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Howard Marks: 4 Routes to Investment Profit

You could use leverage, but should you?

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Aug 02, 2019
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In his book, "The Most Important Thing," value investor

Howard Marks (Trades, Portfolio) identifies four distinct ways to make money in the financial markets.

Benefitting from a rise in an asset’s intrinsic value

In this instance, we assume the security is fairly priced, but gains in value because of some unforeseen shift in the underlying asset - a company releases a new product or enters a new market. This is sometimes known as growth investing - when an investor buys in the belief a company has the capacity to increase cash flows, revenues, sales, profits, etc.

Unfortunately, as most of us can’t see the future, this is very difficult to do. Moreover, if there is a positive consensus around a company, any potential growth will most likely already be baked into the price. This is why cash-burning tech stocks often trade at elevated multiples. That said, Marks believes there are certain sectors in which this model can be applied:

“In certain areas of investing—most notably private equity (the buying of companies) and real estate - 'control investors' can strive to create increases in value through active management of the asset. This is worth doing, but it’s time-consuming and uncertain and requires considerable expertise. And it can be hard to bring about improvement, for example, in an already good company.”

Applying leverage

Using leverage - investing with borrowed funds - is a double-edged sword. If your calls are correct, you stand to increase your money many times over, but if you are not, you risk financial ruin. Magnified gains, magnified losses. As Marks points out, it doesn’t actually increase the probability of a gain - just the potential payoff or loss. Moreover:

“It introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are depressed.”

I believe this to be the central problem with using leverage for value investors. Buying distressed securities at times when no one else wants them requires a high degree of certainty and belief in your decisions, which may not be shared by your lenders who, after all, have their own risk parameters. Therefore, you may be forced to close out a leveraged position before the tide turns in your favor.

Selling for more than an asset is worth

It’s always great to be in a position where someone wants to buy from you at an inflated price. Market exuberance, however, is not something that can be predicted or counted on and, therefore, cannot be part of a consistent strategy. Furthermore, investing in securities just for the purpose of flipping them to the highest bidder is a sure-fire way to get sucked into a bubble:

“Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.”

Buying for less than intrinsic value

This is the strategy Marks ultimately thinks is the only dependable one. If you are able to accurately assess the intrinsic value of an asset, purchase it at a price well below that value and have the emotional fortitude (and capital) to hold it for as long as it takes for the price to recover, then you will have achieved investment profit. That said, even this does not always work:

“Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, "The market can remain irrational longer than you can remain solvent.'”

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