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.