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.

Howard Marks Memo – Irrational Exuberance – 2000

The second memo of 2000 is a “postmortem” of the tech/dot-com bubble. I wrote postmortem within quotation marks since the memo was written at a time (May 2000) when it was not yet clear how the situation would play out. With the help of hindsight we can now see that the postmortem was more of an mid-mortem. The title for the memo H. Marks borrowed from Alan Greenspan and his famous speech in 1996:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

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 Irrational Exuberance – 2000

1.

“[…] Julian Robertson, who compiled an incredible record through mid-1998, with a return averaging 31.7% a year for 18 years. Then losses and capital withdrawals knocked his Tiger Fund from $22.8 billion to $5.2 billion over the next 18 months. Every day the stock market was ridiculing both value investors like Robertson and the Old Economy companies they specialized in. Robertson announced a few weeks ago that he was closing up shop, saying, “we are in a market where reason does not prevail” and “there is no point in subjecting our investors to risk in a market which I frankly do not understand.”

In a supreme irony, the April week in which Robertson announced his departure turned out to be one of the best of his career, but the damage had already been done. I often think about the corrosive effect of being on the wrong side of a market judgment for prolonged periods, and the phenomenon through which those who resist trends the longest can finally capitulate at just the wrong time.

[…]

Last week saw a pullback from risk on the part of George Soros, head of the remarkable Quantum Fund (up 32%/year after fees for 30 years), and the resignation of Stanley Druckenmiller, its portfolio manager since 1989. Why? Druckenmiller had resisted tech stocks until mid-1999, but then he invested and made a bundle in the second half. When he held on to most of them in 2000, they brought him heavy losses. […]

An analyst who dealt with both Robertson and Soros summed up aptly for the Times:

The moral of this story is that irrational markets can kill you. Julian said, “This is irrational and I won’t play,” and they carried him out feet first. Druckenmiller said “This is irrational and I will play,” and they carried him out feet first.”

My thoughts: This is a good reminder that even the best in the business can fail. Also, it serves as a reminder that investing is hard, especially during crazy times when the  pressure to give in / give up will be hard to evade. On that note, I argue that non-professional/retail investors have some form of an edge since they are not simultaneously  exposed to the performance pressure from the individuals whose money they manage.

2.

“There are two main reasons why stocks fall when rates rise. I’ll discuss them below and offer my explanation for their failure to gain traction this time:

First, stocks dip because higher interest rates mean stiffer competition from fixed income investments. […]

Second, higher rates make it more expensive for consumers to buy houses and cars and for businesses to hold inventories, invest in machinery and build buildings. […] But if the investors setting stock prices don’t know (or care) how the economy and business cycle work, policy increases can be slow to impact the equity market.

Rate increases depress stocks in the short run when people understand how they work and anticipate the longer-term effects described above. That is, they work because people agree they will work. If this requirement isn’t met, then rate rises deserve the description that First Boston’s Al Wojnilower (“Dr. Doom”) applied in the 1970s to manipulating the money supply: “turning on and off a light switch to which no wires are attached.””

My thoughts: I thought this was an interesting and unique view about the relationship between stock prices and interest rates. I had not come across this explanation before. I will try to remind myself of this extract when (if?) interest rates starts to rise again.

3.

“Why did stocks rise so rapidly in 1999? Because people were rabid to buy and no one wanted to sell to them. The result was explosive appreciation. Those gains actually signaled great illiquidity (which is measured as the percentage price change that results from buying or selling a certain dollar value of stock). However, an imbalance of buyers over sellers is never called illiquidity; it’s called profit and doesn’t worry anyone.

In the last six weeks, however, the imbalance has been on the sell side. This time, investors’ inability to find others willing to trade with them has forced prices down drastically, and they are calling it illiquidity. In other words, radical upward movement was greeted warmly, but radical downward movement is being attributed somewhat to a failing on the part of the market.

Certainly the behavior of stocks in 1999 was viewed more benignly than it should have been. Momentum investors irrationally planned to get out when the music stopped, but the market wasn’t able to accommodate all of them.”

My thoughts: This should be a warning for all momentum investors. I’m quite sure H. Marks can use the exact same extract à la copy-paste in a future memo. First level thinking, as it relates to momentum investing, hasn’t changed.

4.

“In my opinion, the market for many stocks is highly efficient. […] But what does that mean?

