by Howard Marks
In short, there are two primary elements in superior investing:
• seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and
• having it turn out to be true (or at least accepted by the market).
It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.
“EVERYONE KNOWS,” APRIL 26, 2007
The global credit crisis of 2007–2008 represents the greatest crash I have ever seen. The lessons to be learned from this experience are many, which is one reason I discuss aspects of it in more than one chapter. For me, one such lesson consisted of reaching a new understanding of the skepticism required for contrarian thinking. I’m not usually given to epiphanies, but I had one on the subject of skepticism.
Every time a bubble bursts, a bull market collapses or a silver bullet fails to work, we hear people bemoan their error. The skeptic, highly aware of that, tries to identify delusions ahead of time and avoid falling into line with the crowd in accepting them. So, usually, investment skepticism is associated with rejecting investment fads, bull market manias and Ponzi schemes.
My epiphany came in mid-October 2008, near the low point of the global credit meltdown. By then we were seeing and hearing things that we never imagined possible:
• The demise or bailout of Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae and AIG
• Concern about the viability of Goldman Sachs and Morgan Stanley, and huge declines in their stocks
• Rising prices for credit-default-swap protection on U.S. Treasury securities
• Rates on short-term T-bills close to zero because of an extreme flight to safety
• Awareness for the first time, I think, that the U.S. government’s financial resources are finite and that there are limits on its ability to run the printing press and solve problems
It was readily apparent immediately after the bankruptcy of Lehman Brothers that … a spiral was under way, and no one could see how or when it might end. That was really the problem: no scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish.
There was an element of truth in this, of course: nothing was impossible. But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.
During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. …
For forty years I’ve seen the manic-depressive pendulum of investor psychology swing crazily: between fear and greed—we all know the refrain—but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd—and swinging with the pendulum—will give you average performance in the long run and can get you killed at the extremes. …
JOEL GREENBLATT: Investor sentiment was extreme in October 2008. Valuations were incredibly cheap, and stocks offered wonderful returns looking forward. In fact, over the next two years returns were spectacular. Unfortunately, stocks first fell another 20 percent from the already low October 2008 levels before they eventually turned around (in March 2009).
If you believe the story everyone else believes, you’ll do what they do. Usually you’ll buy at high prices and sell at lows. You’ll fall for tales of the “silver bullet” capable of delivering high returns without risk. You’ll buy what’s been doing well and sell what’s been doing poorly. And you’ll suffer losses in crashes and miss out when things recover from bottoms. In other words, you’ll be a conformist, not a maverick; a follower, not a contrarian.
Skepticism is what it takes to look behind a balance sheet, the latest miracle of financial engineering or the can’t-miss story. … Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity.
Lots of bad things happened to kick off the credit crisis that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical—or pessimistic—enough.
But that triggered an epiphany: skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
As the credit crisis reached a peak last week, … I found very few who were optimistic; most were pessimistic to some degree. No one applied skepticism, or said “that horror story’s unlikely to be true.” The one thing they weren’t doing last week was making aggressive bids for securities. So prices fell and fell—the old expression is “gapped down”—several points at a time.
The key—as usual—was to become skeptical of what “everyone” was saying and doing. The negative story may have looked compelling, but it’s the positive story—which few believed—that held, and still holds, the greater potential for profit.
“THE LIMITS TO NEGATIVISM,” OCTOBER 15, 2008
The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.
“TOUCHSTONES,” NOVEMBER 10, 2009
Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”
Most purchases of depressed, distressed debt made in the fourth quarter of 2008 yielded returns of 50 to 100 percent or more over the next eighteen months. Buying was extremely difficult under those trying circumstances, but it was made easier when we realized that almost no one was saying, “no, things can’t be that bad.” At that moment, being optimistic and buying was the ultimate act of contrarianism.
Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable—although the experienced contrarian takes comfort from his or her position outside the herd.
HOWARD MARKS: Fear of looking wrong: Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. Usually—and certainly at the extremes of the pendulum’s swing—being part of the herd should be a reason for worry.
Whenever the debt market collapses, for example, most people say, “We’re not going to try to catch a falling knife; it’s too dangerous.” They usually add, “We’re going to wait until the dust settles and the uncertainty is resolved.” What they mean, of course, is that they’re frightened and unsure of what to do.
The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.
SETH KLARMAN: And the high volumes that accompany a sharp selloff will also likely be over. Not only will prices be on the rebound, but buying a sizeable position will be much harder.
Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling—and if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.
12
The Most Important Thing Is … Finding Bargains
The best opportunities are usually found among
things most others won’t do.
The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
CHRISTOPHER DAVIS: This is a great summary.
The first step is usually to make sure that the things being considered satisfy some absolute standards. Even sophisticated investors may not say, “I’ll buy anything if it’s cheap enough.” More often they create a list of investment candidates meeting their minimum criteria, and from those they choose the best bargains. That’s what this chapter is all about.
For example, an investor might start by narrowing the list of possibilities to those whose riskiness falls within acceptable limits, since there can be risks with which certain investors aren’t comfortable. Examples might include the risk of obsolescence in a fast-moving segment of the technology world, and the risk that a hot consumer product will lose its popularity; these might be subjects that some investors consider beyond their expertise. Or investors might find some companies unacceptable in the absolute because their industries are too unpredictable or their financial statements aren’t sufficiently transparent.
