Kleinheinz Capital Partners, January 2004

I ran into this quick interview with John B. Kleinheinz by site Hedge Fund News.
It is brief, it speaks of investment process, but as you read many of these over the years  you accumulate ideas that you start to test with your own portfolios and you see that they do increase your risk-adjusted returns.

As I mentioned in this blog many times, this is key if one wants to make money for years and years.

Profile of John B. Kleinheinz

Born: 1961 in Wisconsin
Education: BA in Economics, Stanford University
Family: Married, three children (two teenagers)
Last vacation: Hawaii
Last book read: The Da Vinci Code by Dan Brown
Hobbies: Skiing
Favorite quote: "Ninety percent of life is just showing up", Woody Allen
How he best describes himself: Resilient and competitive.



JOHN B. KLEINHEINZ, KLEINHEINZ CAPITAL PARTNERS - JANUARY 2004

After graduating from Stanford University in 1984, John Kleinheinz started his career as an investment banker doing corporate finance and mergers and acquisitions work for Nomura Securities and Merrill Lynch in Tokyo, New York and London. In 1993, he became the second principal of San Antonio Capital Management, a hedge fund management company started in 1990 by Dana McGinnis. In February 1996, he hung his own shingle in Fort Worth where he launched the Global Undervalued Securities Fund, L.P. By the end of 1996, the fund was up 130% and had $25 million in capital. Since then, John¿s record has been nothing short of remarkable, multiplying the original dollar invested by a factor of more than 15 in 8 years. As the name indicates, the Global Undervalued Securities Fund focuses on value situations on a global basis. Over the years, the fund has shifted its focus to countries or industry sectors as varied as Russian equities, internet stocks, Japanese equities, healthcare stocks and emerging market debt. John¿s conviction style of investing is not for the faint of heart, as he has occasionally suffered significant drawdowns. However, on a calendar year basis, he lost less than 4% in his only down year (2000). John has paid careful attention to matching his investor base with his investment style and limiting the amount of capital managed by closing to new investors (the fund is currently closed). Presently, he manages $750 million, of which half has come from Texas-based investors.


John Kleinheinz spoke to HFN publisher, Antoine Bernheim, in late January 2004.

Q. Could you describe your investment philosophy?

A. We are contrarian, opportunistic and value-oriented. We are a macro firm in that we think about where we are being best paid to take risk and we mostly manifest that macro theme through a global long-short equity approach. We try to buy quality companies with great business franchises at inexpensive prices. We don¿t buy things just because they are cheap. We try to invest in companies in industry sectors where the fundamentals are improving. We like companies that have pricing power, natural monopolies or large market shares. We like bigger companies that are first or second in their category. We look at regions of the world similarly. For instance, we got very excited about Russia in 1999 and 2000 because oil prices were moving up quickly and global economic growth was strong . There was a big disconnect between the perception of Russia and the fundamentals which were improving dramatically. Last year in Japan when the Nikkei was hovering around 8000, we looked at the situation in Asia. We saw that there was a lot of excess capacity and that Japan was going to be a supplier of goods to China and the rest of Asia and the economy would improve.

Q. Could you describe your research process and where you see your edge?

A. There are five areas where we think we have a considerable knowledge base and contacts: Japan, where I used to work, Russia (I used to run a Russia fund in the mid 90s), telecom, healthcare and energy which are three industries where we have developed contacts and a knowledge base over the years. Eighty percent of the profits we have made since we started have been made in those five areas. Within those areas, we are very committed to independent research; we don¿t use a lot of standard brokerage house research and would rather use people who are good enough to be out on their own and away from Wall Street. We like people like Ed Hyman who runs ISI and a number of other industry research people and contacts we have in our areas of interest.

