Seth Klarman's Warning for "The Everything Bubble"

The first thing is, we've been in an everything bubble. I think that a lot of money has flowed into virtually everything. You've had speculation during that bubble in all kinds of things from crypto to meme stocks to SPACs.

That day is Seth Klam, and he is the chief executive and portfolio manager of the Bell Post Group, one of the world's largest hedge funds, an author of the 1991 book Margin of Safety. Seth is one of the world's best value investors, having achieved a net worth of 1.5 billion dollars. But chances are you probably haven't heard of him, as he's one of those investors that avoids the spotlight at all costs.

You are somebody who shies away from publicity. I've been trying to get you to come on the show for years, so has Andrew. So we are thrilled to have you here today. But luckily for value investors, Seth finally came around. And for those that don't know how much of a big deal Seth Klam actually is, well, Warren Buffett himself regards Seth as one of the few investors that he would trust to beat the market over time. When I asked Warren Buffett at one point, like people who could beat the market, there's probably about five people who could actually beat the markets over time, and you're one of the names that he listed on that.

And while that's nice and all, it's also just a little bit concerning when he comes out of the woodwork for his first interview in years and warns us that we've been living in an everything bubble and the rampant speculation in the stock market is going to cause us some problems. But what's really awesome about Seth is that he isn't all doom and gloom. In fact, while his sentiment may be one of concern, he does give us some really good pointers as to how we, as value investors, should be navigating these tricky market conditions.

So definitely stay tuned for that later in the video, where Seth essentially tells us his secrets. But for now, let's start at the start. What's the problem that Seth is currently seeing in the stock market? We've been in an everything bubble. I think that a lot of money has flowed into virtually everything. Historically low interest rates, even zero rates, have precipitated that bubble.

So while Seth does see a large bubble forming in almost everything, he's quick to point out that this was almost inevitable based on the last decade of low interest rates. A sustained period of low interest rates means investors are no longer able to generate a decent return from low-risk assets like government bonds or savings accounts. This ultimately causes the big money to flow into other riskier asset classes like stocks as they hunt for returns.

But this economic phenomenon was left unchecked for the better part of 10 years, and what this meant is that as asset classes like real estate and blue-chip stocks got bid up to the Moon, investors continued searching and searching for less mainstream asset classes they could park their money in to keep hunting for returns.

The problem is these asset classes became increasingly speculative. This is why we saw the rise of cryptocurrency, meme stocks, and SPACs, as Seth is about to talk about. You've had speculation during that bubble in all kinds of things from crypto to meme stocks to SPACs.

And the book has some important reminders for people about the dangers of speculation and the importance of remembering what kind of environment you're in. That's the real problem: as investors look to shovel their money elsewhere, it increasingly went into speculative assets. These are assets where you don't have a robust way of predicting future cash flows and therefore can't be sure of the intrinsic value.

Cryptocurrency is the classic example of this. It does not produce any cash flows at all; its value is derived only from what the next person is willing to pay for it. And the issue with these types of assets is that they tend to be extremely volatile. Sure, they can skyrocket occasionally, but when the reins get pulled in on the economy and greed turns to fear, they can also reverse course just as quickly.

And that's what we've seen as the market came to grips with the Fed's change of monetary policy. All of these assets suffered heavy losses. Cryptocurrency got hammered; Bitcoin is roughly halved from its peak. SPACs are dying back. In 2021, Forbes notes we saw over 700 SPACs created, but in 2023, hundreds of these blank-check companies have been unable to close deals and look to soon be liquidated. Meme stocks have been crushed. GameStop is down around 70% from its peak, AMC is down 90%. Heck, as the Fed raised rates throughout 2022, stocks in general suffered big losses.

And we're in a really weird economic environment right now. Nobody is really quite sure of what's next. Inflation has cooled for the time being, but the Fed's next move is unknown, and business performance across the board is mixed. So with that said, what does Seth think we should be focused on right now as investors?

One of the things I really admire about Graham and Dodd, writing almost 90 years ago, is they knew they were in an unusual environment being enmeshed in the Great Depression. Yet they tried to write something for the ages. They said, “We know this won't be the permanent condition, but we don't know what conditions we will experience.”

So I think every investor has that challenge: that you have to look at the moment you're in and say which part of this is real, which part of this may be enduring, and which part of this may look completely different as soon as tomorrow? And how do I position myself, maintaining somewhat of a longer-term perspective? Because I think trying to trade day-to-day is not a game anybody really is well-equipped to win.

So just like Graham and Dodd did back in the day, a big part of understanding what to do in an environment like this is to firstly acknowledge that the environment you're in might be completely abnormal. And once you can admit to yourself that it's impossible to know what the future of the market may bring, it's actually incredibly freeing because it can detach from that short-term macro mindset and instead look at each business on its own merit, maintaining a long-term perspective.

One of the things that's really important there is an enormous amount of firehose information coming at all of us all the time. And as an investor, I've learned to try to be focused on things that actually are going to move the needle for me and my portfolio. So I try to focus on bottom-up individual situations: stocks, funds, real estate transactions. I don't spend a lot of time thinking about things where I think the answer is pretty imponderable.

That Seth Klam's trick: work bottom-up, look at the individual stocks that pique your interest, and judge those companies based on their own merit. And throughout the rest of the interview, Seth really focuses in on two big factors that the individual investor can focus on to ensure they come out ahead during this tricky time.

And the first is to try and find an edge. I think you have to almost run harder to stay in place. That you have more competitors, smarter competitors, more information is available at everybody's fingertips. Investors need an edge to be successful. They need to think about what it is they know or how they are structured that will allow them to outperform to create alpha for their clients in a way that buying the average stock won't do.

