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Howard Marks: Notes and Books


Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is less than satisfactory- none is indispensable…  Loser’s game (The Financial Analysts Journal, July-August 1975), A Short History of Financial euphoria, by John Kenneth Galbraith (New York: Viking,1990). Fooled By Randomness. Thinkers: John Kenneth Galbraith on human foibles,  Warren Buffet on patience and contrarianism, Charlie Munger on the importance of reasonable expectations, ; Bruce Newburg on ‘probability and outcome’, Michael Milken on conscious risk bearing, Ric Kayne on setting ‘traps’ (underrated investment opp’s where you can make a lot but not lose a lot… Psychology plays a major role in markets, and because it’s highly variable, cause and effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. Investment approach must be intuitive and adaptive rather than fixed and mechanistic… Few achieve superior insight, intuition, sense of value and awareness of the psychology required for above-average results… What is the range of future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does consensus think? How does my expectation differ from consensus? How does current price for asset comport with consensus view and mine? Is the consensus psychology incorporated in the price too bullish or bearish? What will happen if consensus turns out to be right, and if I’m right… Only if your behavior is unconventional is performance likely to be unconventional, and only if judgments are superior is your performance likely to be above average… First test is always the same: ‘who doesn’t know that?’ Describing market as inefficient akin to saying the market is prone to mistakes that can be taken advantage of. Respect concept of market efficiency, believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there. If return appears so generous in proportion to risk, overlooking some hidden risk? Do know more about the asset than the seller? If such a great proposition, why hasn’t someone else snapped it up? Limit effort to relatively inefficient markets where hard work and skill pay off. Theory should inform but not dominate decision. Can fool ourselves into thinking it’s possible to know more than everyone else and regularly beat heavily populated markets. Can buy 50 correlated securities and mistakenly think diversified… Accurate estimate of intrinsic value is the indispensable starting point… All approaches based on analysis of company attributes known as ‘fundamentals’ and those based on study of the price behavior of the securities themselves. Distinct difference b/w using technical analysis vs. studying price and volume patterns to grasp the ‘asset psychology’. Asset is tangible object that should have intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value should consider it. Estimates must be derived rigorously based on ALL available information… Lots of candidates make security or underlying company valuable, financial resources, management, factories, outlets, patents, human resources, brand names growth potential and most of all, ability to generate earnings and cash flow… Establishing current value of a business requires opinion regarding its future so MUST take into account the likely put in macro-economic environment, COMPETITIVE developments and technological advances… Upside potential for being right about growth is more dramatic and the upside potential for being right about value is more consistent… If establish intrinsic value being correct isn’t synonymous with being proved correct right away (be careful-gives excuse for being wrong). Being too far ahead of your time is indistinguishable from being wrong… Value investors score their biggest gains whey buy an underpriced asset, average down unfailingly had have their analysis proved out. Have to hold view strongly enough to be able to hang in and buy even as price declines suggest you’re wrong; BUT you have to be right… Investment success doesn’t come from buying good things, but rather from buying things well… Right price driven by primarily by underlying fundamental value and psychology… Can’t make a career out of buying from forces sellers and selling to forced buyers (mutual fund inflows) b/c not around all the time, just on rare occasion of crises and bubbles… Key to ascertain value is skilled financial analysis, the key to understanding the price/value relationship and the outlook for it lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals… Prices 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, eventually though valuation has to matter… Value exerts a magnetic pull on prices… “The market can remain irrational longer than you can remain solvent.” John Maynard Keynes… Since no approach works all the time, the best investors can have some of the greatest periods of underperformance… Pragmatic investors feel opposite to capital market line high risk/return theory, feel just the opposite that high return and low risk can be achieved simultaneously by buying things for less than worth. In the same way, overpaying implies both low return and high risk… Much of the time, the greatest risk in these low luster bargains lies in underperforming in heated bull markets… If all investors met in a room and showed their cards, would never agree on a single number representing an investment’s riskiness, why risk and return aren’t machinable… Alternative histories- Nicholas Taleb. Even after investment closed out it’s impossible to tell how much risk it entailed; b/c investment worked out doesn’t mean it wasn’t risky or vice versa… Lucky Idiots, congenially aggressive s. those that were smart to anticipate good times and bulk up on beta… One of the most important things can know about investment risk: “Probable things fail to happen and improbable things happen all the time.” Bruce Newberg… Many futures possible, but only one occurs. The future you get may be beneficial or harmful and that may be attributable to foresight, prudence or luck… Success of 3 portfolios can be entirely contingent on one odd ball development but if it occurs wild aggression can be mistaken for conservatism and foresight… Many things could have happened in the past, and the fact that only one did understates the variability that existed… It’s invariably that some investors; especially those who employ high leverage will