by Howard Marks
“HEMLINES,” SEPTEMBER 10, 2010
After the process described above had gone on long enough, and holdings of them had been reduced enough, bonds were positioned to become superior performers. All it took was a change in the environment that would increase the desirability of safety relative to upside potential. And as usually happens after an asset has appreciated for a while, investors suddenly recognized the attractions of bonds and realized they didn’t own enough. This is a pattern that regularly produces profits for those who figure it out early.
Fairly priced assets are never our objective, since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved. And, of course, overpriced assets don’t do us any good.
Our goal is to find underpriced assets. Where should we look for them? A good place to start is among things that are:
• little known and not fully understood;
• fundamentally questionable on the surface;
• controversial, unseemly or scary;
• deemed inappropriate for “respectable” portfolios;
• unappreciated, unpopular and unloved;
• trailing a record of poor returns; and
• recently the subject of disinvestment, not accumulation.
PAUL JOHNSON: This is an excellent “shopping list.”
To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.
When I shifted from equity research to portfolio management at Citibank in 1978, I was fortunate to be asked to work in asset classes that met some or all of these criteria. My first assignment was in convertible securities. These were even more of a small and underappreciated market backwater than they are now. Since they gave investors the advantages of both bonds and stocks, they were issued only as a last resort by weak companies lacking alternatives, such as conglomerates, railroads and airlines. Mainstream investors felt they introduced unnecessary complexity: if you want the characteristics of bonds and stocks, they might say, why not just buy some bonds and some stocks? And if you like the company, why not buy the stock and garner its entire return, rather than investing in a defensive hybrid vehicle? Well, whenever “everyone” feels there’s no merit in something, it’s reasonable to suspect it’s unloved, unpursued and thus possibly underpriced. That’s why a 1984 BusinessWeek article about me carried the line “Real men don’t buy converts, so chickens like me can buy cheap.”
Later in 1978, I was asked to start a fund for high yield bonds. These low-rated securities, burdened with the unpleasant sobriquet junk bonds, fell short of most investing institutions’ minimum requirement of “investment grade or better” or “single-A or better.” Junk bonds might default, so how could they possibly be appropriate holdings for pension funds or endowments? And if a fund bought a bond from a speculative-grade company and it went under, how could the trustees escape embarrassment and blame for having done something that they knew in advance was risky?
CHRISTOPHER DAVIS: The same is also true of headline risk.
A great clue to these securities’ potential could be found in one rating agency’s description of B-rated bonds as “generally lacking the characteristics of a desirable investment.” By now you should be quick to ask how anyone could issue a blanket dismissal of a potential class of investments without any reference to price.
SETH KLARMAN: More broadly, this is the problem with all agency ratings. The supposed safety attracts investors who fail to do their own homework, making them the ultimate buyers of conventional wisdom. Ironically, ratings downgrades typically occur long after the markets have figured out that a problem exists, leaving investors who trusted the ratings with large losses.
The subsequent history of these bonds shows that (a) if nobody owns something, demand for it (and thus the price) can only go up and (b) by going from taboo to even just tolerated, it can perform quite well.
Finally, in 1987, my partners Bruce Karsh and Sheldon Stone came to me with the bright idea of forming a fund to invest in distressed debt. What could possibly be more unseemly and less respectable than investing in the bonds of companies that are bankrupt or deemed overwhelmingly likely to become so? Who would invest in companies that already had demonstrated their lack of financial viability and the weakness of their management? How could anyone invest responsibly in companies in free fall? Of course, given the way investors behave, whatever asset is considered the worst at a given point in time has a good likelihood of being the cheapest.
PAUL JOHNSON: This is a nice litmus test for finding bargains.
Investment bargains needn’t have anything to do with high quality. In fact, things tend to be cheaper if low quality has scared people away.
Each of these asset classes satisfied most or all of the criteria listed earlier in this chapter. They were little known, not understood and not respected. No one had a good word to say about any of them. Each exemplified the uncomfortably idiosyncratic and imprudent-appearing investments that David Swensen talked about in chapter 11 … and thus each turned into a great place to be for the next twenty or thirty years. I hope these large-scale examples give you a good idea for where bargains may be found.
