I’ve just been reading the latest Graham & Doddsville newsletter which features Howard Marks. the Co-Chairman of Oaktree Capital.
It’s a great interview with Mark’s in which he discusses his investing strategy, investor psychology, investing timeframes and how great investors stick to their approach through thick and thin. Here’s an excerpt from the newsletter:
Graham & Doddsville (G&D): You last spoke to Graham & Doddsville for the Fall 2009 issue during a more stressful time for markets. How has Oaktree changed since 2009, and what do you think you’ve learned since then?
Howard Marks (HM): I hope we haven’t changed much. The foundation of our investment philosophy and business principles is holding up, so I don’t think there’s a need for change. We’re trying to roll with what the market gives us. We have no alternative. We’ve probably grown in assets since then by maybe $60 billion and we’re at about $100 billion today. We have some new products. I think we have evolved, but I hope we have not changed.
We hired a CEO three years ago. When he arrived, he sent a memo to the staff saying that he was not there to change Oaktree, only to make it better, and I hope that’s what we’ve done.
G&D: Equities are one area you’ve expanded in since 2009, especially the value equity strategy. You’ve said before that the stock market is a little more efficient than other areas you’ve historically been in. Has your thinking about equities evolved?
HM: No, but my previous comment about efficiency pertains primarily to what I would call mainstream equities. The process that produces efficiency in those mainstream stocks starts with the fact that a lot of people are looking at them. If you can find some equities, either a sector or a country, where not many people are looking, then the assumption of efficiency could go out the window. I wouldn’t say we’ve done a lot more in equities. We now have maybe less than $5 billion in equities out of the total $100 billion, so it’s not a major transformation. If you go back eight years ago, we already had emerging market and Japanese equities. Value equities is only a few hundred million dollars, so I don’t think its addition is a transformation.
In 1978, when I left the research department of Citicorp they asked me, “What do you want to do next?” I said, “I’ll do anything except spend the rest of my life choosing between Merck and Lilly.” I stand by that comment.
It’s not the fact that if something is an equity that makes it efficient; it’s the fact that it’s well-known, wellfollowed, and understood. If we can find exceptions to that, we can find superior opportunities for risk adjustment and returns.
G&D: Could you talk about how Oaktree structures its many strategies?
HM: Each strategy has its own process. The people who run the various strategies have generally been here a very long time, and they have the complete confidence of me and my partners. We do not have an overview committee. In some firms, every investment must come to the investment committee. We don’t have that. It’s decentralized, and we let the people who know the strategies best make the decisions. We provide a lot of guidance as how to behave vis-à-vis the macro, and what philosophy and approach to adapt. But the portfolio decisions are decentralized.
G&D: You’ve written a lot over the years about market psychology. Any new thoughts these days?
HM: There’s a chapter in my book, The Most Important Thing, that says that the most important thing is knowing where we stand. I start the chapter by saying, “As to the macro, including the level of the market, we never know where we’re going, but we sure as hell ought to know where we are.” It’s not so hard to know where we are; the question is where we’re going. I advocate a two-pronged approach.
First, you look at valuations—price-earnings ratios, yields, yield spreads, transaction multiples, cap rates in real estat —and you ask “are they high or low relative to history and relative to interest rates?” You gauge the appropriateness of valuations. That’s entirely quantitative.
Then, there’s the qualitative. How are people behaving? Are people euphoric or depressed? Are they skeptical or unquestioning? If a new fund comes out, is it oversubscribed overnight, or does it go begging? All these kinds of things. What are they saying on TV? What are the newspapers saying? Take the temperature of the market. Look at the behavior around us, that’s the key.
Warren Buffett says, “The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.” In other words, when other people are carefree, we should beworried. When other people are panicked, we should turn aggressive. As an analyst, if you could only ask one question about pricing, I think it should be how much optimism is incorporated in the price. When there’s a lot of optimism in the price, number one there’s not too much further to go, and number two, there’s a lot of air that can leave the balloon if the optimism is disappointed. If there’s no optimism, then all the surprises will be on the upside. You can’t have less than zero optimism, so we try to figure that out.
