I’m a big fan of Howard Marks (Trades, Portfolio) - he has had a very successful track record as an investor, his memos are well-written and numerous and he makes frequent appearances at conferences and industry events, giving other investors the opportunity to learn from his experiences. Here are two points that are central to his investing philosophy.
No trend goes on forever
Most things are governed by cycles - the economy, businesses, markets and really anything else that involves human beings. And yet, people forget this simple fact. They think trends will continue to move forever in one direction. Marks believes the biggest mistakes that investors make happen in exactly these kinds of situations. For instance, if things are getting better and stocks rise as a result, investors tend to extrapolate that trend out far further than it can realistically go.
Marks has used the example of the Arab oil embargo of 1973, when members of the Organization of Petroleum Exporting Countries halted the sale of crude oil and its derivatives in retaliation for Western support of Israel during the Yom Kippur War. During this crisis, oil prices jumped from around $3 per barrel (around $21 per barrel when adjusted for inflation) to around $12 per barrel (around $55 per barrel, inflation adjusted) - a 400% price increase! Plenty of people expected that trend would continue indefinitely, but what actually happened was a stagnation in the commodity price that lasted until the end of the decade.
Risk and safety have nothing to do with asset quality
If you ask an average Joe to describe what a "safe" stock investment looks like, they will probably refer you to a list of well-known companies. To the average person, the idea of investing in Apple (AAPL, Financial) or Coca-Cola (KO, Financial) seems a lot more appealing than purchasing the shares of some unknown Midwestern utility provider. Marks points out that such a point of view is wrong. For investors, "risk" is not determined by how well known the business in question is; rather, it is determined by whether the price of the asset will go down in value. To quote Marks: "There is no company so good that any price is right."
In fact, buying expensive businesses is a sure-fire way to incinerate your own capital. As we established earlier, trends tend to run out of steam at some point, meaning that an expensive business is more likely to become cheaper than more expensive. You run the very real risk of capital loss, as well as the opportunity cost of having your money tied up in a losing stock (assuming you do not cut your losses).
Marks believes in this dictum so strongly that his entire investment approach is centred around distressed debt. In other words, he goes out of his way to find the most beaten-down companies, staying well away from "quality" businesses, because quality is sometimes not a good thing.
Disclosure: The author owns no stocks mentioned.
Read more here:
- A 1924 Economist Explains Why Warren Buffett’s Berkshire Hathaway Doesn’t Pay Dividends
- Seth Klarman: First, Don't Lose Money
- Warren Buffett and the Problem of Executive Compensation, Pt. 2​
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