When I say efficient, I mean “speedy,” not “right.” My formulation is that analysts and investors work hard to evaluate all of the available information such that:

  • the price of a stock immediately incorporates that information and reflects the consensus view of its significance, and
  • thus, it is unlikely that anyone can regularly outguess the consensus and predict a stock’s movement.

That is, the market may often misvalue stocks, but it’s not easy for anyone person – working with the same information as everyone else and subject to the same psychological influences – to consistently know when and in which direction. That’s what makes the mainstream stock market awfully hard to beat – even if it isn’t always right.”

My thoughts: The distinction between speedy and right is extremely important to understand as it relates to the definition of market efficiency. Applying H. Marks definition you will develop a humility-opportunistic-mindset towards investing. This will lower your expectations to a realistic level (i.e. investing is hard) while simultaneously pointing out the importance of focusing on finding pockets of slow. Reading the final sentence in the extract above, “the mainstream stock market” is probably not one of those pockets.

5.

“I listed some of the elements that have been at the foundation of prudent investing during my time in the business and more:

  • pursuing both appreciation and income,
  • balancing growth and value investments,
  • balancing the desire for gain and the fear of loss,
  • buying companies with a history of profitability,
  • caring about valuation parameters,
  • emphasizing cheap stocks,
  • taking profits and reallocating capital,
  • rotating industries, groups and themes,
  • diversifying,
  • hedging,
  • owning some bonds, and
  • holding some cash.”

My thoughts: This is a great checklist if one want’s to apply a prudent investing philosophy. However, during certain market environments (e.g. 1999) this list will also make you look like a fool and underperform as H. Marks points out in the memo.

Howard Marks Memo – bubble.com – 2000

In this fantastic memo from 2000 H. Marks starts out with an overview of The South Sea Company and the bubble, known as The South Sea Bubble, that followed in its path. With that overview he sets the stage for his review of what “certainly seems to me to be another market bubble“. This is the longest and most detailed memo so far. In order to fully grasp the stories and all the wisdom it contains I recommend that you read it in full.

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 bubble.com – 2000

1.

Changing the world — Of course, the entire furor over technology, e-commerce and telecom stocks stems from the companies’ potential to change the world. I have absolutely no doubt that these movements are revolutionizing life as we know it, or that they will leave the world almost unrecognizable from what it was only a few years ago. The challenge lies in figuring out who the winners will be, and what a piece of them is really worth today.

[…]

As usual, Buffet puts it as succinctly as anyone could: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

My thoughts: The extracts above perfectly demonstrates second-level thinking. In the memo, H. Marks shares an interesting story about the invention of the radio (which was expected to change the world, and did) and a company called RCA (Radio Corporation of America). Based on the lessons from that story it seems likely that investors will overpay for companies with the characteristics and the ability to change the world.

2.

“I feel strongly that no investment opportunity is so good that it can’t be screwed up by the wrong relationship between supply and demand. Too much money for too few ideas can mean ruinous terms and purchase prices that are too high.

[…]

In my experience, the big, low-risk profits have usually come from investments made at those times when recent results have been poor, capital is scarce, investors are reticent and everyone says “no way!” Today, great results in venture capital are in the headlines, money is everywhere, investors are emboldened and the mantra is “of course!”

My thoughts: Although the extracts above are related to venture capital I would argue that they are equally relevant for the public capital markets. Also, what H. Marks explains in the second extract above are the endpoints on the market pendulum (greed and fear) as he laid out in the 1991 memo – First Quarter Performance.

3.

How will the companies make money? — […]

I don’t think anyone would disagree that it’s one thing to innovate and change the world and another thing entirely to make money. Business will be different in the future, meaning that not all of the old rules will hold. On the other hand, profits come from taking in more in revenue than you payout in expense, and I don’t think that’s going to change. I’ll highlight below just three of the areas in which I have questions about profitability.

First, will the Internet and dot-com companies be able to charge enough for their products to make money? […]

Second, how practical are the business models of the dot-com firms? […]

Lastly, what will be the effect of competition? […] 

My thoughts: The three questions above should be remembered and applied to any innovation that you come across with a promise to “change the world”. Similar to H. Marks argument about profits, these questions will most likely not come to change. In other words; pricing power, the application/execution of a business model and competition will always be relevant to review and asses from the perspective of profitability. Especially for companies that “will change the world”.

