The Most Important Thing Illuminated

by Howard Marks

  JOEL GREENBLATT: Buffett’s famous line about the economics of airlines comes to mind. Aviation is a huge and valuable innovation. That’s not the same thing as saying it’s a good business. Buffett said that a true capitalist would have shot down Wilbur in Kitty Hawk given the capital-destroying history of the aviation industry.

  Greed, excitement, illogicality, suspension of disbelief and ignoring value cost people a lot of money in the tech bubble. And, by the way, a lot of brilliant, disciplined value investors looked dumb in the months and years before the bubble burst—which of course it eventually did.

  HOWARD MARKS: The riskiest things: Positive feelings—sometimes called animal spirits—are major contributors to asset overpricing. Disciplined value investors look like pessimists, grumps, or old fogeys … until they turn out to be among of the few who protected against losses.

  To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored. Doing these things isn’t easy, and thus few people are able to abstain. In just the same way, it’s essential that investors avoid selling—and preferably should buy—when fear becomes excessive in a crash. (That reminds me to point out that bubbles are capable of arising on their own and need not be preceded by crashes, whereas crashes are invariably preceded by bubbles.)

  As hard as it was for most people to resist buying in the tech bubble, it was even harder to resist selling—and still more difficult to buy—in the depths of the credit crisis. At worst, failing to buy in a bull market means you may look like a laggard and experience opportunity costs. But in the crash of 2008, the downside of failing to sell appeared to be unlimited loss. Armageddon actually seemed possible.

  HOWARD MARKS: Emotion and ego: Refusing to join in the errors of the herd—like so much else in investing—requires control over psyche and ego. It’s the hardest thing, but the payoff can be enormous. Mastery over the human side of investing isn’t sufficient for success, but combining it with analytical proficiency can lead to great results.

  What, in the end, are investors to do about these psychological urges that push them toward doing foolish things? Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces described in this chapter do so at their own peril. If they influence others enough to move whole markets, why shouldn’t they affect you, too? If a bull case is so powerful that it can make adults overlook elevated valuations and deny the impossibility of the perpetual-motion machine, why shouldn’t it have the same influence on you? If a scare story of unlimited loss is strong enough to make others sell at giveaway prices, what would keep it from doing the same to you?

  Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying, the pundits are positive, the rationale is widely accepted, prices are soaring and the biggest risk takers are reporting huge returns. It’s also hard to resist selling (and very tough to buy) when the opposite is true at the bottom and holding or buying appears to entail the risk of total loss.

  HOWARD MARKS: Fear of looking wrong: Remember, you’re not going to be wrong in a vacuum. Assets go too far because of the actions of others. Just as you look wrong for a while, the members of the herd look (and feel) right. Comparing your lot with theirs is a very corrosive process—albeit natural—and will put a lot of pressure on you.

  Like so many other things described in this book, there’s no simple solution: no formula that will tell you when the market has gone to an irrational extreme, no foolproof tool that will keep you on the right side of these decisions, no magic pill that will protect you against destructive emotions. As Charlie Munger says, “It’s not supposed to be easy.”

  What weapons might you marshal on your side to increase your odds? Here are the ones that work for Oaktree:

  • a strongly held sense of intrinsic value,

  JOEL GREENBLATT: Without this, an investor has no home base. A strong sense of intrinsic value is the only way to withstand the psychological influences that affect behavior. Those who can’t value companies or securities have no business investing and limited prospects (other than luck) for investing successfully. This sounds simple, but plenty of investors lack it.

  • insistence on acting as you should when price diverges from value,

  • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded,

  • a thorough understanding of the insidious effect of psychology on the investing process at market extremes,

  • a promise to remember that when things seem “too good to be true,” they usually are,

  • willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and

  • like-minded friends and colleagues from whom to gain support (and for you to support).

  These things aren’t sure to do the job, but they can give you a fighting chance.

  11

  The Most Important Thing Is … Contrarianism

  To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.

  SIR JOHN TEMPLETON

  There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite. Superior investing, as I hope I’ve convinced you by now, requires second-level thinking—a way of thinking that’s different from that of others, more complex and more insightful. By definition, most of the crowd can’t share it. Thus, the judgments of the crowd can’t hold the key to success. Rather, the trend, the consensus view, is something to game against, and the consensus portfolio is one to diverge from. As the pendulum swings or the market goes through its cycles, the key to ultimate success lies in doing the opposite.

  This is the core of Warren Buffett’s oft-quoted advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He is urging us to do the opposite of what others do: to be contrarians.

  PAUL JOHNSON: Contrarianism is an important skill for successful value investors. However, I have found that the most important ingredient to developing this skill is experience. Contrarianism is challenging to teach.

  Doing the same thing others do exposes you to fluctuations that in part are exaggerated by their actions and your own. It’s certainly undesirable to be part of the herd when it stampedes off the cliff, but it takes rare skill, insight and discipline to avoid it.

  “THE REALIST’S CREED,” MAY 31, 2002

  The logic of crowd error is clear and almost mathematical:

  • Markets swing dramatically, from bullish to bearish and from overpriced to underpriced.

  • Their movements are driven by the actions of “the crowd,” “the herd” or “most people.” Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers. The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so. (If buyers didn’t predominate, the market wouldn’t be rising.)

  PAUL JOHNSON: This is a key insight into one of the best ways to use contrarianism to one’s favor.

  • Market extremes represent inflection points. These occur when bullishness or bearishness reaches a maximum. Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further and the market is as high as it can go. Buying or holding is dangerous.

