Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 8 “The Most Important Thing Is…Being Attentive to Cycles”

When To Buy, When To Sell

“Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”

“Cycles are self-correcting…because trends create the reasons for their own reversals. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.”

“…every decade or so, people decide cyclicality is over. They think either the good times will rool on without end or the negative trends can’t be arrested. At such times they talk about ‘virtuous cycles’ or ‘vicious cycles’…‘this time it’s different’…should strike fear – and perhaps suggest an opportunity for profit…it’s essential that you be able to recognize this form of error when it arises.”

Curiously, why is “every decade” the magic number?

Expected Return, When To Buy, When To Sell

These cycles at their core are driven by return expectations – correct and incorrect:

The economy moves into a period of prosperity.
Providers of capital thrive, increasing their capital base.
Because bad news is scarce, the risks entailed in lending and investing seems to have shrunk.
Risk averseness disappears.
Financial institutions move to expand their businesses – that is, to provide more capital.
They compete for market share by lower demanded returns…lower credit standards, providing more capital for a given transaction and easing covenants.

As the Economist said… ‘the worst loans are made at the best of times.’ This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital. When this point is reached, the up-leg described above – the rising part of the cycle – is reversed.

Losses cause lenders to become discouraged and shy away.
Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
This process contributes to and reinforces the economic contraction.

Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.