JOEL GREENBLATT: Marks’s description outlines the opportunities for both value and special-situation investing in general.
Since bargains provide value at unreasonably low prices—and thus unusual ratios of return to risk—they represent the Holy Grail for investors. Such deals shouldn’t exist in an efficient market for the reasons specified in chapter 2. However, everything in my experience tells me that while bargains aren’t the rule, the forces that are supposed to eliminate them often fail to do so.
We’re active investors because we believe we can beat the market by identifying superior opportunities. On the other hand, many of the “special deals” we’re offered are too good to be true, and avoiding them is essential for investment success. Thus, as with so many things, the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.
It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.
13
The Most Important Thing Is … Patient Opportunism
The market’s not a very accommodating machine; it won’t provide high returns just because you need them.
PETER BERNSTEIN
The boom-bust cycle associated with the global financial crisis gave us the chance to sell at highly elevated levels in the period 2005 through early 2007 and then to buy at panic prices in late 2007 and 2008. This was in many ways the chance of a lifetime. Cycle-fighting contrarians had a golden opportunity to distinguish themselves. But one of the things I want to do in this chapter is to point out that there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism—waiting for bargains—is often your best strategy.
PAUL JOHNSON: Marks offers great wisdom in this chapter. The challenge is that many investors confuse action for adding value when, in fact, all of the studies suggest that most investors overtrade their portfolio. Compounding the challenge, it is not clear that human beings are naturally wired to be patient.
So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when pri
ces aren’t low.
At Oaktree, one of our mottos is “we don’t look for our investments; they find us.” We try to sit on our hands. We don’t go out with a “buy list”; rather, we wait for the phone to ring. If we call the owner and say, “You own X and we want to buy it,” the price will go up. But if the owner calls us and says, “We’re stuck with X and we’re looking for an exit,” the price will go down. Thus, rather than initiating transactions, we prefer to react opportunistically.
At any particular point in time, the investment environment is a given, and we have no alternative other than to accept it and invest within it. There isn’t always a pendulum or cycle extreme to bet against. Sometimes greed and fear, optimism and pessimism, and credulousness and skepticism are balanced, and thus clear mistakes aren’t being made. Rather than obviously overpriced or underpriced, most things may seem roughly fairly priced. In that case, there may not be great bargains to buy or compelling sales to make.
JOEL GREENBLATT: This is one of the hardest things to master for professional investors: coming in each day for work and doing nothing.
It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly. The other possibilities are (a) acting without recognizing the market’s status, (b) acting with indifference to its status and (c) believing we can somehow change its status. These are most unwise. It makes perfect sense that we must invest appropriately for the circumstances with which we’re presented. In fact, nothing else makes sense at all.
I come to this from a philosophic foundation:
In the mid-sixties, Wharton students had to have a nonbusiness minor, and I satisfied the requirement by taking five courses in Japanese studies. These surprised me by becoming the highlight of my college career, and later they contributed to my investment philosophy in a major way.
Among the values prized in early Japanese culture was mujo. Mujo was defined classically for me as recognition of “the turning of the wheel of the law,” implying acceptance of the inevitability of change, of rise and fall. … In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn’t that the essence of investing?
… What’s past is past and can’t be undone. It has led to the circumstances we now face. All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.
“IT IS WHAT IT IS,” MARCH 27, 2006
Warren Buffett’s philosophy is a little less spiritually based than mine. Instead of mujo, his reference is to baseball.
In Berkshire Hathaway’s 1997 Annual Report, Buffett talked about Ted Williams—the “Splendid Splinter”—one of the greatest hitters in history. A factor that contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball-sized “cells” and charting his results at the plate, he learned that his batting average was much better when he went after only pitches in his “sweet spot.” Of course, even with that knowledge, he couldn’t wait all day for the perfect pitch; if he let three strikes go by without swinging, he’d be called out.
Way back in the November 1, 1974, issue of Forbes, Buffett pointed out that investors have an advantage in that regard, if they’ll just seize it. Because they can’t strike out looking, investors needn’t feel pressured to act. They can pass up lots of opportunities until they see one that’s terrific.
Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.
