Howard Marks (Trades, Portfolio), Chairman of Oaktree Capital, is one of my favorite thought leaders in investing. I finally realized why - it's because with my background in gambling, I've always gravitated towards how he frames investing questions. Turns out he is an avid gamer. His latest memo is a lengthy and a winding discussion of his personal love of games, from gin and backgammon to poker and blackjack:
"Success in gambling doesn’t go to those who pick winners, but to those with the ability to identify superior propositions. The goal is to find situations where the odds are generous to one side or the other, whether favorite or underdog. In other words, a mispricing.
It’s exactly the same in investing. People often say to me, 'XYZ is a great company with a bright future, so I bought the stock.' They’re picking a favorite but ignoring the proposition. The former alone isn’t enough; they should consider the latter as well."
Marks goes into the entire gambling vs. investing thing because he wants to talk about dealing with uncertainty and unknown data within a framework that is easily relatable. But the underlying message of his memo that I enterpreted was this: the market may be flying up, but that doesn't mean it is the wrong move to be cautious.
:While in investing we generally aren’t offered explicit odds, the attractiveness of the proposition is established by the price of the asset, the ratio of the potential payoff to the amount risked, and what we perceive to be the chance of winning versus losing."
There's also the matter of time, and I believe it is also fairly important how the payout ultimately materializes. A steady stream of small payouts is different from sitting through years of torturous declines to be rewarded at last with a massive payout.
"Superior investors may be superior because they can figure out which companies are likely to be winners. But the best investors I know also have a sense – perhaps innate and instinctive – for situations where the proposition is too favorable relative to the underlying fundamentals. It might be a company whose securities are cheap enough to more than compensate for its poor prospects, or one where the future is exceptionally bright, but its securities aren’t priced high enough to charge fully for that potential."
Anyone can figure out which companies are likely to be winners of the future. If you just pick the ones with growth and high multiples you should do well. However, making money on those is one of the hardest things there is. A successful growth investor is a true unicorn.
"In May 1968, when I showed up at First National City Bank for a summer job in the investment research department, the bank (and many other banks) invested primarily in the “Nifty Fifty.” These were considered to be the best and fastest-growing companies in America: companies so good that there was “no price too high.” And if you bought those stocks the day I arrived and held them firmly for five years, you lost almost all of your money . . . investing in the best companies in America. All the companies were considered future winners. Some actually were, but far from all. (What happened to Kodak, Polaroid and my favorite, Simplicity Pattern?) The proposition was wrong: they were priced as if they couldn’t lose, and it turned out several would."
Except this doesn't always turn out to be the case. Sometimes the highest priced growth companies are merely expensive while lacking any special sauce. I'm thinking of you, WeWork, Uber (UBER) and Tesla (TSLA, Financial). Often the companies are winners and are still around decades later, but their investors aren't necessarily winners.
Then, in 1978, I switched to Citi’s bond department, and I was asked to start a high yield bond fund. Now I was investing in the bonds of the worst public companies in America – all rated speculative grade, or “junk.” And I was making good money safely and steadily. Not because the companies were flawless – in fact, about 4% by dollar amount would go on to default each year on average – but because “the price” was too favorable to those who bet on them.
One of the reasons I really like Marks is because his investment philosophy is very much in alignment with mine. We both like to buy deeply undervalued securities and don't mind if they aren't representative of the best businesses in the world.
My first investment ever back in the late 90's was in mutual funds with a China focus. This did not work at all because everyone knew that China was booming and growing. This was all in the price. In other words, the multiple I paid was too high.
"And because popular opinion was stacked so heavily against high yield bonds, those who invested in them received excessive compensation for taking the associated risk: the proposition was too good. Moody’s defined a B-rated bond as one that “fails to possess the characteristics of a desirable investment.” In other words, Moody’s panned those bonds because they were underdogs but never asked about the price. It’s usually non-objective, too-positive or too-negative attitudes like these that give rise to propositions that are too good or too bad for the takers. That’s what we should search for as investors."
It is the non-objective, too-positive or too-negative attitudes that we need to search for. Areas that come to mind for me are energy, with fossil fuels very much out of favor, because the sector hasn't made a lot of money for a long time. Financial services are another. It is not a coincidence value investing portfolios are loaded with these. Trophy real estate, communication services, consumer cyclicals and companies masquerading as tech companies, like Tesla (TSLA, Financial), come to mind as overly positive on investor sentiment.
Disclosure: author is short TSLA
Read more here:
- Bill Miller Sees Stocks Going Higher in 2020
- David Rolfe Makes an Interesting Case for Alphabet
- Gundlach: The Long-Term Vallue Is in Emerging Markets
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