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by
Howard Marks
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May 13 - May 16, 2020
If you read widely, you can learn from people whose ideas merit publishing. Some of the most important for me were Charley Ellis’s great article “The Loser’s Game” (The Financial Analysts Journal, July-August 1975), A Short History of Financial Euphoria, by John Kenneth Galbraith (New York: Viking, 1990) and Nassim Nicholas Taleb’s Fooled by Randomness (New York: Texere, 2001). Each did a great deal to shape my thinking.
An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.
Everyone wants to make money. All of economics is based on belief in the universality of the profit motive. So is capitalism; the profit motive makes people work harder and risk their capital. The pursuit of profit has produced much of the material progress the world has enjoyed. But that universality also makes beating the market a difficult task. Millions of people are competing for each available dollar of investment gain. Who’ll get it? The person who’s a step ahead.
your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others—both more powerful and at a higher level.
What is second-level thinking? • First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.
You can’t do the same things others do and expect to outperform. . . . Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.
But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers. To consistently achieve superior investment returns, you must be one of them.
The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk-adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the efficient market hypothesis.
In January 2000, Yahoo sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.
First, one or two good years prove nothing; chance alone can produce just about any result. Second, statisticians insist nothing can be proved with statistical significance until you have enough years of data; I remember a figure of sixty-four years, and almost no one manages money that long. Finally, the emergence of one or two great investors doesn’t disprove the theory. The fact that the Warren Buffetts of this world attract as much attention as they do is an indication that consistent outperformers are exceptional.
In fact, some asset classes are quite efficient. In most of these: • the asset class is widely known and has a broad following; • the class is socially acceptable, not controversial or taboo; • the merits of the class are clear and comprehensible, at least on the surface ; and • information about the class and its components is distributed widely and evenly. If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated.
Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception. My son Andrew is a budding investor, and he comes up with lots of appealing investment ideas based on today’s facts and the outlook for tomorrow. But he’s been well trained. His first test is always the same: “And who doesn’t know that?”
In the vocabulary of the theory, second-level thinkers depend on inefficiency. The term inefficiency came into widespread use over the last forty years as the counterpoint to the belief that investors can’t beat the market. To me, describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.
One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.
mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.
Think of it this way: • Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that’s too cheap? • If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk? • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return? • Do you really know more about the asset than the seller does? • If it’s such a great proposition, why hasn’t someone else snapped it up?
Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty.
Abstention on the part of those who won’t venture in creates opportunities for those who will.
The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.
For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.
Part of the decline of technical analysis can be attributed to the random walk hypothesis, a component of the Chicago theory developed in the early 1960s, primarily by Professor Eugene Fama. The random walk hypothesis says a stock’s past price movements are of absolutely no help in predicting future movements. In other words, it’s a random process, like tossing a coin.
Momentum investing might enable you to participate in a bull market that continues upward, but I see a lot of drawbacks.
To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.
The emphasis in value investing is on tangible factors like hard assets and cash flows. Intangibles like talent, popular fashions and long-term growth potential are given less weight.
Growth investing lies somewhere between the dull plodding of value investing and the adrenaline charge of momentum investing.
Thus, it seems to me, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.
Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit. Yogi Berra is famous for having said, “Nobody goes to that restaurant anymore; it’s too crowded.” It’s just as nonsensical to say, “Everyone realizes that investment’s a bargain.” If everyone realizes it, they’ll buy, in which case the price will no longer be low. . . . Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates....
• seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and • having it turn out to be true (or at least accepted by the market).
But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.
The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.
“TOUCHSTONES,” NOVEMBER 10, 2009
check out Marks' notes from November, 10.
Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”
Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill.
That’s why the concept of intrinsic value i...
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The best opportunities are usually found among things most others won’t do.
The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
Examples might include the risk of obsolescence in a fast-moving segment of the technology world, and the risk that a hot consumer product will lose its popularity
Having defined the “feasible set,” the next step is to select investments from it. That’s done by identifying those that offer the best ratio of potential return to risk, or the most value for the money. That’s what Sid Cottle, editor of the later editions of Graham and Dodd’s Security Analysis, was talking about when he told me that in his view, “investment is the discipline of relative selection.”
Thus, it’s not what you buy; it’s what you pay for it.
It usually starts with an objectively attractive asset. As people raise their opinion of it, they increasingly want to own it. That makes capital flow to it, and the price rises. People take the rising price as a sign of the investment’s merit, so they buy still more. Others hear about it for the first time and join in, and the upward trend takes on the appearance of an unstoppable virtuous cycle. It’s mostly a popularity contest in which the asset in question is the winner.
• Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection. • Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to
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After the process described above had gone on long enough, and holdings of them had been reduced enough, bonds were positioned to become superior performers. All it took was a change in the environment that would increase the desirability of safety relative to upside potential. And as usually happens after an asset has appreciated for a while, investors suddenly recognized the attractions of bonds and realized they didn’t own enough. This is a pattern that regularly produces profits for those who figure it out early.
Our goal is to find underpriced assets. Where should we look for them? A good place to start is among things that are: • little known and not fully understood; • fundamentally questionable on the surface; • controversial, unseemly or scary; • deemed inappropriate for “respectable” portfolios; • unappreciated, unpopular and unloved; • trailing a record of poor returns; and • recently the subject of disinvestment, not accumulation.
To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.
The Most Important Thing Is . . . Patient Opportunism
Mujo was defined classically for me as recognition of “the turning of the wheel of the law,” implying acceptance of the inevitability of change, of rise and fall.... In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond.
“The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action—one classic mistake—that I most strongly feel is wrong: reaching for return.
