The Most Important Thing Illuminated

by Howard Marks

  PAUL JOHNSON: The bullet on the role of leverage needs extra emphasis. Too many investors fail to appreciate this wise nugget.

  • Excesses correct. When investor psychology is extremely rosy and markets are “priced for perfection”—based on an assumption that things will always be good—the scene is set for capital destruction. It may happen because investors’ assumptions turn out to be too optimistic, because negative events occur, or simply because too-high prices collapse of their own weight.

  Most of these eleven lessons can be reduced to just one: be alert to what’s going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them. We know what it feels like when there’s too little capital around and great hesitance to part with it: worthwhile investments can go begging, and business can slow throughout the economy. It’s called a credit crunch. But the opposite deserves to receive no less attention. There’s no official term for it, so “too much money chasing too few ideas” may have to do.

  Regardless of what it’s called, an oversupply of capital and the accompanying dearth of prudence such as we saw in 2004–2007—with their pernicious effects—can be dangerous for your investing health and must be recognized and dealt with.

  “NO DIFFERENT THIS TIME,” DECEMBER 17, 2007

  The global crisis provided a great opportunity to learn, since it entailed so many grave errors and offered up the lessons enumerated in my December 2007 memo. Pitfalls were everywhere: investors were unworried, even ebullient in the years leading up. People believed that risk had been banished, and thus they need worry only about missing opportunity and failing to keep up, not about losing money. Risky, untested investment innovations were adopted on the basis of shaky assumptions. Undue weight was accorded opaque models and “black boxes,” financial engineers and “quants,” and performance records compiled during salutary periods. Leverage was piled on top of leverage.

  HOWARD MARKS: The riskiest things: A high level of belief and a corresponding low level of skepticism always play a large part in the ascent of prices that, afterward, everyone sees as having risen too high. Buying with borrowed money often increases the extent to which prices will become elevated, the likelihood of ensuing disaster, and the extent of the pain when it arrives. These are among the riskiest things.

  Almost no one knew exactly what the consequences would be, but it was possible to have a sense that we were riding for a fall. Even though specific pitfalls may not have been susceptible to identification and avoidance, this was a perfect time to recognize that many were lurking, and thus to adopt a more defensive posture. Failure to do so was the great error of the crisis.

  Leading up to it, what could investors have done? The answers lay in

  • taking note of the carefree, incautious behavior of others,

  • preparing psychologically for a downturn,

  • selling assets, or at least the more risk-prone ones,

  • reducing leverage,

  • raising cash (and returning cash to clients if you invested for others), and

  • generally tilting portfolios toward increased defensiveness.

  Any of these would have helped. Although almost nothing performed well in the meltdown of 2008, it was possible as a result of elevated caution to lose less than others and reduce the pain. While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take greater advantage of the rebound.

  The crisis was rife with potential pitfalls: first, opportunities to succumb and lose, and then opportunities to go into a shell and miss out. In periods that are relatively loss free, people tend to think of risk as volatility and become convinced they can live with it. If that were true, they would experience markdowns, invest more at the lows and go on to enjoy the recovery, coming out ahead in the long run. But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is at its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the greatest error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.

  CHRISTOPHER DAVIS: We experienced this at Davis Advisors in 1975.

  JOEL GREENBLATT: Investor, know thyself. How much pain can you take on the downside? This should inform the size of your initial portfolio allocations to specific investments and investment categories.

  Since countercyclical behavior was the essential element in avoiding the full effect of the recent crisis, behaving pro-cyclically presented the greatest potential pitfall. Investors who maintained their bullish positions as the market rose (or added to them) were least prepared for the bust and the subsequent recovery.

  • The declines had maximum psychological impact.

  • Margin calls and confiscations of collateral decimated levered vehicles.

  • Troubled holdings required remedial action that occupied managers.

  • As usual, the loss of confidence prevented many from doing the right thing at the right time.

  While it’s true that you can’t spend relative outperformance, human nature causes defensive investors and their less traumatized clients to derive comfort in down markets when they lose less than others. This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that often make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.