Q. What is the mix between macro factors and bottom-up analysis in your investment decisions?

A. From time to time we put on macro trades that involve positions in currencies or commodities, but eighty-five percent of our activity is global long-short equities. One of the things we do, however, is trade government bonds against our net equity risk and, depending upon how we see the economic environment, we might be long as much as 100% of our portfolio in US Treasury bonds or European government bonds as a natural hedge against our equity risk. That is a trade we used very effectively in 1998 during the Russian crisis when we got hurt in our Russian and emerging markets positions but were very quickly bailed out by the flight to quality and the 20 point rally in U.S. treasury bonds. Most of the time, you don¿t make or lose money owning bonds except when the world looks like it is about to fall apart. We bought bonds again at the beginning of 2000 and held them until the second quarter of 2003, when we decided that the economy was growing too quickly for bonds to be a useful hedge against our equities.

Q. How do you pick individual long and short positions?

A. It is an iterative process. In Russia, for instance, we have had much success in individual stocks, picking Russian cellular companies, shorting Yukos at the end of last summer and being long Lukoil. In Japan on the other hand, we haven¿t had the time to do a lot of work, so many of our picks are blue chip market-driven names. Sometimes, we even buy ETFs in Japan. A lot of the stock picking process is serendipitous. We may hear about a company from another portfolio manager or an executive at a company we visit, and a trading opportunity may occur to establish a position. We have several core positions in our fund that have been there for more than five years but it takes a long time for a company to become a core position. We need to own it, do research on it, visit the company and understand it thoroughly and that is very much an iterative and long-term process.

Q. Could you describe the typical structure of your portfolio?

A. We have about 80 longs and 50 shorts. We have four or five positions that are 4% to 6.5% of the portfolio. During the bear market of 2000 to 2003, we were on average 50% to 55% net long and we also had the bond hedge I spoke about. We currently are 90% net long, 130% gross long and 40% gross short, although we have puts underneath that would protect us on 75% of the downside after the market falls 5% or 10%. We are probably near the top of our potential gross exposure. We trade a fair amount, particularly around our shorts. In regional terms, apart from the U.S. where our exposure can get up to 40%, we tend to be no more than 15% in any country and in most cases 7% or 8%. We are about 14% in Russia and 13% in Japan currently.

Q. What is a typical duration of a trade or theme for you?

A. The longer the duration the better but there is nothing typical. One of my principles of investing is that you don¿t want to miss big investment themes. You can miss individual stock ideas but you don¿t want to miss the three or four big themes you get in an investment career. In my lifetime, I think people will look back and say Russia¿s convergence from a communist country to a capitalist society was a major investment theme. I have been investing in Russia since 1994 and I think we probably have four or five more years before Russia is fairly priced. Themes go in big cycles and we don¿t have to always be long Russia but as long as it is a market we are interested in we are going to be there on one side or another. The trick is to get the big directional moves approximately correct. The huge growth of telecommunications technology is another theme you would not want to miss. Energy is a theme that has been prominent for us for a long time. Unfortunately, we have not done as much in energy because it overlaps with Russia. Healthcare is another theme that will be increasingly important as a result of demographic changes.

Q. What is your approach to cutting losses when a position or a theme goes against you?

A. We routinely do two things: first, we sell losers on a quarterly basis and more aggressively at the end of the year. I started to do that for tax reasons and it turned out to have very positive implications on risk management. Secondly, I reduce exposure, both long and short, if we are down 5% from a month-end value. Five percent seems to be a number that suggests something is going against you and that our analysis may be wrong. It is better to cut risk and stay in the game than to press the bet and get hurt badly and be out of the game. I adopted that rule after 1998 and the first time I used it was in March 2000. We continued to lose money in April and May too, but after we got hurt our losses were smaller and smaller and then we started treading water and were able to make money again toward the end of the year. It also happened during the September 11th tragedy.

Q. Can you describe how your organization functions?

A. We are eleven employees, three portfolio managers, two analysts, two traders and four individuals for settlement, administration and client relations. I am a real believer in small organizations and I want to spend my time managing money and not people. The two other portfolio managers are individuals I have known for a long time and I can let them operate independently, managing a part of the portfolio with their own P&L. They now manage approximately 20% of the portfolio. I manage the rest and we interact with each other when we see something of mutual interest.

