PM Jar Exclusive Interview With Howard Marks - Part 1 of 5

“Investing is an art form. Take the hundred greatest painters, their paintings look nothing alike. The definition of great is not uniform.” When asked about the art on the walls, he answers he is not a collector, merely an admirer. There’s no corner office with custom or museum-quality furniture. There’s no glaring display of power or wealth. Yet the scent of importance and influence is most definitely present, only subtly so. Accepted and balanced, not flaunted.

Here is a thoughtful and reflective man who is acutely aware of himself and his environment. Here is a man who has been called ‘Guru to the Stars’ by Barron’s, whose admirers include Chris Davis, Warren Buffett, and Jeremy Grantham, and whose firm oversees nearly $80 billion in assets.

Ever gracious and generous with his time, Howard Marks, the co-founder and chairman of Oaktree Capital Management, sat down with PM Jar to discuss his approach to the art of investing: transforming symmetrical inputs into asymmetric returns. What follows are excerpts from that conversation.

Part 1: An Idea of What Is Enough

“I think that having an idea of a goal is something to work for, but it's also important to have an idea of what is enough.”

Marks: The goal of investing is to have your capital be productive. It's to make money on your money. Certain investment organizations – pension funds, insurance companies, endowments – have specific goals and requirements to make a certain amount of money that will permit them to accomplish their objectives. Everybody has a goal, and some are different from others. Some people don’t have a specific goal – they just want to make money.

In 2007, people said: “I need 8%. It would be nice to make 10%. It would terrific to make 12%. It would be wonderful to make 15%. It would be absolutely fabulous to make 18%. 20% would be fantastic.” Whereas they should have said: “I need 8%. If I get 10%, that would be great. 12% would be wonderful. I’m not going to try for 15% because to try for 15%, I’d have to take risks that I don’t want to take.” I think that having an idea of a goal is something to work for, but it’s also important to have an idea of what is enough.

PM Jar: In your book, The Most Important Thing, you wrote that it’s difficult to find returns if they’re not available, and chasing returns is one of the dumbest things that an investor can do. Does an investor’s return goal change with the market cycle or where the pendulum is located?

Marks: You should be cognizant of where you are buying because where you buy says a lot about the return which is implied in your investment. Every time we organize a fund, we talk about the return we can make, which is informed by where we expect to buy things. Consequently, sometimes we think we will get very high returns because we have the opportunity to buy stuff cheap. Sometimes we think we’ll get lower returns because we can’t buy that much stuff cheap. So clearly, different points in time and different positions of the pendulum imply different kinds of returns – not with any certainty, but you should have a concept of whether you are getting great bargains, so-so bargains, or paying excessive prices (in which case, you should be a seller not a buyer).

But we’re dangerously close to confusing two topics. A return goal is what you want, what you need to be successful, or what you aspire to. An expected return is what you think you can make on the things you can buy today – sometimes you should be able to make 5% and sometimes you should be able to make 15% – which may have nothing to do with your desired return or required return. 

Continue Reading -- Part 2 of 5: Real World Considerations  

Howard Marks' Book: Chapter 12

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 12 “The Most Important Thing Is…Finding Bargains” Definition of Investing, Portfolio Management, Position Review, Intrinsic Value, Opportunity Cost

“…‘investment is the discipline of relative selection.’” Quoting Sidney Cottle, a former editor of Graham and Dodd’s Security Analysis.

“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risk involved in each, and of the effect their inclusion would have on the portfolio being assembled.”

The “process of intelligently building a portfolio” doesn’t end with identifying investments, and calculating their intrinsic values and potential risks. It also requires choosing between available opportunities (because we can’t invest in everything) and anticipating the impact of inclusion upon the resulting combined portfolio of investments. Additionally, there’s the continuous monitoring of portfolio positions – comparing and contrasting between existing and potential investments, sometimes having to make room for new/better investments by “selling the lesser ones.”