4.

“As Alan Abelson wrote when he ran the graph, “Our reservation here is that (a) technology, like everything else in life, is cyclical; and (b) there’s something goofy about the price of a stock discounting as much as a century of earnings for a company in a field where change is the only constant and where the pace of change is constantly quickening.””

My thoughts: One should always be on the lookout for similar subtle oxymoronic assumptions built into a situation that one tries to analyze and understand.

5.

“I am convinced that a few essential lessons are involved here.

  1. The positives behind stocks can be genuine and still produce losses if you overpay for them.
  2. Those positives – and the massive profits that seemingly everyone else is enjoying – can eventually cause those who have resisted participating to capitulate.
  3. A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.
  4. “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so.
  5. Eventually, though, valuation has to matter.

My thoughts: As always, H. Marks makes a good job summarising the lessons from the memo.

Howard Marks Memo – How’s the Market? – 1999

The 1999 memo is a short review of the market environment at that point in time. To conduct the review H. Marks takes help of an article published in The Wall Street Journal. In my opinion, the overarching lesson from this memo (based on the events that followed) is that one should be worried if one comes across similar arguments being used in the financial press (if one reads the financial press…).

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 How’s the Market? – 1999

1.

Indifference to valuation – The entire bullish article – 22 column inches long – omitted all mention of valuation parameters such as P/E ratio, EBITDA multiple or dividend yield. The bottom line is that many of the investors setting the prices in today’s market don’t care about valuation.”

My thoughts: In bullish times the story is more important than valuations. That will most likely come to change.

2.

Looking on the bright side – The bulls – who are firmly in control – have joined with the media to interpret things in a positive light. I got a chuckle out of the article’s description of investor reaction to the jobs data released on April 2:

Those showed low unemployment, which was good for consumer spending; low wage increases, which implies weak inflation; and mild job creation, which implies a growing but not overheating economy.

I’m sure that in other times and climes, it would have come out this way instead:

Those showed low unemployment, which carries a threat of renewed inflation; low wage increases, which implies an anemic economy; and mild job creation, which presages weak consumer spending.

My thoughts: This is why I very seldom read any financial press. It’s all a game of interpretation in order to fit a specific pre-chosen narrative. Sometimes it’s not even that as p. 3 and p. 4 will demonstrate:

3.

Weak underpinnings – The article reflected the bulls’ preoccupation with things that either don’t really matter in any fundamental sense . . .

. . . people are buying cars, they are buying houses, they are spending money. . . I think the wind is still at the market’s back.

. . . or say absolutely nothing about long-term value:

The whisper today was that the online firms are going to have very strong earnings.

4.

Gobbledegook — Lastly, some of what’s going on just makes no sense at all.

People are very comfortable that the earnings projections are going to be hit, but the expectations are higher than that.

I have no idea what that means […].

5.

“The “rational” value investors have been decrying the excesses of the market for years – myself included. I’ve never felt more strongly the truth of the saying I picked up in the 1970s: “being too far ahead of your time is indistinguishable from being wrong.” But as they say, “that’s my story and I’m stickin’ with it.””

My thoughts: As H. Marks pointed out in the 1998 memo Genius Isn’t Enough (and Other Lessons from Long-Term Capital Management) one core ingredients of success is; timing.   The problem though, investing with a non-consensus view, is that one has to be able to look wrong during certain time periods in order to be successful.

Howard Marks Memo – Genius Isn’t Enough (and Other Lessons from Long-Term Capital Management) – 1998

The second 1998 memo is a bit longer than the previous ones. It’s a deep dive case study about the rise and fall of Long Term Capital Management and the lessons thereof. As the title of the memo will tell you, being a genius isn’t enough. To the contrary, it might have a negative effect on your ability to succeed. I truly recommend that you read the whole memo as this one is particularly interesting.

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 Genius Isn’t Enough (and Other Lessons from Long-Term Capital Management) – 1998

1.

“In his wonderful book, Against the Gods, Peter Bernstein shows how development of the study of probability made possible both informed gambling and informed investing (along with other forms of decision making concerning the future). But the products of this pursuit remain mere probabilities, or reasonable expectations. Likely events sometimes fail to occur, and unlikely events sometimes do. Or, as my friend Bruce Newberg says when I get the one improbable roll of the dice needed to beat him in backgammon, “there can be a big difference between probability and outcome.” If you are conscious of the difference between a likely outcome and a certain one, you may not want to bet the ranch.”

