The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing)

by Howard Marks

The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers. From time to time, holders become forced sellers for reasons like these: • The funds they manage experience withdrawals. • Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums. • They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.

If a single holder is forced to sell, dozens of buyers will be there to accommodate, so the trade may take place at a price that is only slightly reduced. But if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity. The difficulties that mandate selling—plummeting prices, withdrawal of credit, fear among counterparties or clients—have the same impact on most investors. In that case, prices can fall far below intrinsic value.

The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.

To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach. Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

We have two classes of forecasters: Those who don’t know—and those who don’t know they don’t know. JOHN KENNETH GALBRAITH

But a great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability.

The second possibility is to accept that the future isn’t knowable, throw up our hands, and simply ignore cycles. Instead of trying to predict them, we could try to make good investments and hold them throughout. Since we can’t know when to hold more or less of them, or when our investment posture should become more aggressive or more defensive, we could simply invest with total disregard for cycles and their profound effect. This is the so-called buy-and-hold approach.

It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.

The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response?

If you make cars and want to sell more of them over the long term—that is, take permanent market share from your competitors—you’ll try to make your product better.... That’s why—one way or the other—most sales pitches say, “Ours is better.” However, there are products that can’t be differentiated, and economists call them “commodities.” They’re goods where no seller’s offering is much different from any other. They tend to trade on price alone, and each buyer is likely to take the offering at the lowest delivered price. Thus, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price.... It helps to think of money as a commodity just like those others. Everyone’s money is pretty much the same. Yet institutions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money—that is, get people to go to you instead of your competitors for their financing—you have to make your money cheaper. One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.

In the years 2004–2007, the notion arose that if you cut risk into small pieces and sell the pieces off to investors best suited to hold them, the risk disappears. Sounds like magic.

At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because of the nature of randomness.

The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors. Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million. They write books titled like How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. Sound familiar?

• Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit). • The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa. • Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly). • For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row. • Thus, it’s essential to have a large number of observations—lots of years of data—before judging a given manager’s ability.

the quality of a decision is not determined by the outcome.

Short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof ).

Investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting performance, but the questions they should ask are, Were the events that unfolded (and the other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead? Those other events are Taleb’s “alternative histories.”

• We should spend our time trying to find value among the knowable—industries, companies and securities—rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.

contradiction?

His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.

So much is within the control of professional tennis players that they really should go for winners. And they’d better, since if they serve up easy balls, their opponents will hit winners of their own and take points. In contrast, investment results are only partly within the investors’ control, and investors can make good money—and outlast their opponents—without trying tough shots.

What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that maybe uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again, the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry.

The contrast is simple. The lender who insists on margin for error and lends only to strong borrowers will experience few credit losses. But this lender’s high standards will cause him or her to forgo lending opportunities, which will go to lenders who are less insistent on creditworthiness. The aggressive lender will look smarter than the prudent lender (and make more money) as long as the environment remains salutary.

The cautious seldom err or write great poetry.

As an aside, it’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment.

There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation—and thus the limitations of diversification—is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish. The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.

Too much capital availability makes money flow to the wrong places. When capital is scarce and in demand, investors are faced with allocation choices regarding the best use for their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made.

When capital goes where it shouldn’t, bad things happen. In times of capital market stringency, deserving borrowers are turned away. But when money’s everywhere, unqualified borrowers are offered money on a silver platter. The inevitable results include delinquencies, bankruptcies and losses.

When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. When you think about it, bidding more for something is the same as saying you’ll take less for your money. Thus, the bids for investments can be view...

One is beta, a measure of a portfolio’s relative sensitivity to market movements. The other is alpha, which I define as personal investment skill, or the ability to generate performance

beta, theory means relative volatility, or the relative responsiveness of the portfolio return to the market return.

A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile.

To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally, all three.

The relationship between price and value holds the ultimate key to investment success.

Likewise, the psychology of the investing herd moves in a regular, pendulum-like pattern—from optimism to pessimism; from credulousness to skepticism; from fear of missing opportunity to fear of losing money; and thus from eagerness to buy to urgency to sell. The swing of the pendulum causes the herd to buy at high prices and sell at low prices. Thus, being part of the herd is a formula for disaster, whereas contrarianism at the extremes will help to avert losses and lead eventually to success.

In particular, risk aversion—an appropriate amount of which is the essential ingredient in a rational market—is sometimes in short supply and sometimes excessive. The fluctuation of investor psychology in this regard plays a very important part in the creation of market bubbles and crashes.

The power of psychological influences must never be underestimated. Greed, fear, suspension of disbelief, conformism, envy, ego and capitulation are all part of human nature, and their ability to compel action is profound, especially when they’re at extremes and shared by the herd. They’ll influence others, and the thoughtful investor will feel them as well. None of us should expect to be immune and insulated from them. Although we will feel them, we must not succumb; rather, we must recognize them for what they are and stand against them. Reason must overcome emotion.

Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: “Being too far ahead of your time is indistinguishable from being wrong.” It can require patience and fortitude to hold positions long enough to be proved right.