that may also detract from the credit opportunity. There's still equities that are interesting. People want to buy the Mag 7. People want to buy the most speculative stocks in crypto or AI land. But there are others that we think are not unreasonable. The area of most interest at the moment is probably commercial real estate, where we're seeing office markets starting to strengthen a little bit and the logjam where you've had a lot of owners of property that wish they owned less, finally finding prices that meet their needs or getting permission, getting balance sheet to take losses. And so we're doing more on the buy side of sectors within the real estate market.

And that's probably the most interesting area at the moment. We're reasonably fully invested, and we still think that baked-in returns within our portfolio point to mid- to upper teens to more, based on asset-by-asset.

So, Seth, let me sharpen it a little bit. I mean, you pointed out, I think very correctly, the ample economic and geopolitical uncertainty that we face and the market seems to be glossing over a lot of it. But there is a megatrend, which is artificial intelligence and specifically generative AI, which is top of mind for most business people and most investors. So how do you see AI affecting the competitive landscape, the rate of change, which you talked about a few moments ago? Have you all changed anything you're doing in terms of process or how you look at businesses, or both, as a consequence of AI?

So, look, it's a critical question. I think the first thing I'd say is we're not really tech investors, so I don't think we're going to be at the forefront of figuring out what to buy. We try to get smarter about the area. We read a lot. We listen to experts just to understand, will this confer particular competitive advantage on certain companies or sectors? Which businesses are going to benefit? Which might lose out? I think there's still a great deal of uncertainty about all the use cases. We have, ourselves, started using it as essentially a capable assistant, a summer intern—not somebody who knows which stocks to buy, but a way to tabulate data quicker. One of my guys was saying to me, he asked AI to take a look at 10 years of annual reports for a company

and compare what changed in the annual report from year to year, the way they communicate, which may reveal something about the change in the business or what the lawyer was worried about or whatever it might be. Another thing he described was being interested in a particular industry, watching a call where he took a screenshot of 10 logos that were presented of companies in a space that he didn't know what they were. He would run that to an intern, but AI did it in like five minutes and saved three days' worth of work to identify which were those companies and what were their financials or where they're headquartered if we want more information. So I think using it as an assistant, and over time, who knows?

I'm sure that AI will find patterns that will be useful to people. But I also, just as somebody who watches society, I wonder whether AI will cause us to be less creative in our thinking. That, the same way that your kids and my grandkids will never read gas station maps because they have Waze, I think that if we use AI the wrong way, we'll solve the problem without having applied our own brain. I had to give a speech and I wanted to ask AI—it occurred to me it was a good opportunity to say, 'What question should I ask so-and-so who's a well-known business executive?' in that talk, in that conversation—and what came back was useless. It felt like... I like to ask things that they haven't thought about before, things that provoke them to new ideas, to new perspectives.

And so I worry, not that AI can't do that, but that the first step probably should be use your brain. And the next step should be, 'What did I leave out? Where can AI make what I came up with better?' rather than—it would be like reading the end of a novel and then not needing to really know as well, how did the whole thing come about? So I like doing it in order. I think the right order is, 'Here's what I think,' and then I can improve my thinking.

So, Seth, I'm going to change the subject a little bit here. After I read Moneyball by Michael Lewis back in 2003, I invited Paul DePodesta, who was then the assistant GM of the Oakland A's, and one of the analytical stars of the book, to speak at a conference in Rhode Island. And he said—he asked, and since his schedule was a little bit flexible, he agreed to speak at a lunch with investors in Boston. And, Seth, you were there and you were a very active participant. And after that lunch, Paul pulled me aside and he said, 'Who was that guy? He seems to really get it,' was his exact phrase. So can you talk a little bit about how the principles of value investing extend beyond financial markets? Essentially, how does the Moneyball mindset—does it pervade other things besides just investing?

