Seth A. Klarman, President, The Baupost Group, Boston, MA

I thought I would talk for a while about our approach, about how we're thinking about the world right now, how we're seeing opportunities and what we're doing, and then leave some time for questions at the end, if that's okay. Okay. So I graduated from business school, as was said, in 1982. And the world in 1982 was extremely different than the many years after that. In 1982, we had very high interest rates. U.S. Treasury securities were yielding about 12%, on their way to peaking out around 14%. The prime interest rate shortly after we started the firm got to over 20%. The stock market, a little bit like today, was down in the dumps. You had a market that the Dow was trading in the 700s and had done nothing for the past 18 years.

So a little bit like Japan, actually, down market over a very long period of time. No one was graduating business school to go into Wall Street. I've often thought that the day they come into the business. So if you started in 2005 or 2006, you probably were influenced by the optimism of those markets. If you came in in 1982 or perhaps in 2009, you were influenced by the pessimism of those markets. And it does affect you. If you remember how cheap things can get, you don't easily forget that lesson. So my background was I had worked for a couple of years at Mutual Shares. Mutual Shares was run at that point by Max Heine, who was one of the founders many, many years before. And when I started, it was a $40 million no-load mutual fund applying value investing principles.

When I left a couple of years later, it was $200 million. I learned an enormous amount there, probably more than I learned in my subsequent two years at business school. And the really important thing that I learned was value investing. Value investing is a risk-averse approach. Value investing is a series of principles and a way of thinking about investing that tells you to first focus on risk before you focus on return. I think ultimately all people are risk-averse, that it's a human tendency in a sense to be risk-averse. That if I offered anyone in your class or anyone I ran into double or nothing their net worth on the toss of a coin, they would all turn me down. Everybody would turn me down. And it's not because people wouldn't like to double their net worth, but it's because at the margin, the incremental value of more money is not as high as the pain from losing what you have.

So given that, the value investing principles make sense. That causes you to make a lot but runs enormous risk. And you can actually see that in action today, that people that are down 30%, 40%, 50% or more are in excruciating financial pain. Being down that much actually causes your thinking to blur. It causes you to stare into the abyss and wonder if you've lost half, how hard would it be to lose the rest? And most people aren't prepared to start over. So what you see actually is a dysfunction. They're holding cash. Endowments are rethinking whether they should be invested anywhere near the way they were invested before, and so are individuals. There's actually a fair amount of panic going on, and I think that could spread if things don't get better in fairly short order.

We started our firm—well, let me say first of all, you know, Benjamin Graham is really the intellectual father of value investing. He had the opportunity to work in the markets during the 1920s, 1930s, very much like Buffett after him, and in some ways like our beginning. A small amount of capital rummaging around for really mispriced situations, situations where there was a reason for a mispricing, a catalyst, something that would cause you to make money. The classic principle that Graham espoused is the net working capital test, where he said that if you can buy a stock for less than two-thirds of its net working capital, which is working capital minus all liabilities, that that would be a real bargain.

And the reason it's a bargain is you're basically buying that business for less than you could liquidate it for. And that's a critically important principle. It didn't mean you'd actually liquidate the business, but it meant that you could get out with a profit and that if the business turned around or the market perceived that it was about to turn around, you would then make money without actually ever needing to take control or to cause it to liquidate. Trading down below liquidation value, then, for most of the time in the last 75 years, there weren't so many periods where that actually was applicable. If you applied that test, as I said, like two or three years ago, you would have found almost nothing that fit.

And now, once again, there are stocks trading down towards cash per share, below working capital per share. So again, that test might be applicable. Now, I'm not in favor of a paint-by-numbers approach to value investing, where you just follow a few simple mathematical rules and start buying. My understanding of value investing from reading a lot about the studies that have been done is that value investing adds one to two, and avoided the more expensive half under whatever metrics you wanted—under price-to-earnings, price-to-cash-flow, dividend yield, price-to-book—that you would add a percent or two a year. But I also thought, why would you ever trust a dumb, blind formula when you perhaps could do better with your own analysis and investigation?

So I always thought, well, you can tell they aren't that cheap. The inventories are obsolete, the receivables are uncollectible, there are bad assets on the books, there's off-balance-sheet liabilities like environmental problems or litigation. So the thought from my firm's perspective was that we'd always follow value principles but try to improve on them through in-depth fundamental analysis and detailed research. The other thing that we try to focus on—in a sense, our approach is built on three underlying pillars. One is that, as Graham says, you want to focus on risk before you focus on return. Some of that comes from the worrying that George described in his introduction. A lot of it is focused on multiple scenarios.

What can go wrong? How much can you lose? We don't think of risk in an academic sense of beta, which doesn't make any sense to us at all. Volatility is not risk. Volatility is volatility. Volatility creates opportunities and isn't necessarily risk at all unless you absolutely need to sell the day that the price was very low. Rather, risk is the probability of losing and how much you can lose if you lose. So we focus on risk before we focus on return. That's obviously very different from Wall Street, where they still, even after pressure, write a huge percentage of research reports that are bullish, very few that are bearish. And even when they do think about other scenarios, they tend to oversimplify with single-point estimates rather than a range of possible outcomes.

In other words, inevitably you're focused mostly on how much you can make and with a spurious precision. Now, the second underlying principle that we think about is: the world is oriented towards relative performance. It's one of the giant weaknesses in the investment world. All the big mutual funds are focused on competing against each other, competing against the market. So they're looking at relative numbers. If the market's up 20, they want to be up 21. If the market's down 20, they want to be down 19. The reason for that, by and large, is everybody's an asset gatherer. And when you gather assets, if you perform in the top half of performance, or of performance, you almost certainly never get fired, you don't lose clients, and your firm is very profitable and successful.

