Howard Marks Memo – Learning From Enron​ – 2002

The first memo of 2002 is a long one. 21 pages to be precise. As the title will tell you, it focuses on the rise and fall of Enron and the lessons thereof. In a sense, this memo is an in-depth case study of fraud and corruption. The style of the memo reminded me of Genius Isn’t Enough (and Other Lessons from Long-Term Capital Management) that H. Marks wrote in 1998. Everyone should read this memo as the lessons it contains will, most likely, stay relevant across time and space. In other words, future cases of fraud and corruption will just be old ideas embedded in new narratives.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from Learning From Enron – 2002

1.

“For those seeking an explanation for fortuitous outcomes, luck has been described as “what happens when preparation meets opportunity.” I think Enron inspires a similar explanation for corruption: it’s what happens when exigency meets moral weakness.”

My thoughts: Or more explicitly; corruption/fraud; it’s what happens when greed and envy meets ego and misaligned incentives. Having greed and envy meet ego and misaligned incentives at the top of the organisation means trouble for the whole organisations:

2.

Corporate Rot Can Spread From the Executive Suite 

[…]

It certainly appears that Enron was a company where: 

  • hubris was encouraged, 
  • schemers rose to the top,
  • people were rewarded for ends, not means, and
  • no one ever asked “but is it right?” 

[…]

And encouraging moral behavior, perhaps above all else, is the responsibility of top management. One thing I’m convinced of is that you can’t have a great organization without someone at the top setting the tone. The Chairman and CEO can’t know everything that goes on in a company, can’t be conversant with the details and merits of every transaction, and can’t participate in any but the most senior hires. But they can create a climate where expectations are high and the emphasis is on means, not just ends. 

3.

Aligning Interests

About a decade ago, Forbes published a special issue on executive compensation. In it, a sage, experienced director said of managers, “I’ve given up on getting them to do what I tell them to do; they do what I pay them to do.” I’ve never forgotten that statement.

When individual compensation gets into the tens or even hundreds of millions of dollars per year (including stock and options), managers profit as if they owned the company and took the risk. They appropriate a major share of profits for themselves in the good years, even though they lose nothing (other than perhaps potential or previously-accrued profits) in the bad ones.

Set up this way, management has lots of incentive to take risk and cut corners. It sure worked that way at Enron. The executives can point out that the board approved the key elements in the compensation program. But once again, I say the board’s control over management is limited.

[…]

Management should be incentivized, but constructively. Excessive, short-term focus on stock price performance is not in shareholders’ long-term interest and, in egregious cases like Enron, obviously can bring disastrous results.

My thoughts: As the old German saying goes: “Wes Brot ich ess, des Lied ich sing” (whose bread I eat, his song I sing). Furthermore, I think its fair to say that Enron’s management had a lot of incentives but few disincentives, i.e. they lacked skin in the game.

4.

Where Does the Buck Stop?

Ours is a free market. If undeserving (or crooked) companies get capital they shouldn’t, the responsibility ultimately falls to the providers of equity capital. I’ve read everything I could on Enron, and yet there’s almost no mention that shareholders may have been remiss.

Sure, the shareholders were victims of what appears to have been organized and pervasive fraud. But no one can say there weren’t warning signs. Shareholders held and bought Enron stock although they couldn’t possibly have thought they understood the financial statements, or where the profits came from. They held while the top executives were selling. And they remained unperturbed when the CEO quit without explanation.

And I’m not just talking about individual investors. Al Harrison of Alliance, Enron’s biggest holder, has been quoted as saying he bought on “faith.” He even admits, “The company seemed to be on a deliberate path not to give full information. Shame on me for not doing something about it.” (New York Times, March 3, 2002) Good marks for candor; not so good for due diligence.

I believe many investors underestimate the difficulty of investing, the importance of caution and risk aversion, and the need for their active, skeptical involvement in the process. Caveat emptor. Or as they say on TV, “don’t try this at home.”

My thoughts: In short, grow up, stop being naive and take responsibility for your mistakes of commission (buying Enron) as well as your mistakes of omission (not selling Enron).

5.