Obviously, it pervades baseball and, by extension, other sports. I think you've got so many examples of that. I think I've always been intrigued by the general manager job at a baseball team, not that I'd be remotely qualified. But there, you have vast amounts of information, maybe very much like financial markets. You've got 10,000 or 15,000 players in every draft, and they're high schoolers, and they're college level, and they're in various leagues, and play in ballparks that are hitter-friendly and pitcher-friendly against better or worse competition. So it's a vast data and information problem. And then you've got a human element of, 'Is this kid wired to self-improvement? Do they have an improvement mindset or not?'

And what's their family background? And what clues might be there in their teenage lives that would help you think about, 'Are they going to be a good teammate? Are they going to be down the straight and narrow? Or is being a major league ballplayer going to get them in some kind of trouble? Will we be proud to have them in our uniform?' So there's so many variables. And I now, over the years, have gotten to know some GMs, and I think you're probably on Moneyball 4.0, where it's not as simple as figuring out a better statistic than runs batted in or noticing that a pudgy catcher is still good if they can hit and get on base and frame pitches, but a lot of improvements in how the game... There's an idea that I think is very valuable.

At one point, they essentially started putting chips in the pads of people's uniforms and said, 'That guy makes a lot of spectacular-looking catches, but did they run the right course to the ball? Did they run in a straight line? If you are not good, you might make a spectacular catch, but it's only because you made an easy catch look hard.' So there's a lot of information there to think about. I'm a big horse racing fan as well, growing up in the shadow of Pimlico Racetrack in Baltimore. And again, if you wanted to be a horse race owner or you wanted to bet on horses, where's the opportunity? Where's the inefficiency in that market? And like most markets, I think competition moves faster, money floods in quickly to reprice inefficiencies.

But I also think they're still there. And in some ways, the nature of the markets never changes that I think about over the span of my career. Firms like mine came into business to pick up crumbs left by the elephants. You had giant firms like Fidelity and Putnam and State Street up here in Boston and similar everywhere. And they followed a certain regimen and things fell through the cracks that they just didn't care about making the last few dollars in an arbitrage. It—it needed to look a certain way to be in their portfolio and things that didn't look and fit fell behind. But over time, smaller firms have come along to run circles around the larger firms. A lot of our competitors aren't $20 billion like they were five or 10 years ago, like we are today.

They're now $70 billion or $150 billion. And so I'm hoping, I believe, that we can now still run circles around them a little bit. So there'll always be minnows that grow up and whales that are getting too complacent. That's going to be true in any market situation where there's human touch, where there's inefficiencies. The inefficiencies get cleaned up over time, but new ones form because of institutional constraints or because of the nature of the market, or even imagine that a market became fully efficient. People would stop looking at it. There's no way to make money. But at some point, that generation will die out, and it maybe could become inefficient again.

So, Seth, our students often ask us what the difference is in skill between being an analyst and a portfolio manager. As someone who's served in both of those roles, how do you see those differences? And do you have any advice, for example, to a young analyst who aspires to become a portfolio manager?

The main thing I would say to your question and the advice would be, don't assume they're the same thing—that an analyst needs to get to know a company, a stock, a bond incredibly well, go a mile deep. And they need to develop a conviction. In a weird way, they need to fall in love. They need to say, 'This is the one.' They have to find the courage to recommend it, to risk their job, to risk their bonus, whatever it might be. And that's not the easiest thing to do. And they need to do that over and over. A portfolio manager needs to see the bigger picture. They need to see their individual ideas in a context of diversification or concentration, of duration, of catalyst or non-catalyst. They need to think about other things.

And the portfolio manager also needs to take into a context, where's the market in its historic path? what's going on in the economy or in technology or in geopolitics that maybe should factor in. So I think a good analyst can become a good portfolio manager. I think I'm probably a better portfolio manager than I was an analyst, frankly. And certainly today, it's hard to be an analyst. There's so much competition. There's so much information. You've really got to focus on what's really important here. The best analysts that have come through Baupost were able to say, these are the two or three things that are really important about this company. Because otherwise, if you think all hundred things are equally important, you're going to get lost.