So, by contrast, we think wealthy individuals and established institutions, because of their risk aversion, are actually interested in absolute returns. In other words, if you're focused on absolute returns, the idea of losing people's money becomes... Focus on relative returns, you're happy with losses as long as you lose less than everybody else. So, the relative approach ends up forcing people into a kind of a closet indexing approach that you don't want to look very far away from the indexes. You don't want to look very different from the indexes because if you underperform by taking a chance at being different, you could lose a lot of your assets under management. So, you end up kind of tracking the indexes and lying very close to them, which basically gives you

won't severely underperform, but you won't outperform either. Our view is that the idea of sending a letter to a client, you know, 'Dear client, the markets were down 30%, we were down 28%,' would make us sick. That your goal is not to lose less. Your goal is to kind of try to make money all the time, protect capital on the downside, and still do well enough on the upside. The third part of those three principles: most of the investment world has a top-down orientation. They think about, 'How's the economy going to do?' and, 'How are foreign currencies going to do?' and, 'What are interest rates going to do?' And I'm not saying that stuff's totally extraneous. You certainly want to think about it. But you analyze investments bottom-up, one at a time.

Top-down investor like George Soros in his heyday would have a view that the pound is overvalued or undervalued or that the Fed was going to cut rates or raise rates. And that would drive your decision-making and lead you to specific areas of investing and then specific companies within those areas to try to take advantage of those themes. And my view is that is incredibly difficult. Long-term demonstrated record of success with macro forecasting... And beyond that, you not only need to be incredibly good at the macro forecast, you need to translate it correctly into industries and companies and then be early or the prices may have already moved to reflect your viewpoint. So as we were forming Baupost in 1982,

We employed those principles, so we weren't just buying formulaic value, we were looking creatively for value. We did a number of things at our firm that we think helped us be in a position to be successful over time. One was we wanted flexibility from our clients, that the more flexibility you have, the better. Complicated and volatile and ultimately fairly competitive markets. So if you have a narrow mandate, like the only thing you can buy is investment-grade debt, you will for sure own investment-grade debt whether or not it's actually interesting. When the spreads are narrow, you'll own it. When the spreads are wide, you'll own it. When interest rates are low, you'll own it. When interest rates are high, you'll own it.

By contrast, if you have a broader mandate—all kinds of debt, all kinds of equity, perhaps some private assets like real estate, perhaps hold to cash when you can't find anything great to do—you now have more weapons at your disposal to take advantage of conditions in the market. Real estate is such a great example that I'll just illustrate with it. If you have a mandate that is only common stocks or you can only invest in REITs, you have a limited opportunity set: REITs might be cheap, they might be expensive. But if you can expand that mandate to all of real estate, so you might own a REIT or you might own the debt on a REIT or the convertible debt. You might own an equity in a property, you might buy a building, you might own the bank loan on that building.

You might own a municipal bond that's backed by real estate. You might own a commercial or residential mortgage-backed security backed by real estate. So the more weapons in your arsenal, the better the chances that you'll be able to take advantage of a mispricing in a private market or an international market that you wouldn't have been able to do if you had a narrower mandate. Another principle that we think is very important is putting our own money alongside our clients' capital, that collectively the partners in our firm are the largest client in the firm, and we don't allow people to have a lot of their capital outside the firm or active trading accounts. We want people focused on what we're doing here.

We want this to be the best place we can invest our capital. We work very hard. One of the things I think every investor needs to think about is to identify an edge. This has to be something that's legal and legitimate, by which they'll outperform. Investing is, as I said, often highly competitive. You're charging fees that you need to earn, by which we mean you have to have an edge. I think this is something many investors never really give that much thought to, and we think about it a huge amount. We think the biggest edge any investor can have, and the biggest edge we do have, is a long-term orientation. It's easy for people to say they do, and it's harder to actually have it. One thing that's really hard is, in a world where people are comparing your results often, where you have short-term

oriented money, and that's why we only have wealthy families and institutions. We don't have funds of funds. We don't have sovereign funds. We don't have pension funds. We don't have public mutual funds that we offer. We only have this long-term money that is able to take that approach, and quite sophisticated money at that. In today's world especially, you can see how clear it is that a fund that's down 25 or 30 or 40 percent has almost no ability to take a long-term approach because—how do you make an investment decision for a three- or five-year hold when you don't know if you'll have that capital for even six months? So a lot of funds feel this enormous pressure to either hold cash or to buy very short-term situations, bonds maturing in three or six months, stocks that have a catalyst that will work out almost immediately.

And that leaves a huge swath of the market with much less competition than usual. So long-term orientation is critically important. The congruity of interest that I described earlier is critically important in terms of putting our own money where our mouths are. Relationships are incredibly important. In some of our activities, it's more obvious than others, but for example, in the buy side part of Wall Street, we work really hard to have the best brokers and be really important clients to them. saying, we've got a big block of this for sale. Are you interested? But if we're somebody's first or second biggest client, and they get an order to sell a $500 million piece of something, they're going to call a client that they know can respond, can move quickly, can act with integrity, cannot blab it all over the street.

And that's a huge advantage to have those relationships. And many of the people covering our account have covered us 8, 10, 12 years, or in some cases, much longer. Similarly, on the private side of what we do, for example, real estate, the relationships are critically important. We work very hard to find people that think like us, that have a value orientation, that are finding mispriced assets. We don't have to shoot down a lot of deals that aren't interesting. They are patient, so when the markets are fully overvalued, they're not pressing us to do transactions, negotiate a contract on every deal. We have an agreement that we're going to work with. When we—when they tell us they've done their analysis, we know what that means because we've seen their analysis before. When—when they come to the table with an interesting transaction, they know that we have a large amount of capital, that we have cash ready to close, that we will meet our commitments and close.