“What’s the bottom line, then? The real lessons from Enron, in my opinion, are these: 

  • As long as there are disclosure rules – and that’s forever – there’ll be “technically correct” statements that leave investors in the dark. In order to get numbers with integrity, you need people with integrity.
  • Rules are just the first building block in creating a safe market. We also need compliance and enforcement, neither of which will ever be 100%. Even though it’s the best in the world, our system for corporate oversight is far from perfect. The collective power of directors, auditors and regulators to protect shareholders withers in the face of serious corporate corruption. It’s amazing what con men can get away with for a while.
  • As Enron’s complex, questionable transactions indicate, the people looking for holes in the rules are often highly motivated, well financed and well advised. Those whose job it is to plug the loopholes are often over-matched, and their efforts to do so usually amount to a holding action. The furor over Enron’s accounting shows that we need the ability to insist on adherence to general principles and punish those who violate them.
  • Security analysis and knowledgeable investing aren’t easy. Investors must be alert for fuzzy or incomplete information, and for companies that don’t put their interests first. They must invest only when they know what they don’t know, and they must insist on sufficient margin for error owing to any shortcomings.
  • We all must watch out for unintended consequences, and that’s especially true when promulgating regulations. Accounting rules and option programs were created with the best of intentions, but in the extreme they led to Enron’s noxious transactions and counterproductive incentives. It’ll be no less true the next time around. 

My thoughts: The extract above is a brilliant summary of this lengthy memo. Unfortunately, I think that there is a high probability that the same list of lessons be relevant when evaluating future cases of fraud, i.e. we won’t learn.

Howard Marks Memo – You Can’t Predict. You Can Prepare.​ – 2001

The fifth and final memo of 2001 is focused on H. Marks favorite topic; cycles. Reading the title you’ll get a glimpse of the main takeaway from this memo. This memo is a must read if you have any interest understanding the environment that you interact with when investing and how you should cope with that environment as it changes.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from You Can’t Predict. You Can Prepare. – 2001

1.

The Economic Cycle 

How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late.”

My thoughts: The last sentence is absolute gold. Survival is rationality as N. Taleb would say. However, prudence is also cyclical. Extract 2 and 3 will give you some examples of that:

2.

The Credit Cycle

[…]

At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

[…]

Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled. 

[…] Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. 

[…]

In making investments, it has become my habit to worry less about the economic future – which I’m sure I can’t know much about – than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone’s throwing money at is a formula for disaster. 

3.

The Corporate Life Cycle 

[…]

The biggest mistakes I have witnessed in my investing career came when people ignored the limitations imposed by the corporate life cycle. In short, investors did assume trees could grow to the sky. In 1999, just as in 1969, investors accepted that ultra-high profit growth could go on forever. They also concluded that for the stocks of companies capable of such growth, no p/e ratio was too high. People extrapolated earnings growth of 20%-plus and paid p/e ratios of 50-plus. Of course, when neither the growth nor the valuations turned out to be sustainable, losses of 90%-plus became the rule. As always, the folly of projecting limitless growth became obvious in retrospect.

[…]

So the latest “wonder-company” with a unique product rarely possesses the secret of rapid growth forever. I think it’s safer to expect a company’s growth rate to regress toward the mean than it is to expect perpetual motion. 

4.

The Market Cycle 

At the University of Chicago, I was taught that the value of an asset is the discounted present value of its future cash flows. If this is true, we should expect the prices of assets to change in line with changes in the outlook for their cash flows. But we know that asset prices often rise and fall without regard for cash flows, and certainly by amounts that are entirely disproportionate to the changes in cash flows.

Finance professors would say that these fluctuations reflect changes in the discount rate being applied to the cash flows or, in other words, changes in valuation parameters. Practitioners would agree that changes in p/e ratios are responsible, and we all know that p/e ratios fluctuate much more radically than do company fundamentals. 

The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves in a highly cyclical manner. 

My thoughts: This reminds me of an extract from the 2000 memo We’re Not In 1999 Anymore, Toto that included the following words of wisdom; “Be conscious of investor psychology”.

5.

Cycles and How To Live With Them 

No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn’t impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage. 

Having said that, I want to point out emphatically that many of those who complained about the excessive market valuations – including me – started to do so years too soon. And for a long time, another of my old standards was proved true: “being too far ahead of your time is indistinguishable from being wrong.” Some of the cautious investors ran out of staying power, losing their jobs or their clients because of having missed the gains. Some capitulated and, having missed the gains, jumped in just in time to participate in the losses. 

So I’m not trying to give the impression that coping with cycles is easy. But I do think it’s a necessary effort. We may never know where we’re going, or when the tide will turn, but we had better have a good idea where we are.

