Sunday, 16th October 2011

Howard Marks Investing Ideas, part 1

Written by George Traganidas Topics: Stock Investing, Wealth Building

When the world’s self-made billionaires speak it is good to listen. Then when you find out who they follow on a regular basis, maybe you should look at them too. This is how I learned about Howard Marks. Howard is the chairman of Oaktree since 1995. His approach to money management is based on a simple motto: “if we avoid the losers, the winners will take care of themselves”. His memos to clients are a must read for investors. Here are some pieces of advice taken directly from his memos.

Efficient Markets

The main function of the markets is to drive out excess return by bringing buyers and sellers together at prices from which the return will be just fair. Realising that makes scepticism an indispensable ingredient in superior investing. Most investment failures are preceded by a dearth of it.

A lot is said about the markets been efficient over the years. The markets are efficient in the sense that information is quickly and correctly reflected in the price. Even though some times the markets misprice assets it is very difficult for someone who is working in the market with the information that everyone else has to consistently have views different from the consensus and closer to being correct.

Some markets are inefficient because:

  • Information is not disseminated evenly
  • Investors are not many or not objective
  • They are complicated and a high degree of skill is required

Assets may be mispriced relative to their risk, relative to their intrinsic value and relative to each other. In inefficient markets, “low risk” does not have to mean “low return”. In these markets hard work and skill can pay off.

There are times when the markets are wrong or the risk-adjusted return of an asset is far out of line with the rest. The inefficiency of the markets does not guarantee that someone will achieve above average returns, but it provides a starting point for people to try. Because investing is a zero sum game, for every person who achieves the above average returns another one must achieve the opposite. So it is essential to have superior skill to take advantage of such markets. While that price is often wrong, very few investors are capable of consistently knowing when it is, and by how much, and in which direction.

An inefficient market can offer the ability to achieve a higher return without bearing more risk. Also, it can offer the ability to achieve the same return as the benchmark while taking less risk. Here the manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return.

I absolutely believe that markets can be efficient – in the sense of “quick to incorporate information” – but certainly they aren’t sure to incorporate it correctly. Underpricings and overpricing arise all the time. However, many shortcomings render those mispricings hard to profit from. While market prices are often far from “right”, it’s nearly impossible for most investors to detect instances when the consensus has done a faulty job of pricing assets, and to act on those errors. Thus theory is quite right when it says the market can’t be beat… certainly by the vast majority of investors.

People should engage in active investing only if they’re convinced that (a) pricing mistakes occur in the market they’re considering and (b) they – or the managers they hire – are capable of identifying those mistakes and taking advantage of them. Unless both of these things are true, any time, effort, transaction costs and management fees expended on active management will be wasted. Active management has to be seen as the search for mistakes.

Market Cycles

One thing that has not changed in 200 years of investing is the market cycle. Markets move up and markets move down. That is a fact of the markets that people forget some times and they are reminded of it in the most painful way. This time things are not different.

The higher prices will always attract more buyers who will bid up the prices. This is the start of the greed cycle. People will be scared of missing the boat and buy assets without caring about the price. At some point the prices will move so high that people will stop buying and start selling to capture gains. This will start the prices to starting moving down and more people will sell to avoid been left behind. This is the start of the fear cycle. People will run for the exits because they do not want to be the last one to leave. This will make the prices move low and at some point buyers will come back to buy bargains and the cycle starts again.

The market is like a swinging pendulum that moves from one side to the other. No one knows how long it takes to reverse direction, but the sure thing is that it will. Although the midpoint of its arc best describes the location of the pendulum “on average”, it actually spends very little time there. It always swings towards or away from the extremes of its arc.

What is important in the cyclical markets is not to be ale to predict the future but to know where we are at the moment. As investors we might not know where we are going, but we better have a good idea where we are. By knowing in which part of the pendulum swing we are at the moment we can decide what to do.

Cycles are inevitable, often profound, and the most reliable feature of the business and investment worlds. We cannot know how far the trend will go, when it will turn, what will make it turn, or how far things will then go in the opposite direction. But every trend will stop sooner or later. Nothing goes on forever. Trees do not grow to the sky and neither do many things go to zero and stay there. Success carries within itself the seeds of failure and failure the seeds of success.

It is folly to think we know in advance just what it is that will cause the market pendulum to stop swinging in one direction and start in the other, but it is even greater folly to think that nothing of that nature will happen.

Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.

Overestimating the longevity of the up legs and down legs is one of the mistakes that investors insist on repeating.

The tendency to expect trends to continue is typical of investor behaviour, especially with regard to phenomena that should instead be expected to regress toward the mean.

The cycle isn’t unknowable or unbeatable.

Many of the biggest mistakes made in the business and investment worlds have to do with cycles. People extrapolate uptrends and downtrends into eternity, whereas the truth is that trends usually correct: rather than go well or poorly forever, most things regress to the mean. The longer a trend has gone on – making it appear more permanent – the more likely it usually is that the time for it to reverse is near. And the longer an uptrend goes on, the more optimistic, risk-tolerant and aggressive most people become… just as they should be turning more cautious.

In particular, people tend to forget the cyclical nature of things, extrapolate past trends to excess, and ignore the likelihood of regression to the mean.

The tech bubble may not recur anytime soon. No online grocer may ever again sell at 200 times revenues. There may never be another CDO-squared or SIV. Those aren’t the things that matter. But there’s sure to be another cycle, another bubble and another crisis. There’s be another time when people overpay for exciting investment ideas because their future appears limitless, and then a time of disillusionment and price collapse. There’ll be another period when leverage is embraced to excess, and then, consequently, a period when it gets people killed. And there’ll certainly be another time when people can only imagine the possibility of gain, and then one when – after huge sums have been lost – they can think only of further declines.

These are the kinds of things that rhyme. If we stay alert, we can anticipate and recognize them and thus avoid the losses and opportunity costs they bring so reliably.

Follow the practical way,
George

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