Here, Seth is obviously speaking from the perspective of a fund manager, but the exact same principle applies to us everyday investors looking to find great opportunities. We need to find an edge. These days, the industry of equity analysis and asset management has absolutely exploded versus where it was 25, 30 years ago, and these days, every metric under the sun is available online, and these stats are being poured over by millions of super smart people.

So if you're just looking in the same areas that everyone else is, it's becoming increasingly unlikely that you'll find amazing opportunities. Charlie Munger has spoken about this recently, saying that we, as individual investors, should expect to make less these days, so we have to really think about what our edge is over other investors.

This is classic Peter Lynch thinking because whether you believe it or not, everybody has an edge. I can guarantee you know more about a certain company or industry than even the most experienced Wall Street analysts. For me personally, I have an edge in social media. I run a YouTube channel; I use these social media tools for business. Wall Street analysts aren't doing that. Claude, my video editor, spends eight hours a day on the inside of Adobe's various bits of software. Wall Street analysts aren't doing that.

So think about where your edge may lie and then use it to your advantage. I do think there are opportunities, but people should ask themselves: what are my interests? What kind of edge might I have? If you're from a different country, maybe you have great contacts in that country; maybe you know a lot about the business culture in that country.

So my advice would be to go where you're naturally inclined and go where you think there may be interesting opportunities. Obviously, a market that's setting all-time highs may not be the best place to focus your career. This is exactly the same line of thinking that Money has had over the past few years. He said many times over that he struggles to find great opportunities in the United States simply because everything is so over-examined.

And the proof is in the pudding: he only really holds two U.S. stocks in his portfolio right now, that being Micron and Brookfield, with Heritage being such a tiny position that honestly, I don't even count it. And he said many, many times instead of looking at the United States, he himself is looking more to places like Turkey and India, as that's where he's got an edge.

Those markets are less interesting to other analysts and investors, so there's naturally more opportunities. So it's definitely worth thinking about where your own edge might lie, as it's key to finding those opportunities that others haven't already found. You can find opportunities in around the edges of what other people are doing, finding situations that other people are throwing out like the baby with the bathwater.

And they exist; you have to be patient. They're not always there, but when they're there, they can be particularly attractive because the markets can become quite frenetic these days. So find your edge and watch for the frenetic market to give you an opportunity.

And that leads us to Seth's second big bit of advice for investing in these current market conditions, and that is to watch for growth, but growth at a fair and reasonable valuation. The academic definition of value is buy the stock that's cheapest by the numbers, but I don't think that's what Graham and Dodd wanted. In fact, it's clear that they were talking about earnings power and the growth possibilities in a business, even if they're hard to determine.

And so I think value has to be determined for every company. The way I think about the market is not that there are growth stocks and value stocks, but rather that all stocks may hold value, but that all stocks also could potentially be overvalued. So you have to have a mechanism, a rubric, for figuring out the value of different kinds of assets, different kinds of businesses, and then figure out which ones are trading particularly mispriced.

This has always been my viewpoint on stocks too. In the investing world, there seems to be this division that you're either a value investor or you're a growth investor. But you never hear people like Warren Buffett talking like this.

And this is because what you're really looking for as an investor is growth at a reasonable price. That's what Seth is alluding to here. You need a mechanism or a rubric for figuring out the valuation on different types of assets. And this is why we use tools like the discounted cash flow analysis because you first have to model what you believe the future growth in cash flows will be, and then you work backwards to determine the price you'd be willing to pay for the business.

In a world that's changing as fast as this one, it's really important to think about not just what are the earnings today. The earnings today may not be here tomorrow; they may be disrupted, the business may be gone, or they may be 50 or 100 percent more. So I think investors need to take into account what are the longer-term prospects for a business, and this is critical in your valuation process.

A lot of investors throw a random growth rate on the company and see what they get, but it's the expected growth rate that you use that will have by far the biggest impact on the valuation you come to. So as Seth says, you really do need to think about the expected future cash flows and whether the business has a competitive advantage that will protect those cash flows over the long term.

I think investors have become vastly more sophisticated these days than in Graham and Dodd's era in terms of thinking about what causes a business to be resilient to competitive threats. Also, Warren Buffett has showed all of us the value of growth, that he thinks hard about some of the highest quality businesses in the world but only buys them when they're at attractive prices.

So I think that's an important element of it as well. So just like Warren Buffett would do, take the time to assess the business's moat, then analyze a conservative future growth rate, come to your own conclusion on what you'd be willing to pay, factoring in a margin of safety, and then you can check whether any of these high-quality businesses are available to you today at depressed prices.

And have faith, although we were talking before about the massive increase in analysis done on public markets these days, Seth finishes on an optimistic note that there still are opportunities out there; we just have to find them. For sure, there's more money in public markets; things have become somewhat more efficient, but I also see a short-term orientation that tells me that it's possible some pricing has actually become less efficient.

I think when you look at Meta, the stock's been all over the place in a reasonably short period of time, falling to under 100, then rising back up to almost 300—literally months apart for a large, well-established company that I think everybody can analyze. And Meta is one of the most poured-over stocks, but Seth is right. Just looking at the share price there, we saw it crash 76% and then rise 240%, all of that in the space of about two years.

So short-term mindedness from institutional money will always present us long-term investors with big opportunities, but we do need to stay focused on the long term and not get sucked into the speculation for these opportunities to become apparent. Stay true to the 4M analysis: meaning management margin of safety, watch for big mispricing based on short-term fear, and then act decisively when opportunities present.

And with that said, guys, that's all I've got for today's video. Please leave a like on the video if you did enjoy it, and I'll see you guys in the next one.