Q. What are your goals for the future?

A. My principal goal is longevity. I want to be doing this for as long as I can, and part of that equation involves growing very gradually, and predominantly from investment gains. We try to grow our client base 10% or 15% a year and add one or two employees each year. I think that growing your organization or growing your investor base too quickly are the two single biggest mistakes a hedge fund can make. If we can grow gradually, I think we will be able to be bigger in the long term than if we double the size of the assets or the organization tomorrow. 

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

Seth Klarman & Baupost Group's 2010 Letter Excerpt

For those who don't know the guy yet: you should.

Seth Klarman is one of the most successful investors that I heard of.
His fund, Baupost, is a behemoth, bringing in consistent risk-adjusted returns to his investors.

The key takeaway from Mr. Klarman's words: you must always have some cash in hand and be prepared to stand away from the crowd.
The greatest risk-adjusted returns occur when panics are out there. When volatility is sky-rocketing and every tough macho man is sleeping under his bed, scared the planet will blow up and human kind will be extinct. When that happens risk is usually lower because the much-cheaper prices available give you a much higher margin of safety. So.... liquidity. That's the word of the day. Liquidity.

When opportunities come an investor must be prepared (cash in hand and knowledge) to grab it.

A Framework for Investment Success

Two elements are vital in designing an investment approach for long-term success. First, answer the question, ''what's your edge?" In highly competitive financial markets, with thousands of very smart, hardworking participants, what will enable you to reliably outperform the field? Your toolkit is critically important: truly long-term capital; a flexible approach that enables you to move opportunistically across a broad array of markets, securities, and asset classes; deep industry knowledge; strong sourcing relationships; and a solid grounding in value investing principles.

But because investing is, in many ways, a zero-sum activity in which your returns above the market indices are derived from the mistakes, overreactions or inattention of others as much as from your own clever insights, there is a second element in designing a sound investment approach: you must consider the competitive landscape and the behavior of other market participants. As in football, you are well-advised to take advantage of what your opponents give you: if they are defending the run, passing is probably your best option, even if you have a star running back. If scores of other investors are rigidly committed to fast-growing technology stocks, your brilliant tech analyst may not be able to help you outperform. If your competitors are not paying attention to, or indeed are dumping, Greek equities or U.S. housing debt, these asset classes may be worth your attention, regardless of the currently poor fundamentals that are driving others' decisions. Where to best apply your focus and skills depends partially on where others are applying theirs.

When observing your competitors, your focus should be on their approach and process, not their results. Short-term performance envy causes many of the shortcomings that lock most investors into a perpetual cycle of underachievement. You should watch your competitors not out of jealousy, but out of respect, and focus your efforts not on replicating others' portfolios, but on looking for opportunities where they are not.

Much of the investment business is centered around asset-gathering activities. In a field dominated by a short-term, relative performance orientation, significant underperformance is disastrous for retention of assets, while mediocre performance is not. Thus, because protracted periods of underperformance can threaten one's business, most investment firms aim for assured, trend-following mediocrity while shunning the potential achievement of strong outperformance. The only way for investors to significantly outperform is to periodically stand far apart from the crowd, something few are willing or able to do.

In addition, most traditional investors are limited by a variety of constraints: narrow skill-sets, legal restrictions contained in investment prospectuses or partnership agreements, or psychological inhibitions. High-grade bond funds can only purchase investment-grade bonds; when a bond falls below BBB, they are typically forced to sell (or think that they should), regardless of price. When a mortgage security is downgraded because it will not return par to its holders, a large swath of potential purchasers will not even consider buying it, and many must purge it. When a company omits a cash dividend, some equity funds are obliged to sell that stock. And, of course, when a stock is deleted from an index, it must immediately be dumped by many. Sometimes, a drop in a stock's price is reason enough for some holders to sell. Such behavior often creates supply-demand imbalances where bargains can be found. The dimly lit comers and crevasses existing outside of mainstream mandates may contain opportunity. Given that time is often an investor's scarcest resource, filling one’s in-box with the most compelling potential opportunities that others are forced to or choose to sell (or are constrained from buying) makes great sense.

Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a “hold” at a higher price, and a "sell" at some still higher price. Yet most investors in all asset classes love simplicity, rosy outlooks, and the prospect of smooth sailing. They prefer what is performing well to what has recently lagged, often regardless of price. They prefer full buildings and trophy properties to fixer-uppers that need to be filled, even though empty or unloved buildings may be the far more compelling, and even safer, investments. Because investors are not usually penalized for adhering to conventional practices, doing so is the less professionally risky strategy, even though it virtually guarantees against superior performance.

Finally, most investors feel compelled to be fully invested at all times – principally because evaluation of their performance is both frequent and relative. For them, it is almost as if investing were merely a game and no client's hardearned money was at risk. To require full investment all the time is to remove an important tool from investors' toolkits: the ability to wait patiently for compelling opportunities that may arise in the future. Moreover, an investor who is too worried about missing out on the upside of a potential investment may be exposing himself to substantial downside risk precisely when valuation is extended. A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned.

What drives long-term investment success? In the Internet era, everyone has a voluminous amount of information but not everyone knows how to use it. A well-considered investment process – thoughtful, intellectually honest, team-oriented, and single-mindedly focused on making good investment decisions at every turn – can make all of the difference. Investors with short time horizons are oblivious to kernels of information that may influence investment outcomes years from now. Everyone can ask questions, but not everyone can identify the right questions to ask. Everyone searches for opportunity, but most look only where the searching is straightforward even if undeniably highly competitive.

In the markets of late 2008, everything was for sale as investors were caught in a contagion of selling due to panic, margin calls, and investor redemptions. Even while modeling very conservative scenarios, many securities could have been purchased at extremely attractive prices – if one had capital with which to buy them and the stamina to hold them in the face of falling prices. By late 2010, froth had returned to the markets, as investors with short-term relative performance orientations sought to keep up with the herd. Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptions.

Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation. Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.

Investment success also requires remembering that securities prices are not blips on a Bloomberg terminal but are fractional interests in – or claims on – companies. Business fundamentals, not price quotations, convey useful information. With so many market participants fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements.

Government interventions are a wild card for even the most disciplined investors. On one hand, the U.S. government has regularly intervened in markets for decades, especially by lowering interest rates at the first sign of bad economic news, which has the effect of artificially inflating securities prices. Today, monetary easing and fiscal stimulus augment consumer demand, increasing risks not only regarding the integrity and sustainability of securities prices but also those surrounding the sustainability of business results. It is hard for investors to get their bearings when they cannot readily distinguish durable business performance from ephemeral results. Endless manipulation of government statistics adds to the challenge of determining the sustainability – and therefore the proper valuation – of business performance. As securities prices are propped up and interest rates are manipulated sharply lower (thereby justifying those higher prices in the minds of many), prudent investors must demand a wide margin of safety. This is especially so because financial excesses contain the seeds of their own destruction. Market exuberance leads to business exuberance – production of more goods and services than demand ultimately justifies. Of course, when market and economic excesses are finally corrected, there is a tendency to over-shoot, creating low-risk opportunities for value investors who have remained patient and disciplined.

Yet another long-term risk confronts investors: the government's fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging – always an important tool for investors – takes on heightened significance in today's unprecedentedly challenging environment. Yet, as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and against much higher interest rates seem like necessary hedges to maintain."

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

Regarding Corporate Culture and Investment Process

Through the link is a video that contains, perhaps, one of the most important aspects of an investing firm (and any other successful business or relationship I think):
- Truth-at-all-costs

That means.... 

"We won't sacrifice the pursuit of truth for ego or hierarchy or any other things that in a lot other places stand in the way (...) What are you willing to give up to reach truth?

"What we're willing to give up is feeling comfortable, feeling superior, bosses feeling like they're in charge."
"We're going to settle things on logic."

Bridgewater Website: Culture

Ray Dalio's Speech - 7th Annual Hedge Fund Industry Awards