Howard Marks, Oaktree Capital — 2022-07-26
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Memos from Howard Marks 2022-07-26T07:00:00.0000000Z" pubdate title="Time posted: >7/26/2022 7:00:00 AM (UTC)">Jul 26, 2022
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I've written many times about having joined the investment industry in 1969, when the "Nifty Fifty" stocks were in full flower. My first employer, First National City Bank, as well as many of the other "money-center banks" (the leading investment managers of the day), were enthralled with these companies, with their powerful business models and flawless prospects. Sentiment surrounding their stocks was uniformly positive, and portfolio managers found great safety in numbers. For example, a common refrain at the time was "you can't be fired for buying IBM," the era's quintessential growth company.
I've also written extensively about the fate of these stocks. In 1973-74, the OPEC oil embargo and the resultant recession took the S&P 500 Index down a total of 47%. And many of the Nifty Fifty, for which it had been thought that "no price was too high," did far worse, falling from peak p/e ratios of 60-90 to trough multiples in the single digits. Thus, their devotees lost almost all of their money in the stocks of companies that "everyone knew" were great. This was my first chance to see what can happen to assets that are on what I call "the pedestal of popularity."
In 1978, I was asked to move to the bank's bond department to start funds in convertible bonds and, shortly thereafter, high yield bonds. Now I was investing in securities most fiduciaries considered "uninvestable" and which practically no one knew about, cared about, or deemed desirable ...and I was making money steadily and safely. I quickly recognized that my strong performance resulted in large part from precisely that fact: I was investing in securities that practically no one knew about, cared about, or deemed desirable. This brought home the key money-making lesson of the Efficient Market Hypothesis, which I had been introduced to at the University of Chicago Business School: If you seek superior investment results, you have to invest in things that others haven't flocked to and caused to be fully valued. In other words, you have to do something different.
The Essential Difference
In 2006, I wrote a memo called Dare to Be Great . It was mostly about having high aspirations, and it included a rant against conformity and investment bureaucracy, as well as an assertion that the route to superior returns by necessity runs through unconventionality. The element of that memo that people still talk to me about is a simple two-by-two matrix:
Conventional Behavior Unconventional Behavior Favorable Outcomes Average good results Above average results Unfavorable Outcomes Average bad results Below average results
Here's how I explained the situation:
Of course, it's not easy and clear-cut, but I think it's the general situation. If your behavior and that of your managers is conventional, you're likely to get conventional results – either good or bad. Only if the behavior is unconventional is your performance likely to be unconventional ...and only if the judgments are superior is your performance likely to be above average.
The consensus opinion of market participants is baked into market prices. Thus, if investors lack insight that is superior to the average of the people who make up the consensus, they should expect average risk-adjusted performance.
Many years have passed since I wrote that memo, and the investing world has gotten a lot more sophisticated, but the message conveyed by the matrix and the accompanying explanation remains unchanged. Talk about simple – in the memo, I reduced the issue to a single sentence: "This just in: You can't take the same actions as everyone else and expect to outperform."
The best way to understand this idea is by thinking through a highly logical and almost mathematical process (greatly simplified, as usual, for illustrative purposes):
A certain (but unascertainable) number of dollars will be made over any given period by all investors collectively in an individual stock, a given market, or all markets taken together. That amount will be a function of (a) how companies or assets fare in fundamental terms (e.g., how their profits grow or decline) and (b) how people feel about those fundamentals and treat asset prices.
On average, all investors will do average.
If you're happy doing average, you can simply invest in a broad swath of the assets in question, buying some of each in proportion to its representation in the relevant universe or index. By engaging in average behavior in this way, you're guaranteed average performance. (Obviously, this is the idea behind index funds.)
If you want to be above average, you have to depart from consensus behavior. You have to overweight some securities, asset classes, or markets and underweight others. In other words, you have to do something different.
The challenge lies in the fact that (a) market prices are the result of everyone's collective thinking and (b) it's hard for any individual to consistently figure out when the consensus is wrong and an asset is priced too high or too low.
Nevertheless, "active investors" place active bets in an effort to be above average.
Investor A decides stocks as a whole are too cheap, and he sells bonds in order to overweight stocks. Investor B thinks stocks are too expensive, so she moves to an underweighting by selling some of her stocks to Investor A and putting the proceeds into bonds.
Investor X decides a certain stock is too cheap and overweights it, buying from investor Y, who thinks it's too expensive and therefore wants to underweight it.
It's essential to note that in each of the above cases, one investor is right and the other is wrong. Now go back to the first bullet point above: Since the total dollars earned by all investors collectively are fixed in amount, all active bets, taken together, constitute a zero-sum game (or negative-sum after commissions and other costs). The investor who's right earns an above average return, and by definition the one who's wrong earns a below average return.
Thus, every active bet placed in the pursuit of above average returns carries with it the risk of below average returns. There's no way to make an active bet such that you'll win if it works but not lose if it doesn't. Financial innovations are often described as offering some version of this impossible bargain, but they invariably fail to live up to the hype.
The bottom line of the above is simple: You can't hope to earn above average returns if you don't place active bets, but if your active bets are wrong, your return will be below average.
Investing strikes me as being very much like golf, where playing conditions and the performance of competitors can change from day to day, as can the placement of the holes. On some days, one approach to the course is appropriate, but on other days, different tactics are called for. To win, you have to either do a better job than others of selecting your approach or executing on it, or both.
The same is true for investors. It's simple: If you hope to distinguish yourself in terms of performance, you have to depart from the pack. But, having departed, the difference will only be positive if your choice of strategies and tactics is correct and/or you're able to execute better.
Second-Level Thinking
In 2009, when Columbia Business School Publishing