My thoughts: Cycles are simple, but not easy.

Howard Marks Memo – What Lies Ahead?​ – 2001

The fourth memo of 2001 is “about the economic and investment implications of the attacks.“. If you haven’t done so already, I recommend that you read the last memo, Notes from New Yorkthat focuses on the more important implications and lessons drawn from these tragic events. Although this memo was written in a specific context and with specific events in mind I would argue that the wisdom in it will continue to stay relevant across time and space. It’s a great memo!

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from What Lies Ahead? – 2001

1.

Looking to the Future – All of economics, business and investing entails dealing with the future. […]

That’s what makes investing interesting, challenging and occasionally lucrative. If it didn’t require us to reach conclusions about the future, or if the future wasn’t uncertain, then everyone’s returns would be the same – but not very high. We achieve high returns on occasion because we deal with an uncertain future, and it’s because the future is uncertain that superior investors can get an edge.

The process of investing consists entirely of divining the future – in terms of profits and values – and translating that future into prices that should be paid today. Obviously, doing so requires a view of what the world will look like tomorrow and how businesses and their products will fare in that world.”

My thoughts: This is a fundamental truth of investing. Unfortunately, this truth is often forgotten or well hidden. The reason for that is that the future per definition is uncertain. As I have said before, investors hate uncertainty. In order to cope with uncertainty, investors have turned their attention towards a probabilistic mindset. I try to employ a probabilistic mindset myself and I would argue so does H. Marks. However, many investors have taken this mindset a step too far. For them, probability has morphed into a concept of certainty. That’s dangerous. Remember, we need a margin of safety if we want to survive in the long term.

2.

“We each make thousands of judgments a day based on our understanding of what’s normal. […]

We must make assumptions like these, even though we know they won’t hold true all the time. If we had to start from scratch every time we faced a decision, the result would be paralysis. Thus we start by assuming that the things that worked in the past are likely to work in the future, but we also make allowances for the possibility that they won’t.

We do the same in our roles as investors. We expect well-managed companies with good products to make money and be valued accordingly. We assume companies that have the money will service their bonds. We count on the economy to recover from slowdowns and grow over time.

So most of our actions depend on extrapolation. Certainly in investing, we rely on forecasts that assume the future will look a lot like the past. And most of the time they’re right.

[…]

We all want a feeling of assurance. We want to live in a world where the future seems knowable and decisions that extrapolate normalcy can be depended on. […] So I think we’re eager to embrace predictions that these things will hold true.”

My thoughts: Normal = white swan events. But how about black swan events?

3.

Some of the greatest dilemmas in investing surround highly unlikely events with highly negative implications. It’s hard to know what to do about them, but we should at least be aware of their existence.

We have no alternative to assuming that the future will look mostly like the past, but we also must allow for the fact that we face a range of possible futures today that is wider than usual. In other words, I feel we must allow for greater-than-normal uncertainty.”

My thoughts: The important takeaway from the extract above is “be aware of“. Ignoring (aka swiping under the rug) black swans doesn’t stop them from showing up. So, be prepared!

4.

The Role of Confidence – […] Sometimes I think in the economy, confidence is all there is.

When people are confident, they extrapolate prosperity and borrow and buy. They assume an upward-sloping future and want to jump on board. They worry that if they don’t buy something today, it’ll cost them more tomorrow. That is, they are concerned about the cost of inaction.

When their confidence fades, they worry about losing jobs and defer purchases. They may prefer to build cash or pay down debt. They’re willing to wait before buying, and they assume there’ll be another chance to buy cheaper. In other words, they figure that if they don’t act, they won’t miss out on much. Opportunity costs just don’t seem that important.”

My thoughts: In other words, if you control the confidence you control the economy. This is a powerful realization!

5.

Will I Ever Drop My Cautionary Stance? – […]

[…] I have no interest in being a pessimist or a bear, and I don’t like to think of myself that way. I just may be more impressed by the unknowability of the future than most people. When I reflect on all of the mottoes I use, it seems half of them relate to how little we can know about what lies ahead.

[…] If we insist on a degree of defensiveness that turns out to be excessive, the worst consequence should be that your profits will be a little lower than they otherwise might have been. I don’t think that’s the worst thing in the world.

The longer I’m in this business, the less I believe in investor agility. […] Rather, most people have a largely fixed style and point of view, and the most they can hope for is skill in implementing it – and I don’t exempt Oaktree and myself from that observation.

