by Howard Marks
JOEL GREENBLATT: Paying too much is a great way to lose money regardless of other measures of risk, such as volatility or degree of diversification.
HOWARD MARKS: The riskiest things: The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.
Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.
CHRISTOPHER DAVIS: That is, high price both increases risk and lowers returns.
Thus, awareness of the relationship between price and value—whether for a single security or an entire market—is an essential component of dealing successfully with risk.
JOEL GREENBLATT: The risk of misvaluing an investment is a component of this thought process for the value investor.
Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.
All along the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk. Except for those people who can generate “alpha” or access managers who have it, investors shouldn’t plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums.
But at some point in the swing of the pendulum, people usually forget that truth and embrace risk taking to excess. In short, in bull markets—usually when things have been going well for a while—people tend to say, “Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.”
The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so … and risk compensation will disappear.
HOWARD MARKS: The riskiest things: Too-high prices come from investor psychology that’s too positive, and too-high investor sentiment often stems from a dearth of risk aversion. Risk-averse investors are conscious of the potential for loss and demand compensation for bearing it—in the form of reasonable prices. When investors aren’t sufficiently risk averse, they’ll pay prices that are too high.
This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high price/earnings ratios and private companies at high multiples of EBITDA (cash flow, defined as earnings before interest, taxes, depreciation and amortization), and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates” (the ratio of net operating income to price).
There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.
CHRISTOPHER DAVIS: A good analogy to this is the studies that show there are more traffic fatalities among drivers and passengers in SUVs than in compact cars despite SUVs’ being bigger and more sturdily built. Drivers of SUVs believe they’re not at risk in case of an accident, and this leads to riskier driving. The feeling of safety tends to increase risk while the awareness of risk tends to reduce it.
HOWARD MARKS: The riskiest things: “There are few things as risky as the widespread belief that there’s no risk.” The opening words of this paragraph are valuable because they highlight an excellent example of the ways investors’ behavior creates the risks to which they are subjected. When they swallow worry-free beliefs, it truly is the riskiest thing.
Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.
“SO MUCH THAT’S FALSE AND NUTTY,” JULY 8, 2009
So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether. That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.
In 2005–2007, belief that risk had been banished caused prices to rise to bubble levels and investors to participate in what later turned out to be risky activities. This is one of the most dangerous of all processes, and its tendency to recur is remarkable.
HOWARD MARKS: The riskiest things: A few times in my career, I’ve seen the rise of a belief that risk has been banished, cycles won’t occur any longer, or the laws of economics have been suspended. The experienced, risk-conscious investor takes this as a sign of great danger.
Of the many fairy tales told over the last few years, one of the most seductive—and thus dangerous—was the one about global risk reduction. It went this way:
• The risk of economic cycles has been eased by adroit central bank management.
• Because of globalization, risk has been spread worldwide rather than concentrated geographically.
• Securitization and syndication have distributed risk to many market participants rather than leaving it concentrated with just a few.
• Risk has been “tranched out” to the investors best able to bear it.
• Leverage has become less risky because interest rates and debt terms are so much more borrower-friendly.
• Leveraged buyouts are safer because the companies being bought are fundamentally stronger.
• Risk can be hedged through long/short and absolute return investing or the use of derivatives designed for that purpose.
• Improvements in computers, mathematics and modeling have made the markets better understood and thus less risky.
An apt metaphor came from Pension & Investments (August 20, 2007): “Jill Fredston is a nationally recognized avalanche expert. … She knows about a kind of moral hazard risk, where better safety gear can entice climbers to take more risk—making them in fact less safe.”
JOEL GREENBLATT: This is such an important thought when assessing the true benefits of different methods of diversification.
Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.
The bottom line is that tales like this one about risk control rarely turn out to be true. Risk cannot be eliminated; it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky. These are among the important lessons of 2007.
“NOW IT’S ALL BAD,” SEPTEMBER 10, 2007
The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in question is sure to produce profits intoxicates the herd and causes its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity.
HOWARD MARKS: The riskiest things: In the summer of 2009, the New York Times asked a dozen people to write about the causes of the crisis. My response, published on dealbook.com on October 5, 2009, was entitled “Too Much Trust, Too Little Worry.” Take a look, and note that carefree, unworried investors are their own worst enemy.
The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little and thus took too much risk. In short, they believed they were living in a low-risk world. …
Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming o
verly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.
But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.
Clearly, in the months and years leading up to the crisis, few participants worried as much as they’re supposed to.
“TOUCHSTONES,” NOVEMBER 10, 2009
Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. The key lies in understanding what impact things like these are having.
The investment thought process is a chain in which each investment sets the requirement for the next. Here’s how I described the process in 2004:
I’ll use a “typical” market of a few years back to illustrate how this works in real life: The interest rate on the thirty-day T-bill might have been 4 percent. So investors say, “If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.” Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital market line, normally slopes upward with the increase in asset life.
