Howard Marks is an American investor and founder of the Oaktree Capital Management which specializes in alternative asset management. As of December 31, 2014, the company managed $90.8 billion, primarily on behalf of pension funds, foundations, endowments, and sovereign wealth funds. He is very well known within the investment community for his "Oaktree memos" to clients which detail investment strategies and insight into the economy. In 2011, he published the book, ‘The Most Important Thing: Uncommon Sense for the Thoughtful Investor’.
Recently he gave a talk at Google office, where he shared some of the important ideas that formed his investment philosophy. You can watch the entire video here. If you don't have 69 min you can read the summary points he made and the full Q&A. –
The Most Important Thing Illuminated
1. Fooled by Randomness -- Nassim Nicolas Taleb
The best way to describe this books would be that, it is either: ‘The most importantly badly written book.’ Or it is the, ‘Worst written but most important book.’
Marks says, though Taleb’s idea may not be very clear but many are profound; like, you should not act as the things that should happen will happen.
The biggest learning in this book is to acknowledge the role played by luck. Even if you know what’s most likely, many other things can happen instead.
Decision making under uncertainty: While the book was not recommended by Howard Marks but he mentioned one interesting quote from the book, “You can’t tell from an outcome if the decision was good or bad.” It is quite true in the stock markets, people often end-up buying the wrong stock because of a flawed logic and get rewarded and get punished despite right inference.
2. A short history of financial hysteria -- John Kenneth Galbraith
There are two kinds of forecasters. The ones who don’t know, and the ones who don’t know they don’t know.
The learning here is that on an average the forecasts can be right but no one will be right all the time. When a radical event has taken place, there has been at least one forecaster who had predicted, but for that person it would be only one time when he was right.
3. The Loser's game -- Charles Ellis
The difficulty of getting it right consistently. This is what makes defensive investing so important. There is so much of randomness in the market, which being right consistently is very difficult.
He says if the game isn’t controllable, it’s better to work to avoid losers than to try for winners. And stock markets is similar. Looking for and staying away from losers is far more important than trying to find winners.
4. Initial meeting with Michael Milken, November ‘78
If you buy a triple-A bonds, there is only one way to go, i.e. downside. But if you buy a single-B bonds and they survive, the surprises are likely to be on the upside.
Investing in bonds is “the negative art,” as per Graham and Dodd. Meaning the greatness of your performance does not come from what you buy but from what you exclude.
Oaktree’s Philosophy
If the learnings and ideas from the above 4 points are put together, then Oaktree’s investment philosophy is laid out.
- The primacy of risk control
- Emphasis on consistency
- The importance of market inefficiency
- The benefits of specialization
- Macro-forecasting not critical to investing
- Disavowal of market timing
Oaktree’s Motto: If we avoid the losers, the winners take care of themselves.
On Macro-Calls
The dictum at Oak Capital on macro-forecasting is that it’s all right to have an opinion but you shouldn't be acting as if you are right.
Two adages that Howard Marks shared
- What the wise man does at the beginning, the fool does in the end.Meaning: The fool imitates without understanding why he is imitating.
- Never forget that a six feet man drowned crossing a river that was 5ft deep on an average. Meaning: It is not sufficient to survive on averages. You have to survive on bad days.
- Being too far ahead of your time is indistinguishable from being wrong.Meaning: You may be right but you took the call too early and couldn't survive till the time when you would have been right.
Q: The thing you said about what the wise man does at the beginning, the fool does in the end. And now you are trying to avoid losers, supposedly if everyone starts avoiding losers then maybe it’s time to pick winners? Sort of self-balancing.
A: Well number one, I don’t think that all investors will be becoming too prudent or too wise any time soon because we are talking about the human nature. Charlie Munger gave a great quote from the philosopher Demosthenes, ‘To that what a man wishes, is that what man will believe.’ What is the most people want to wish? They want to get rich. Very few people think that the secret to happiness comes from prudent and caution. Most people think it comes from that stroke of genius that will put them on easy path. But you are right, there are times when most people behave in prudent and cautious manner. When is it? It is in a crash. That’s the time to aggressively buy. Buffett says, the less prudent with which others conduct their business, the greater the prudence with which we should conduct our affairs.
Q: You said you do not make any prediction on macro-side. But macros can affect companies, so how do you make an investment?
A: I said we don’t make investment on the basis of macro-economy. But you have to have an economic framework in mind when you when you predict the fortunes of individual companies.
Suppose the oil is at 50 and we will invest in this company because if the oil remain 50 then it will do fine, survives if it falls to 30 and thrives if it goes to 70.
