Howard Marks on what matters and what doesn't (and some rules to live by)
Article by David Thornton from Livewire Markets ©
If anyone has earned the title of market prophet, it's Howard Marks of Oaktree Capital.
Yet, he's opened his latest note acknowledging the most important and common quality found among the world's top investors: humility.
"The vast majority of investors can’t know for sure what macro events lie just ahead or how the markets will react to the things that do happen," Marks explains.
In other words, you don't know what you don't know. Or as Mark Twain once wrote, "It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so."
But that doesn't mean you should put market engagement and participation in the too-hard basket.
The key, according to Marks, is knowing the difference between the things you can reliably shape your investment decisions on and those you can't.
Unsurprisingly, the insights in Mark's latest note are broken into two categories: what doesn't matter, and what does.
Marks' latest note is 14 pages long, and I implore you to set aside some time in your day to read it. You can find it here.
But if you're time-poor, here's a summary I've put together of his key takeaways and some strategies investors can use to implement them.
WHAT DOESN'T MATTER
Short-term events
The vast majority of investors can’t know for sure what macro events lie just ahead or how the markets will react to the things that do happen.
This is not to say that forecasting is impossible. It's not.
"Most forecasts are extrapolations, and most of the time things don’t change, so extrapolations are usually correct, but not particularly profitable," Marks says.
"On the other hand, accurate forecasts of deviations from trend can be very profitable, but they’re hard to make and hard to act on."
But here's the problem - forecasting events is only half the challenge. The other, arguably harder part is trying to understand how much investor expectations have been baked into prices.
"It’s very difficult to know which expectations regarding events are already incorporated in security prices", says Marks.
"Security prices are determined by events and how investors react to those events, which is largely a function of how the events stack up against investors’ expectations."
We see this play out all the time. For example, a company posts good numbers in its financial reports, and the share price falls. Why? Because the good or bad development is only such through the lens of market expectations. As Marks says:
"It’s not whether the event is simply positive or not, but how the event compares with what was expected."
The trading mentality
Marks believes most investors wrongly adopt a trader's mentality. That is, they buy securities with a view towards selling them rather than a view towards owning them.
If you own something that you plan to sell, then in essence you're admitting that it wouldn't be worth having in the future.
"To me, buying for a short-term trade equates to forgetting about your sports team’s chances of winning the championship and instead betting on who’s going to succeed in the next play, period, or inning," Marks says.
Rather, it's much better to be all in on the securities you own. That kind of emotional buy-in naturally raises the bar in terms of asset quality.
"Are the buyers buying because this is a company they’d like to own a piece of for years? Or are they merely betting that the price will go up?" Marks asks.
If it's the latter, what you're really doing is betting on two things: the quality of a stock and trends in popularity.
"Wanting to own a business for its commercial merit and long-term earnings potential is a good reason to be a stockholder, and if these expectations are borne out, a good reason to believe the stock price will rise," Marks says.
"In the absence of that, buying in the hope of appreciation merely amounts to trying to guess which industries and companies investors will favour in the future."
Short-term performance
If a company releases bad results in a given quarter, its stock will usually be sold off. It's objectively true, therefore, that investors are trading based on this short-term performance.
"Obviously, no one should attach much significance to returns in one quarter or year," says Marks.
"Investment performance is simply one result drawn from the full range of returns that could have materialised, and in the short term, it can be heavily influenced by random events."
It's much better, in Marks' view, to too at performance over the long term.
"Deciding whether a manager has special skill – or whether an asset allocation is appropriate for the long run – on the basis of one quarter or year is like forming an opinion of a baseball player on the basis of one trip to the plate, or of a racehorse based on one race," he says.
Volatility
Protecting yourself from volatility shouldn't be viewed as a free lunch.
"Reducing volatility for its own sake is a sub-optimizing strategy: It should be presumed that favouring lower volatility assets and approaches will – all things being equal – lead to lower returns," Marks says.
He uses a bond yielding 8% as an example of this. Yes, you'll be assured an 8% yield until the note matures, but you're also investing, at least in part, in the fact that the market won't return more than this in the future.
"Volatility is just a temporary phenomenon (assuming you survive it financially), and most investors shouldn’t attach as much importance to it as they seem to," Marks explains.
Hyper-activity
Investing is probably the one area where laziness pays off. Well, maybe laziness is the wrong word. Let's go with deliberate inactivity.
Investors in general are a restless bunch. And that's not hyperbole. Market sell-offs gain momentum because investors somewhere are getting scared they'll be left holding the bag.
"Develop the mindset that you don’t make money on what you buy and sell; you make money (hopefully) on what you hold," Marks recommends.
He also notes that too much diversification isn't a good thing. The more stocks you hold, the less consequence to the portfolio each of them has, making them psychologically more tradable.
Indeed, almost all the world's top investors run concentrated portfolios for this reason.
"I’m not saying it’s worth dying to improve investment performance, but it might be a good idea for investors to simulate that condition by sitting on their hands," Marks says.
WHAT MATTERS
Given everything discussed above, it should come as no surprise that the important thing, in Mark's view, is to play the long game.
"What really matters is the performance of your holdings over the next five or ten years (or more) and how the value at the end of the period compares to the amount you invested and to your needs," he says.
Of course, that's easier said than done. Investors are human and get sucked into cognitive biases.
So here are two simple strategic goals to live by:
"Equity investors should make their primary goals (a) participating in the secular growth of economies and companies and (b) benefiting from the wonder of compounding," Marks says.
Then on the tactical level Marks recommends investors:
Study companies and securities, assessing things such as their earnings potential;
Buy the ones that can be purchased at attractive prices relative to their potential;
Hold onto them as long as the company’s earnings outlook and the attractiveness of the price remain intact; and
Make changes only when those things can’t be reconfirmed, or when something better comes along.