fail to survive… When risk bearing doesn’t work, it REALLY doesn’t work and people are reminded what risk’s all about… It may be more helpful to think of risk as INCREAING during upswings, as financial imbalances build up, and MATERIALIZING during recessions… No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up… Great investing requires both generating returns and controlling risk… All along the upward sloping capital market line, the increase in potential return represents compensation for bearing incremental risk, except for those who can generate alpha. “Risk is my friend” when things going well. “More risk please” (Are we there yet? Doesn’t seem it). When risk tolerant buy stocks at high P/E’s, private companies at high EBITDA multiples and bonds at narrow yield spreads… Developments that make the world look less risky are illusory… Trust has replaced skepticisms and eagerness has replaced reticence. Do you agree or disagree? That’s the key question. Answer it first and the implications for investing become clear… People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus they accept risk unknowingly and in doing so contribute to its creation… Reward for taking incremental risk shrinks as more people move to take it… “I wouldn’t buy at any price-everyone knows it’s too risky” has given rise to the best investment opportunities. The herd is wrong about risk at least as often at it is right about return… High quality assets can be risky and low quality assets can be safe, it’s just a matter of price paid for them… Great investors are those who take risks that are less commensurate with the returns they earn… Taleb: Fact that environment wasn’t negative doesn’t mean risk control wasn’t desirable even though as things turned out it wasn’t needed at the time. Risk control is invisible in good times but still essential, since good times can so easily turn into bad times… A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference… Russian roulette: after a few dozen tries one forgets about the existence of a bullet, under a numbing sense of security… Can’t run a business on worst case assumptions; you wouldn’t be able to do anything. And anyway a ‘worst case’ assumption is really a misnomer, there’s no such thing… We tend to forget about outliers, rarely consider outcomes that have happened only once a century… Don’t run from risk, welcome it at the right time, in the right instances and at the right price…  Risks and exposures are understood, appropriately managed, and made more transparent for everyone. This is not risk aversion; it is risk intelligence… Long term investment success runs through risk control more than through aggressiveness. Skillful risk control is the mark of the superior investor… Just about everything is cyclical, nothing goes in one direction forever. Trees don’t grow to the sky, few things go to zero and little as dangerous for investor health as insistence on extrapolating today’s events into the future… Rule 1) most things will prove to be cyclical. Rule 2) greatest opportunities for gain and loss come when other people forget rule 1… People are emotional and inconsistent, not steady and clinical. Objective factors play a large part in cycles of course- factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that cause investors to overreact or underreact, and thus determines the amplitude of cyclical fluctuations… Cycles reverse b/c trends create the reasons for their own reversal. Success carries within itself the seeds of failure and failure the seeds of success… The longer I’m involved in investing the more impressed I am by the power of the credit cycle. Only takes a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself… Worst loans are made at the best of times where cost of capital exceeds the return on capital and eventually cases where there is no return of capital. Losses cause discouraged lenders, risk awareness rises and with it interest rates, credit restrictions and covenant requirements (need historical perspective on this). Thus, less capital available and at trough only to most qualified buyers. Companies become starved for capital. Borrowers unable to roll over debt, leading to defaults. This process contributes to and reinforces the economic contraction… If there were such a thing as a completely efficient market and if people really made decisions in a calculating and unemotional manner perhaps cycles would be banished; but that’ll never be the case… Companies will anticipate a rosy future and over expand. Providers of capital will be too generous when economy expanding, abetting overexpansion with cheap money… Every decade or so people decide cyclicality is over and that good times will roll on without end or the negative trends can’t be arrested… “When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.” This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend more time at the extremes than it does at a ‘happy medium.’ What the wise man does in the beginning, the fool does in the end. MAJOR bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for… The air goes out of the balloon much faster than it went in… Extreme market behavior will reverse… Not glamorous to follow a path that emphasizes humility, prudence and risk control. Of course, investing shouldn’t be about glamour, but often it is. Desire for more, the fear of missing out, the tendency to compare against others… Believe me, it’s hard to resist buying at the top (and harder still to sell) when everyone else is buying, the pundits are positive, the rationale is widely accepted, prices are soaring and the biggest risk takers are reporting huge returns. It’s also hard to resist selling (and very tough to buy) when the opposite is true and holding or buying appears to entail the risk of total loss… Strong held sense of intrinsic value, insistence on acting as should when prices diverge from value, understanding that market excesses are ultimately punished, not rewarded, thorough understanding of insidious effect of psychology on the investment process at market extremes, promise to remember when things seem too good to be true, usually are, willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), like-minded friends and colleagues from whom to gain support; all these things aren’t sure to do the job but may give a fighting chance… ‘To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.’ Sir John Templeton. The trend, the consensus view, is something to game against, and the consensus portfolio is one to diverge from. ‘Once in a lifetime’ market extremes seem to occur every decade or so- not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach… Contrarianism isn’t an approach that will make you money all the time. Much of the time there aren’t great market excesses to bet against. Even when excess develop, over-priced is different from going down tomorrow… It can appear at times that ‘everyone’ has reached a conclusion that the herd is wrong. What I mean is that contrarianism itself can appear to have become too popular. You must do things not just because is the opposite of what the crowd is doing, but because you know why the crowd is wrong. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios… When dealing with future must think a) what might happen and b) the probability of that… Skepticism is what it takes to look behind a balance sheet and calls for pessimism when optimism is excessive and optimism when pessimism is excessive… Regarding financial crisis: The negative story looked compelling, but it’s the positive story, which few believed, that held and still holds, the greatest potential for profit… Certain common threads run through the best investments: usually contrarian, challenging and uncomfortable, although the experienced contrarian takes comfort from his or her position outside the herd. When buying something has become comfortable again, its price is no longer so low that it’s a great bargain. Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron; why concept of intrinsic value is so important. Portfolio process 1) List of potential investments 2) estimates of intrinsic value 3) sense of how prices compare with intrinsic value d) an understanding of risks involved in each and effect of inclusion on portfolio… If they go on long enough and gain enough force, investment styles become bubbles unlike potential bargains which usually display some objective defect: asset class may have weakness, company may be industry laggard, BS may be over levered, or security may afford its holders inadequate structural protection. Bargains usually based on irrationality or incomplete understanding. Places to look: little knows and not fully understood, fundamentally questionable on surface, controversial, unseemly or scary, deemed inappropriate for ‘respectable’ portfolios, unappreciated/unpopular or unloved, trailing a record of poor returns, recently the subject of disinvestment, not accumulation… There aren’t always great things to do, sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism- waiting for bargains- is often the best strategy. Tend to get better results if you select from the list of things that sellers are motivated to sell rather than start with a fixed notions as to what you want to own. ‘We don’t look for our investments, they find us.’ Rather than obviously overpriced or underpriced, most things may seem fairly priced. In that case may be no great bargains or compelling sales to make. It is essential for investment success that we recognize the condition of the market and decide on our actions accordingly. Mujo: cycles rise and fall, things will come and go, and the environment will change. Buffet: Can wait for the perfect pitch- one way to start is by making every effort to ascertain whether we’re in lower return or high return environment. Missing profitable opportunity is less significant than investing in loser. Stick and carrot can cause the cat to climb high up in the tree, to a treacherous position. When prices are high it’s inescapable that prospective returns are low and risks are high. That single sentence provides a great deal of guidance as to appropriate portfolio action. “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” Peter Bernstein. Classic mistake: reaching for return…  You want to take risk when others are fleeing from it, not when they’re competing with you to do so… Absolute best buying opportunities are when asset holders are forced to sell and in those crises they were present in large numbers. Beauty of forced sellers is that have no choice. Gun at their heads… Key during crisis is being insulated from forces that require selling and positioned to be a buyer instead. To satisfy those criteria, investor needs following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach. Two kinds of people lose money: those who know nothing and those who know everything. Henry Kaufman. We may never know where we’re going, but we’d better have a good idea of where we are. The only thing we can predict about cycles is their inevitability. Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions. Nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or profit from the mistakes of others. As difficult as it is to know the future, it’s really not that hard to understand the present. Take the market’s temperature. If we are alert and perceptive we can gauge the behavior of those around us and from that judge what we should do. Are investors optimistic or pessimistic? Has credit cycle rendered capital readily available or impossible to obtain? Are P/E’s high or low, yield spreads tight or generous? Can make excellent decisions on basis of present observations, with no need to make guesses about future. Below investment grade levered loans, percentage of CCC bond issuance? Golfer’s choice of club depends on wind, shouldn’t investment actions be determined by climate? Must consider ‘alternative histories’ that could have occurred just as easily as the ‘visible histories’ that did? At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. The action of the ‘I know’ school are based on a view of a single future that is knowable and conquerable. My ‘I don’t know’ school thinks of future events of a probability distribution. Emphasize avoiding pitfalls. There are old investors, and there are bold investors, but there are no old bold investors… Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities, govt. can change the rules, or nature can serve up a catastrophe. Defense- significant emphasis on keeping things from going wrong, is an important part of every great investor’s game. .. Effective group can accomplish more than one person, satisfying and enjoyable but much more so when you win...  