One of our favorite investors at The Acquirer’s Multiple is Howard Marks.
Howard Marks is Chairman and Co-Founder of Oaktree Capital Management, the world’s biggest distressed-debt investor. He’s known in the investment community for his “Oaktree memos” to clients which detail investment strategies and insight into the economy, and in 2011 he published the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor.
One of our favorite memos is one where he discusses the most important things in investing. It’s a must read for all investors.
Here’s an excerpt from that memo:
As I meet with clients and prospects, I repeatedly hear myself say, “the most important thing is x.” And then ten minutes later it’s, “the most important thing is y” (and then z, and so on). Am I being disingenuous? Am I confusing the unimportant with the important? Is it that I can’t make up my mind? Or is memory loss setting in?
I hope (and believe) it’s none of these things. If I have to come up with an explanation, maybe it’s that I have strong feelings on a lot of subjects. Whatever the reason, I thought I’d collect in one place the precepts that guide Oaktree. Some might be more important than others, but in my view each one qualifies as “the most important thing.”
The most important thing – above all – is the relationship between price and value.
For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.
When people say flatly, “we only buy A” or “A is a superior asset class,” that sounds a lot like “we’d buy A at any price . . . and we’d buy it before B, C or D at any price.” That just has to be a mistake. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.
Hopefully, if I offered to sell you my car, you’d ask the price before saying yes or no.
Deciding on an investment without carefully considering the fairness of its price is just as silly. But when people decide without disciplined consideration of valuation that they want to own something, as they did with tech stocks in the late 1990s – or that they simply won’t own something, as they did with “junk bonds” in the 1970s and early 1980s – that’s just what they’re doing.
During the course of my 35 years in this business, investors’ biggest losses have come when they bought securities of what they thought were perfect companies – where nothing could go wrong – at prices assuming that degree of perfection . . . and more. They forgot that “good company” isn’t synonymous with “good investment.” Bottom line: there’s no such thing as a good idea regardless of price!
On the way to work the other day, I heard an “expert” tell a radio commentator how to invest in today’s stock market. “Figure out which industries have been doing best, and pick out the leading companies in those industries. The professionals know which they are, so their stocks will sport P/E ratios that are higher than the rest. But that’s okay: do you want the best companies or the worst?” My answer’s simple: I want the best buys.
The most important thing is a solidly based, strongly held estimate of intrinsic value.
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. And the level of belief in estimates of intrinsic value has to be high. Only if the estimate is strongly held will a manager be able to do the right thing.
If there’s no conviction, a drop in the price of a holding can weaken the investor’s faith in the estimate and make him fail to buy more, or maybe even sell, just when a lower price should lead him to increase his position. And price appreciation, which under most circumstances should prompt a review of a holding’s retention, can tend instead to seduce the investor into raising the target price and possibly buying more.
As expressed by David Swensen of Yale, “. . . investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low.”
You may wonder from time to time about the high level of confidence exhibited by your managers. But bear in mind that the most profitable investments are unconventional, and maintaining unconventional positions can be lonely. When you buy something you think is cheap and then see its price fall, it takes a strong ego to conclude it’s you who’s right, not the market. So ego strength is necessary if a manager is going to be able to make correct decisions despite Swensen’s “variance from popular opinion.”
Oh yeah, one last thing: those strongly-held views had better be right. Few things are more dangerous than an incorrect opinion held with conviction and relied on to excess.
Oaktree follows a clearly defined route that it trusts will bring investment success: If we avoid the losers, the winners will take care of themselves. We think the most dependable way for us to generate the performance our clients seek is by avoiding losing investments. We don’t claim that this is the only way to invest well; others may choose more aggressive approaches, and they may work for them. This is the way for us.
Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor . . . but you’re also likely to have fewer strikeouts and fewer inning-ending double plays. The ingredients in defensive investing include (a) insistence on solid, identifiable value at a bargain price, (b) diversification rather than concentration, and (c) avoidance of reliance on macro-forecasts and market timing.
Warren Buffett constantly stresses “margin of safety.” In other words, you shouldn’t pay prices so high that they presuppose (and are reliant on) things going right. Instead, prices should be so low that you can profit – or at least avoid loss – even if things go wrong. Purchase prices below intrinsic value will, in and of themselves, result in larger gains, smaller losses, and easier exits.