My thoughts: In summary; probability ≠ outcome. As the memo demonstrate and explains, relying on the opposite being true can create the path towards a black swan event.

2.

“I think investors are always looking for “the silver bullet.” They seek a course of action that will lead to large profits without risk […]. Often, they align themselves with “geniuses” who they hope will make it easy for them […].

But the silver bullet doesn’t exist. No strategy can produce high rates of return without some risk. And nobody has all of the answers; we’re all just human. Brilliance, like pride, often goes before the fall. Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking the questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management.”

My thoughts: This is an important reminder to always asses ‘investment ideas’ as ideas. Independent of who came up with the them, investment ideas are not absolute truths for how the future will turn out. Once you have accepted that the silver bullet doesn’t exist you will stop looking for it. Or maybe not:

3.

“When I was a kid, my dad used to joke about the habitual gambler who finally heard about a race with only one horse in it. He bet the rent money on it, but he lost when the horse jumped over the fence and ran away. There is no sure thing, only better and worse bets, and anyone who invests without expecting something to go wrong is playing the most dangerous game around.”

4.

“5) “Never confuse brains with a bull market.” When the 1990s began, the economy and the stock market were at very low levels. As a result, success came easily, risk-bearing paid off and the highest returns often went to those who took the most risk. They and their strategies were accepted as the best.

In my opinion, (a) the three ingredients behind success are timing, aggressiveness and skill, and (b) if you have enough aggressiveness at the right time, you don’t need that much skill. But those who have attained their success primarily through well-timed aggressiveness can’t be depended on to repeat it — especially in tough times. When an investment track record is considered, it’s essential that the relative roles of these three factors be assessed

My thoughts: Anytime I hear the word “genius” or “expert” an alarm goes of in my head. Most often, people get credited with those words although they have not yet anything to show for their antifragility.

5.

“Oaktree is built on the following axioms (among many others):

— We can’t know everything about the future, and the “bigger picture” the question, the less we can know the answer.

— We must always expect that something will go wrong and build in margin for error.

— When the market embodies too much greed, we must be conscious of the risk that’s present. When it swings too far toward fear, we should take advantage of the bargains that result.

— We must constantly remind ourselves of our limitations and dedicate ourselves to the avoidance of hubris. If our methodologies are valid and our people are talented, hubris is one of the few things that could make us fail.

My thoughts: This is such a great list, I especially appreciate the last point.

Howard Marks Memo – Who Knew? – 1998

In the first 1998 memo we return to two of H. Marks favorite topics to discuss; predictions and market cycles. This memo is written in the light of the Asian meltdown that took place during 1997.

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 Who Knew? – 1998

1.

“[…] it’s easy to be right about the future . . . if you restrict your predictions to two: (1) something significant is bound to happen eventually, and (2) we never know what it’ll be.”

My thoughts: Still, “experts” get credited for these kinds of forecasts all of the time. Be aware.

2.

“[…] I was in a client’s office in December, cautioning that I thought we would never reside for long in the investment nirvana of the new paradigm where inflation, interest rates, economic growth, expanding profits and rising stock prices stay properly aligned. He said, “I’d think a self-professed non-forecaster like you would never say, ‘never’.”

My response was, “Maybe it’s a result of my sobering experience in the 1970s, but there are plenty of things I’ll say “never” to … on the negative side: Things will never go right forever. Investors’ fondest hopes will never fail to be dashed eventually. Some unpleasant surprises will never fail to arise.””

My thoughts: The phenomena ‘regression towards the mean’ will mandate that you sometime say “never”.

3.

“I read decades ago that every bull market has three stages:

The first, when a few far-sighted people begin to believe that some improvement is possible,

the second, when most investors come to agree that improvement is actually underway, and

the third, when everyone believes everything will get better forever.”

My thoughts: This is really all you need to know about market cycles. In relation to that H. Marks gives us the recipe for how to succeed:

4.

“If you’re going to succeed at all in timing cycles, the only possible way is to act as a contrarian: catch some opportunities at the bottom, let your optimism abate as prices rise, and hold relatively few exposed positions when the top is reached. To find bargains at the bottom, you don’t have to think that things will get better forever; you just have to remember that every cycle will turn up eventually, and that prices are lowest when it looks like it won’t. But it’s just as important to avoid holding at (and past) the top, and the key is not to succumb to the popular delusion that “trees will grow to the sky.””

