Speech Notes: Howard Marks at NYSSA

On April 5, Howard Marks, legendary investor and Chairman of Oaktree Capital Management, spoke at New York Society of Securities Analysts.  He is also the author of the book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Distressed Debt Investing was in attendance as he presented his views on the topic of “Human Side of Investing.”

According to Howard Marks, the discipline that is most important is not accounting or economics, but psychology.  He started off with a quote from Yogi Berra, “In theory, there is no difference between theory and practice; but in practice, there is.”  And this difference is what is at the essence of the human side of investing.  Even though the business schools teach that the markets are objective and efficient, and generally follow the “Capital Market Line (CML) curve (“riskier assets always provide higher returns”), it was handily disproved in both contrasting time periods of Q2 2007 and Q4 2008. Essentially, the upward sloping CML does not work in practice.  In practice, riskier assets must appear to provide higher returns, else they won’t attract capital.  But that does not mean that those promised returns arrive in reality.  If the risky assets provided higher returns, then they can’t be deemed risky after all.  In Q2 2007 the risk premium was very inadequate, whereas in Q4 2008 it was overly excessive.  The truth is that market is made up of people with emotions, insecurities, and foibles, and they often make mistakes.  They tend to swing to erroneous extremes.

One has to be very careful about the value and price relationship.  If you buy without discernment to the price, the returns would be all over the place – sometimes good, and sometimes bad.  In theory, people want more of something at lower prices and less of something at higher prices.  However, in practice, people tend to warm to investments as they rise and shun them when they fall.  In markets, the demand curve looks the opposite of how it looks in microeconomics theory based on supply and demand.

The normal investor behaves like a pendulum with constant swings between optimism and pessimism, between risk tolerance and risk aversion.  Although, the statistical “mean” location for the pendulum swing is in the middle, that happy medium is rarely seen in the markets, just as the pendulum spends almost no time at its “mean” during the swing.

Next, he talked about the 3 stages of bull market.  The first stage occurs when few smart people begin to believe that there will be improvement.  The second stage occurs when most people recognize that improvement is actually taking place.  The third stage occurs when everybody and their brother believe that things will continue getting better forever.  And that’s how bubbles come into existence.  The belief becomes that the price of a particular asset will only rise forever, that it can’t go down.  But when the pendulum swings like it did in 2008-09, bear market happens.  The 3 stages of bear market, conversely, are: first, when few people realize that things are overpriced and will prices likely will fold; second, when most people see that he decline is taking place; and third, when everybody believes that things will only get worse forever.  That last stage was the apt description of the credit markets in fourth quarter of 2008 and equities in first quarter 2009.  Any asset can be attractive or unattractive depending on the stage in which it is bought, i.e. depending on how much optimism or pessimism is embodied in the price.  The adage we should remember is: “What a wise man does in the beginning, the fool does in the end.”  What we should be is a contrarian.  We should be a seller in the third stage of the bull market, and buyer in the third stage of the bear market.  He quoted Mark Twain: “When you find you are on the same side as the majority, it is time to reform.”

Contrarianism is very important but very difficult.  To make his point, he quoted David Swenson who runs investments for Yale’s endowment fund: “Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolio which frequently appear to be downright imprudent in the eyes of the conventional wisdom.”  However, if one wants to be a successful contrarian, one has to believe that conventional wisdom by itself is a bit of an oxymoron because what is conventional is often not wise because most people start believing in something only when it is the third stage of either market extreme.

What is it that permits bubbles and crashes to happen frequently?  Howard Marks pointed the reason to be failure of investor memory especially since when the investor’s memory is faced with greed/fear, memory loses.  When people forget the past, they tend to repeat the same mistakes done previously.  He recommended reading his latest memo, “Déjà vu all over again” in which he discusses contrarian signals. He went on to say that behaving pro-cyclically is one of the greatest, most frequent mistakes.  We should strive to be anti-cyclical, but it requires strong memory and contrarian bent.

Another important thing is understanding and knowing what you don’t know.  A lot of people do not know what they don’t know, and essentially overestimate what they know.  Investing is a business full of testosterone and they think that you are not a man if you don’t know what’s exactly going to happen in say, five years.  In fact, some people think they know everything, some people think they are supposed to know everything, and a lot more act as if they know even when they don’t.  Mark Twain put it the best: “It ain’t what you don’t know that gets you in trouble.  It’s what you know for sure that ain’t so.”