But it’s another thing to say that if oil is 50 I think it will go to 110; and I will invest in this company because if the price goes to 110 then it will be a great investment and if it stays at 50 then it goes bankrupt.
So the question is how radical are your forecast. And we try to anticipate the future which pretty much looks like the norm and make allowance for the things that can happen other than the norm.
All this stuff is judgement. There are no rules and there are no algorithms, there are no formulae that will always work. None of this is any good unless the person making the decisions has superior judgement. The first chapter of the book is, the most important thing is the second level thinking. Most people think on the first level, to be a superior investor you have to think at second level. Think different from everyone else. In being different you have to be better.
The first level thinker is naive, he says this is a great company, lets buy the stock. The second level thinker says, this is a great company but it’s not as great as everyone thinks it is, so let’s see the stock. This is the difference between an average person and a person with insight.
Q: Do you think the diversified index fund protects the amateur investor from losers?
A: It’s a great questions. A lot of people say, ‘I am going to take a low risk approach and I will invest in index fund.’ And they are confused. What an index fund does is that it guarantees you with a performance in line with index. The point is because of the operation of what is called the efficient market, not many people can beat the market. Most mutual fund do not beat the market, and most mutual fund investor will be better off to invest in an index fund. In fact most active investment impose fees that they don’t earn. And that is the major reason why most of the active investment scheme perform below average.
So the index fund which is called the passive investing. Yes, it does eliminate the likelihood that you will fail to keep up with the index but it also eliminates the possibility that you will outperform the index. Therefore, you trade away the two sides of the probability that you get index results. This doesn't remove the risk to investment, it removes the risk of deviating from the index. What you have to keep in mind is that the index fund investor loses money every time the index goes down. Why? Because there is no value added to keep it above.
By the way, index investing is a fine thing for an average amateur investors because the average amateur investor cannot beat the market, can’t find anyone or hire anyone, who can beat the market. The only thing is he (the investors) shouldn't think that it is a risk-less trade (index fund investing).
Q: With the ease of information available and the various books available on the topic of the value investing, do you see any change in the behaviour of retail investors from 20 years ago?
A: I think there is a minor movement towards the indexation. It’s not ground swell, there is still lots of money in actively managed mutual fund where there is 1.5%-2% a year fees/cost. But I think there is more in indexation every year and that is probably a problem.
Let me leave you with a question: Why can’t people beat the market? Because the market is pretty efficient and it prices most of the time accurately. That’s what I have learnt in college, and it is pretty much right.
What happens when they stop trying?
So when the interest in active investment declines because people give up on it and turn to passive investor and all the analyst quit studying the companies, then prices resume their deviation from intrinsic value, then it becomes possible to beat the market again. So it is really paradoxical and I would say counter-intuitive.
Q: You mentioned that price/value is one dimension and then other is time. How do you estimate the time it will take to bridge the value?
A: We never do it.
Let me explain the question. What we want to do, is find investment where the intrinsic value and the price has a huge gap, his question is how do we estimate the time it will take for this gap to close? And the answer is, there is no way to say.
On occasion there are what we call as catalyst. One catalyst would be the pending maturity of the bond. If a bond is going to mature in 2012 and it is selling at 60 as most people think it is going to go bankrupt and we think it is going to pay off at maturity. Then the date of maturity will force the price to converge. Another catalyst today is all these activist investor. They think the gap is high between the intrinsic value of a company and the price at which it sells in the market, because the management is sub-par. So they try and get the board seat and then the active investor try to force the management to do the right thing to cause the price to converge the value.
So there are few catalyst in the wold but generally, you buy a stock and you hope. There is no way to estimate your time. And that is the reason why being too ahead of your time is no different from being a fool. Because it can take a long time.
Q: Would you always look for a presence of a catalyst when you find a gap?
A: Most of what we do is in the fixed income world and there are more catalyst in the fixed income world than in the equity world.
Q: How did you raise capital for oak tree in the early days? Was it different at that time?
A: By the time we started Oak Tree it wasn’t that hard because we had a reputation. But when I started raising money for our strategies, like 1978 junk bond, 90% of the investment organisation like google had a rule against any bond investing below A or below investment grade which is BBB. And ofcourse Moody said, it is prudent investment. So that was very hard to overcome. You have to do what you have to do. You have to go and find few people, and go tell them you have to do it, because no one else is doing it and hence, it is languishing cheap. You make no money doing things that everybody is doing, you make money by doing what no one wants to do who then turn out to have value. So if you say that message to 100 investors at the beginning, then maybe 10 jump on board. After it works for a while, then the rest come on.