Now let’s factor in credit risk. “If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.” This introduces the concept of credit spreads. Our hypothetical investor wants 100 basis points to go from a “guvvie” to a “corporate.” If the consensus of investors feels the same, that’s what the spread will be.
What if we depart from investment-grade bonds? “I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.” So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the Treasury note, if they’re going to attract buyers.
Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not “fixed”). But investors have a sense for these things. “Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so. … And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.”
From there it’s onward and upward. “If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts … and 30 percent to induce me to go for venture capital, with its low success ratio.”
That’s the way it’s supposed to work, and in fact I think it generally does (although the requirements aren’t the same at all times). The result is a capital market line of the sort that has become familiar to many of us, as shown in figure 6.1.
Figure 6.1
A big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s closer to 1 percent….
Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now4 percent is the right rate for the ten-year (not 6 percent). They won’t go into stocks unless they get 6 to 7 percent. And junk bonds may not be worth it at yields below 7 percent. Real estate has to yield 8 percent or so. For buyouts to be attractive they have to appear to promise 15 percent, and so on. Thus, we now have a capital market line like the one shown in figure 6.2, which is (a) at a much lower level and (b) much flatter.
Figure 6.2
The lower level of the line is explained by the low interest rates, the starting point for which is the low riskless rate.
JOEL GREENBLATT: This may suggest that the risk-free rate should be normalized in some way before being used to assess riskier investments.
After all, each investment has to compete with others for capital, but this year, due to the low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.
Not only is the capital market line at a low level today in terms of return, but in addition a number of factors have conspired to flatten it. (This is important, because the slope of the line, or the extent to which expected return rises per unit increase in risk, quantifies the risk premium.) First, investors have fallen over themselves in their effort to get away from low-risk, low-return investments. … Second, risky investments have been very rewarding for more than twenty years and did particularly well in 2003. Thus, investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case, and require less risk compensation to move to them. … Third, investors perceive risk as being quite limited today. …
In summary, to use the words of the “quants,” risk aversion is down. Somehow, in that alchemy unique to investor psychology, “I wouldn’t touch it at any price” had morphed into “looks like a solid investment to me.”
“RISK AND RETURN TODAY,” OCTOBER 27, 2004
This “richening” process eventually brings on elevated price/earnings ratios, narrow credit spreads, undisciplined investor behavior, heavy use of leverage and strong demand for investment vehicles of all types. Just as these things raise prices and reduce prospective return, they also create a high-risk environment.
Risk is incredibly important to investors. It’s also ephemeral and unmeasurable. All of this makes it very hard to recognize, especially when emotions are running high. But recognize it we must. In the passage that follows, written in July 2007, I take you through the evaluation process we used at Oaktree to gauge the investment environment and the “risk mood” at the time. In other time periods the specifics might be different, but I hope this example of the thought process will be useful.
Where do we stand today [mid-2007]? In my opinion, there’s little mystery. I see low levels of skepticism, fear and risk aversion. Most people are willing to undertake risky investments, often because the promised returns from traditional, safe investments seem so meager. This is true even though the lack of interest in safe investments and the acceptance of risky investments have rendered the slope of the risk/return line quite flat. Risk premiums are generally the skimpiest I’ve ever seen, but few people are responding by refusing to accept incremental risk. …
Markets have tended recently to move up on positive developments and to recover easily from negatives. I see few assets that people are eager to get rid of, and few forced sellers; instead, most assets are strongly bid for. As a result, I’m not aware of any broad markets that I would describe as underpriced or uncrowded. …
It is what it is. We’ve been living in optimistic times. The cycle has been swinging strongly upward. Prices are elevated and risk premiums are slender. Trust has replaced skepticism, and eagerness has replaced reticence. Do you agree or disagree? That’s the key question. Answer it first, and the implications for investing become clear.
In the first quarter of this year, significant delinquencies occurred in subprime mortgages. Those directly involved lost a lot of money, and onlookers worried about contagion to other parts of the economy and other markets. In the second quarter, the impact reached CDOs or collateralized debt obligations (structured, tranched investing entities) t
hat had invested in subprime mortgage portfolios, and hedge funds that had bought CDO debt, including two Bear Stearns funds. Those who had to liquidate assets were forced—as usual in tough times—to sell what they could sell, not what they wanted to sell, and not just the offending subprime-linked assets. We began to read about ratings downgrades, margin calls and fire sales, the usual fuel for capital market meltdowns. And in the last few weeks we’ve begun to see investor reticence on the rise, with new low-grade debt issues repriced, postponed or pulled, leaving bridge loans unrefinanced.
The last four and a half years have been carefree, halcyon times for investors. That doesn’t mean it’ll stay that way. I’ll give Warren Buffett the last word, as I often do: “It’s only when the tide goes out that you find out who’s been swimming naked.” Pollyannas take note: the tide cannot come in forever.
“IT’S ALL GOOD,” JULY 16, 2007
I want to point out emphatically that none of the comments in the July 2007 memo, and none of my other warnings, has anything to do with predicting the future. Everything you needed to know in the years leading up to the crash could be discerned through awareness of what was going on in the present.