He then referred to the memo he wrote 8-10 years back, “Us Versus Them,” describing two schools – the “I Know” school, and the “I Don’t know” school.  He is a proud, card carrying-member of the latter.  It is very important to understand the difference between the two schools.  “I Know” school is confident about its forecast of the future, and “I Don’t Know” school is skeptical about that forecast.  The former can only prepare for one outcome, whereas the latter hedges against uncertainty and prioritizes avoidance of losses over the maximization of gains.  The latter approach is more likely to result in a successful investment career.  Therefore, the motto at Oaktree is to “Avoid the losers; the winners will take care of themselves.”  As long as the portfolios are built to avoid losers, they will do okay.

Most of the times, investors think that only the most likely thing is going to happen and they really only  prepare for just one outcome.  Howard Marks doesn’t seem to think highly of economists as they do not draw ranges or probabilities of the forecasts they give out, and are more often than not proven wrong.  He implored that while investing one should never forget the story of the 6 feet tall man who drowned in a stream which, on average, was five feet deep.  It is not enough to know what the average outcome will be; instead one has to have an idea of the likely shape of the outcome distribution curve.  One of the things investors should always be ready for is the unlikely disaster and should not ignore the “tails.”  Unlikely things happen all the time, and the likely things do not happen all the time; we need to build our portfolios to account for that.  This is not easy as Charlie Munger says, “None of this is easy, and if anyone thinks it is easy, he is stupid.”  It is not easy in investing to make above average returns as most of the people do single scenario investing which ignores that more things can happen than will happen.  The most likely outcome does not happen that often.  And that is what Howard Marks thinks risk actually is.  It is not standard deviation or volatility of returns; for him it is losing money.

There are 3 ingredients for success in investing: aggressiveness, timing, and skill.  If you have the first two, you don’t need the third.  But that’s unlikely to remain the case in the long run as it is very hard to do the right thing, at the right time consistently in the investing business.  He then went on to talk about the two twin imposters in investing: Short term outperformance, and Short term underperformance.  They really don’t tell anything about an investor’s ability to outperform in the long run.  He referred to the memo he wrote in 2006 after the melt down of the hedge fund, Amaranth, in which he dissects the events from his vantage point.  He thinks that Amaranth’s problems didn’t start in 2006 when it went down a 100%; the problems started in 2005 when it went up a 100%.  Going up or down 100% can be two sides of the same coin, and can be result of combination of sheer aggressiveness and luck/timing.  If a person goes up a 100% one year, it does not guarantee that he will go up significantly again next year.

He recommended reading the book “Fooled by Randomness” by Nassim Taleb, and understanding not only black swan phenomenon but also the concept of “alternative histories,” especially as it pertains to judging investors for the long term given that there is a lot of randomness in the world.  Just because something should happen does not mean that it would happen.  One of the things Howard Marks believes is that the correctness or the quality of a single decision can’t be judged by one outcome alone because of that randomness.  One has to assess the decision-makers outcomes over a somewhat longer period of time to assess that person’s skill.

Lastly he concluded by saying that forces that influence investors also push them towards mistakes.  Investing in obvious things, things that are easily understood, things that are doing well, etc. – these are all easy to do.  These things become names everybody wants to invest in.  But just by that virtue, most of the times these assets become overpriced and unlikely to be bargains.  Bargains that investors find in their lifetimes are likely to have hidden appeal, not be easily understood, and be unpopular.  Things that appear hard to invest in are where bargains are found.  Bargains do not appeal to herds.  Any given asset can be a good buy or a bad buy depending on the price.  There is no such thing as a “good idea” until you know the price.

In the Q&A session, he shared his view that he did not believe that equities currently have excessive optimism built into the prices. He also thought that the high yield is relatively more attractive now than it was in 2007 despite the similarly low yields as the spreads are generous right now versus the treasuries.  It is hard for investors to get away from the business of relative selection.  Next, he suggested that as a professional investor you should not let the clients put you up on a pedestal, but rather should set reasonable expectations with them.  On the question of why CEOs of companies consistently overestimate performance, he felt that a lot of CEOs are good salesmen who might belong to the “I Know” school.   (By the way, unsurprisingly, he thought CNBC is big on that school as well.)  On how to protect against black swans, he suggested using portfolio diversification, basically buying those assets that would behave differently in a certain environment.  However, this can be hard to do especially if one is mandated to only be in a particular asset class, but one has to nevertheless try to reduce the correlation.  Finally, currently he is reading Sebastian Mallaby’s book, “More Money than God.”