By the time this Graham & Doddsville issue comes out, I’ll have put out a new memo which talks about my views on the state of the market. I think there’s a lot of credulousness, and not much risk aversion, and I think that’s a cause for concern. The memo is entitled “There They Go Again . . . Again.” It talks about what’s going on today stock market valuations are high, VIX is at the lowest reading in history, and the FANGs are adored. The market leaders are being sucked up by ETFs in a kind of virtuous circle, where they go up in price, which makes people buy them, which makes them go up in price, which makes people buy them. High yield bonds are at their lowest yields in history, emerging market debt is yielding still less, private equity is raising the most money ever, Softbank is raising a $100 billion fund for technology investments.
Each of those things suggests a hot market, where people are happy to trust the future. All of them together should be something that people pay attention to. You can’t argue that things are languishing cheap today, you have to adjust your behavior.
Remember what Mark Twain said, “History does not repeat, but it does rhyme.” Things are never the same from cycle to cycle in terms of the details. The things you look at today are different than the things you looked at 20 years ago. Twenty years ago, there was no CNBC and no Internet. The things you look at change, and you have to stay current, but the process, the goal, and the principles of trying to take the temperature of the market doesn’t change. I’ll have a book out next year about cycles, and that’s most of what the book will be about, trying to understand where we are in the cycle.
G&D: Speaking of cycles, a lot of investors today haven’t gone through a bear market. What would you recommend to these investors?
HM: There’s no lesson like experience. You can read about it, and you can talk to old timers, but there’s nothing like living through it. The most important lessons in investing are learned in the tough times.
I started in 1968, and we came across tough times right away, and I learned a lot of very valuable lessons. You can read, and there are a lot of books. For example, I read A Short History of Financial Euphoria, by John Kenneth Galbraith, and that was very, very helpful. It talks about the excesses of psychology.
G&D: With the age of the quant, should a value investor change anything about first-level, second-level, or even third-level thinking?
HM: Artificial intelligence is probably a threat to all of us. We just don’t know how. I believe great investing is as much art form as science, and I don’t know if a computer can be taught to paint a Rembrandt, but maybe it can. A computer beat the greatest chess player. We were told that Go, the Asian game, is not scientific, and that unique intuition prevents a computer from succeeding at Go—but now computers beat the best Go players. It seems clear to me that a computer could probably be programmed to beat the average investor. Can it outperform the best investor with a golden intuition or gut? I don’t know, but we’ll see.
What would happen, though, if there were a thousand investors in the world, and they all used the same screen? Then prices would be set, since every seller and every buyer is guided by the same screen; that means prices would be set the way the screen says it should be. That means the goal would be to find the things that the screen hasn’t thought of. That’s what second-level thinking would be here: thinking different from the herd, and better.
If the whole herd is directed by a screen, you’ve got to find something that the screen hasn’t thought of. I believe that will always be possible, because one important thing to remember is that the actions of investors change the market. When all the investors use a given screen, that fact will change the market, meaning things the screen hasn’t thought of determine attractiveness.
Other aspects that the screen has not been set up to look for will become the determinants of success. It’s all kind of circular, and kind of zen. I exaggerate by saying everything that’s important about investing is counterintuitive, and everything that’s obvious is wrong. The question is, can a computer, a spreadsheet, a model, a screen, be taught to make counterintuitive judgements? I don’t know. Can a computer, or AI, figure out which companies will be best managed and which new technologies will succeed? We’ll see.
G&D: Do you think investing timeframes have materially changed as a result of the information age?
HM: Well, I don’t know if it’s because of the information age. I think a lot of it is because of the pressure on investors for performance. We used to think about holding stocks for five years, and at the end of the year, it took a week or two before the bookkeepers figured out what your rate of return was for the year. I may be exaggerating, but then it became a matter of an hour, then it became a matter of a minute. Today, everybody has their performance every second in real time, and in one of the biggest mistakes that took place in this process, the clients decided to put a lot of emphasis on short-term performance. It tells you nothing.