But that’s not so bad. It’s my conclusion that if you wait at a bus stop long enough, you’re sure to catch your bus, while if you keep wandering all over the bus route, you may miss them all. So Oaktree will adhere steadfastly to its defensive, risk-conscious philosophy and try to implement it with skill and discipline. We think that’s the key to successful long-term investing – especially in today’s uncertain environment.

My thoughts: I admire H. Marks thinking about the future and how to cope with uncertainty in general. As I have said before, I think H. Marks mindset could best be described as an humility-opportunistic-mindset. This is something that I closely try to emulate and develop.

Howard Marks Memo – Notes from New York – 2001

The third memo of 2001 is special. Unfortunately, this memo is special for all of the wrong reasons. H. Marks wrote this memo on the 16th of September 2001, five days after the attacks on the World Trade Center and the Pentagon. H. Marks explains in the memo that this was “My way of dealing with them [thoughts of New York] is to turn them into sentences and paragraphs.“. As you would expect, this memo is not about investing, forecasting, market cycles or any of the other topics that H. Marks usually write about. Because of that fact alone, this is a memo worth your time and attention. The lessons and wisdom in this memo will not make a you better investor. However, it serves as an important reminder that the quest of becoming a better investor is far from the most important thing in life.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from Notes from New York – 2001

1.

“Depending on how far and in what ways the terrorist campaign spreads, we might begin to see armed personnel where people gather. And they might need to be able to search those they suspect. We may see surveillance cameras, computer facial and fingerprint recognition and the use of profiling. Internet and telephone privacy may be abridged. Travel will be less convenient, and our borders may be made less porous. These subjects are likely to be hotly debated, but the debate is certain to be conducted from a new perspective. And I think the answers are likely to be different from what they would have been a week ago.”

My thoughts: H. Marks often points out that he doesn’t play the game of trying to predict the future. However, I would argue that he did on this occasion. Unfortunately, it turned out that his forecasting abilities were quite good.

2.

“There will be – already has been – violence against Americans of Middle Eastern origin. But know this: People say that if we let stocks fall, if we don’t rebuild the Towers, or if we don’t return to normalcy, then our enemies will have won. All of this is true, but if the events of the week are able to turn Americans against Americans and erode the values that have made this country great, they also will have won.

My thoughts: In times like these, this has to be remembered.

3.

“Last week’s events proved that money, position and technology are not the most powerful or important things in our lives. The cornerstones of our lives were shown to be family, faith and principle, friends and colleagues we know we can count on, and the American spirit. These are the things we have to be thankful for . . . maybe now, we realize, more than ever.

My thoughts: No words of mine are needed.

Howard Marks Memo – What’s It All About, Alpha? – 2001

The second memo of 2001 is focused on some core concepts of investing/finance and how they hang together; market efficiency, inefficiency, return, beta, alpha, risk, correlation, and tracking error. H. Marks has written this memo in a way that makes the concepts informative and comprehensible even if you haven’t taken any university courses in finance. Furthermore, if you have taken finance courses, this is an insightful memo to read and reflect upon based on your established knowledge and beliefs. As H. Marks puts it “[…] I believe few people use them to mean the same thing, or correctly.

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from What’s It All About, Alpha? – 2001

1.

“If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or non-consensus, view. But because the consensus view is as close to right as most people can get, a non-consensus view is unlikely to make you more right than the market (and thus to help you beat the market).

The bottom line for me is that, although the more efficient markets often misvalue assets, its not easy for anyone person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat – even if they aren’t always right.”

My thoughts: This extract is more or less a recap of what H. Marks has written about market efficiency in previous memos. Nevertheless, this message is worth repeating for the sake of its importance but it’s also included in order to provide context to the four extracts below.

2.

“First of all, inefficiency doesn’t come and go in quick bursts. Markets are inefficient for longer-term structural reasons relating primarily to shortcomings on the part of their participants and infrastructure. Second, “inefficient” absolutely does not mean “cheap” (or “dear”).

[…]

[…] Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material – mispricings – that can allow some people to win and others to lose on the basis of differential skill. If prices can be very wrong, that means it’s possible to find bargains or overpay. For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that, “In every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.”