  • Since there’s no one left to turn bullish, the market stops going up. And if on the next day one person switches from buyer to seller, it will start to go down.

  • So at the extremes, which are creat
ed by what “most people” believe, most people are wrong.

  • Therefore, the key to investment success has to lie in doing the opposite: in diverging from the crowd. Those who recognize the errors that others make can profit enormously through contrarianism.

  From time to time we see rabid buyers or terrified sellers; urgency to get in or to get out; overheated markets or ice-cold markets; and prices unsustainably high or ridiculously low. Certainly the markets, and investor attitudes and behavior, spend only a small portion of the time at “the happy medium.”

  What does this say about how we should act? Joining the herd and participating in the extremes of these cycles obviously can be dangerous to your financial health. The markets’ extreme highs are created when avid buyers are in control, pushing prices to levels that may never be seen again. The lows are created when panicky sellers predominate, willing to part with assets at prices that often turn out to have been grossly inadequate.

  “Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite. The proper response lies in contrarian behavior: buy when they hate ’em, and sell when they love ’em. “Once-in-a-lifetime” market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach.

  JOEL GREENBLATT: I love this thought. Extreme circumstances (or, more accurately, opportunities) occur more often than seems reasonable. You never catch the bottom or the top of these situations, and that’s where the pain and degree of difficulty come in!

  Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

  JOEL GREENBLATT: One of Buffett’s and Marks’s greatest concepts. In the long run, the market gets it right. But you have to survive over the short run, to get to the long run.

  But if you’re alert to the pendulum-like swing of the markets, it’s possible to recognize the opportunities that occasionally are there for the plucking.

  “THE HAPPY MEDIUM,” JULY 21, 2004

  Accepting the broad concept of contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction.

  On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond). Investors who believed that the pendulum would move in one direction forever—or, having reached an extreme, would stay there—are inevitably disappointed.

  On the third hand, however, because of the variability of the many factors that influence markets, no tool—not even contrarianism—can be relied on completely.

  • Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against.

  JOEL GREENBLATT: I’ve put it this way: just because no one else will jump in front of a Mack truck barreling down the highway, doesn’t mean that you should!

  • Even when an excess does develop, it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.”

  • Markets can be over- or underpriced and stay that way—or become more so—for years.

  • It can be extremely painful when the trend is going against you.

  SETH KLARMAN: This is where it is particularly important to remember the teachings of Graham and Dodd. If you look to the markets for a report card, owning a stock that declines every day will make you feel like a failure. But if you remember that you own a fractional interest in a business and that every day you are able to buy in at a greater discount to underlying value, you might just be able to maintain a cheerful disposition. This is exactly how Warren Buffett describes bargain hunting amid the ravages of the 1973 to 1974 bear market.

  • It can appear at times that “everyone” has reached the conclusion that the herd is wrong. What I mean is that contrarianism itself can appear to have become too popular, and thus contrarianism can be mistaken for herd behavior.

  • Finally, it’s not enough to bet against the crowd. Given the difficulties associated with contrarianism just mentioned, the potentially profitable recognition of divergences from consensus thinking must be based on reason and analysis. You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.

  David Swensen heads the Yale University endowment. Yale’s investment performance has been outstanding, and Swensen has had a greater impact on endowment investing than anyone else over the last two decades. His thinking, which was highly unusual when Yale began to implement it in the 1980s, came to represent endowment canon. He has a beautiful way of describing the difficulties associated with contrarianism.

  Investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

  … Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

  PIONEERING PORTFOLIO MANAGEMENT, 2000

  The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).

  PAUL JOHNSON: The reward for successfully following Marks’s advice is well articulated here.

  These actions are lonely and, as Swensen says, uncomfortable. How can we know it’s the opposite—the consensus action—that’s the comfortable one? Because most people are doing it.

  HOWARD MARKS: Fear of looking wrong: The very words used here—uninstitutional, idiosyncratic, imprudent, lonely, and uncomfortable—provide an idea of how challenging it is to maintain nonconsensus positions. But doing so is an absolute must if superior performance is to be achieved.

  The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious—on which everyone agrees—turn out not to be true.

  I’m not saying accepted investment wisdom is sometimes valid and sometimes not. The reality is simpler and much more systematic: Most people don’t understand the process through which something comes to have outstanding moneymaking potential.

  What’s clear to the broad consensus of investors is almost always wrong. … The very coalescing of popular opinion behind an investment tends to eliminate its profit potential. … Take, for example, the investment that “everyone” believes to be a great idea. In my view by definition it simply cannot be so.

  • If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has b
orrowed from the future and thus presages subpar performance from here on out.

  JOEL GREENBLATT: This is extremely simple and extremely insightful.

  • If everyone likes it, it’s likely the price has risen to reflect a level of adulation from which relatively little further appreciation is likely. (Sure, it’s possible for something to move from “overvalued” to “more overvalued,” but I wouldn’t want to count on it happening.)

  • If everyone likes it, it’s likely the area has been mined too thoroughly—and has seen too much capital flow in—for many bargains to remain.

  • If everyone likes it, there’s significant risk that prices will fall if the crowd changes its collective mind and moves for the exit.

  Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit. Yogi Berra is famous for having said, “Nobody goes to that restaurant anymore; it’s too crowded.” It’s just as nonsensical to say, “Everyone realizes that investment’s a bargain.” If everyone realizes it, they’ll buy, in which case the price will no longer be low. … Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates. …