The Most Important Thing Illuminated

by Howard Marks

  The alpha/beta model is an excellent way to assess portfolios, portfolio managers, investment strategies and asset allocation schemes. It’s really an organized way to think about how much of the return comes from what the environment provides and how much from the manager’s value added. For example, it’s obvious that this manager doesn’t have any skill:

  But neither does this manager (who moves just half as much as the benchmark):

  Or this one (who moves twice as much):

  This one has a little:

  While this one has a lot:

  This one has a ton, if you can live with the volatility:

  What’s clear from these tables is that “beating the market” and “superior investing” can be far from synonymous—see years one and two in the third example. It’s not just your return that matters, but also what risk you took to get it.

  “RETURNS AND HOW THEY GET THAT WAY,” NOVEMBER 11, 2002

  It’s important to keep these considerations in mind when assessing an investor’s skill and when comparing the record of a defensive investor and an aggressive investor. You might call this process style adjusting.

  In a bad year, defensive investors lose less than aggressive investors. Did they add value? Not necessarily. In a good year, aggressive investors make more than defensive investors. Did they do a better job? Few people would say yes without further investigation.

  A single year says almost nothing about skill, especially when the results are in line with what would be expected on the basis of the investor’s style. It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investor is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill suited.

  A two-by-two matrix tells the story.

  The key to this matrix is the symmetry or asymmetry of the performance. Investors who lack skill simply earn the return of the market and the dictates of their style. Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction. These investors contribute nothing beyond their choice of style. Each does well when his or her style is in favor but poorly when it isn’t.

  On the other hand, 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. Aggressive investors with skill do well in bull markets but don’t give it all back in corresponding bear markets, while defensive investors with skill lose relatively little in bear markets but participate reasonably in bull markets.

  Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill. 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. Superior skill is the prerequisite for it.

  JOEL GREENBLATT: Once again, finding the skilled investor comes down to understanding investment process, not merely assessing recent returns.

  Here’s how I describe Oaktree’s performance aspirations:

  In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough.

  There is a time, however, when we consider it essential to beat the market, and that’s in the bad years. Our clients don’t expect to bear the full brunt of market losses when they occur, and neither do we.

  Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.

  In order to stay up with the market when it does well, a portfolio has to incorporate good measures of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down?

  If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill.

  That’s an example of value-added investing, and if demonstrated over a period of decades, it has to come from investment skill.

  JOEL GREENBLATT: However, unlike Oaktree, many investment firms raise a large amount of assets as a result of a good long-term record. With more capital, managers are often forced to invest differently than they did when they were building their great track record. Oaktree actually returns capital whenever the opportunity set shrinks. Few investment firms follow this path.

  Asymmetry—better performance on the upside than on the downside relative to what your style alone would produce—should be every investor’s goal.

  20

  The Most Important Thing Is … Reasonable Expectations

  Return expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk than is perceived.

  I want to point out that no investment activity is likely to be successful unless the return goal is (a) explicit and (b) reasonable in the absolute and relative to the risk entailed. Every investment effort should begin with a statement of what you’re trying to accomplish. The key questions are what your return goal is, how much risk you can tolerate, and how much liquidity you’re likely to require in the interim.

  Return goals must be reasonable. What returns can we aspire to? Most of the time—although not necessarily at any particular point in time (and not necessarily today)—it’s reasonable to aspire to returns in single digits or perhaps low double digits. High teens are something very special, and anything more should be viewed as the province of experienced pros (and only the best of those). The same is true of particularly consistent results. Expecting too much in these regards is likely to lead to disappointment or loss. There’s just one antidote: asking whether the result you’re expecting is too good to be true. This requires the application of skepticism, a quality that’s absolutely essential for investment success.

  I don’t think normal risk bearing and the normal functioning of the capital markets should be expected to produce returns greater than those just described. Higher returns are “unnatural,” and their achievement requires some combination of the following:

  • an extremely depressed environment in which to buy (hopefully to be followed by a good environment in which to sell),

  • extraordinary investment skill,

  • extensive risk bearing,

  • heavy leverage, or

  • good luck.