As they say in real estate, real estate's a business where many transactions just don't happen at the 11th hour because the people were fooling around trying to get a better price or trying to get an improvement in the deal in some other way. So those kinds of things are critically important. We have a team that's been together a really long time. Our senior team has been together 10 years plus. Many of the senior operating positions in the firm have been here 10 to as much as over 20 years, 23 years in one case, and it's a 26-year-old firm. So we have the—we have shared knowledge. We have institutional memory. Those things also matter a huge amount. Our particular niche, I would say, our particular focus in the markets is we think there are a lot of smart people out there.

We don't think we're the world's best forecasters. We like situations with a catalyst where there's some reason that a pricing irregularity will correct. So you buy at a discount and something will cause it to correct. That leads us into interesting places. So for example, one of our favorite areas is distressed debt. Why distressed debt? Why do people buy bonds? Basically for the simple reason that they want a senior claim and they want what they think is a very high probability of getting interest on time and then their principal back upon maturity. And senior debt has a catalyst. If you don't get paid at maturity, you throw them into bankruptcy and you hopefully get paid after bankruptcy. What happens though is people that are buying debt for this safety, when a situation becomes impaired, when a bond gets downgraded below investment grade or when it actually files, when it defaults on payments or files for bankruptcy, there's a huge constituency of forced sellers.

People who may not wish to sell but their charter says you can't own a bond that's in bankruptcy, you need to own performing debt or you need to own only investment grade debt and that bond just got downgraded to a single-B. So the day that that trigger event happens, a downgrade, a filing, something of that kind, that bond is suddenly being sold by many, many of the holders who have no choice. They're not analyzing and saying, 'That's a great sale at 40 cents on the dollar.' They're saying, 'Get me out.' Inevitably, you want to buy from people that don't know what they're doing. Warren Buffett has this saying that if you can't figure out who the patsy is, the person who's supposed to lose money, it's you.

And investing is the same way. That if you are buying something and there's a chance that the person selling knows more than you, there's a chance you're a sucker. If you're buying and management is selling, you might want to think twice if you can figure that out. If you're buying and, you know, Steve Mandel at Lone Pine Capital is selling, that's a really bad thing because Steve Mandel does great analysis and probably knows more than you do. So if you can find a situation where somebody's selling a bond at 40, not because they've carefully analyzed the present value of the cash flows and concluded it's worth 30, last week and it's 40 and they have to sell and their boss is looking over their shoulder and their clients are yelling at them and they have a mandate that says they can't hold that bond, that has a much bigger chance of being mispriced than a stock that's being sold by Steve Mandel.

So we love to find situations where there's this kind of supply-demand imbalance. Now, most of the time those are rare. One example would be a stock in the S&P 500, and once in a while they rebalance the indices, and that stock has not performed that well, earnings have been terrible, the market cap has shrunk, and it no longer would fit even into the S&P 1000. They'll get around to throwing that stock out. The day they throw it out, 10% of the shareholders have to sell because 10% of the market is owned by indexers. So the day that that stock is kicked out of the index, 10% has to trade at 4 o'clock. And that may be cheap and it may not, but it's a really interesting thing to look at because 10% of a company trading at the close of a business day is a lot of volume to absorb.

And that is a place to begin filling your inbox. Time is scarce. You need to think about how you're going to spend your time, what you're going to look at. So I would say looking at situations that are bonds that are downgraded, looking at situations that are kicked out of an index, looking at corporate spinoffs. A corporate spinoff typically would be a situation where you have a fairly large company that has an unwanted division of some sort. It has a major liability. It has a lower return on assets, or the consultants say, 'Get out of that business.' It has weak management. It has some kind of problem. They paid too much for it. They want it to go away, but they don't want to take the loss for tax purposes.

A spinoff, where you mail the shares out to your shareholders, is a way that companies deal with problems. The day that spinoff gets spun out, if the parent's in the index and the spinoff's not, 10% has to trade at the close that day. And moreover, many of the people that hold the parent wouldn't be interested in the spinoff. It's in a slightly different business. It's, as they say, not growing as fast or lower margin or lower return on capital. And so that spinoff, maybe because it has litigation, that spinoff may go begging. Spinoffs are a really interesting thing to look at because there's a natural constituency of sellers and there's not a natural constituency of buyers. In today's market, this is way easier in a sense because there's distress selling all over the place.

modeling on the equity side. There are funds of every type getting redemptions. So across the entire universe, a huge amount of what's going on is forced selling. It doesn't mean it all works. Certainly anything that was forced selling a year ago is now down, and we have our bargains. We think the underlying principle still applies, that stocks are trading often today not because people have crisply analyzed them and understand what's going to happen, but rather because a seller has to sell a large block and there's no buyer that's coming along. There are very few people with large amounts of capital looking to throw it right into the market. Bit off the beaten path, some of them are smaller, some of them have some kind of event going on, a catalyst if you will. One of our favorite holdings is—we have two holdings in oil and gas limited partnerships that are publicly traded. In both cases, they have hedged their production out for the next five years, virtually all of it. They trade—one trades at probably

The other one trades at probably a third of its reserve value unhedged. In both cases, they trade for approximately equal to or below where their likely distributions will be. If you just add up what you're going to get over the next five years, that's already locked in with hedges. They trade at or at a discount to that value. So five years from now, you'll have all your money back, and you'll own this giant pile of reserves extremely inexpensively. The other has a current yield of 30%, again, based on those locked-in hedge distributions. So that's a weird piece of paper in a sense. It's not a conventional equity, but there are aspects to it that make it superior to a conventional equity. We own shares in a biotech or a pharmaceutical company.

drugs and has partnered with major firms. They therefore own a large royalty stream. The company felt that they were getting no credit in the market for this very large royalty stream because they were also spending a lot of money on discovering new drugs, and that was causing them to not look profitable. They decided to split into two. So the spin-off was the drug discovery parent, which was losing significant amounts of cash and was investing that to find new drugs. And the royalty-receiving entity was separated from that parent. The royalty-receiving entity trades right now—it's called PDL BioPharma, it trades in the low to mid-sixes—or, based on the present value, based on the likely collections discounted back.

