The Most Important Thing Illuminated

by Howard Marks

  In 2004 I wrote a memo titled “Risk and Return Today.” In it, as described in chapter 6, I expressed my view that (a) the capital market line then was “low and flat,” meaning prospective returns in almost all markets were among the lowest we’d ever seen and risk premiums were the narrowest, and (b) if prospective returns should rise, it’d likely happen through price declines.

  But the hard question is, what can we do about it? A few weeks later, I suggested a few possibilities:

  How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

  JOEL GREENBLATT: A great statement.

  • Invest anyway—trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.

  • Invest anyway—ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.

  • Hold cash—but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.

  SETH KLARMAN: In recent years, holding cash is so completely out of favor that it has become the ultimate contrarian investment.

  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

  The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action—one classic mistake—that I most strongly feel is wrong: reaching for return.

  Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

  “THERE THEY GO AGAIN,” MAY 6, 2005

  SETH KLARMAN: This highlights one of the pitfalls of investing with a return requirement, as corporate pension funds are forced to do. Trying to earn aggressive returns not only doesn’t ensure that you will achieve them but also increases the likelihood that by making increasingly risky investments you will incur losses and fall far short, exacerbating your problem.

  It’s clear that this was written too early. May 2005 wasn’t the perfect time to get off the merry-go-round; May 2007 was. Being early provided a good reminder about the pain involved in being too far ahead of your time. Having said that, it was much better to get off too soon in May 2005 than to stay on past May 2007.

  JOEL GREENBLATT: High valuations can often go higher and last for longer than expected, continually frustrating disciplined and patient value investors.

  I’ve tried to make clear that the investment environment greatly influences outcomes. To wring high returns from a low-return environment requires the ability to swim against the tide and find the relatively few winners. This must be based on some combination of exceptional skill, high risk bearing and good luck.

  High-return environments, on the other hand, offer opportunities for generous returns through purchases at low prices, and typically these can be earned with low risk. In the crises of 1990, 2002 and 2008, for example, not only did our funds earn unusually high returns, but we feel they did it through investments where loss was unlikely.

  The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers. From time to time, holders become forced sellers for reasons like these:

  • The funds they manage experience withdrawals.

  • Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums.

  • They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.

  PAUL JOHNSON: Interestingly, although Marks only implies it, investors should work to never put themselves in a position to be a forced seller for these exact reasons.

  As I’ve said many times, the real goal of active investment management is to buy things for less than they’re worth. This is what the efficient market hypothesis says we can’t do. The theory’s objection seems reasonable: why should someone part with something at a bargain price, especially if the potential seller is informed and rational?

  Usually, would-be sellers balance the desire to get a good price with the desire to get the trade done soon. The beauty of forced sellers is that they have no choice. They have a gun at their heads and have to sell regardless of price. Those last three words—regardless of price—are the most beautiful in the world if you’re on the other side of the transaction.

  If a single holder is forced to sell, dozens of buyers will be there to accommodate, so the trade may take place at a price that is only slightly reduced. But if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity. The difficulties that mandate selling—plummeting prices, withdrawal of credit, fear among counterparties or clients—have the same impact on most investors. In that case, prices can fall far below intrinsic value.

  The fourth quarter of 2008 provided an excellent example of the need for liquidity in times of chaos. Let’s focus on leveraged investment entities’ holdings of senior bank loans. Because these loans were highly rated and credit was freely available during the years leading up to the crisis, it was easy to borrow large sums with which to lever debt portfolios, magnifying the potential returns. A typical investor on “margin” might have agreed to post additional capital if the price of the collateral fell below 85 cents on the dollar, secure in the knowledge that in the past, loans like these had never traded much below “par,” or 100 cents on the dollar.

  When the credit crisis hit, everything went wrong for leveraged investors in bank loans. (And because the yields on these supposedly safe loans had been so low, almost all of the buyers had used leverage to enhance their expected returns.) Loan prices fell. Liquidity dried up. Since much of the buying had been done with borrowed funds, the credit market contraction affected large numbers of holders. As the number of would-be sellers exploded, buyers for cash disappeared. And with additional credit unavailable, no new levered buyers could step forward to absorb the selling.

  Prices fell to 95, and then 90, and then 85. And as each portfolio reached its “trigger,” the bank issued a margin call, or a demand for a capital infusion. Few investors had the resources and nerve required to add capital in that environment, so the banks took over the portfolios and liquidated them. BWIC, pronounced “bee-wick,” came into common use, an acronym for “bid wanted in competition.” Investors were informed of a BWIC in
the afternoon and told bids were wanted for an auction to be held the next morning. The few possible buyers bid low, hoping to get real bargains (no one needed to worry about bidding too low, since there was sure to be another BWIC behind this one). And the banks weren’t concerned with getting fair prices; all they needed was enough proceeds to cover their loans (perhaps 75 or 80 cents on the dollar). Any excess would go to the investor, but the banks didn’t care about generating anything for them. Thus BWICs took place at incredibly low prices.

