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.

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