My thoughts: The extract above is not an inversion of the concept market efficiency as explained in theory. Rather, this is an explanation of how to approach investing if one is not indexing. The key takeaway from the memo is that one has to be conscious and aware of where one decides to go fishing for bargains. If one does a bad or sloppy job at this first step of the investing process the likelihood of generating persistent generous returns declines drastically for the investor. Still, as H. Marks points out, finding an inefficient pond to fish in is not enough to guarantee generous returns.

3.

It’s essential to recognize that investment skill isn’t distributed evenly – that the investment world isn’t democratic or egalitarian. […] It’s also why I think so little of investment management firms that describe their edge in terms of head count; an army of average analysts will do you no good.

That’s because, in my view, alpha is best thought of as “differential advantage,” or skill that others don’t possess. Alpha isn’t knowing something, it’s knowing something others don’t know. If everyone else shares a bit of knowledge, it provides no advantage. It certainly won’t help you beat the market, given that the market price embodies the consensus view of investors – who on average know what you know.”

My thoughts: This extract should serve as a humble reminder that we should on a recurring basis ask ourselves and evaluate; do I add alpha or not? It reminds me of something W. Buffett wrote in his 1993 letter: “Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

4.

What is risk? First of all, I don’t think risk is synonymous with volatility. And second, the indicia of risk vary by asset class.

At Oaktree, when we think about adding an asset to a portfolio, we ask whether the risk entailed is tolerable (i.e., within our charter from our clients) and offset by the likely return. And by risk we mean the chance of losing our clients’ money.

[…]

We do not think about volatility. With our capital in either locked-up funds or long-term relationships, we worry only about whether the ultimate result, perhaps years down the road, will be positive or negative, and by how much. We think this is what our clients pay us to do.”

My thoughts: H. Marks is not alone in his thinking on “What is risk?”. I would argue that most value investors share this view, i.e. risk = permanent loss of capital. However, I think H. Marks framed his risk definition in a unique way by saying (my interpretation) that: risk should be thought about in the light of a) what amount of permanent loss of capital for adding a position/asset to my portfolio can I tolerate/endure? and b) is the potential loss of capital offset by the positions/assets upside potential?

5.

“In short, I think, theory should inform our decisions but not dominate them.

If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and regularly beat heavily populated markets. We can buy securities for their returns but ignore their risk. We can buy fifty correlated securities and mistakenly think we’ve diversified. […]

But swallowing theory whole can make us turn the process over to a computer and miss out on the contribution skillful individuals can make. The image here is of the efficient-market-believing finance professor who takes a walk with a student. “Isn’t that a $10 bill lying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The professor walks away, and the student picks it up and has a beer.

So how do we balance the two? By applying informed common sense.

My thoughts: This is, in my opinion, the most important extract of the memo. It’s a great reminder that in investing we need to strike a common-sense balance between theory and practice in order to have the ability to reach the ultimate goal. That is, to become long-term successful investors.

Howard Marks Memo – Safety First . . . But Where? – 2001

In the first memo of 2001 H. Marks focuses on “I am writing to explore the question of where to look for successful investments when sheer aggressiveness stops paying off.” In order to address this topic H. Marks first reviews; what’s been tried? and then moves on to; what do we do now?. Before we dive into the extracts below I would like to point out that this was a hard memo to narrow in on what I considered to be the top five extracts. This memo was filled with layers on layers of investing knowledge and wisdom!

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from Safety First … But Where? – 2001

1.

“I am a great believer in common stock investing, but I hold tight to a few caveats:

  • Return expectations must be reasonable.
  • The ride won’t be without bumps.
  • It’s not easy to get above-market returns.

[…] In general, it’s great to own productive assets like companies and their shares. But occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them. Or to paraphrase Warren Buffett, when people forget that corporate profits grow at 8 or 9% per year, they tend to get into trouble.”

My thoughts: A reasonable expectation mindset is important if one is to be a long-term successful investor. However, this mindset is both rare and highly underappreciated. To some extent I think people have too high expectations since they, as the extract points out, don’t understand that “returns roughly parallel profit growth in the long run“. In investing and life in general, too many individuals have been disappointed as a result of having too high expectations. So, keep em’ low!

2.

“By the end of 1999, technology stocks constituted roughly 40% of the S&P, and thus it no longer delivered “unbiased” participation in equities. Prudent index investors looked for alternatives like the Russell 5000, while trend-followers threw more and more money into the S&P. As usual, investors got carried away with the simplistic solution; in some people’s minds, index funds’ infallibility was transmuted from “incapable of failing to capture the gains of stocks” into “incapable of performing poorly.” Of course, money flooded in.”