Be less willing to bet on continued prosperity. Achieving gains usually has something to do with being right about events that are to come; whereas losses can be minimized by ascertaining that tangible value is present… Graham and Dodd: can you exclude bonds that don’t pay, negative art… Oaktrees competitors gone b/c too many losers. Bet too much when think have a winning idea or a correct view of the future, concentrating portfolio rather than diversifying… Avoidance of losses and terrible years is more easily achieved than repeated greatness… Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors I know. AVOID BIG MISTAKES. Failure of imagination: being unable to conceive of the range of possible outcomes or not fully understand the consequences of the more extreme occurrences. Short run outcomes can diverge from long-run probabilities and occurrences can cluster… Too much capital availability makes money flow to the wrong places and BAD things happen… Widespread disregards for risk creates great risk: “If I don’t move quickly someone else will buy it, someone will pay more. People worry about missing out not about not losing money and time consuming skeptical analysis becomes the province of old fogeys. Bullish investors focus on what might work not what might go wrong… CONFIDENCE matters more than anything else in the short run. Capital cycle CRITICAL… The formula for error is simple, but the ways it appears are infinite. Usual ingredients: data or calculation error in the analytical process leas to incorrect appraisal of value; full range of possibilities or their consequences is underestimated; greed, fear, envy, ego, suspension of disbelief, conformity or capitulation, or some combination of these, moves to an extreme; as a result, either risk taking or risk avoidance becomes excessive; prices diverge significantly from value; investors fail to notice this divergence. Astute, second-level thinkers take note of the analytical error as well as the failure of other investors to react appropriately. Detect over or underprices assets in the context of too hot or too cool markets. Sometime the error lies in doing something and sometimes in not doing it, sometimes in being bullish and sometimes being bearish. What’s TODAY’s mistake: AVOID IT. There are times when there when there’s no glaring error. When investor psychology is at equilibrium and fear and greed are balanced, asset prices are likely to be fair relative to value. When there’s nothing particularly clever to do the potential pitfall lies in insisting on being too clever… The real question is how they do in the long run and in climates for which their style is ill suited. Insight into value must be superior. Must learn things others don’t. See things differently or do a better job of analyzing them. Relation b/w price and value influenced by psychology and technical, can dominate value in the SHORT run. Extreme price swings in price due to those two factors provide opportunities for big profits or big mistakes. Whatever direction markets go in people think will go forever; psychology of herd. Eagerness to buy from urgency to sell. The power of psychological influences must never be underestimated. Don’t expect to be immune and insulated from greed and fear. Power of psychological influences must never be underestimated. Greed, fear, suspension of disbelief, conformism, envy, ego, and capitulation are all parts of human nature, and ability to compel action is profound. Will feel them, must not succumb, must RECOGNIZE them for what they are and stand against them. Buying based on STRONG value, low price relative to value and depressed general psychology is likely to provide the best results. But underprices is far from synonymous from going up soon. “Being too far ahead of time indistinguishable from being wrong.” Differences in correlation despite same absolute riskiness can formulate portfolio. Heavy emphasis on not doing the WRONG thing. No one can KNOW macro, the more micro the focus, the more likelihood, can learn things others don’t (ENVIRONMENT STILL CRITICAL but don’t know what lies ahead of the macro future.). World not orderly, many ignore randomness and the probability distribution that underlies future developments. NEITHER DEFENSIVE INVESTORS in DOWN MARKET NOR AGGRESSIVE IN UP MARKET DEMONSTRATE SKILL, only those who succeed in ill-suited market.


Repeating themes: Risk and risk control, repetitiveness of behavioral patterns and mistakes, role of cycles, volatility of credit market conditions, brevity of financial memory, errors of the herd, investor psychology enormous, the desirability of contrarianism and counter-cyclicality, the futility of macro forecasting… Convinced that fluctuations in investor attitudes towards risk contribute more to major market movements than anything else- I don’t ever expect this to change. Much risk comes not from companies but from investor behavior… Confidence and pendulum swings between: optimism and pessimism, greed and fear, euphoria and depression, credulousness and skepticism, risk tolerance and risk aversion, and reckless aggressiveness and excessive caution; the extent and the error of each move all reflect common themes, examples of ways in which history rhymes.  EM example: sometimes considered exotic and scary and sometimes high-growth alternative to the stagnant developed world. When most investors are driven to drop their prudence by an excess of confidence, we should be terrified. In the same way, when most investors become devoid of confidence and flee the market, we should turn aggressive... “It’s different this time,” EITHER WAY. Air goes out of balloon much faster than it goes in; takes years for confidence to reach dangerous zenith , but only weeks of months for it to collapse. The essential raw material for a bull market is cheapness. “Of course there will be a price to pay for today’s policy excesses- an equal and opposite reaction. We just haven’t seen it yet. Will it take the form of a collapse of the dollar and the end of dollar hegemony, high interest rates, failed treasury auctions and runaway inflation, a wrenching and protracted downturn requiring exceptional sacrifice, or something else? We will find out soon enough” (Klarman). “Leverage buys you a glimpse of prosperity you haven’t really earned” (Lewis). “Asset values contingent; debt is forever” (Grant).


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