  Certainly this is what happened in the last few years. The credit markets were particularly hard-hit in 2007–2008, since they had been the focus of innovation, risk taking and the use of leverage. Correspondingly, their gains in 2009 were the best in their history. Surviving the declines and buying at the resultant lows was a great formula for success—especially relative success—but first it required the avoidance of pitfalls.

  The formula for error is simple, but the ways it appears are infinite—far too many to allow enumeration. Here are the usual ingredients:

  • data or calculation error in the analytical process leads to incorrect appraisal of value;

  • the full range of possibilities or their consequences is underestimated;

  • greed, fear, envy, ego, suspension of disbelief, conformity or capitulation, or some combination of these, moves to an extreme;

  • as a result, either risk taking or risk avoidance becomes excessive;

  • prices diverge significantly from value; and

  • investors fail to notice this divergence, and perhaps contribute to its furtherance.

  Ideally, astute and prudent second-level thinkers take note of the analytical error as well as the failure of other investors to react appropriately. They detect over- or underpriced assets in the context of too-hot or too-cool markets. They set their course to avoid the mistakes others are making and hopefully take advantage instead. The upshot of investment error is simple to define: prices that differ from intrinsic value. Detecting it and acting on it are less simple.

  The fascinating and challenging thing is that the error moves around. Sometimes prices are too high and sometimes they’re too low. Sometimes the divergence of price from value affects individual securities or assets and sometimes whole markets—sometimes one market and sometimes another. Sometimes the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes in being bearish.

  And, of course, by definition most people go along with the error, since without their concurrence it couldn’t exist. Acting in the opposite direction requires the adoption of a contrarian position, with the loneliness and feeling of
being wrong that it can bring for long periods.

  As with the rest of the tasks discussed in this book, avoiding pitfalls and identifying and acting on error aren’t susceptible to rules, algorithms or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.

  One way to improve investment results—which we try hard to apply at Oaktree—is to think about what “today’s mistake” might be and try to avoid it.

  There are times in investing when the likely mistake consists of:

  • not buying,

  JOEL GREENBLATT: It’s a big world out there. Good investors don’t worry too much about this one.

  • not buying enough,

  • not making one more bid in an auction,

  • holding too much cash,

  • not using enough leverage, or

  • not taking enough risk.

  I don’t think that describes 2004. I’ve always heard that no one awaiting heart surgery ever complained, “I wish I’d gone to the office more.” Well, likewise I don’t think anyone in the next few years is going to look back and say, “I wish I’d invested more in 2004.”

  Rather, I think this year’s mistake is going to turn out to be:

  • buying too much,

  • buying too aggressively,

  • making one bid too many,

  • using too much leverage, and

  • taking too much risk in the pursuit of superior returns.

  There are times when the investing errors are of omission: the things you should have done but didn’t. Today I think the errors are probably of commission: the things you shouldn’t have done but did. There are times for aggressiveness. I think this is a time for caution.

  “RISK AND RETURN TODAY,” OCTOBER 27, 2004

  Finally, it’s important to bear in mind that in addition to times when the errors are of commission (e.g., buying) and times when they are of omission (failing to buy), there are times when there’s no glaring error. When investor psychology is at equilibrium and fear and greed are balanced, asset prices are likely to be fair relative to value. In that case there may be no compelling action, and it’s important to know that, too. When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

  CHRISTOPHER DAVIS: This is a great quote.

  19

  The Most Important Thing Is … Adding Value

  The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer. … Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.

  It’s not hard to perform in line with the market in terms of risk and return. The trick is to do better than the market: to add value. This calls for superior investment skill, superior insight. So here, near the end of the book, we come around full circle to the first chapter and second-level thinkers possessing exceptional skill.

  The purpose of this chapter is to explain what it means for skillful investors to add value. To accomplish that, I’m going to introduce two terms from investment theory. One is beta, a measure of a portfolio’s relative sensitivity to market movements. The other is alpha, which I define as personal investment skill, or the ability to generate performance that is unrelated to movement of the market.

  As I mentioned earlier, it’s easy to achieve the market return. A passive index fund will produce just that result by holding every security in a given market index in proportion to its equity capitalization. Thus, it mirrors the characteristics—e.g., upside potential, downside risk, beta or volatility, growth, richness or cheapness, quality or lack of same—of the selected index and delivers its return. It epitomizes investing without value added.