“WHAT’S YOUR GAME PLAN?” SEPTEMBER 5, 2003
JOEL GREENBLATT: I think of this analogy often (especially when I’m feeling a little lazy).
One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable.
SETH KLARMAN: Still, calibration is important. Set the bar too high and you might remain out of the market for a very long time. Set it too low and you will be fully invested almost immediately; it will be as though you had no standards at all. Experience and versatile thinking are the keys to such calibration.
Where does the penalty for missing winners come in? Well, investors are generally competitive and in it for the money. Thus, no one’s totally comfortable with missing a profitable opportunity.
For professional investors paid to manage others’ money, the stakes are higher. If they miss too many opportunities, and if their returns are too low in good times, money managers can come under pressure from clients and eventually lose accounts. A lot depends on how clients have been conditioned.
CHRISTOPHER DAVIS: The key is managing clients effectively—which almost always means lowering client expectations.
Oaktree has always been explicit about our belief that missing a profitable opportunity is of less significance than investing in a loser. Thus, our clients are prepared for results that put risk control ahead of full participation in gains.
JOEL GREENBLATT: We may look through fifty or seventy investments to find a handful of good ones. If we buy six that work out and miss fifteen that we should have bought, we never view this as a loss.
Standing at the plate with the bat on your shoulders is Buffett’s version of patient opportunism. The bat should come off our shoulders when there are opportunities for profit with controlled risk, but only then. One way to be selective in this regard is by making every effort to ascertain whether we’re in a low-return environment or a high-return environment.
A few years ago I came up with an allegory applicable to low-return environments. It was called “The Cat, the Tree, the Carrot and the Stick.” The cat is an investor, whose job it is to cope with the investment environment, of which the tree is part. The carrot—the incentive to accept increased risk—comes from the higher returns seemingly available from riskier investments. And the stick—the motivation to forsake safety—comes from the modest level of the prospective returns being offered on safer investments.
The carrot lures the cat to higher branches—riskier strategies—in pursuit of its dinner (its targeted return), and the stick prods the cat up the tree, because it can’t get dinner while staying close to the ground.
Together, the stick and the carrot can cause the cat to climb until it ultimately arrives high up in the tree, in a treacherous position. The critical observation is that the cat pursues high returns, even in a low-return environment, and bears the consequences—increased risk—although often unknowingly.
Bond investors call this process “reaching for yield” or “reaching for return.” It has classically consisted of investing in riskier credits as the yields on safer ones decline, in order to access the returns to which investors were accustomed before the market rose. That same pattern of taking new and bigger risks in order to perpetuate return often repeats in a cyclical pattern. The motto of those who reach for return seems to be: “If you can’t get the return you need from safe investments, pursue it via risky investments.”
We saw this behavior playing out in the middle of the past decade:
[In the days before the credit crisis], investors succumbed to the siren song of leverage. They borrowed cheap short-term funds—the shorter the cheaper (you can get money cheap if you’re willing to promise repayment monthly). And they used that money to buy assets that offered higher returns because they entailed illiquidity and/or fundamental risk. And institutional investors all over the world took Wall Street up on the newest promises of two “silver bullets” that would provide high returns with low risk: securitization and structure.
On the surface, t
hese investments made sense. They promised satisfactory absolute returns, as the returns on the levered purchases would more than pay the cost of capital. The results would be great … as long as nothing untoward happened.
But, as usual, the pursuit of profit led to mistakes. The expected returns looked good, but the range of possible outcomes included some very nasty ones. The success of many techniques and structures depended on the future looking like the past. And many of the “modern miracles” that were relied on were untested.
“NO DIFFERENT THIS TIME,” DECEMBER 17, 2007
It’s remarkable how many leading competitors from our early years as investors are no longer leading competitors (or competitors at all). While a number faltered because of flaws in their organization or business model, others disappeared because they insisted on pursuing high returns in low-return environments.
You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns—and give back your profits in the process. If it’s not there, hoping won’t make it so.
When prices are high, it’s inescapable that prospective returns are low (and risks are high).
CHRISTOPHER DAVIS: And again: a high price both increases risk and lowers return.
That single sentence provides a great deal of guidance as to appropriate portfolio actions. How are we to factor such an observation into our practices?
