I’m a bit late on this one, but hey…it’s always a joy to read Howard Marks and his memos.
We have repeatedly heard or read many of his thoughts and they are a good reminder to rational thinking, especially since market movements can easily suck us up into emotional and thought restlessness.
Link to memo: I Beg to Differ
He realized early in his career that the value opportunities are often where there is no attention from other market participants. Efficient market hardly exists if there is no liquidity - something I’ve witnessed in my domestic (Croatia) stock market.
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 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.
On Second-Level Thinking
I like to make a comment on ‘active investing’ as being cocky and arrogant, because it involves going against a large number of market participants that we don't know if they have more knowledge about the asset than we do, but we still bet against the other party either selling us the stock or buying it from us. It was Seth Klarman who said:
“In investing, whenever you act, you are effectively saying, “I know more than the market. I am going to buy when everybody else is selling. I am going to sell when everybody else is buying.” That is arrogant, and we always need to temper it with the humility of knowing we could be wrong—that things can change—and acknowledging that we have a lot of smart competitors.”
This is where Marks includes second-level thinking as a differentiator to generate returns higher than the average.
The idea of second-level thinking builds on what I wrote in Dare to Be Great. First, I repeated my view that success in investing means doing better than others. All active investors (and certainly money managers hoping to earn a living) are driven by the pursuit of superior returns.
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”
Second-level thinking is deep, complex, and convoluted. The second-level thinker takes a great many things into account.
The components of second-level thinking are laid below:
Instead, their superiority has to come from an ability to:
better understand the significance of the published numbers,
better assess the qualitative aspects of the company, and/or
better divine the future.
…but there is never a confirmation of us understanding the asset better than the others, at least not before the asset gets fairly valued, meaning it has been recognized by the rest of the market - which reminds us of Buffett’s ‘rock turning’ comment:
“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map.”
On Contrarianism
Being a contrarian more than often looks like being alone on the island.
Market extremes represent inflection points. These occur when bullishness or bearishness reaches a maximum. Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further, and the market is as high as it can go. Buying or holding is dangerous.
(…)
Therefore, the key to investment success has to lie in doing the opposite: in diverging from the crowd. Those who recognize the errors that others make can profit enormously from contrarianism.
Being alone is not a goal ‘per se’. Being alone (as a contrarian) is an act of confidence and the deeper understanding of the company and its future than the rest of the market. Not being too emotional is a part that helps a lot.
First-level thinkers – to the extent they’re interested in the concept of contrarianism – might believe contrarianism means doing the opposite of what most people are doing, so selling when the market rises and buying when it falls. But this overly simplistic definition of contrarianism is unlikely to be of much help to investors. Instead, the understanding of contrarianism itself has to take place at a second level.
Like the second-level thought process laid out in bullet points on page four, intelligent contrarianism is deep and complex. It amounts to much more than simply doing the opposite of the crowd. Nevertheless, good investment decisions made at the best opportunities – at the most overdone market extremes – invariably include an element of contrarian thinking.
The Decision to Risk Being Wrong
Daring to be wrong essentially leads us to being different.
If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior....
As said before, holding rarely talked about assets, inevitably looks like a lonely island situation. And the discomfort (as a result of volatility) may lead us to sell the asset too soon, because of our lack of conviction.
Most great investments begin in discomfort. The things most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive, and the outlook is rosy – are unlikely to be available at bargain prices. Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late.
I like to borrow Dhaval Kotecha’s share on Twitter. The research part of the process is the basis for previously mentioned second-level thinking and the generator of our conviction which will help us hold the asset even when we start questioning our investing decisions.
But then, perhaps most importantly, I took the idea a step further, moving from daring to be different to its natural corollary: daring to be wrong. Most investment books are about how to be right, not the possibility of being wrong. And yet, the would-be active investor must understand that every attempt at success by necessity carries with it the chance for failure. The two are absolutely inseparable, as I described at the top of page three.
Therefore, being different from the crowd starts by daring to be wrong. It is easy to buy the most talked about stocks, but in that case it is almost certainly better to buy a market ETF and simplify our investing aspirations.
Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes. Thus each person has to assess whether he’s temperamentally equipped to do these things…
One Way to Diverge from the Pack
…is by getting rid of the short-termism, avoiding everyday noise and focusing on the long term expectations of the underlying investment. And that’s the hard part, from what I know, because emotional vortex easily sucks you in after which I make stupid impulsive decisions.
All the discussion surrounding inflation, rates, and recession falls under the same heading: the short term. And yet:
We can’t know much about the short-term future (or, I should say, we can’t dependably know more than the consensus).
If we have an opinion about the short term, we can’t (or shouldn’t) have much confidence in it.
If we reach a conclusion, there’s not much we can do about it – most investors can’t and won’t meaningfully revamp their portfolios based on such opinions.
We really shouldn’t care about the short term – after all, we’re investors, not traders.
Does the fact that there’s a recession ahead mean we should reduce our investments or alter our portfolio allocation? I don’t think so. Since 1920, there have been 17 recessions as well as one Great Depression, a World War and several smaller wars, multiple periods of worry about global cataclysm, and now a pandemic. And yet, as I mentioned in my January memo, Selling Out, the S&P 500 has returned about 10½% a year on average over that century-plus. Would investors have improved their performance by getting in and out of the market to avoid those problem spots ...or would doing so have diminished it? Ever since I quoted Bill Miller in that memo, I’ve been impressed by his formulation that “it’s time, not timing” that leads to real wealth accumulation.
Two of the six tenets of Oaktree’s investment philosophy say (a) we don’t base our investment decisions on macro forecasts and (b) we’re not market timers.
Easier said than done, we’re getting back to the importance of being able to hold the asset during the times of high volatility.
At the beginning of my career, we thought in terms of investing in a stock for five or six years; something held for less than a year was considered a short-term trade. One of the biggest changes I’ve witnessed since then is the incredible shortening of time horizons.
And modern investors are bad at holding the stocks for a longer periods of time.
Many investors – and especially institutions such as pension funds, endowments, insurance companies, and sovereign wealth funds, all of which are relatively insulated from the risk of sudden withdrawals – have the luxury of being able to focus exclusively on the long term ...if they will take advantage of it.
It would be nice if stocks would only go up, but they don’t…and that’s where the value of these memos comes out.
Best wishes,
Marko
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