  Let’s say, then, that all equity investors start not with a blank sheet of paper but rather with the possibility of simply emulating an index. They can go out and passively buy a market-weighted amount of each stock in the index, in which case their performance will be the same as that of the index. Or they can try for outperformance through active rather than passive investing.

  Active investors have a number of options available to them. First, they can decide to make their portfolio more aggressive or more defensive than the index, either on a permanent basis or in an attempt at market timing. If investors choose aggressiveness, for example, they can increase their portfolios’ market sensitivity by overweighting those stocks in the index that typically fluctuate more than the rest, or by utilizing leverage. Doing these things will increase the “systematic” riskiness of a portfolio, its beta. (However, theory says that while this may increase a portfolio’s return, the return differential will be fully explained by the increase in systematic risk borne. Thus doing these things won’t improve the portfolio’s risk-adjusted return.)

  Second, investors can decide to deviate from the index in order to exploit their stock-picking ability—buying more of some stocks in the index, underweighting or excluding others, and adding some stocks that aren’t part of the index. In doing so they will alter the exposure of their portfolios to specific events that occur at individual companies, and thus to price movements that affect only certain stocks, not the whole index. As the composition of their portfolios diverges from the index for “nonsystematic” (we might say “idiosyncratic”) reasons, their return will deviate as well. In the long run, however, unless the investors have superior insight, these deviations will cancel out, and their risk-adjusted performance will converge with that of the index.

  Active investors who don’t possess the superior insight described in chapter 1 are no better than passive investors, and their portfolios shouldn’t be expected to perform better than a passive portfolio. They can try hard, put their emphasis on offense or defense, or trade up a storm, but their risk-adjusted performance shouldn’t be expected to be better than the passive portfolio. (And it could be worse due to nonsystematic risks borne and transaction costs that are unavailing.)

  That doesn’t mean that if the market index goes up 15 percent, every non-value-added active investor should be expected to achieve a 15 percent return. They’ll all hold different active portfolios, and some will perform better than others … just not consistently or dependably. Collectively they’ll reflect the composition of the market, but each will have its own peculiarities.

  Pro-risk, aggressive investors, for example, should be expected to make more than the index in good times and lose more in bad times. This is where beta comes in. By the word beta, theory means relative volatility, or the relative responsiveness of the portfolio return to the market return. A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve, omitting nonsystematic sources of risk. If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).

  Theory looks at this information and says the increased return is explained by the increase in beta, or systematic risk. It also says returns don’t increase to compensate for risk other than systematic risk. Why don’t they? According to theory, the risk that markets compensate for is the risk that is intrinsic and inescapable in investing: systematic or “non-diversifiable” risk. The rest of risk comes from decisions to hold individual stocks: nonsystematic risk. Since that risk can be eliminated by diversifying, why should investors be compensated with additional return for bearing it?

  According to theory, then, the formula for explaining portfolio performance (y) is as follows:

  y = α+βx

  Here α is the symbol for alpha, β stands for beta, and x is the return of the market. The market-related return of the portfolio is equal to its beta times the market return, and alpha (skill-related return) is added to arrive at the total re
turn (of course, theory says there’s no such thing as alpha).

  Although I dismiss the identity between risk and volatility, I insist on considering a portfolio’s return in the light of its overall riskiness, as discussed earlier.

  CHRISTOPHER DAVIS: But is beta the right measure of risk? This seems to run a bit counter to the earlier discussion of risk. But even if beta is not the most meaningful or relevant measure, it is certain that Oaktree has done a wonderful job on a risk-adjusted basis.

  A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio. Risk-adjusted return holds the key, even though—since risk other than volatility can’t be quantified—I feel it is best assessed judgmentally, not calculated scientifically.

  JOEL GREENBLATT: Such an important concept for business students (who have likely been taught otherwise)!

  Of course, I also dismiss the idea that the alpha term in the equation has to be zero. Investment skill exists, even though not everyone has it. Only through thinking about risk-adjusted return might we determine whether an investor possesses superior insight, investment skill or alpha … that is, whether the investor adds value.