So that'd be my main piece of advice is try to stay focused, but don't get confused that the analyst job is not the same as the portfolio manager job.

Continuing with the theme of advice, you're a member of the Board of Dean's Advisors at Harvard Business School. Is there anything you're suggesting that the dean do differently in terms of curriculum, for instance, to better prepare the students for the world they're going to face?

I've had this ongoing conversation on two fronts. One is, I think business school doesn't talk enough about risk. They talk about business. They talk about when it goes well, or they'll have some cases where it didn't go that well. But risks often come up out of left field—the risk, I'm sure they're talking about now, of technological disruption or obsolescence, but also the risk of a president that decides that the tariff rates weren't just a little bit wrong, but were incredibly wrong, and then decide right after that, that they weren't wrong at all, they're going back. Or a president that decides that the nation should no longer be investing in science and medical research. Who did that and why?

Isn't that one of America's great strengths, is that we're actually driving biomedical innovation in our country? It's one of the three or four greatest strengths of the country, and we're radically cutting it back, and it's not obvious why. So, thinking about risk, preparing your organization for adversity, and maybe even, in the words of Taleb, making it antifragile, knowing that adverse things will happen and that you need to not only get through them, but maybe you can make yourself stronger as you go through them. So, that's number one. The other is business ethics, that Harvard Business School, like many schools, got a grant and teaches business ethics, which I'm all in favor of. It is critically important.

But my real life experience is that you don't get to say, oh, I'm in a business ethics class. I guess the point of this case is that it's an ethical dilemma, that ethical dilemmas bite you on the bottom when you're not looking. And so the key, I think, is not to put those in their own class, but to put them in every course. where you'll have a dilemma in accounting and you'll have a dilemma in finance. You'll have a dilemma in organizational behavior. And because the business executive needs to have a mental dashboard all the time of what are the five or 10 things I need to think about. And number one of those is, is this okay to do? Is this ethical? Is this legal?

So, Seth, time to wrap up. We have two final questions. One is Tano usually asks, but I'll ask it on his behalf. You've mentioned a bunch of things to worry about, so maybe this will just be your answer, but what worries you about the future? And is there anything that excites you where you say, 'This looks really exciting to me and I'm fired up about it'?

I can answer it several ways. I'm worried that we're taking our eye off the ball as a country, that we're fighting with each other. We're a very divided country, and I think we have leadership that likes us that way. We are tackling, in some cases, real problems, but over-dramatizing them, and in other cases, not even really addressing them. What are the real problems I'd like to deal with? I'd love to think about the effect on the climate of all the carbon we're burning and what that means while we're, on the other hand, at this moment, radically reversing policies that were attempting to address the problem. So, we're not dealing with our debts. We're not dealing with climate. We're not dealing with crumbling infrastructure, and on and on.

And it just bothers me that I feel like our generation has not moved forward in any of the real areas that we're leaving for our kids and will be on their top five problem list. In the meantime, we've also got great news. We've got wonderful things going for us. We're actually, with a few blips notwithstanding, we're basically on the way to living longer. We're developing amazing technology, including AI, that has been a dream of technologists for an incredibly long time. And with some good luck that it doesn't get out of control, will be a huge benefit to making things more efficient and cheaper and taming inflation and all of that. But we also are great scientists. We can travel to other planets.

Elon Musk, for all of his complications and flaws, has figured out how to reuse rockets and land them again. Nobody could do that. Now we can do that. And then the higher education is amazing in this country. People come from around the world. It's actually our largest export industry. People come from around the world to get an education at great American schools. Why are we dismantling that? And in fact, why have we lost confidence and faith in experts and scientists? It seems backwards and not where we should be. And if there are things that are wrong, we can fix those things without throwing the whole thing over the side of the ship. So I feel like it's still within our capability to solve our problems, but I feel like we're way off track and I'm doing what I can, but one person can't totally fix this.