It’s worthwhile to point out that intrinsic value is important not only because it tells you when to buy or sell a particular asset, but also because it serves as a way to compare & contrast between available opportunities. Intrinsic value is yet another input into the ever complicated “calculation” for opportunity cost.

Mandate, Risk

“Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told ‘Here’s my money; do what you want with it.’”

This type of risk avoidance is a form of structural inefficiency caused by mandate restrictions. It creates opportunities for those willing to accept that particular risk and/or don’t have mandate restrictions. A great example: very few investors owned financials in 2009-2010. Fear of the “blackhole” balance sheet was only a partial explanation. During that period, I heard anecdotally that although some institutional fund managers believed the low price more than compensated for the balance sheet risk, they merely didn’t want to have to explain owning financials to their clients.

Pyschology

“…the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.”

Howard Marks' Book: Chapter 5 - Part 3

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” No commentary necessary - self explanatory and eloquently written.

Definition of Investing, Risk

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.”

Risk, Process Over Outcome, Luck

“Many futures are possible…but only one future occurs…Many things could have happened in each case in the past, and fact that only one did happen understates the variability that existed.”

“In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Nicholas Taleb calls 'lucky idiots,' and in the short run it’s certainly hard to tell them from skilled investors.

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.”

More from Ted Lucas

In this piece, Ted Lucas of Lattice Strategies discusses the relationship between correlation and diversification, as well as the intricate task of building investment portfolios that remain resilient during market drawdowns, yet retain upside participation during bull markets. To explore some of his other writings, they are all archived on Lattice Strategies’ website.Risk, Capital Preservation, Compounding

“But ‘risk management’ on its own is an abstraction, as is ‘beating the market’ over a short time period, if the end goal is to generate a real capital growth over a longer time window…For an asset manager seeking to generate long-term real growth of capital, the design problem is creating a portfolio structure that can both withstand periods of market turbulence and capture returns when they are available.”

Lucas highlights a very real dilemma for all investors: the tricky task of reconciling the goals of capital growth (compounding) with capital preservation. The frequently mentioned “abstraction” of “risk management” is merely a tool available to each investor to be incorporated, if and when necessary, to assist with this task.

Correlation, Diversification

Prior to the financial crisis in 2008, people believed that correlations between asset classes had “decoupled” given new breakthroughs on how risk was redistributed in the financial and economic markets, etc. Investors paid dearly for this assumption when many asset classes (equity, high yield, real estate, commodities, etc.) originally believed to be uncorrelated, all plummeted in value at the same time.

With investors still licking 2008 wounds, the opposite is now occurring. As Lucas writes, “There is much recent discussion about asset correlations rising to such elevated levels that diversification has been rendered useless.”

Correlation of assets/securities has a meaningful impact on the effects of diversification. Afterall, as Jim Leitner astutely points out, “diversification only works when you have assets which are valued differently…” Therefore, if all the assets/securities in your portfolio are highly correlated, diversification would be rendered useless regardless of how many positions you hold.

Lucas believes that investor fear of high asset correlations are overdone. I don’t have enough evidence to either agree or disagree with this view. However, the investing masses have a tendency to project the near-term past into the long-term future, and today’s assumptions about elevated levels of asset correlation could very well be overdone.

Regardless of whether you believe today’s asset correlations are high or low, the takeaway is that your view on future asset/security correlations will (or at least it should) influence your portfolio allocation decisions, because it directly impacts diversification and the volatility profile of your return stream.

Definition of Investing

“Here is a basic idea: the purpose of investing is to grow whatever capital is invested in real terms.”

Howard Marks' Book: Chapter 1

In his recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks of Oaktree writes about a lot of different investment topics. I’ve done my best to lift out relevant portfolio management details. Without further ado, below are highlights from Chapter 1, titled “The Most Important Thing Is…Second-Level Thinking.” Portfolio Management

“Because investing is at least as much art as it is science, it’s never my goal – in this book or elsewhere – to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.”

