In September of 2015, Howard Marks wrote a memo where he discussed one of the most important concepts in investing. It’s the paradox that exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them. It’s a must read for all investors.
Here’s an excerpt for the Marks memo titled, It’s Not Easy, which explains why the broad consensus of investors is almost always wrong:
The Things Everyone Likes
The most outstanding characteristic of first-level thinkers – and of the investing herd – is that they like things with obvious appeal. These are the things that are easy to understand and easy to buy. But that’s unlikely to be the path to investment success. Here’s how I put it in “Everyone Knows” (April 2007):
What’s clear to the broad consensus of investors is almost always wrong.
First, most people don’t understand the process through which something comes to have outstanding moneymaking potential. And second, the very coalescing of popular opinion behind an investment tends to eliminate its profit potential.
Take, for example, the investment that “everyone” believes to be a great idea. In my view by definition it simply cannot be so.
- If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages sub-par performance from here on out
- If everyone likes it, it’s likely the price has risen to reflect a level of adulation from which relatively little further appreciation is likely. (Sure it’s possible for something to move from “overvalued” to “more overvalued,” but I wouldn’t want to count on it happening.)
- If everyone likes it, it’s likely the area has been mined too thoroughly – and has seen too much capital flow in – for many bargains to remain
- If everyone likes it, there’s significant risk that prices will fall if the crowd changes its collective mind and moves for the exit
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 have bought, in which case the price will no longer be low.
So the things with the most obvious merit become the things that everyone likes. They’re also likely to be the things that are most hotly pursued and most highly priced, and thus least promising and most treacherous. What are some examples?
When I first showed up for work in First National City Bank’s investment research department in 1968, the bank was investing heavily in the “Nifty Fifty”: the stocks of America’s best, fastest growing companies. Since these were companies where nothing could go wrong, the official dictum said it didn’t matter much what price you paid. It didn’t seem unreasonable to pay p/e ratios of 80 or 90 given these companies’ growth rates.
But it turned out that the price you pay does matter, and 80-90 times earnings had been too high. Thus, when the market ran into trouble in the early 1970s, many of these stocks lost the vast majority of their value, and investors learned the hard way that it’s possible to like a good thing too much. Unsurprisingly, it also turned out that predictions of a flawless future can be wrong, as once-dominant companies such as Kodak, Polaroid and Xerox eventually went bankrupt or required turnarounds.
Roughly ten years ago, everyone was gaga over real estate, especially residential. This was underpinned by some bits of “accepted wisdom” that seemed compelling, such as “you can always live in it,” “home prices always go up” and “real estate is a hedge against inflation.” Conservative debt investors (rather than buyers of homes themselves) were persuaded to buy levered and tranched mortgage-backed securities by the fact that “there has never been a nationwide wave of mortgage defaults.”
But in 2007 it turned out that home prices can go down as well as up, and mortgage loans extended casually based on their flawless record can have flaws. Homes and mortgages, bought when everyone liked them, turned out to be terrible investments.
The fact is, painful bubbles can’t come into existence if there isn’t an underlying grain of truth. The Nifty Fifty were generally terrific companies. Home prices do tend to rise over time and offset inflation.
Mortgages generally are repaid or carry adequate collateral. The Internet would change the world. Oil at $147/barrel was indispensable and in short supply. But in each case the merits were too obvious; the investment ideas became too popular; and asset prices consequently became dangerously high.
Following the trends that are popular at a point in time certainly isn’t a formula for investment success, since popularity is likely to lead investors on a path that is comfortable but pointed in the wrong direction. Here’s more from “Everyone Knows”:
The fact is, there is no dependable sign pointing to the next big moneymaker: a good idea at a too-low price. Most people simply don’t know how to find it. . . .
Large amounts of money (and by that I mean unusual returns, or unusual risk-adjusted returns) aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.
In short, there are two primary elements in superior investing:
- 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).
It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.
Risk and Counterintuitiveness
If what’s obvious and what everyone knows is usually wrong, then what’s right? The answer comes from inverting the concept of obvious appeal. The truth is, the best buys are usually found in the things most people don’t understand or believe in. These might be securities, investment approaches or investing concepts, but the fact that something isn’t widely accepted usually serves as a green light to those who’re perceptive (and contrary) enough to see it. A great example can be found in the area of risk (again from “Everyone Knows”):
“I wouldn’t buy that at any price – everyone knows it’s too risky.” That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in. In fact, to an extent, it has provided the foundation for my career. In the 1970s and 1980s, insistence on avoiding non-investment grade bonds kept them out of most institutional portfolios and therefore cheap. Ditto for the debt of bankrupt companies: what could be riskier?
The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true.
I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:
- When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price
- And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing – no “risk premium” – is demanded or provided. That can make the thing that’s most esteemed the riskiest
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them.
For me, it follows from the above that the bottom line is simple: the riskiest thing in the world is the widespread belief that there’s no risk. That’s what most people believed in 2006-07, and that belief abetted the careless behavior that brought on the Great Financial Crisis. Only an understanding that risk was high could have discouraged that behavior and rendered the world safe.
I call this “the perversity of risk.” For most people it’s hard to grasp that a perception of safety brings on risk, and a perception of risk can lead to safety. But it’s clear for the deeper second-level thinker. This is just another example of the fact that what “everyone knows” is what shapes the environment, bringing high prices when things are perceived to be good, and vice versa.
A perception that fundamental risk is low and the future is positive causes investors to be optimistic. This, in turn, causes asset prices to rise, and thus investment risk to be high. The problem that befalls most people – the first-level thinkers – is that they fail to distinguish between fundamental risk and investment risk.
What has to be remembered is the defining role of price. Regardless of whether the fundamental outlook is positive or negative, the level of investment risk is determined largely by the relationship between the price of an asset and its intrinsic value. There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe). This is one of the greatest examples of counterintuitiveness. Only those who are able to see its logic can hope to be superior investors.
You can download the full memo here.
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