I hope that everybody will pull together and that we'll see change in the years ahead, hopefully not too far ahead, where the country comes back together, not because we face some crisis that drives us together, but because we realize we're stronger together than alone and apart, and that there's a lot to be proud of being an American citizen. I also think we've taken our eye off the ball. We've lived basically for the last 75 years in peace and safety because we've been a positive influence on the rest of the world, supported global institutions and lifted up America's name. And now, for no obvious reason at all, we're taking away food and medicine from children around the world. And I just saw a piece today on a new study that over the next five years, 12 million children will die because of dismantling USAID and changes in policies.

I just don't understand. If somebody could explain to me why we're doing it, maybe there's a good reason, but I haven't heard it. And I don't understand why we've taken this radical change in direction. Just because each time a new person comes along doesn't mean we have to reinvent everything. Sometimes we could say, let's tweak this or let's leave it alone. It's actually going pretty well.

And, Seth, is there anything you're reading or listening to these days that you have enjoyed? A book or books that you would recommend to our listeners?

The best book I've read in the last five years is something called Lost and Found. It actually was written up in an Ezra Klein column recently when he interviewed Kathryn Schulz, the author. It's a beautiful memoir. Kathryn Schulz wrote about her father, who was always losing things—losing his keys, losing his wallet, over time starting to lose his recall and his memory, and then he passed away, so she lost her father. And I feel like she had an insight, almost like Daniel Kahneman had about our brains. She had a fuller experience of the day-to-day that I think most of us do, and it made me wish to be her and wish to absorb deeper into minute-by-minute situations to fully experience things. She was brilliant.

And then she wrote about Lost & Found. She wrote about finding her life partner. So it's a wonderful book and a great memoir. And then as you point out, she had written other books. And I do this too, when I love a book by somebody, I actually just today ordered one of your books that I hadn't read yet because I realized I should know everything you have to say because it's also rich and full of good ideas. So I ordered Being Wrong. And Being Wrong is great. I wrote about it in our client letter at the end of the year. And Being Wrong is a Kahneman-like book also of what it means to be wrong. Why is it so hard to admit we're wrong? Why do you find so many excuses for being wrong? Why do we say, 'Well, I was about to be right, but the clock ran out,' or, 'I was about to be right,' or, 'I was right, and this thing came out of left field and made me wrong,' as though that's not part of being right and being wrong?

Why do we not see the luck that made us right, but we see the bad luck that made us wrong? What is wrong with us? And so understanding that it's your lifelong pursuit and mine to understand what makes us how we are, and I feel like Kathryn Schulz did that twice. And the third book I'd recommend is called The Light Eaters—the light like the sun and eating like plants, eating the light to do photosynthesis. So it's a book about plants. But what it really is is a stunning book. Again, talk about noticing that I would have said animals are interesting. Plants just sit there, but they don't really. They don't just grow, but they grow roots and they communicate with other plants in all kinds of ways.

They communicate with insects. In various ways, plants change their behavior based on what's happening to them. So there's actually a mustard-type plant that, when their leaves are under attack by a kind of butterfly, produce a more astringent mustard taste. So they're actually changing the chemical composition of their leaves. There are plants that will mimic the plants next to them. And according to this book, at least, nobody knows how because plants don't have eyes, yet they seem to mimic the plants that are near them in the lived environment. So I just think it's sometimes good to put away finance and put away human nature and think about science and what else is out there that we're not thinking about that might be rather formidable.

And maybe realizing that plants are so capable might even put us in our place a little bit.

Well, Seth, you write so well and your wonderful answer is just a great testament to the fact that great writers are also great readers and that you are. Seth Klarman, thank you for joining the Value Investing with Legends podcast. To our listeners, thank you for tuning in and we will see you in our next episode. Thank you.

Thank you so much, Michael.

Thank you for listening to this episode of the Value Investing with Legends podcast. To subscribe to the show or learn more about the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School, please visit grahamanddodd.com. Thank you.