So it's about a 30% annualized return over a number of years based on—nothing great needs to happen. Those drugs need to just continue to be sold, and we have estimates. So, that seems to be a remarkable mispricing, but it's an odd security. It's not a big-cap stock. It's not widely followed. And you have some uncertainty that drugs could turn into problems. There could be challenges to the patent. But we basically are assuming very conservatively what happens and think it's just remarkably inexpensive. The other part of the company, the biotech research, has about $16 or $17 a share in cash, and until yesterday traded at $6 a share. So you could clearly liquidate that, stop all discovery activities, and probably mail out $10 or $12 or $14 a share back to the holders, and it's trading at $6.

So it's a classic Graham and Dodd stock, $16 or $17 in cash, trading at $6 with no debt at all. In debt instruments, we have the same kind of experience. We look at things, especially in today's world, to a worst-case scenario. We don't know how bad the economy will be. Certainly there's been a giant upheaval. It's hard to think about things just getting better in a hurry. You never know. You don't want to bet the ranch in any case. One of the things that's going on today in a highly publicized way is anybody that is long is an idiot. Anybody that's short is a genius. Astonishing geniuses. And the problem is, as I said earlier, nobody's really good at forecasting over time. There are a lot of people that can call one recession or one bear market, but inevitably they get hung up on overstaying their welcome.

We're looking for the same thing to happen more than once, and history doesn't exactly repeat. So our view is it might recover, and it might stay awful, but to be safe, to have that margin of safety in our investments, we want to assume that it's pretty darn bad, and we want to assume that for quite a while. Nevertheless, with all the forced selling out there, there are plenty of opportunities in corporate debt, in mortgage debt. We think there will be large opportunities in commercial real estate debt. There will be opportunities in corporate bankruptcies that are not yet bankrupt, but given the number of LBOs out there that will hit a wall, a huge opportunity there. Opportunities in complicated structured securities, CLOs, CDOs, that kind of thing.

Opportunities in private markets, especially in real estate, but also perhaps in bank loans of every size as banks get around to tackling some of their smaller problems. They've got plenty of large problems you don't read about, but they also have a very large and growing amount of smaller problems, loans to the local supplier, distributor, franchisor of restaurants, and those ones are all going to eventually need to get sold as banks clean up their balance sheets. And a lot of those companies are running into trouble in this difficult economy. So we have spent down a fair amount of our cash. We entered 2008 with about 35% cash. And it's not because of some top-down market timing thing. It's because we couldn't find bargains.

And we have spent that down to where cash is probably in the high teens, low 20s. And it's only that high because we keep selling stuff to buy better stuff because we don't want to run out of cash right now because we see an environment where there's just ongoing dumping of large amounts of debt instruments in particular across. We are buying things almost every day. We don't think the world's ending. We don't understand how people could think the world's ending. The world doesn't end that easily. But rather it's a world where you're shrinking balance sheets. You're cutting back from 25 or 30 times leverage to 10 or 12 times leverage at a lot of financial institutions. People that were speculating

entirely. So you will likely have a world where there's assets with higher returns than have historically been, although not as high as today. You will have less competition and perhaps years of runway before the speculative juices really get going. Not that they would like to get going because they're clearly people ready to go on CNBC and tout stocks again, but I think that the world has changed enough, people's behavior has changed enough that things aren't coming rushing back anytime soon. To find bargains, we are modeling several years of serious GDP decline into everything we do and only buying when we can get comfortable. We earn a very high return even through that, and that makes us comfortable that we're sort of prepared for a depression and we'll have positive optionality if we have anything short of a depression.

I have a great team. We think very hard about our team and our culture at our firm. Our culture is highly collaborative. We want people to be able to impact the firm at the junior levels as well as the senior levels. So we have a very active, open trading room with people meeting all the time in small groups. The whole team comes together, which activity people do anywhere from once a week to several times a week in various permutations. And the entire team, everyone, comes together once every three or four weeks. We want people to challenge the thinking and decision-making. We often tell people, in effect, that we're a firm whose DNA is changing because every new person adds to the cumulative DNA.

And that if somebody comes in and has been here a week and says, 'Why are we doing this this way?' the answer can't ever be, 'Because we always have.' The answer is, 'Because we've thought it through and this is the best way. But if you have a better approach, please tell us because we'd like to look at that.' We compensate people based on, certainly, their own progression, their own development, but also based on how the firm is doing. So if the firm has a better year, everyone does better. And that creates a great alignment of interests as well. One of my pet peeves is a lot of firms have more rigid allocation of capital internally. So they would have, you know, Jim has $200 million to invest, and Bob has $100 million, and Susie has $300 million.

And the problem with that kind of allocation is that there are times when Bob's ideas are the best. There are times when Susie's ideas are the best. If they each have their own pile and work in their own little silo, there's no real incentive for them to collaborate, cooperate. And what if it's obvious to Bob that all of Susie's ideas are better than Bob's best idea? Bob should want his money and her ideas too, but he can't accomplish that because his silo doesn't permit it. And other times Susie will want her money and Bob's ideas. If you have a firm where the capital isn't predetermined to people, different asset classes, or countries, that the money could slosh into the best bargains. And that ultimately makes you more money with less risk.

