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.

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