Howard Marks Memo – Investment Miscellany – 2000

This is one of my favorite memos so far. The main credit for that I don’t attribute to H. Marks, believe it or not, but a man with the name Richard Bookstaber. Don’t worry if you haven’t heard of him before, neither had I. In August 1999 R. Bookstaber presented the paper A Framework for Understanding Market Crisis at a AIMR (what is today CFA) seminar called “Risk Management: Principle and Practices”. Somehow H. Marks came across this article and thought it presented “a rigorous framework“. Presenting the article H. Marks said; “What smart people do is put into logical words the thought we may have had but never formulated and expressed.”. As you will soon see, this description fits R. Bookstaber very well (extract 2-5 is related to his article).

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 Investment Miscellany – 2000

1.

What Can Reasonably Be Expected from Equities?

[…]

Corporate earnings have traditionally grown at single-digit rates, and I don’t feel that’s about to change substantially. With p/e ratios unlikely to rise further and dividends immaterial, single-digit earnings growth should translate into single-digit average equity performance at best for the foreseeable future.

In the end, I feel there has been unreasonable reliance on the average historic return from equities, be it 10% for 1929-92 or 13% for 1940-99. What’s been lost track of is the fact that p/e ratios were much lower when these periods began and since then have risen substantially. I just don’t believe that further p/e expansion can be counted on. How do I view the issue? I ask the bulls one question: What’s been the average performance of stocks bought at p/e ratios in the twenties? I don’t think the return has been in double digits. I’m not even sure it’s been positive.”

My thoughts: The lesson from the extract above is that one should always remember and take into consideration the context and the circumstances of a particular average/base rate. For example, your average 60-yard dash time when you were twenty years old will be quite different from your average 60-yard dash time when you are eighty years old. In other words, relying on the average/base rate alone is not a good idea.

2.

““Liquidity demanders are demanders of immediacy.” I would describe them as holders of assets in due course, such as investors and hedgers, who from time to time have a strong need to adjust their positions: When there’s urgency, “the defining characteristic is that time is more important than price …. they need to get the trade done immediately and are willing to pay to do so.”

“Liquidity suppliers meet the liquidity demand.” They may be block traders, hedge fund managers or speculators with ready cash and a strong view of an asset’s value who “wait for an opportunity when the liquidity demander’s need for liquidity creates a divergence in price [from the asset’s true value]. Liquidity suppliers then provide the liquidity at that price.” What they offer is liquidity; providing liquidity entails risk to them (which increases as the market’s volatility increases and as its liquidity decreases); and the profit they expect to make is their price for accepting this risk. “To liquidity suppliers, price matters much more than time.””

My thoughts: As you probably figured out, one wants to be a liquidity supplier not a liquidity demander. Price should matter more than time. That is especially true in times of crisis:

3.

“Usually when the price of something falls, fewer people want to sell it and more want to buy it. But in a crisis, “market prices become countereconomic,” and the reverse becomes true. “A falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they get scared). The number of liquidity demanders increases, and they become more highly motivated. “Liquidity demanders use price to attract liquidity suppliers, which sometimes works and sometimes does not. In a high-risk or crisis market, the drop in prices actually reduces supply [of liquidity] and increases demand.”

In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market’s increased volatility and decreased liquidity have reduced the price they’re willing to pay. And maybe they’re scared, too. […]”

My thoughts: The extract above is important since far too many investors don’t think about the notion of liquidity. Even worse, some investors blindly expect or have factored into their investing models that liquidity will always be there to serve their needs. This is far from true.

4.

““One of the most troubling aspects of a market crisis is that diversification strategies fail. Assets that are uncorrelated suddenly become highly correlated, and all positions go down together. The reason for the lack of diversification is that in a [volatile] market, all assets in fact are the same. The factors that differentiate them in normal times are no longer relevant. What matters is no longer the economic or financial relationship between assets but the degree to which they share habitat. What matters is who holds the assets.” In recent years, the “habitat” in which most investors feel comfortable has expanded. Barriers to entry have fallen, access to information has increased and, perhaps most importantly, most investors’ forays abroad have been rewarded. Thus “market participants become more like one another, which means that liquidity demanders all [hold] pretty much the same assets and grab whatever sources of liquidity are available.” If they are held by the same-traders, “two types of unrelated-assets will become highly correlated because a loss in the one asset will force the traders to liquidate the other.” […]”

My thoughts: This is one of the most important things I have read in recent years. I have never thought about diversification/concentration this way before. Also, I think  it demonstrates the importance of having a contrarian mindset seeking non-consensus investment ideas.

5.

“Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber’s analysis applies equally to the opposite – times when the desire to buy outstrips the willingness to sell. It’s called a buying panic and represents no less of a crisis, even though – because the immediate result is profit rather than loss – it is discussed in different terms. Certainly 1999 was just as much of an irrational, liquidity-driven crisis as 1987.”

My thoughts: Remember, the buying panic is what sows the seeds to the selling panic.

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