Sunday, 16th October 2011

Howard Marks Investing Ideas, part 3

Written by George Traganidas Topics: Stock Investing, Wealth Building


A bit above average performance is not that bad if you can consistently do it for many years. You do not need to swing for the fences in order to achieve long term gain. If you are willing to take huge bets on assets to gain the spectacular results you should be ready to fail some times and then have huge losses. That will give you an average return over the years, unless of course you can be right about the future most of the times. Not an easy task to accomplish.

Therefore, if you keep getting a bit above average over the years and your down years are not that much different from your up years (in percentage points), you will get a good return overall. In the good years it is good enough to be average, because the average investor makes a lot of money. The time to outperform is in falling markets. Most of the investing careers that produce the best records are notable at least as much for the absence of losses and losing years as they are for the spectacular gains. The challenge is that these virtues usually become apparent only in big downdrafts. But certainly they figure greatly in long term.

I believe that in many cases, the avoidance of losses and terrible years is more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for superior long-term track record.

Above average investment performance (in any market) has to be the result of either unusual insight into values or the intersection of risk taking and luck. It is hard to tell the difference between the two in the short term, but the truth always becomes clear in time, because luck rarely holds up for long.

When someone achieves a high return you need to question it. “How much risk did he take in order to generate that?” The problem is that few people find high returns worrisome.

Unusual risk-adjusted returns are not made by buying what everybody likes. They are made by buying what everybody underestimates.

Leverage does not make investments betters; it just magnifies the gains and losses.

Ensuring the protection of capital under adverse circumstances is incompatible with maximising returns in good times, and thus investors must choose between the two.

Everyone dreams of return without risk. But where can it be found? Not in markets that are working properly – that is, markets that are efficient. Not in leverage, which should be expected to cut both ways, magnifying both risks as well as return. Not in doing what everyone else is doing, or in buying the product du jour that’s being touted broadly and purchased unquestioningly. At best it can be found, with regard to markets that are less than fully efficient, in possessing – or aligning yourself with investors who possess – that scarce attribute: personal skill … superior insight…alpha.

People who think excess return is readily available fail to ask a few simple questions:

  • Why should a free lunch exist despite the presence of thousands of investors who are ready and willing to bid up the price of anything that is too cheap?
  • Why is the seller of he asset willing to part with it at a price from which it will give me an excessive return? Do I really know more about the asset than he does?
  • If it is such a great proposition, why has not someone else snapped it up?
  • Why is the broker offering it to me (rather than grabbing it for his prop desk)?
  • If the return appears so generous in proportion to the risk, might I be overlooking some hidden risk?

In the end, superior investing is all about mistakes… and about being the person who profits from them, not the one who commits them.

Theory assumes investors are clinical, unemotional and objective, and always willing to substitute a cheap asset for a dear one. In practice, there are numerous reasons why one asset can be priced wrong – in the absolute or relative to others – and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently.

Playing the market in the short term based on macro forecasts is one of the many things in investing that could add greatly to results if it could be done right… but it can’t, certainly not consistently.

The expected value from any activity is the product of the gains available from doing it right multiplied by the probability of doing it right, minus the potential cost of failing in the attempt multiplied by the probability of failing. Investors are often blinded by the potential gains from a tactic and thus don’t think much about the likelihood they can get it right.

The best response when seas are choppy is to focus on completing the long-term voyage and not think about whether the next wave is going to push the nose of the boat up or down. Our investment destination is best reached by accurately valuing assets, assessing the relationship between price and that value, and acting resolutely and unemotionally when mispricings are detected. That’s still the best – I think the only – reliable path to investment success.

At what price?

In investing there is no such thing as a good or bad idea. Only a good idea at a price. Anything can be a good idea at one price and time, and a bad one at another. There is no investment idea so good that it can not be ruined by a too-high entry price. And there are few things that can not be attractive investments if bought at a low-enough price.

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. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

Investment success doesn’t come primarily from “buying good things”, but rather from “buying things well” (and the difference isn’t just grammatical).

The thing to think about isn’t whether you’d rather have junior or senior securities in a recession, or fixed rate securities versus variable ones in deflation. The question is which securities are priced right for the future possibilities: which ones are priced to give good returns if things work out as expected and not lose a lot if they don’t? You mustn’t fixate on a security’s intrinsic merits, but rather on how it’s priced relative to those merits.

The attractiveness of one investment relative to another doesn’t come from what it’s called or how it’s positioned in the capital structure, but largely from how it’s priced relative to the other.

There are two key concepts that investors must master: value and cycles. For each asset you are considering, you must have a strongly help view of its intrinsic value. When its price is below that value, it is generally a buy. When its price is higher, it is a sell. In a nutshell, that is value investing. But values are not fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behaviour; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle.

Investors generally overestimate their ability to see the future, and the worst of them act as if they know exactly what lies ahead. It is important to worry about what’s coming next. The fact that we don’t know what it is shouldn’t permit us to think there’s nothing to worry about. Low asset prices allow us to invest aggressively, without much consideration given to worrisome fundamentals and the possibility of negative surprises. But as prices rise, so should our degree of concern over these things. The bottom line is this: the fact we don’t know where trouble will come from shouldn’t allow us to feel comfortable in times when prices are full. The higher prices are relative to intrinsic value, the more we should allow for the unknown.

When there’s too much money chasing too few deals, asset prices are driven up, prospective returns are driven down and risk rises.

Let’s think back to Galbraith’s statement that “Past experience… is dismissed as the primitive refuge of those who do not have insight to appreciate the incredible wonders of the present”. In other words, when a hot new investment fad gets rolling and an idea is elevated to bubble status, those with memory of the past – who might point out that the merits are overstated and the price is too high – are dismissed as “too old to get it”.

In some ways, understanding the market is like mathematics. You don’t have to be knowledgeable regarding the specifics of the underlying subject matter to know whether a conclusion makes sense. You just have to be able to apply principles, tell logic from illogic, and exclude the deleterious effects of emotion and psychology.

If I were asked to name just one way to figure out whether something is a bargain or not, it would be through assessing how much optimism is incorporated in its price:

  • No matter how good the fundamental outlook is for something, when investors apply too much optimism in pricing it, it won’t be a bargain. That was the story of the Internet bubble; the Internet was expected to change the world, and it did, but when the optimism surrounding it proved to have been excessive, stock prices were decimated.
  • Conversely, no matter how bad the outlook is for an asset, when little or no optimism is incorporated in its price, it can easily be a bargain capable of providing outsized returns with limited risk.
  • Even with a bad “story”, the price of an asset is unlikely to decline (other than perhaps in the very short term) unless the story deteriorates further or the optimism abates. And if there’s no optimism built into its price, certainly the latter can’t happen.

Follow the practical way,

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