My thoughts: I don’t think this lesson is remembered by todays index investing community. Unfortunately, next time around this lesson will affect a lot more investors. As a result, the repercussions will be much more severe and the consequences much harder to endure. Remember, index investing is not immune to market cycles.

3.

Stocks of great companies – Over the years, buying and holding the stocks of leading companies has been a favorite way to strive for high return and low risk. […]

People too easily forget that in determining the outcome of an investment, what you buy is no more important than the price you pay for it. As Oaktree consistently demonstrates, we’d much rather buy a so-so asset cheap than a great asset dear.

The stocks of great companies often sell at prices that assume their greatness can be perpetuated, and usually it cannot. […] “Great company today” doesn’t mean “great company tomorrow,” and it certainly doesn’t mean “great investment.”

[…]

Pursuing quality regardless of price is, in my opinion, one of the riskiest – rather than the safest – of investment approaches. Highly respected companies invariably fall to earth. When investors’ hopes are dashed, the impact on price is severe. For example, if a high p/e ratio is attached to earnings that are expected to grow rapidly, an earnings shortfall will cause the p/e ratio to be reduced, bringing about a double-barreled price decline.

[…] investing in the stocks of great companies that “everyone” likes at prices fully reflective of greatness is enormously risky. We’d rather buy assets that people think little of; the surprises are much more likely to be favorable, and thus to produce gains. No, great companies are not synonymous with great investments . . . or even safe ones.”

My thoughts: What has been summarised in the extract above has formed the foundation of my investing philosophy. The first time I came across H. Marks writing on the topic of “great companies” I was blown away, it was a true AHA-moment. I’m sure to return to this extract in the future!

4.

Accept change – Among the important elements that clients, consultants and managers must possess is adaptability. The only thing you can count on is change. Even if the fundamental environment were to remain unchanged – which it won’t – risk/return prospects would change because (a) investors will move the prices of assets, certainly in relative terms, and (b) investor psychology will change. That’s why no strategy, tactic or opinion will work forever. It’s also why we have to work with cycles rather than ignore or fight them.”

My thoughts: Change is synonymous with uncertainty. As human beings, we hate uncertainty. Still, we have to accept change as H. Marks puts it. In relation to the extract above I would therefore like to add; accept uncertainty. I tweeted about this topic the other day:

1/ Say “I don’t know” out loud when thinking/discussing something even though you are 100% certain. It forces you towards different paths/interpretations. Being certain is comfortable, being uncertain is not. Why? Being certain is less complex and has been key for our survival.
2/ However, embracing uncertainty is a way to learn that; asking question is more important than giving answers. Embracing uncertainty is a way to learn that “I don’t know” should be ones starting position in order to attain new knowledge.
3/ “The more I learn, the more I realize how much I don’t know.” – A. Einstein. In other words, learning can be seen as a negative art, i.e. to attain knowledge about what we *don’t* know. In my opinion, that is how we should embrace uncertainty. /End

5.

“Search for alpha […]

To me, alpha is skill. It’s the ability to profit from things other than the movements of the market, to add to return without adding proportionately to risk, and to be right more often than is called for by chance.

More important, alpha is differential advantage; it’s skill that others don’t possess. That’s why knowing something isn’t alpha. If everyone else knows it, that bit of knowledge gives you no advantage.

Lastly, alpha is entirely personal. It’s an art form. It’s superior insight; some people just “get it” better than others. Some of them are mechanistic quants; others are entirely intuitive. But all those I’ve met are extremely hard working.

[…] Only in markets that are not efficient can hard work and skill pay off in consistently superior risk-adjusted returns. […] When someone says “my market is inefficient” or “I have alpha,” make him prove it.

You want to be sure the claimed alpha is there. Just about everyone in this business is intelligent and articulate. It’s not easy to tell the ones with alpha from the others. Track record can help but (a) it has to be a long one and (b) it’s still possible to play games.”

My thoughts: This is the best definition and explanation for the concept of alpha that I have come across. I think it does a good job showcasing how nuanced the concept is and how hard it is to grasp. Also, this extract should serve as a reminder that you need to make sure that you only invest in areas that are not efficient if you seek superior risk-adjusted returns.