You're moving into the best bargains, so you're buying things that are cheaper, which means you have less downside, and you have more upside. That's the whole idea of Benjamin Graham's principle: buying bargains. Unlike what people say about risk and beta, you know, if a stock has—let's just say the most simple case, let's take that biotech stock, forget the complexities of it—that biotech stock was $16 or $17 of cash trading at $6. If that stock suddenly drops to $3, does that make it more risky because it's very volatile, or does it make it a ludicrously good bargain because it's now trading for half the price? You can only lose half. Collaborative environment, we end up doing ourselves and our clients a favor, having a portfolio with less risk, more return, and ultimately, therefore, generating more profit for the clients, more profit for ourselves.

I could go on forever, but I think it's a great opportunity to interact.

So why don't I try to open up for questions, and we can talk about anything that would be helpful at all. I guess I would say a few things. First of all, when I think about value and growth, I think about something very different than what the academics have modeled in their studies. I don't think that the stocks trading at the lowest half of the PEs in the market... You get a high PE. So I would sort of say companies that are growing fast are growth. Companies that are very cheap are value. Sometimes the growth stocks are the value stocks. So I don't understand a lot of the conventional thinking about that. A second thing I'd say is I think, in a way, value, but really all stocks, got caught up.

There was a kind of thinking before the bubble burst that said, 'Let's price everything off of a leveraged buyout model,' and that people assumed debt would be always available, and that a company that got cheap for even five seconds would inevitably attract predatory activity by leveraged buyout firms. So, in a sense, all public stocks started to trade on this invisible grid that priced them to the perfection of an LBO. Many of those stocks were value stocks. The buyout guys couldn't; you could. So you ended up with a lot of stocks priced to that model. And when the world got worse, you both had all sorts of economic pressures, deteriorating earnings, uncertainty, and you lost the support of that pricing model.

So things maybe that had been too high—maybe I'm saying value stocks, in a way, certain of them at least were too high. There was not enough margin of safety. There was not enough room for error for those stocks. But the third point, which I think is the best one, is one of the things that looked cheapest in the market were financials. Financials had gone crazy in terms of—they'd gone from a much lower number to close to 40% of S&P 500 earnings over a long period of time. They got bigger and bigger and bigger. In a sense, people were paid less. Much of the economy was based on lending money and managing money and earning money through debt financing. And we were fortunate because we had a view across a variety of markets, including securitization markets, so that when the housing market started to turn down in early 2007, we just realized this thing could be—

but we had an idea that if housing just stopped going up, you would have tremendous amounts of defaults because people were assuming that housing would only go higher and that some of the Option ARMs and strange securities like that, subprime loans, would reset and people wouldn't be able to pay them and wouldn't be able to sell their house at a profit. That would cause a default and ultimately a fairly large loss because of the friction involved in selling it. Go down, this would become a fairly large problem. So then we realized, who owns this junk? We weren't sure who owned exactly how much, but we knew that people like AIG and people like the big banks were the major originators and the major speculators in a lot of these things.

So we just steered clear. A lot of the value guys sort of drank the Kool-Aid—power of $5 a share or $10 a share—and would buy it no matter what. And when it fell from a high level to a slightly less high level, they thought it was a ridiculous bargain because I think they didn't understand just how bad book value could be of a financial. So we feel like a lot of people got the financial part wrong. I don't think value investing is discredited, but I do think some people have made a fairly big mess for themselves. You know, as I said earlier, we think of risk as how much can you lose and the chances of losing it. We run intensive sensitivity analyses on everything we do. For example, we're looking hard at the mortgage market and the market for mortgage securities.

And we will run a whole variety of assumptions. So we'll assume that, you know, what if housing drops 20% more in 2009 and 20% more in 2010 and 10% more in 2011? Voluntary prepayments drop to 4% a year, to 2% a year, to zero. And we just look at everything that is in every part of the analysis that matters and vary it to understand how it would affect us. If we could find a security that modeling to depression conditions still generates a high return for us, as we have with some mortgages and some corporate debt and some equities, we're very happy to get involved. Risk and return interact in the way I was trying to describe, that the academic definition of these is so off from the truth that the way we think about it is, if you really—academics think securities are basically efficiently priced, and we think that it's easy to find things that are not efficiently priced, and there are often reasons for that: bad management, or, or...

Complicated structures or fees and expenses. But if you could find, let's just say, a closed-end fund that has $20 worth of value trading at $10—you might find such a thing today—that would be interesting. Now, if that drops to $5 and the NAV stays the same, it drops to $5 because a Russian bank that owned a lot goes bankrupt and has to sell tomorrow, academics would say that's an efficient price, and they would say it's become riskier because that stock moved 50% in one day, so the beta's higher. And we would say, 'Wait a minute. You have half as much that you can lose. It's gone from 10 to 5. It can only go to 0. So you can only lose half as much. And now you can go from 5 to—instead of going from 10 to 20, you can go from 5 to 20.'

You can make twice as much. So we would say that they interact because the less risk, the more return. They're two sides of the exact same coin. But that's not what academics say. Academics say the riskier it is, the more return. But we'd say the less risky it is, the more return. So we're really talking at complete odds with each other. And I have 26 years of experience. Warren Buffett has 50 years of experience saying I'm right and academics are wrong. Yeah, I mean, News Corp is a hodgepodge of valuable media assets, including their satellite in there. There's a whole bunch of different businesses. Fox News is incredibly valuable. We have talked to a number of cable industry people that have told us it's the one thing they have to have, no matter what News Corp charges.