The point is, it was very hard in the beginning. It was extremely difficult in foreign country because if I tell them you should do it because no one is doing it, then they would call in the guy in the white coat.
Americans are semi-intuitively understand contrarianism, you know being a maverick but in many countries they just don’t get it. Then in 1988 we came out with our distressed debt fund. Now we are not investing in companies that had the risk of default, now we are investing in funds that are in default or sure to be. And investors would ask how you would make money in the bonds of bankrupt company. Then we had to explain to them, that if the creditor of a company doesn't get paid then interest on the principal then they have claim against the value of the company. And they exert that claim in the process called bankruptcy. In simple terms, and to over generalise the old owners are wiped out and the old creditors become the new owners. So if you bought the ownership stake through the debt for less than it’s worth then you make money. We have made about 23% a year for 28 years investing in distressed debt before fees without any leverage. So that’s pretty astronomical.
Q: Buffett in 1999 says that if he was running a small fund then he would give returns of 50% per year by finding all the opportunities. And he used the word guarantee. I presume that he meant that there are lots of inefficiency in the small cap stocks. In the debt world, the inefficiency can only be exploited by the institutional investors, are there any portions where even the small investor can make money?
A: I think the small investor cannot buy enough to get on the board but he can definitely find value. So what I was saying earlier that if you have good performance then you can get more clients. And if you let it unchecked then you get more money and your performance goes bad. And this is one of the conundrums in our world. So the truth is the little guy has an advantage as long as he remains small. So the more money you manage when you get fees, it’s a great lure to take on more money but you have to stop it before it ruins your performance. So a person who has big brain, little money and a lot of time and exceptional insight can find great bargain. But that is a pretty daunting list.
So I don’t think that Buffett’s guarantee necessarily extends to everybody in this room.
Q: Do you see any unhealthy trends in valuation in the market today?
A: Yes I do, because the market extends the menu. It extends from the risk free rate. In general terms, the risk free rate in the 30 day Treasury bill. Then in order to tie-up your money for five year treasury you want 4% and in 10yr Treasury you would demand 5% and if you move to corporate debt then you would demand 6% as the risk is higher and to go to a high yield bond you will demand 12%. So the slope is upward, and the process is called equilibration. Which makes things line up in terms of relative risk-to-return but always pegged from the risk free rate. Today the risk-free rate is zero. So this entire parallel market line has had a parallel shift and so before the crisis I had turned bearish, and all my money was in treasury. All the money I had outside of Oak Tree was in treasury and I was getting 6 ½% for 1-6 years maturities. I was getting income and safety. Today you have a choice income or safety because the things today that are highly safe pay no income.
Go to fidelity, vanguard, etc. and their short-term yield on treasury is zero. And he gets the statement and zero 0% returns, he panics and calls the 800 number and says get me out of there, and he goes into high-yield bond. He doesn’t understand what the dangers are, he doesn't know how to pick a high yield bond manager but he is seduced by that 6% vs 0%. And all around the investment world today, people are chasing the investment return. They don’t like the low returns on the safe investment and they are going for the gusto. They are going for risky instruments and they are doing it mindlessly.
If you look at my memos I wrote one in March of 2007 called, ‘Race to the bottom.’ And I talked about the fact that when people are (1) Eager to invest (2) and not sufficiently risk conscious, they do risky things. And when people do risky things, markets become a risky place. And that is why Buffett says, ‘the less prudence with which others conduct their affairs the more prudence with which we should conduct our own affairs.’ And that is going on now to some extent, because people can’t get returns from safe instruments they are going for risky instruments and they are bidding. So there is a race to the bottom like an auction. So if you go to buy a painting, then it goes to the person who pays the highest price. But in the investment world, it’s the reverse auction; so sometimes you pay the highest price and bid for the lowest returns. Supposedly there is a company which is issuing bond, and I say, ‘I demand 7% on it’. This person says ‘I will take 6%.’ And that guy says, ‘I will take 5%’. My argument that I will take some coverage against the risk and hence demand 7%. The guy at 6% says I will take less coverage, and the guy at 5% says I need no coverage. What happens? The bond is issued at 5% with no coverage and that is the race to the bottom. And anyone who participates in that bond, probably has made a huge mistake.
And that is going on now. Not to the same terrible extent as it was going in 2006-07 but you got to be careful. Oaktree’s model for the last three and half-years has been move forward but with caution. Caution has to be a very important component of everybody’s action.
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