It’s not unreasonable to want to emphasize assets that fall within a certain portion of the risk spectrum. Securities that the market deems ultrasafe may offer uninteresting returns, while securities at the other extreme may exceed investors’ risk tolerance. In other words, there can reasonably be some places investors won’t go, regardless of price.
CHRISTOPHER DAVIS: These are good caveats to Marks’s earlier discussions of price and risk.
Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told “Here’s my money; do what you want with it.” The money manager’s job isn’t just to make investments with profit potential, but also to give clients what they want, since most institutional investors are hired to carry out specific assignments in terms of asset class and investment style.
CHRISTOPHER DAVIS: This is a realistic description of a money manager’s job, but I still think it’s important for managers not to become overly cautious as this attitude can easily turn into a paralyzing fear of headline risk or controversy.
If the client came for one kind of investment, there’s little to be gained in going into others, regardless of their attractiveness. For example, if a manager solicits accounts on the basis of expertise in high-quality, large-capitalization value stocks, there’s risk to the business in investing in a bunch of high-tech start-ups.
Thus, the starting point for portfolio construction is unlikely to be an unbounded universe. Some things are realistic candidates for inclusion, and others aren’t.
Having defined the “feasible set,” the next step is to select investments from it. That’s done by identifying those that offer the best ratio of potential return to risk, or the most value for the money. That’s what Sid Cottle, editor of the later editions of Graham and Dodd’s Security Analysis, was talking about when he told me that in his view, “investment is the discipline of relative selection.” That expression has stayed with me for thirty-five years.
Sid’s simple phrase embodies two important messages. First, the process of investing has to be rigorous and disciplined. Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there. Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.
JOEL GREENBLATT: With some investment experience, it may be possible to compare current investment opportunities that appear to be relative bargains to valuation-based bargains that were available in the past. In this way, available opportunities that appear to be relative bargains based on the current opportunity set can be compared to a potential future set of bargain opportunities as well.
What is it that makes something the superior investment we look for? As I mentioned in chapter 4, it’s largely a matter of price. Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it.
CHRISTOPHER DAVIS: This is subject to the risk and selection criteria mentioned above.
A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.
CHRISTOPHER DAVIS: Agreed!
Because the search is for good buys, my main goal in this chapter is to explain what makes a buy a good one. In general, that means price is low relative to value, and potential return is high relative to risk. How do bargains get that way?
In chapter 10, I used the tech-stock mania as an example of the reliable process through which a good fundamental idea can be turned into an overpriced bubble. It usually starts with an objectively attractive asset. As people raise their opinion of it, they increasingly want to own it. That makes capital flow to it, and the price rises. People take the rising price as a sign of the investment’s merit, so they buy still more. Others hear about it for the first time and join in, and the upward trend takes on the appearance of an unstoppable virtuous cycle. It’s mostly a popularity contest in which the asset in question is the winner.
If they go on long enough and gain enough force, investment styles turn into bubbles. And bubbles give thoughtful investors lots of things to sell and sell short.
The process through which bargains are created is largely the opposite. Thus to be able to find them, it’s essential that we understand what causes an asset to be out of favor. This isn’t necessarily the result of an analytical process. In fact, much of the process is anti-analytical, meaning it’s important to think about the psychological forces behind it and the changes in popularity that drive it.
So what is it that makes price low relative to value, and return high relative to risk? In other words, what makes something sell cheaper than it should?
• Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
• Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
• Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
SETH KLARMAN: Generally, the greater the stigma or revulsion, the better the bargain.
• Usually its price has been falling, making the first-level thinker ask, “Who would want to own that?” (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean. First-level thinkers tend to view past price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
• As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.
Here’s an example of how bargains can be cre
ated when an entire asset class goes out of style.
The story of bonds in the last sixty years is the mirror opposite of the rise in popularity enjoyed by stocks. First bonds wilted as stocks monopolized the spotlight in the fifties and sixties, and at the end of 1969, First National City Bank’s weekly summary of bond data died with the heading “The Last Issue” boxed in black. Bonds were decimated in the high-interest-rate environment of the seventies, and even though interest rates declined steadily during the eighties and nineties, bonds didn’t have a prayer of standing up to equities’ dramatic gains.
By the latter half of the nineties, any investment in bonds rather than stocks felt like an anchor restraining performance. I chaired the investment committee of a charity and watched as a sister organization in another city—which had suffered for years with an 80:20 bond/stock mix—shifted its allocation to 0:100. I imagined a typical institutional investor saying the following:
We have a small allocation to fixed income. I can’t tell you why. It’s a historical accident. My predecessor created it, but his reasons are lost in the past. Now our bond holdings are under review for reduction.
Even though interest in buying more stocks remained low in the current decade, little money flowed to high grade bonds. The continued decline in bonds’ popularity was caused, among other things, by the decision on the part of the Greenspan Fed to keep interest rates low to stimulate the economy and combat exogenous shocks (like the Y2K scare). With Treasurys and high grade bonds yielding 3–4 percent, they didn’t do much for institutional investors trying for 8 percent.