CNN, they don't have to have. Fox News, they have to have. They just raised their rates, so they'll actually be increasing cash flow significantly in that area. We think the breakup value of News Corp is easily $15 or $20 even today, and in a normal environment is $20 to $30 a share. There's not a lot of—almost no—debt maturities in the next 10 years. There's like one and a half times EBITDA in the form of debt, but it's all way out there. The company's earnings will drop from the low $1 to $0.50 or $0.70. It could even go lower. But the stock's at $5, and it represents ridiculously good value. Certain parts of print media will go away or will decline for a number of years. Most of it will be okay.

We think they're actually fairly well run. Most of the acquisitions have worked out. And if you look at sum of the parts, it's very hard not to get comfortable. The value is way, way higher than here. Did we own it too soon? Absolutely. Have we been buying it lately? Yes, we have. Somebody asked me this, I spoke at Harvard Business School about a month ago, and somebody said, 'Tell me some good news.' And I said, 'Look, it's going to be harder to get a job anywhere and harder on Wall Street, but it'll be a much better job. It looked easy in 2006 when the market only went up, but it in fact was hard. If you started your career in 2006, you've probably been fired, you probably have a terrible track record, and you've lost your bearings because the world you thought you knew after only a year and a half or two years, it was not recognizable.'

Today, there are huge investment opportunities. It's obvious that amidst the greatest amount of chaos comes the greatest amount of opportunity. There's opportunity to screw up, but there's opportunity to get it right. In the meantime, when things are less expensive, it augurs well for the future. When you look at any kind of back-test, if you look at any study, the highest returns going forward are achieved when you've had the lowest returns looking backward. So a period where we're almost at 12-year lows or 13-year lows a few weeks ago, that suggests that the next 10 years will be much brighter than if the past 10 years had been up 15%, which would suggest that the next 10 years would be awful.

So I think we're looking at a period that is likely to be better than the one we've been through. We have to get through this downturn. But mostly, you'll have a very fertile environment in which to be an analyst if you enter the investing side of Wall Street. Yeah, I think there's circularity to those tools. So I think that's part of sort of modern finance theory, and we would never use any of that. That your cost of capital changes based on your stock price and your bond prices. So how can that be a way to value a business? It would be a way of saying when the price is high, it's justified, and when the price is low, it's justified. So we don't believe in that. Our view is always, you can't really have a single point value.

You need a range of value. So you look at replacement cost and you look at book value and you look at present value of cash flows and you look at multiple of P/E or price to cash flow. You look at sum of the parts. You look at private market value. You look at everything you can look at. Some of them don't apply to some companies. And then you sort of have a range. And if you're in that range, it's perhaps quite interesting. So that's the way we think about it. We don't really understand the concept of how to think of a permanent cost of capital that would give you any kind of analytical ability. Often, the greatest opportunities are around the edge of things. If everyone's looking at something a certain way, looking at it a little differently can...

You want a stock that hasn't quite made that. If people are valuing companies off of lofty projections of 2010 earnings, you might say, 'Well, what about liquidation value? What can I buy where I can liquidate it and get my money back?' The world thinks about something as a business. We think of it as a pile of assets. The world thinks about it as a future LBO. We think about it as, 'Where would we, in fact, be willing to buy control of this company?' People often talk about that. We actually think about it as part of analysis because if you would only buy 2% of a company at a price but would be afraid to own it all there, it kind of highlights maybe you're speculating and not actually investing. So we look at a lot of different approaches to kind of narrow in on what the value is without ever having a high degree of conviction that we've gotten the exact number.

I often say to people, you know, if you drive a car and you know exactly everything about the car—it's never been in an accident, you have 18,000 miles on it, it's a two-year-old model—you don't know what that's worth within $2,000 or $5,000, perhaps. So how do you know what a gigantic, complicated business is worth to an exact dollars and cents per share?

Nobody can know that.

There are many kinds of managers that I admire, and they do different things. In terms of a plain, long-only manager, I think highly of the folks at FPA Crescent. Bob Rodriguez, he was just at Barron's, I think. I think the folks at Southeastern Asset Management have been struggling lately, but actually are very, very smart and do a good job over time. I think people at Tweedy, Browne do a consistently good job. They've also got some really interesting material on their website in terms of what works in investing and a number of other publications that are worth looking at. In terms of—many of the best managers now are in hedge funds because they can make more—I have very high regard for people like Paul Singer, like David Abrams—used to work with me—the folks at Perry Capital, very, very smart guys, very capable people.

I like the people, I like Jeff Halis at Tyndall, I like Michael Lowenstein and his partners at Kensico. There's a lot of really talented, good investors in a variety of different asset classes. Most of them are equity, some of them are multi-strategy. His value... Somebody like Steve Mandel, somebody like Brookside, the Bain Capital subsidiary. So there are a variety of people that have different approaches and I think one of the nice things about investing is you can both have collegial relations with people who are also your competitors and that a number of different approaches can work, although I would view them all as one way or another subsets of value investing. Yeah, I guess what I would say is, you know, we're not running five-year earnings forecasts, so it's not like we would say the economy's exactly down this much in which year.

But to highlight an example, we have looked at some of the auto finance companies and looked at their debt. They're captive, so their equity doesn't trade. We have said right now the default rate on auto loans has not gone up all that much. So you're running a 2% to 4% annual loss rate at these companies. That's way less than the number of defaults on houses in many markets. It's way less than the losses on credit cards all of a sudden. And we don't have a really good reason for why it's so. Very few of these loans are subprime, so that's good. If you're into a car over a few years, you're very unlikely to walk away. You don't have the money to buy a new car. It's hard to get a new car loan, so you'll probably keep paying on your old car.