In fact, if you put a manager on probation because he had a bad quarter, if he sells the stocks that are down and buys the stocks that are up, you have forced him into a poor decision. But it has happened, and now everybody wants to know how you did last quarter. Nobody says, “how did you do in the last ten years?” which is what matters.
Every manager and every approach has times when he, she, or it is out of favor. In theory, an investor who skillfully changes his approach and keeps up with the demands of the market—if that person existed—could do well all the time. Very few people, if any, satisfy that criteria. Most great investors stick to an approach through thick and thin, and yet every approach goes out of favor sometimes, which means that every investor has periods in the dog house.
To be a great investor, you must have an approach, and you have to stick to it, despite the times when it’s not working. If the clients look at the performance every six months, three months, month, week, then it becomes harder for the manager who wants to keep the account to stick to his approach. Instead you start buying the things that have gone up—we call that chasing. You sell the things that have gone down—we call that puking. That can’t be the right formula.
Most investment management clients give more money to the manager who’s been doing well. Very few have a program of giving more money to the manager who’s been doing poorly. That’s what you should do, though, because that’s how you buy the things that are out of favor. Obviously, you have to separate the ones that are good at their job but may be out of favor from the ones that are just bad at their job. That’s not easy either. None of this stuff is easy.
The greatest quote in my book is from Charlie Munger, who said, “None of this is meant to be easy, and anybody who thinks it’s easy is stupid.” All this stuff is really complex. It’s easy to talk about, but it’s hard to implement. How do you tell the ones who are good but unlucky, from the ones that are bad? It’s not easy. It takes judgment. That’s why I believe that this whole thing can never be completely computerized, because I think exceptional investment success requires judgment, and I don’t know if AI can be taught to make those judgments.
G&D: Do you have any advice for folks that have trouble not being able to step back from the noise, especially in an environment where there is so much scrutiny on short-term performance?
HM: Number one, every investment manager who manages money for other people must spend a lot of time on client education, and you have to explain to them the error of putting pressure on managers and acting in response to short-term performance. You must convince them to figure out who the good ones are. Stay with the good ones, get rid of the bad ones, and put more money with good managers who are down. That’s counterintuitive and hard to do. It means resisting emotions, and it requires a certain degree of stalwartness, which many people don’t have.
G&D: There is one last opinion we want to ask of you—what would your advice be to an MBA student trying to enter investment management today?
HM: I think that investment management is fascinating, because it’s not easy; it’s challenging. In Fooled by Randomness, Nassim Taleb talks about the difference between investing and dentistry. There’s no randomness in dentistry, and if you do the same things to fill a tooth, you’ll be successful every time. That’s not true of investing.
First of all, there’s no magic formula. There are no physical laws at work. Number two, there’s a lot of randomness. Those things make it interesting. It’s an intellectual puzzle with partial information. The process is messy and imprecise. To me, that’s fascinating. You can have guidelines developed over a career, but they sure don’t work every day. I love it for that reason. I think your classmates should pursue investing if they’ll love it. That’s why you should do it. The main reason you shouldn’t do it is to make a lot of money, because number one, money isn’t everything. Number two, I predict the investment management business is not going to remain as remunerative for everyone as it has been in the last 35 years.
My favorite quote comes from a British author named Christopher Morley, “There’s only one success: to be able to live your life your way.” I believe you shouldn’t let society determine what your way is, and you shouldn’t let money determine what your way is. If the proposition of investment management is interesting to someone, then they should do it, because they’ll have a great deal of fun. Not everybody has the intuition you need to be successful, to be a great second-level thinker. Warren Buffett says he tap dances to work every day. But not everybody’s Warren Buffett.
This business isn’t a lot of fun when you’re not successful, but it sure is when you are.
You can find the full interview at G&D here.
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