This week we got a peek at some of Seth Klarmans shareholder letter and he was pretty blunt in his assessment of the markets right now. To put it mildly he is not a fan. I reviewed his comments earlier this week in a column on Real Money:

Klarman is a smart guy and unlike a lot of prognosticators and predictors has the track record to back up his opinions. He is one of the rare 20% club who has been able to earn compound returns near that benchmark for an extended period. When I hear that he is holding around 50% in cash and is saying things like, "No one can know what the future holds, but any year in which the S&P 500 jumps 32% and the NASDAQ Composite 40% while corporate earnings barely increase should be cause for concern, not further exuberance", I have tendency to pay attention. Ignoring a smart guy with a record that indicates he knows what he is talking about strikes me as the greatest of follies.

Klarman does say that no one knows when the market will roll over and drop to a point that reflects economic reality. No one knows these things. Market movements are pretty much impossible to predict with any degree of certainty. When the stage is set, however, and the possibility of a decline is growing, it makes sense to increase your sense of caution. As Andrew Lo of MIT told us, our job as long-term investors is to survive until the long term.

Shortly after I wrote that I got an mail from a prospective subscriber asking how the value strategy did back in 2007 and 2008. He also inquired what protection plans I use. Below I share my reply to him and I although I have shared this with some of you before I think it bears repeating as the market continues to worm its way higher:

Value is the hedge. As markets move higher there are fewer cheap stocks so cash levels build and as they decline the opportunity set increases.

Here are direct quotes from my blog and Real Money articles during the meltdown and recovery:

December 5, 2006

“You might be able to sell me the fact that this market is fairly priced, providing I’ve been drinking heavily, but undervalued, I can’t see it. The bond market and the dollar are telling you it’s just not that good out there right now. We have rallied almost 12% since August without a real pause of any length and anybody who is not cautious now pretty much deserves what they get.”

April 1, 2008

“Even if I am dead wrong here I think the risk of being fully committed to stocks carries too many risks for the idea of a margin of safety to exist. I am willing to miss this run up to protect capital. There appears to be very little common sense being used on Wall Street these days when it comes to the overall economic and financial matters, as well as a total lack of fear. Bottoms are accompanied by fear and loathing not cheerleading and bottom predictions. The bullish arguments are laughable.”

June 20,2008

“Interest rates are starting to rise. I continue to think that only an illiterate deaf mute kamikaze could be aggressively long the US stock market. Of course there are lots of those around. We call them mutual fund managers

11-20-2008

As for the market itself there is a fortune to be made over the next several years. I see companies that are profitable trading for less than 3 times E/EBITDA. I see an ever growing list of companies that sell for less than cash in the bank. We are fast approaching the depths of an ugly bear market and there is money to be made. I am buying DAR, HDNG, DOW,ASH and others like a crack addict at a rock convention.

March 14, 2009

You can buy stocks like ADPT, TECD, and ESIO for less than the value of the company’s liquid assets. You can literally build a portfolio of 40-50 of these that have a good credit scores, viable businesses and excellent recovery prospects. That’s enough to make me salivate at the possibilities for gains over the next several years.

DIS trade for about two thirds of my appraisal value. That is provided we give no value at all to the film library or character rights and price the parks as raw land and put a 5 multiple on after tax earnings .DELL trade for less than two cash. HTH is a pile of cash in the hands of a proven investor in distressed banks and other financials. As a bonus the company landed a back door bank charter and will be able to bid on distressed assets and institutions. Southwest Airlines is stupid cheap, trading below tangible book value. Oil service companies like RDC and PTEN trade below net asset value at these levels. I like the idea of buying the Forest City senior debentures at a 30% YTM and what looks to be more than adequate asset coverage.

January 16, 2010

“This is the type of trade I am hoping begins to develop in earnest in the first half of 2010. As commercial and real estate woes continue to fall I am looking for the market to wake up to the problems facing the small banks. When it starts the stock market, being the bastion of irrational insanity that it is ,the baby will go out with the bathwater. This type of activity created a situation back in the early 1990s that allowed many people to literally get rich over the next decade. When the good get sold with the bad I am looking to buy up a portfolio of small banks below tangible book value that have low loan losses and adequate reserves. As real estate improves-and it will someday- we will start to see a wave of mergers and acquisitions in the banking community. These transactions will occur at multiples of book, not at a discount. Those solid bank stock bought in this next sell off will show tremendous gains for those bold enough to step up.”

August 8,2011

“The current turmoil in the markets is creating some opportunities. Any type of corporate disappointments is leading to a steep and drastic sell off. Right now foreign banks are god-awful, point of maximum pessimism cheap. I like two of the larger Japanese banks, Mitsubishi UFJ (MTU) and Mizhou (MFG). Both sell at a fraction of tangible book value and for an investor with a time horizon of five years or more should be very profitable. The same is true for Royal Bank Of Scotland (RBS). The stock is at 40% of tangible book and management has a solid plan to de-risk the balance sheet and return to profitability. As a final foreign excursion the shares of Dutch insurer Aegon (AEG) are also very, very cheap. They have repaid the Dutch government for the emergency funding and should pay a dividend again starting next year.”

If I rely entirely on the price to value relationships the market timing tends to take care of itself. I hope this helps.

Right now I am not finding a ton of cheap stocks outside of small banks, energy companies and mining concerns. The caution flag is up based almost entirely on the lack of safe and cheap stocks. We have high cash level in all of the portfolios and I am quite comfortable with that right now.

Have a great week everyone

Cheers,

Tim

Song of the week. The one you do NOT want to have to sing to your stock portfolio if Klarman is right about the market valuations:

 http://www.youtube.com/watch?v=GZ5yUqK9ClE