Successful investing involves equal parts sniffing out ideas, effective diligence, and thoughtful portfolio management. Marks’ comments may not have been written to pertain specifically to the portfolio management process, but it certainly applies.

It’s difficult to routinize portfolio management since the process differs by person and by strategy. Tug on one side of the intricate web and you change the outcome in several other areas. Portfolio management, like the “investing” in Marks’ words, is an art, not the science – distilled into a perfectly eloquent formula or model as many academics and theorists have attempted to extract. (Ironically, Howard Marks and I were both educated at the University of Chicago.) Art demands some degree of inherent messiness – constant changes, tweaks, paint everywhere. Art, like portfolio management, requires practice, dedication, and reflection over time.

Creativity

“No rule always works…An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.”

“Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.”

Investment performance is ever forward looking. A strategy or idea that’s worked in the past may or may not provide the same success in the future. Marks’ comments regarding the importance of creativity have broad applications – from idea sourcing to the diligence process to portfolio management technique.

Maintaining that creative spirit, staying one step ahead of the competition (sounds oddly like running a business, doesn’t it?) is crucial to generating superior investment returns over the long run.

Definition of Investing, Benchmark

“In my view, that’s the definition of successful investing: doing better than the market and other investors.”

Here, the definition of successful investing depends upon “doing better than” a certain “market” or “other investors.”

In order to “do better” than something, an investor must identify that something ahead of time – whether it be a single market index or a bundle of indices and other competing funds.

We’ve discussed the topic of benchmarks in the past (see benchmark tag). For example, during the Partnership days, Buffett used the Dow as his primary benchmark, but also showed investors his performance against a group of well-known mutual and closed end funds. Some Brazilian hedge funds use the local risk-free-rate as their benchmark.

The point is: your choice of benchmark can vary, just make sure that you’ve at least made a choice.

Lessons from Jim Leitner - Part 3 of 3

Here is Part 3 on the wonderfully insightful interview in Steve Drobny's book The Invisible Hands with Jim Leitner, who runs Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 3 of a summary of those thoughts (please also see Part 1 and Part 2). I would highly recommend the reading of the actual chapter in its entirety.

Definition of Investing

“Investing is the art and science of extracting risk premia from financial markets over time.”

Risk, Preservation of Capital, Volatility

The risk management process starts with what you buy and how you structure those “themes and trades.” Jim manages his portfolio with a particular focus on the downside, where he “never wants to lose more than 20 percent and structures his portfolio to make sure that under no possible scenario can he ever exceed this loss threshold.”

People have a tendency to spend “more time thinking about returns than about how to manage downside risk. The investment process seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”

Jim gives a number of reasons why it’s important to preserve capital and limit downside volatility.

1. Psychological – the emotional damage and potential impact on decision making, associated with large losses even if they’re unrealized or not permanent. He talks about not being willing to lose more than 10% in any given month, no more than 20% in any given year – these figures were determined based on personal “psychological recognition.”
2. Career Risk – investors and bosses may not care that your losses are unrealized or not permanent
3. Negative Compounding – After a drawdown, the law of mathematics makes it an uphill battle to get back to even. For example, when an investor is down 40%, it means he/she would need to make 67% to breakeven. This doesn’t account for any cash outflows/redemptions, which makes it even more difficult to get back to breakeven $ wise.

“While I am not sure what my focus on truncating downside risk has cost me over time in terms of lost opportunity, I am certain that I have not maximized return. But at least I can be sure that I will be around for future opportunities.”

Diversification

As a part of his process, he tries to identify crowded trades, securities, assets, “even portfolio approaches” because “…diversification only works when you have assets which are valued differently…If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”

Lesson from 2007-2008: “At the beginning of this period, all risk assets were no longer cheap. There was no real diversification in owning a portfolio of overvalued assets. This is the true lesson. Overvaluation becomes a risk factor that must be addressed directly in portfolio construction.”