Also, if you have a job, you need to drive to get to work often enough. So there are reasons to think people will keep paying, but we expect it to get worse. So we've modeled that. We said, what would be really bad? A base case scenario for really bad is—it has been—if it quadruples, the bonds that we're buying in, give or take 50 cents on the dollar, are still worth 90 to par. And if it goes up eightfold, which is Armageddon—40% loss rate over the life of a car loan, 40% loss rate on the life of a lease, 40% loss rate on the new cars sitting in dealer showrooms, all of which these companies lend to, in Armageddon. And that is as close to Armageddon as we can look at, you know, a housing market that's already corrected massively, and we assume literally down 20% more in '09, '10, and 10% more in '11.

That will get you down, for instance, in California to 1979 home prices. It will get you way past any affordability metric, and will get you to a mid- to high-teens current yield on renting. So if you can buy mortgage securities to earn a high return to that assumption, which you can't always, but perhaps in some cases you can, that's the kind of Armageddon scenario that makes us very excited to invest. You could not apply that same stress test to any bank and still buy it. Every bank in the country would be wiped out under those scenarios. So I don't think it will happen, but we can apply that and still buy things to quite high returns. Every asset's different. Some of the harder things to figure out, whether it's a Las Vegas casino or Hilton Hotels, the revenues are down 15% to 20% year-over-year on these things.

And what you can't tell is, is next year flat from here, back up 15% or 20%, or down another 15% or 20%? When you have that kind of wild disparity, we think it's uncomfortable to assume that you know what will happen, and so you need to be able to buy it to a deteriorating scenario and still get a good return. It's much harder to make those assumptions in certain businesses than in others. Will the volume of Kleenex go down 20%? No, it won't. But might the revenues at a gambling casino go down another 20%? They could, because people don't have to do that. We're trying to be really careful, and it's easy for us to just say, you know, we don't have any opinion on that. We'd like to have an opinion, but we just can't get comfortable.

And so we have so many opportunities out there in this kind of turmoil. We just don't need to do everything.

We're comfortable saying no.

I think it's helpful to work on Wall Street for a few years. Goldman Sachs obviously has a great training program. Many of the investment banks and commercial banks have a very good training program. I think working at a small fund could be a good experience if it's reputable, if they apply similar standards to what we apply. If they're a growth or momentum fund, we would disqualify somebody because they would have learned the wrong things. But if they're looking for value like we are, that would be perfectly valid. Consulting could be good. We have some people with that background, really good view into industries, into thinking about tearing apart a P&L statement. It depends on what firm and whether that was a relevant experience.

So we're not that fussy, but people right out of college often just have no the ability to train people to that extent. We certainly work with our people and train them a lot, but they need to have some facility with what we're trying to do. I don't really, other than it perhaps is only in recent years that Buffett has looked overseas. Graham and Dodd was focused here. I don't really know. I would just guess the historical origins of where value investing came from are here. But you do have people like Jean-Marie Evelard and others who have expanded internationally. We recognized in the security analysis update that the chapter that's not written in the original is international value investing.

And the principles apply exactly the same. It's more complicated when you're investing cross-border with settlements and currency hedging and voting and notice requirements and that sort of thing. But we think there's fertile ground for value investing in foreign markets, in other asset classes even, and I imagine over time that will all even out. We're looking for egregious mispricings. I don't feel as talented as Buffett by any means in identifying a great company and buying it at a fair price. As he has demonstrated, you often just can't find those great companies at a fair price. We're looking for very low-risk, high-return situations, and that often involves smoking the last few puffs out of a cigar that somebody dropped.

The nice thing in today's market is you can buy surprisingly good-quality companies or assets and not have to pay up for them.

I would say a number of things.

First of all, we're very careful with the analysis. We have several people work together on situations. So if one person might have made a mistake, hopefully other—that we want people that are experienced and capable analysts. We don't want people that are right out of college that just don't have enough background to know what to look for. There's tremendous intellectual discipline and intellectual honesty in what we do. If we do make mistakes, we want to learn from it so we never make it again. We want to be able to call a mistake a mistake. Really hard to have a very high degree of intellectual honesty. If we do recognize we made a mistake, we try to admit it immediately so we can sell without much pain.

One of the biggest problems is if you have a culture where you get yelled at, which we don't have, but it happens at other firms. If you bought something and—if you raise it to your boss and your boss yells at you, you have a disincentive to raise it. You have more incentive to hide it and hope it works out. And we never want to have that. So one of the messages I give loud and clear to everyone in the firm is, look, don't view it as not your business if someone else is doing something problematic. If we're buying something and you think it's stupid, I want you to find a way to communicate. I don't want you to do it in a humiliating way to the person that had the idea. You owe it to the firm, and you owe it to yourself, since you have money invested here and your bonus depends on how the firm does, to raise your concern.

We heard about a firm that blew up in the last year or year and a half, and many people in that firm were worried that the firm was doing things that were not going to work out well, and yet nobody felt comfortable raising their voice. But they didn't actually raise their hand and say, 'Let's sit down and talk about this because we're taking a huge chance.' So by having a good culture, I think you also limit the possibility of serious mistakes.

Yeah, we never hold on for the last nickel.

I think you make a big mistake. A lot of times people will fall in love with something. They buy a stock at 10, they think it's worth 20, but it's acting so well when it hits 20 that they hold on until 25 and it's no longer a value at all. Not that you shouldn't reassess if you decide, you know, it really has added value, their business is better than I thought, their retained earnings bring the value higher. That's okay, but to just fall in love with it because it acts well is irresponsible. One of the things we try to think a lot about is this business is largely about psychology—that if you're down a huge amount, you're not thinking straight. If the markets do something that completely surprises you, you can be a deer in the headlights.