5.

“Prices near highs and optimism in bloom — that’s a dangerous combination, especially with perceived risk on the rise. Peter Bernstein wrote around 1979 that “The great buying opportunities … are never made by investors whose happiest hopes are daily being realized.” And yet many of today’s investors have only known success, and few appear seriously chastened by recent developments. This permits me to conclude that this is not a buying opportunity and, although no collapse need be imminent, the stock market’s best days are behind it for a while.

My thoughts: I’m afraid that this is a fair analysis of our current market environment as well.

Howard Marks Memo – Are You An Investor or a Speculator? – 1997

The 1997 memo focuses on an old and seemingly never-ending debate. Other investing gods, e.g. B. Graham, W. Buffett and S. Klarman, have written their fair share about what they think separates the concepts of investing/investor vs. speculation/speculator. While we’re on the topic, I recommend that you read the following article by R. Hagstrom titled What Is the Difference between Investing and Speculation?.

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 Are You An Investor or a Speculator? – 1997

1.

“In short, we believe (and have witnessed many times over) that the easiest way to make unusually high risk-adjusted returns is to buy from depressed sellers and sell to euphoric buyers…thus to buy when assets are underpriced and sell when they’re overpriced. The opposite is a nightmare.”

My thoughts: “Investing is simple, but not easy.” as W. Buffett likes to say.

2.

“John Maynard Keynes said (roughly) that “a speculator is someone who takes risks of which he is aware, and an investor is someone who takes risks of which he is unaware.” We think speculating, according to this definition, is more prudent than investing. It makes a lot of sense to purchase unpopular assets that promise excessive compensation for knowingly bearing risk. Buying high- priced, popular assets which “everyone knows have no risk” often proves terribly dangerous.”

My thoughts: The extract above demonstrates the difficulty in separating these two concepts. On this specific debate I would agree with H. Marks argument.

3.

“We’re not expecting any surprises,” people say, and that has become our new favorite oxymoron. Surprises are never expected — by definition — and yet they’re what move the market. (If they were expected, their effects would already be priced into the market, rendering a price reaction unnecessary.) The next surprise might be geo-political (oil embargo, war in Korea), economic (tight money, slowing profit growth) or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it’s most likely to be something that no one has anticipated – – including us.”

My thoughts: I laughed hard when I read this part of the memo. It’s spot on. When you hear the words “We’re not expecting any surprises” you should ask the individual who expressed that statement in what areas he/she is most certain and confident. Oxymoronly, it is probably in those areas surprises will most likely show up.

4.

“What does all of this tell us? That we must return yet again to what may be the greatest Warren Buffet quote: The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. Prudence is in short supply today, along with skepticism and disbelief. Thus we must be disciplined and selective in our investing today, and postpone our greatest enthusiasm for the bargains which are likely to be found in the months and years ahead.”

My thoughts: I have included similar extracts to the one above by H. Marks from earlier memos. Nonetheless, I think you should pay special attention to the last sentence in this particular extract. I like the fact that H. Marks frames “patience” not in terms of lowering enthusiasm but rather to “postpone” it. I would argue, thinking in terms of postponing your enthusiasms will help to decrease your FOMO and as a result fewer mistakes of commission will be made.

5.

“We have been privileged to read a recent letter from Julian Robertson to his investors. In it, Robertson compares today’s fund managers to the Phoenician sea captains of thousands of years ago who were paid a percentage of the value of the goods they transported and thus were incentivized to design boats which emphasized speed over safety. This worked as long as the weather was good, but the storms that eventually came consigned the less safe ships to the bottom of the sea. He goes on as follows:

The last several years have been a great period for the audacious captains with their fleets of fair-weather ships. There has not been a storm for years; perhaps climatic conditions have changed and there will never be another storm. In this scenario the audacious crew with its fleet of swift but flimsy ships is the cargo carrier of choice.

[…]

This metaphor suits Oaktree exactly; we couldn’t say it better. Being prepared for stormy weather, even if it could cost us some of the easy money in good times, is certainly the course for us.”

My thoughts: This is an awesome summary of this memo in my opinion. The metaphor ties together the statement “We’re not expecting any surprises” with the debate of what defines and differentiates investors vs. an speculators.