In previous chapters of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” Howard Marks (Trades, Portfolio) explained how to capitalize on cycles and swings of the investing pendulum.
But, as he acknowledged in chapter 13, the market isn’t always prepared to offer the buying opportunities that come at the peaks. For value investors, that is.
Most of the time, the market is between peaks, making it necessary to be relatively inactive. That’s why he recommended waiting for bargains, or “patient opportunism” as he called it. An associated recommendation is that investors wait for investments to come to them, rather than chasing after them. According to Marks, the professionals at his firm try to make a practice of sitting on their hands—to wait for those who are motivated to sell.
This approach also means investors must accept what’s given to them at any point in time. At most of those times, assets such as stocks are fairly priced, rather than clearly overpriced or underpriced. So there are few, if any, bargains available. Given that, Marks recommended investors recognize the market for what it is and act accordingly.
As he often does in this book, Marks turned to the words of Warren Buffett (Trades, Portfolio). The latter famously discussed the career of baseball great Ted Williams in Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) 1997 annual report. Williams broke down the batting zone into 77 baseball-sized cells and had his best results when he received a pitch in the cells he designated as his “sweet spot.” But he didn’t always get the pitches he wanted and, to avoid striking out, had to swing at less desirable pitches.
Investors, Buffett emphasized, were spared that problem. They could not be struck out by watching pitches fly by. Investors are under no pressure to act. They can watch many opportunities go past before they act:
“Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.”
Note the phrase “no penalty except opportunity,” which refers to the opportunity cost of not acting. In most cases, though, the opportunity cost will be less than the cost of a bad or mediocre investment. While that’s true for individual investors, it isn’t necessarily true for investment managers with impatient clients.
In any case, patient opportunism means investors refrain from buying until they find a “profit with controlled risk” situation. Give emphasis to the “controlled risk” portion of that statement, since many investors do find themselves out a limb because they looked for “profit” without fully considering the “risk” necessary to earn that profit.
In the world of bond investors, this is known as “reaching for yield” or “reaching for return.” As yields on safer bonds decline, investors try to maintain their returns by taking new and riskier positions—often without knowing what they’ve done.
Before the credit crisis, for example, investors got caught up in a leverage crisis. They borrowed (shorted) cheap, short-term funds. The money earned by shorting was then used to buy assets with higher returns—higher because they involved a lack of liquidity or increased risk. According to Marks, institutional investors from all over the globe took up these “silver bullets.” They were called silver bullets because they should have provided high returns with low risk thanks to securitization and structure.
That was the theory, but "as usual, the pursuit of profit led to mistakes. The expected returns looked good, but the range of possible outcomes included some very nasty ones.” And, as we know, the silver bullets did work for a few years, but the “nasty ones” prevailed and blew up. The problem was investors were trying to pursue high returns in low-return environments.
He also wrote, “When prices are high, it’s inescapable that prospective returns are low (and risks are high).” What, then, is an active investor to do? Marks offered these solutions:
- “Invest as if it’s not true”: This might be called the “wishing and hoping” solution, because investors are expecting “traditional” returns despite asset prices being high.
- “Invest anyway”: Accept more modest returns until bargains become available.
- “Hold cash”: As he noted, this is hard, especially for fund managers who could lose their jobs for not having all their capital at work.
- “Concentrate your investments in special niches and special people”: This isn’t easy either.
In other words, there is no simple solution for investors who want more than average returns. Or, “the investment environment greatly influences outcomes. To wring high returns from a low-return environment requires the ability to swim against the tide and find the relatively few winners.”
The keys to being able to do this, to be a patient opportunist, are:
- Avoiding the need to be forced into selling; in most cases this means not using any, or little, leverage.
- Being positioned to be a buyer.
To fill out those keys, Marks added:
- Being value focused.
- Minimal or no leverage.
- Capital available for the long term.
- “A strong stomach.”
Finally, he wrote, “Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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