  Thus, investors should pursue such returns only if they believe some of these elements are present and are willing to stake money on that belief. However, each of these is problematic in some way. Great buying opportunities don’t come along every day. Exceptional skill is rare by definition. Risk bearing works against you when things go amiss. So does leverage, which operates in both directions, magnifying losses as well as gains. And certainly luck can’t be counted on. Skill is the least ephemeral of these elements, but it’s rare (and even skill can’t be counted on to produce high returns in a low-return environment).

  There are occasional demonstrations of the importance of reasonable expectations, and none is more dramatic than the recent Madoff scandal.

  Bernard Madoff perpetrated the greatest Ponzi scheme ever to come to light. He got away with it primarily because his investors failed to question whether his purported accomplishment was feasible.

  The returns Madoff claimed weren’t outrageously high: just 10 percent a year or so. What was extraordinary was the way he reported them year in and year out. Even a down month was a rarity. Yet few of his investors asked how these returns were achieved or wondered whether they were actually possible.

  For most of the twentieth century, common stocks averaged a 10 percent return. But they did it with substantial volatility and a fair num
ber of down years. In fact, while 10 percent was the average, individual-year returns were only rarely within a few percentage points of that figure. History shows equity returns to be highly variable.

  If it’s dependable returns you’re after, you can get them from Treasury bills without subjecting yourself to price volatility, credit risk, inflation risk, or illiquidity. But the returns on T-bills historically have been in low single digits.

  How could Madoff have produced the much higher returns of stocks with the dependability of T-bills? Which of the five elements listed above might he have possessed?

  • He reported those returns for almost twenty years, regardless of the investment environment.

  • No one understood him to possess particular investment skill, and if there was something exceptional about his computer model, what kept others from discovering it and emulating it?

  • He claimed not to base his efforts on predicting the direction of the market or picking individual stocks.

  • His avowed approach didn’t involve leverage.

  • No one can be that lucky that long.

  There simply was no rational explanation for Madoff’s returns. His investors could say either “I checked it out” or “I think it makes sense,” but it was impossible to say “I checked it out, and it makes sense.” His method and results were simply unsupportable: there weren’t enough options outstanding to accommodate the capital he managed, and even if there were, the strategy he described couldn’t produce the virtual absence of losing months he claimed. But people regularly suspend disbelief and accept unreasonable expectations when they’re told free money is available. The Madoff scandal is an exceptional example of the importance of saying “too good to be true” to return expectations that are unreasonable. But few people seem capable of doing so.

  While on the subject of Madoff, I want to mention a good way to sort out the reasonable from the unreasonable. In addition to “Is it too good to be true,” just ask “Why me?” When the salesman on the phone offers you a guaranteed route to profit, you should wonder what made him offer it to you rather than hog it for himself. Likewise, but a little more subtly, if an economist or strategist offers a sure-to-be-right view of the future, you should wonder why he or she is still working for a living, since derivatives can be used to turn correct forecasts into vast profits without requiring much capital.

  Everyone wants to know how to make the correct judgments that can lead to investment success, and lately people have been asking me, “How can you be sure you’re investing at the bottom rather than too soon?” Finding the bottom is one of the things about which our expectations have to be reasonable. My answer is simple: “You can’t.”

  “The bottom” is the point at which the price of an asset stops going down and gets ready to start going up. It can be identified only in retrospect.

  If markets were rational, such that nothing would sell for less than its “fair value,” we could say the bottom has been reached when the price arrives at that point. But since markets overshoot all the time—and price declines continue long after they should have stopped at fair value—there’s no way to know when the price has reached a level below which it won’t go. It’s essential to understand that “cheap” is far from synonymous with “not going to fall further.”

  I try to look at it logically. There are three times to buy an asset that has been declining: on the way down, at the bottom, or on the way up. I don’t believe we ever know when the bottom has been reached, and even if we did, there might not be much for sale there.

  If we wait until the bottom has been passed and the price has started to rise, the rising price often causes others to buy, just as it emboldens holders and discourages them from selling. Supply dries up and it becomes hard to buy in size. The would-be buyer finds it’s too late.

