STABLEBOY SELECTIONS

Seth Klarman significantly underperformed the S&P 500 Index in the 1990′s because he stuck to his principles. These are written about at length in Margin of Safety and in Baupost’s partner letters. Year after year Klarman would preach about how the world “should” work, that money should not be flowing into large cap and Internet stocks, that liquidation value was the most reliable metric. Most unfortunate of all, after years of underperformance (which Klarman attributed to his risk aversion) Baupost lost 16.3% in 1998 while the S&P 500 gained 20%. (He had been long several emerging market stocks during the Russian debt default.)

I have always found Klarman’s thinking to be too idealistic. If you never pay more than liquidation value, you will miss out on some of the best investments around. Besides, liquidation value is usually straightforward and most market participants can figure it out if they try. (Indeed more and more investors are practicing this strategy.) So usually with liquidations you end up waiting a long time for a mediocre payout.

There is a prisoner’s dilemma among relative return investors vs. absolute return investors. Absolute returns can be very unattractive during periods of strong performance of relative return investors. If these conditions last long enough, they become self-fulfilling as they did in the late 1990′s. Money left old economy stocks to participate in the speculative mania in Internet stocks. Julian Robertson liquidated. And Stanley Druckenmiller jumped in at precisely the wrong time. This episode, along with the meltdown in 2008, has convinced me that aiming for absolute returns may not be ideal. The way the markets have evolved, with once obscure investment strategies becoming commonplace, I think that absolute returns are going to become generally less attractive.

When I play bridge, I prefer to play duplicate games. In a duplicate game, multiple tables are dealt the same hand. You then compare your score with the players at the other tables. Because the same hand was dealt, any variance in scores indicates differences in the skill of the players. If you play thousands of hands and end up with the highest score, you are good at bridge. The goal is to achieve a good relative return. Over time a good relative return must be a good absolute return.

Skill in bridge involves two components: (1) coming up with the right bid and (2) playing your cards right. I would argue that the first factor matters most. It’s probably 90% of the skill factor in bridge. For that, players follow certain “conventions,” or rules on what suit to bid given the cards one has and the bids made by one’s partner and opponents. There are a handful of bidding systems and standard rules. So if everyone learns the systems, skill becomes less and less important to success in the game. This skill-neutralizing phenomenon exists in any other game like checkers or chess or poker. Still, bridge and chess are complicated enough that truly skilled players emerge over time.

Investing has gotten very complicated, too. It is common today for two diligent investors to be on opposite sides of a trade.

I was recently involved in such a situation with Longtop Financial Tech (LFT). I had learned of the unverifiable revenue claims, abysmally low capital requirements, “unrelated” third party relationships and dishonest management. Another investor told me that the company did not want to answer questions about capital requirements, so I figured they wouldn’t answer other questions I had. So I called Chase Coleman at Tiger Global because I happened to have his number. I muscled past the secretary and was introduced to Scott Shleifer, who is pretty well-known. He was rude to me as though he were rushing to do something more important. I asked him whether it made any sense that a company which spent only 4% of its revenue on research and development could achieve 90% gross margins on some products. I asked whether he really believed that Longtop had no relationship with Xiamen Longtop Human Resource Services, which oddly had no other customers but Longtop. I asked whether he knew about the shady history of Longtop’s founder. Mr. Shleifer never directly addressed my concerns. He repeatedly told me that his team had done extensive research on the company before the company went public in 2007. That stood out to me because I felt as though he might not have followed the company closely in the four years since. Then Mr. Shleifer said he was paid a dividend years ago, as though that invalidated all the red flags. To his credit, he did say that Tiger Global would expect to lose money if I was right that the company was fraudulent. I said that I would get back to him with more research as my investigation continued, but he told me not to call back.

At the same time, I wanted to talk to Lone Pine Capital, another substantial holder of LFT shares. Lone Pine and Tiger Global are both run by “Tiger Cubs”–as is Maverick, which I did not contact. I guessed that only one of the Cubs had actually researched Longtop and that the buy recommendation had been passed on to the others. The analyst at Lone Pine who covered Longtop was in Hong Kong at the time and offered to meet with me to discuss the red flags. After a week we finally arranged a call. When I discussed Longtop’s unbelievable margins, the analyst said that this was to be expected of a niche software provider. I talked about how $26 million in property and equipment seemed far too low. His response was the same as before. I talked about how Longtop’s revenue did not match up with claims made by its biggest customer, Construction Bank of China. He said that CCB was a very large, decentralized bank and that you couldn’t get a grasp on what the enterprise as a whole was buying exactly. I mentioned that Longtop’s claimed revenues had gone up at one CCB division where it had actually reduced its IT budget. Longtop’s competitors reported a decline in revenues at this division. This was only one division, so maybe it was a fluke. Then I asked what the analyst thought about XLHRS. Apparently he had seen many companies in China with similar human resource outsourcing. But had he ever seen something so strange as this, where XLHRS had no other customers but Longtop? The analyst didn’t repeat his previous argument, and instead said, “It seems like you are of the view that this company is a fraud; so there is not much I can say to refute that. It is what you believe versus what we believe.” It turns out that this analyst was more friendly than Mr. Shleifer, but similarly closed-minded. I asked to keep in touch with the analyst online because I had seen his profile, but he declined.

To do a good job I figured I should also contact Deloitte & Touche because it had done Longtop’s audit. I happened to have a partner’s number there and he promised to pass my information along to Deloitte Touche Tohmatsu, which was responsible for handling Longtop’s audit in China. I never received a call or email back. I still want to find out whether the information was passed on.

Now the auditors have resigned. Apparently Longtop management interfered with the audit and the cash balances were faked. It has been a fantastic short–actually the second terrible company in which I have traded against Tiger Cubs. The game has gotten a whole lot more complicated.