Howard Marks Memo – We’re Not In 1999 Anymore, Toto – 2000

The fourth and final memo of 2000 is once again focused on the insights and lessons drawn from the tech/dot-com bubble. The title for this memo H. Marks got from the movie ‘The Wizard of Oz’. As was the case in the movie, the main character of 1999 (the investor) eventually had to return to reality (i.e. the story mean reverted) .

Please comment if you have read the memo and what you thought of it. Also, if you have found a worldly wisdom in the memo that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Worldly wisdom’s from We’re Not In 1999 Anymore, Toto – 2000

1.

Respect cycles – There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero.

That was really the problem with the bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability will bring imitation and competition, which will cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive, technological progress, could at some point render them obsolete.

My thoughts: Having an understanding for how market cycles work is extremely important if one is to be a long-term successful investor. I would also add, understanding concepts such as mean reversion, base rates, and moats is important in relation to your knowledge about market cycles. A sidenote, in October 2018 H. Market will release his new book on the topic of market cycles: Mastering the Market Cycle: Getting the Odds on Your Side. Consider this a future must read for 2018!

2.

Worry about time – Another element that investors ignore in their optimism is time. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, “Markets can remain irrational longer than you can remain solvent.” Whenever you’re tempted to bet everything on a long-run phenomenon, remember the six-foot tall man who drowned crossing the stream that was five feet deep on average.

One of the great delusions suffered in the 1990s was that “stocks always outperform.” I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton’s Prof. Jeremy Siegel demonstrated, but only with the qualification “in the long run.”

My thoughts: Always make sure to minimise time constraints and time pressures when investing. First and foremost, make sure to not used borrowed money when investing and that you can survive without the capital that you have deployed. And finally, remember that in order to profit from the long-term you have to be there for the long-term. In other words, survival is the most important thing.

3.

Remember that, for the most part, things don’t change – The five most dangerous words in our business aren’t “The check’s in the mail” but “This time it’ll be different.” Most bubbles proceed from the belief that something has changed permanently. It may be a technological advance, a shortage or a new fad, but what all three have in common is that they’re usually short-lived.

Most “new paradigms” turn out to be just a new twist on an old theme. No technological development is so significant that its companies’ stocks can be bought regardless of price. Most shortages – whether of commodities or securities – ease when supply inevitably rises to meet demand. And no fad lasts forever.

My thoughts: Do you see any resemblance to the situation and the arguments used in today’s market environment?

4.

Be conscious of investor psychology – I don’t believe in the ability of forecasts or forecasters to tell us where prices are going, but I think an understanding of investor psychology can give us a hint. […] When the man on the street thinks stocks are a great idea and sure to produce profits, I’d watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it’s a formula for disaster.

I find myself using one quote, from Warren Buffett, more often than any other: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are euphoric, that puts us in danger. When others are terrified, the prices they set are low, and we can be aggressive.”

My thoughts: I would even go as far as; current investor psychology of the consensus is the predictor of future performance. In other words, euphoric consensus = low future returns and terrified consensus = high future returns.

5.

Check your own mindset – For me, mindset holds many of the keys to success. We at Oaktree believe strongly in contrarianism. As suggested in the paragraph above, that means leaning away from the direction chosen by most others. Sell when they’re euphoric, and buy when they’re afraid. Sell what they love, and buy what they hate.

Closely related to contrarianism is skepticism. It’s a simple concept, but it has great potential for keeping us out of trouble. If it sounds too good to be true, it probably is. [….] Oaktree was founded on the conviction that free lunches do exist, but not for everyone, or where everyone’s looking, or without hard work and superior skill. Skepticism needn’t make you give up on superior risk-adjusted returns, but it should make you ask tough questions about the ease of accessing them.

We think humility is essential, especially concerning the ability to know the future. Before we act on a forecast, we ask if there’s good reason to think we’re more right than the consensus view already embodied in prices. As to macro projections, we never assume we’re superior. About under-researched companies and securities, we think it’s possible to get an edge through hard work and skill.

Finally, we believe in investing defensively. That means worrying about what we may not know, about what can go wrong, and about losing money. If you’re worried, you’ll tend to build in more margin for error. Worriers make less when everything goes right, as in the tech bubble, but they also lose less – and stay in the game – when things return to earth. At Oaktree, we’re guided more by one principle than any other: if we avoid the losers, the winners will take care of themselves.

My thoughts: One should remind oneself of these investing principles and their meaning on a daily basis. Sticking to these principles in both rain an shine are as much of a bulletproof formula for long-term success as one can get.