  That leaves buying on the way down, which we should be glad to do. The good news is that if we buy while the price is collapsing, that fact alone often causes others to hide behind the excuse that “it’s not our job to catch falling knives.” After all, it’s when knives are falling that the greatest bargains are available.

  There’s an important saying attributed to Voltaire: “The perfect is the enemy of the good.” This is especially applicable to investing, where insisting on participating only when conditions are perfect—for example, buying only at the bottom—can cause you to miss out on a lot. Perfection in investing is generally unobtainable; the best we can hope for is to make a lot of good investments and exclude most of the bad ones.

  How does Oaktree resolve the question of knowing when to buy? We give up on trying to attain perfection or ascertain when the bottom has been reached. Rather, if we think something is cheap, we buy. If it gets cheaper, we buy more. And if we commit all our capital, we assume we’ll be able to raise more.

  One of the six tenets of our investment philosophy calls for “disavowal of market timing.” Yet we expend a lot of effort to diagnose the market environment, and we certainly don’t invest regardless of what we think the environment implies for risk and return. Rather, our disinterest in market timing means—above all else—that if we find something attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in six months, so we’ll wait.” It’s just not realistic to expect to be able to buy at the bottom.

  In addition to an excess of trust and shortage of risk consciousness, I think unrealistic expectations played a leading role in creating the recent financial crisis and the ensuing market crash.

  Here’s how I imagine the attitude toward return of a typical investor—both individual and institutional—in 2005 through 2007:

  I need 8 percent. I’d be glad to earn 10 percent instead. Twelve percent would be even better. Fifteen percent would be great. Twenty percent would be terrific. And 30 percent would be out of this world.

  Most people see nothing wrong in this imaginary monologue. But something is very wrong … because the investor has failed to ask (a) whether a given goal is reasonable and (b) what would have to be done to achieve it. The truth is that trying for higher returns in a given environment usually requires some increase in risk taking: riskier stocks or bonds, greater portfolio concentration, or increased leverage.

  What that typical investor should have said is something like this:

  I need 8 percent. I’d be glad to earn 10 percent instead. Twelve percent would be even better. But I won’t try for more than that, because doing so would entail risks I’m just not willing to bear. I don’t need 20 percent.

  I encourage you to think about “good-enough returns.” It’s essential to realize that there are returns so high that they aren’t worth going for and risks that aren’t worth taking.

  Investment expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk than is perceived. Before you swallow the promise of sky-high returns without risk or of steady “absolute returns” at levels much higher than T-bills, you should wonder skeptically whether they’re really achievable and not simply alluring; how an investor with your skill can reasonably expect to achieve them; and why an opportunity so potentially lucrative is available to you, ostensibly cheaply. In other words, are they too good to be true?

  21

  The Most Important Thing Is … Pulling It All Together

  The best foundation for a successful investment—or a successful investment career—is value. You must have a good idea of what the thing you’re considering buying is worth. There are many components to this and many ways to look at it. To oversimplify, there’s cash on the books and the value of the tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.

  PAUL JOHNSON: All of the snippets offered in this chapter are worth reading and remembering. This chapter is an excellent recap of the book and the one chapter investors should make a point of rereading regularly.

  To achieve superior investment results, yo
ur insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally, all three.

  Your view of value has to be based on a solid factual and analytical foundation, and it has to be held firmly. Only then will you know when to buy or sell. Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day. Of course, for your efforts in these regards to be profitable, your estimate of value has to be on target.

  The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.

  JOEL GREENBLATT: This is the foundational principle behind all good investing.

  What causes an asset to sell below its value? Outstanding buying opportunities exist primarily because perception understates reality. Whereas high quality can be readily apparent, it takes keen insight to detect cheapness. For this reason, investors often mistake objective merit for investment opportunity. The superior investor never forgets that the goal is to find good buys, not good assets.

  In addition to giving rise to profit potential, buying when price is below value is a key element in limiting risk. Neither paying up for high growth nor participating in a “hot” momentum market can do the same.