“Defensive investing” sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.
The most important thing is avoiding bad years.
Preparing for bad times is akin to attempting to avoid individual losers, and equally important. Thus time is well spent making sure the downside risk of our portfolios is limited. There’s no need to prepare for good times; like winning investments, they’ll take care of themselves.
The mantra “beat the market” has been vastly overdone in the last 25 years, when outperforming an index has become the sine qua non of good management. But why should this be the case? Keeping up with the market while bearing less risk is at least as great an accomplishment, although few people talk about it in the same glowing terms.
At Oaktree we believe strongly that in the good times, it’s good enough to be average. In good times, the average investor makes a lot of money, and that should suffice. In good times the greatest rewards are likely to go for risk bearing rather than for caution. Thus, to beat the averages in good times, we’d probably need to accept above-average risk . . . risk that could turn around and bite us in a minute.
There is a time when it’s essential that we beat the market, and that’s in bad times.
Oaktree and its clients don’t want to succumb to market forces in bad times and participate fully in the losses. And because we don’t know when the bad years will come, we insist on investing defensively all of the time.
Our goal is to generate performance that is average in good times (although we’ll accept more) and far above average in bad times. If in the long run we can accomplish this simple feat (which time has shown isn’t simple at all), we’ll end up with (a) above-market performance on average, (b) below-market volatility, (c) highly superior performance in the tough times, helping to combat people’s natural tendency to “throw in the towel” at the bottom, and thus (d) happy clients. We’ll settle for that combination.
The most important thing is facing up to the limits on your knowledge of the macro-future.
Investing means dealing with the future – anticipating future developments and buying assets that will do well if those developments occur. Thus it would be nice to be able to see into the future of economies and markets, and most investors act as if they can. Thousands of economists and strategists are willing to tell us what lies ahead. That’s all well and good, but the record indicates that their insights are rarely superior, and it’s never clear why they’re willing to give away gratis their potentially valuable forecasts.
One thing each market participant has to decide is whether he (or she) does or does not believe in the ability to see into the future: the “I know” school versus the “I don’t know” school. The ramifications of this decision are enormous.
If you know what lies ahead, you’ll feel free to invest aggressively, to concentrate positions in the assets you think will do best, and to actively time the market, moving in and out of asset classes as your opinion of their prospects waxes and wanes. If you feel the future isn’t knowable, on the other hand, you’ll invest defensively, acting to avoid losses rather than maximize gains, diversifying more thoroughly, and eschewing efforts at adroit timing.
Of course, I feel strongly that the latter course is the right one. I don’t think many people know more than the consensus about the future of economies and markets. I don’t think markets will ever cease to surprise, or thus that they can be timed. And I think avoiding losses is much more important than pursuing major gains if one is to achieve the absolute prerequisite for investment success: survival.
The most important thing is contrarian behavior.
Because of the fluctuation of both fundamental developments and investor behavior, assets are sometimes offered for sale at bargain prices and at other times at prices that are too high. A technique that works most dependably is putting money into things that are out of favor.
Although investors often seem not to grasp it, it shouldn’t be hard to understand: only unpopular assets can be truly cheap. And those that are in favor are likely to be dear.
For example, one of the best reasons for the profitability of distressed debt over the years is that there’s no such thing as a distressed company everybody loves. By the time they’ve made their way to our arena, distressed debt companies can no longer be on what I call “the pedestal of popularity.” We buy at low dollar prices from depressed owners at a time when corporate performance is well off from the top. Not a bad formula.
Certainly that doesn’t have to mean that the investment’s cheap enough, but at least there’s a low probability it’s pumped up on hot air (or investors’ ardor).
The momentum player buys what’s up and bets that it’ll keep going up. The style devotee buys one thing whether it’s up or down. But the contrarian, or value investor, buys something that other people aren’t interested in, in the belief that it’s cheap and will become less cheap someday. There’s no sure recipe for profit, but I think this one stacks the cards in your favor. As Sir John Templeton put it, “To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage but provides the greatest profit.”
To read more of the Howard Marks memos, you can find them here.
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