Right now, many firms are not willing or able to commit capital, even if they have cash sitting there, because they're afraid of redemptions. They really badly don't want to be down again in 2009. They face an ongoing task of getting back to high water. That is a huge benefit to not have your own psychology get interrupted. The example I like to use: let's say, again, you find a stock at $10 that's worth $20. If that stock goes to, let's say, $18, $18.50, we will have sold it. We'll be gone. And we'll let somebody else make the last dollar or two. There to buy it to make that last dollar or two—if they're not there, you may not get it, you know, it may not go to that level. So if you hold out, and then it shortly afterwards announces terrible earnings, and the stock plummets back to 10.

How do we feel? First of all, I feel pretty darn good that we sold it, took our profit. Second, we think we got another chance to get another bite at this apple. We think it's worth 20 still. Let's say we reanalyze it. We verify it's still worth 20. We can invest at least as much, maybe more, because now we know it better. We like management. We're comfortable with the business. Now, let's say we didn't sell any. We were greedy. We're holding out for 20. We're so annoyed. We're annoyed with ourselves. Being human, we don't really admit that. So we yell at the analyst. We yell at management. Those idiots, why didn't they tell us it was a bad quarter? And it goes back to 10. And at best, you hold on.

And at worst, you hate them, you sell it, you certainly aren't adding because you've been burned. So that psychology of the round trip, if you will, is devastating. So we always, for a whole variety of reasons, including also some of our positions are less liquid. They're small-cap companies or we own 10% of the company. And you need to sell that, as a friend of mine refers to it, as feeding the birdies when they're hungry. You need to sell that stock on the way up. On the way up, there's volume. On the way down, after bad news, there's no volume until it opens down 30% or 50%, and then there's volume, but it doesn't do you any good. So we'll always sell too soon, we'll always buy too soon, and hopefully we'll make money somehow in between nevertheless.

There are not formal policies.

I would say, first of all, we have a Chief Risk Officer who sits right next to me. In some ways, I am also the co-Chief Risk Officer. Risk is different here than a lot of funds. We don't use leverage. We never have margin debt ever in the history of the firm. We don't have a meaningful short-selling book. I think if we have any shorts today, it's like under $20 million, so it's irrelevant. And we really don't think that's—we understand why people do it, and we think it's very legitimate for people to do it. It's not our approach. So when we want to hedge, we try to do it with disaster insurance, out-of-the-money options, or something like that. We don't think shorting most of the time adds any value.

And what it actually does is give you an overly short-term orientation, because you've got to worry about, will they beat their earnings in the next quarter? If your analysis for your shorts is short-term, your analysis for your long starts being short-term, and you aren't a long-term investor anymore. So we're acutely focused on risk. We think about diversification. We think about position limits. We think about industry limits. And at the same time, we think that one of the mistakes most investors make is overly diversifying. Owning 101 ideas trying to limit their losses by only losing at most 10 or 20 basis points on a loss and I think that the problem with that is it presupposes that all your losses will be one-off events from from a company having a particular problem rather than the whole market going down if the whole market drops 40% and you have a hundred one percent positions or ten percent positions you're probably going to be down around 40% either way so we don't think that actually

And what it really does is limits your return. If you can tell a good idea from a bad idea, how can you not tell a great idea from a good idea? And so we're very comfortable that we'll have 3 and 5 and even 8 and 10% positions from time to time and that overly diversifying actually eliminates return and doesn't really defend against risk very much. So that's our risk control. In terms of an investment policy, we don't know what our benchmark should be. 'We want to come in and tell you how we're benchmarking you.' And I said, 'I won't meet with you. I'd like to meet with you on anything else, but I won't meet with you on that because it will change what I do. I will inevitably start thinking about, well, gee, if my benchmark is the S&P plus some bond index, I will now think, gee, I better hold my cash in the form of S&P futures.'

And that's not right. I guess we have enough—this is our product. Our product is we're going to buy the best things we can find, and if we can't find great things, we're going to hold cash. And if you benchmark me, I don't want to know about it because I don't want to influence our product. Our product is our product and I truly don't know a correct benchmark. You know, there are times when we're heavily in equities and times when we're not in equities at all, times when we're fully invested and times when we're in a lot of cash and I don't know a benchmark for that. The benchmark ultimately is, are we delivering a good absolute return to our clients over a long-term horizon?

Which, touch wood, over many years we've managed to do.

Easily the most important thing is to act with high integrity. The watchword of our firm has been, first of all, put the clients first. If you treat the clients first, with respect and with 100% of your efforts, you don't gouge them on fees. You don't proliferate products. You don't put yourself in a position where you're thinking only about what's good for you. They know that, and I think that, in an indirect way, you actually maximize your own good by maximizing your clients' good first. It's the real value of an incentive-fee-based approach, that we make some money off of management fees, but the lion's share of what we make is off of the performance fee, and that means that we only make a lot of money after the clients have made a lot of money.

And there are not a lot of businesses that actually can operate that way. There are a lot of businesses that sell overpriced, shoddy merchandise that make a lot of money regardless of how the client does. We work very hard to put our employees first. We have a great working environment in the firm. In the good years, everybody gets a bigger bonus. 30-odd people own stock in the firm. So again, putting other people first. And finally, it's sort of obvious, you hear about it all the time, but your reputation is the only thing you really have. You come into the world with it, and all you can do is make it worse. So you really have to work hard not to make it worse. And the football field test is to play the game inside the lines, that it's easy to cross the line, it's easy to step out of bounds, and you will forever regret that.

And you should assume that whatever you're doing could be on the front page of the paper. And it's a great humbler to say, you know, 'I thought about that, and it would just sound really bad.' It may be legal, but it would sound awful if people... In 26 and a half years of Baupost, that's never been a wrong approach.