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by
Howard Marks
“Experience is what you got when you didn’t get what you wanted.” Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.
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.
Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.
Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Every once in a while, then, people learn an essential lesson. They realize that nothing—and certainly not the indiscriminate acceptance of
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To simplify (or oversimplify), all approaches to investing in company securities can be divided into two basic types: those based on analysis of the company’s attributes, known as “fundamentals,” and those based on study of the price behavior of the securities themselves. In other words, an investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.
Thus, it seems to me, the choice isn’t really between value and growth, but between value today and value tomorrow.
There’s no question about it: it’s harder to see the future than the present. Thus, the batting average for growth investors should be lower, but the payoff for doing it well might be higher. The return for correctly predicting which companies will come up with the best new drug, most powerful computer or best-selling movies should be substantial. In general, the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent.
Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.
No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.
At Oaktree we say, “Well bought is half sold.” By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves. If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.
The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.
The polar opposite of conscientious value investing is mindlessly chasing bubbles, in which the relationship between price and value is totally ignored. All bubbles start with some nugget of truth: • Tulips are beautiful and rare (in seventeenth-century Holland). • The Internet is going to change the world. • Real estate can keep up with inflation, and you can always live in a house. A few clever investors figure out (or perhaps even foresee) these truths, invest in the asset, and begin to show profits. Then others catch on to the idea—or just notice that people are making money—and they buy
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I’ve never heard anyone at Oaktree—or anywhere else, for that matter—say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.
Let’s say an investment manager knows there won’t be more money forthcoming no matter how well a client’s account performs, but it’s clear the account will be lost if it fails to keep up with some index. That’s “benchmark risk,” and the manager can eliminate it by emulating the index.
Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)
A fundamentally weak asset—a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town—can make for a very successful investment if bought at a low-enough price.
Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.
However, people often use the terms bell-shaped and normal interchangeably, and they’re not the same. The former is a general type of distribution, while the latter is a specific bell-shaped distribution with very definite statistical properties.
If we say “2 percent of mortgages default” each year, and even if that’s true when we look at a multiyear average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. It’s invariably the case that some investors—especially those who employ high leverage—will fail to survive at those intervals.
The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.
I’ll use a “typical” market of a few years back to illustrate how this works in real life: The interest rate on the thirty-day T-bill might have been 4 percent. So investors say, “If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.” Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital market line, normally slopes upward with the increase in asset life.
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But achieving high returns with high risk means very little—unless you can do it for many years, in which case that perceived “high risk ” either wasn’t really high or was exceptionally well managed.
Of course, when markets are stable or rising, we don’t get to find out how much risk a portfolio entailed. That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.
In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm (A) most of the time, but we know it’s not unusual to see outcomes that are better (B) or worse (C). Although we should bear in mind that, once in a while, a result will be outside the usual range (D), we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never
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Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you. • The first, when a few forward-looking people begin to believe things will get better • The second, when most investors realize improvement is actually taking place • The third, when everyone concludes things will get better forever
What weapons might you marshal on your side to increase your odds? Here are the ones that work for Oaktree: • a strongly held sense of intrinsic value, • insistence on acting as you should when price diverges from value, • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded, • a thorough understanding of the insidious effect of psychology on the investing process at market extremes, • a promise to remember that when things seem “too good to be true,”
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To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit. SIR JOHN TEMPLETON
Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against. • Even when an excess does develop, it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.” • Markets can be over- or underpriced and stay that way—or become more so—for years. • It can be extremely painful when the trend is going against you.
You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views
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....
That’s why successful investors are said to spend a lot of their time being lonely.
Fairly priced assets are never our objective, since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved.
Predictions are most useful when they correctly anticipate change. If you predict that something won’t change and it doesn’t change, that prediction is unlikely to earn you much money.
Nassim Nicholas Taleb in his book Fooled by Randomness. Some of the concepts I explore here occurred to me before I read it, but Taleb’s book put it all together for me and added more. I consider it one of the most important books an investor can read.
In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.
The easy way to see this is that in boom times, the highest returns often go to those who take the most risk.
A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known. By that standard, the Miami ski resort looks like folly.
We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
Charley Ellis took Ramo’s idea a step further, applying it to investments. 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.
Achieving gains usually has something to do with being right about events that are on the come, whereas losses can be minimized by ascertaining that tangible value is present, the herd’s expectations are moderate and prices are low.
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 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 viewed as a statement of how little return investors demand and how much risk they’re willing to accept.
• Inadequate due diligence leads to investment losses. The best defense against loss is thorough, insightful analysis and insistence on what Warren Buffett calls “margin for error.” But in hot markets, people worry about missing out, not about losing money, and time-consuming, skeptical analysis becomes the province of old fogeys. • In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t
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On the other hand, the performance of investors who add value is asymmetrical.
In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough.
Oaktree’s motto, “If we avoid the losers, the winners will take care of themselves,”