  Loan prices eventually fell into the 60s, and every holder on short-term credit who couldn’t access additional capital was likely wiped out. Selling prices were ridiculous. The declines on senior loan indices in 2008 exceeded those on subordinated high yield bond indices, certainly signaling an inefficiency. You could buy first lien debt at prices from which you would break even if the issuing company turned out to be worth 20 to 40 percent of what a buyout fund had paid for it just a year or two earlier. The promised yields were very large, and in fact much of this paper appreciated dramatically in 2009.

  This was a time for the patient opportunist to step forward. It was primarily those who had been cognizant of the risks in 2006 and 2007 and kept their powder dry—waiting for opportunity—who were able to do so.

  The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.

  PAUL JOHNSON: Although extremely challenging to follow, this is excellent advice.

  To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach. Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

  14

  The Most Important Thing Is … Knowing What You Don’t Know

  We have two classes of forecasters: Those who don’t know—and those who don’t know they don’t know.

  JOHN KENNETH GALBRAITH

  It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.

  AMOS TVERSKY

  There are two kinds of people who lose money: those who know nothing and those who know everything.

  HENRY KAUFMAN

  I’ve chosen three quotes with which to lead off this chapter, and I have a million more where those came from. Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.

  I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. There are two caveats, however:

  • The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to “know the knowable.”

  • An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums. That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.

  I am not going to try to prove my contention that the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise. Of all the economists and strategists you follow, are any correct most of the time?

  PAUL JOHNSON: I can sum up the chapter with the following: Be very careful with your own forecasts and even more careful with those of others! I have found that the message from this chapter is exceedingly important to deliver to students. Most are in their late twenties or early thirties and overconfident in their own abilities, particularly in forecasting the future. No matter how much evidence I present discounting the value of forecasting, most leave school undaunted. I am sure these students are not the only ones that will benefit from Marks’s excellent treatment of the impossibility of consistently producing valuable forecasts.

  My “research” on this subject (and I use quotation marks because my efforts in the area are too limited and anecdotal to be considered serious research) has consisted primarily of reading forecasts and observing their lack of utility. I wrote two memos as a result, “The Value of Predictions, or Where’d All This Rain Come From?” (February 15, 1993) and “The Value of Predictions II, or Give That Man a Cigar” (August 22, 1996). In the second memo, I used data from three semiannual Wall Street Journal economic polls to examine the usefulness of forecasts.

  First, were the forecasts generally accurate? The answer was clearly no. On average, the predictions for the ninety-day T-bill rate, thirty-year bond rate and yen/dollar exchange rate six and twelve months out were off by 15 percent. The average forecaster missed the interest rate on the long bond six months later by 96 basis points (a divergence big enough to change the value of a $1,000 bond by $120).

  Second, were the forecasts valuable? Predictions are most useful when they correctly anticipate change. If you predict that something won’t change and it doesn’t change, that prediction is unlikely to earn you much money. But accurately predicting change can be very profitable. In the Journal polls, I observed, the forecasters completely missed several major changes (when accurate forecasts would’ve helped people make money or avoid a loss): the interest rate increases of 1994 and 1996, the rate decline of 1995 and the massive gyrations of the dollar/yen relationship. In summary, there simply wasn’t much correlation between predicted changes and actual changes.

  Third, what was the source of the forecasts? The answer here is simple: most of the forecasts consisted of extrapolations. On average, the predictions were within 5 percent of the levels that prevailed at the time they were made. Like many forecasters, these economists were driving with their eyes firmly fixed on the rearview mirror, enabling them to tell us where things were but not where they were going. This bears out the old adage that “it’s difficult to make accurate predictions, especially with regard to the future.” The corollary is also true: predicting the past is a snap.

  Fourth, were the forecasters ever right? The answer is a firm yes. For example, in each semiannual forecast, someone nailed the yield on the thirty-year bond within 10 or 20 basis points, even as interest rates changed radically. The winning forecast was much more accurate than the consensus forecast, which was off by 70 to 130 basis points.

  Fifth, if the forecasters were sometimes right—and right so dramatically—then why do I remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.

  I went on in the 1996 memo to show “two things that might make you think twice about heeding the winners’ forecasts.” First, they generally failed to make accurate predictions in surveys other than the one they won. And second, half the time in the surveys they didn’t win, their forecasts were much more wrong than even the inaccurate consensus. The most important thing, of course, isn’t the data, but the conclusions (assuming they’re correct and capable of being generalized) and their ramifications.

  One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value. …

  It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have
to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.

  “THE VALUE OF PREDICTIONS II, OR GIVE THAT MAN A CIGAR,” AUGUST 22, 1996

  This discussion of forecasts suggests that we have a dilemma: investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are “normal,” we can’t know much about what will happen at those moments when knowing would make the biggest difference.

  PAUL JOHNSON: With this, Marks presents the great investing dilemma.

  • Most of the time, people predict a future that is a lot like the recent past.

  • They’re not necessarily wrong: most of the time the future largely is a rerun of the recent past.

  • On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: They’ll usually extrapolate recent experience and be right.

  • However, the many forecasts that correctly extrapolate past experience are of little value. Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of recent history. Thus if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would.

  • Once in a while, however, the future turns out to be very different from the past.

  • It’s at these times that accurate forecasts would be of great value.