Howard Marks | Learn From The Best
Uncommon Sense For The Thoughtful Investor
Howard Marks, the ultra successful American investor who is worth an estimated $2.2bn (as at 2022), is known for his insightful investment memos, which are widely read by those seeking the secret of his success.
There is much that we can learn from his unconventional wisdom and I try to capture some of it in this article. Marks’ philosophy, as he describes it, is broken down into six parts:
Risk Control ~ It isn’t difficult to make money in the market, especially in good years, and most years are good years. The challenge requiring real skill is to make money with the risk under control so that when a bad year arrives, you aren’t hit too hard and you fare better then others. This, Marks believes is the secret to running a successful investment fund.
Consistency ~ It is better to have consistently slightly better than average returns year after year, than it is to have big wins followed by big losses.
Exploiting Market Inefficiency ~ This represents low hanging fruit and depends upon strength of character and contrarian thinking.
Specialize Within Your Circle Of Competence ~ Why try to compete on a basketball court when your skill and expertise is playing hockey? You can’t be good at everything, so expend energy where it will be most productive.
Never Rely On Macro Forecasting ~ Economists are wrong more often than not and black swan events are more frequent than most imagine.
Avoid The Timing Trap ~ Time in the market is better than timing the market.
This short article will not delve into all of these factors, but will focus on two of the most important:
Risk Management and Patience
Contrarian Thinking
Risk Management and Patience
Marks points out that most players in the market are dazzled by the prospect of making a fast buck and this blinds them to the risk that they are exposed to. He argues that investors should always be cognizant of the risks that they are taking, but suggests that they rarely are.
He goes on to say that investors should always have a plan for how they will deal with risk and, more particularly, how they will deal with the happening of a risk event. If the investor has an investment thesis based on a set of assumptions, and one or more of those assumptions proves to be flawed, what will the investor do? He points out that most investors don’t even consider such things and so they are entirely unprepared to pivot if circumstances change.
Conventional economic theory suggests that we measure risk as volatility, the standard deviation of a stock price. But Marks argues that this is not the risk that an investor faces. The real risk is the permanent loss of the investor’s money.
Riskier investments are those where the outcome is less certain. Risk means more things can happen than will happen. Standard deviation doesn't tell you anything about that. So Marks argues that conventional economic theory is itself flawed.
Managing risk is priority number one. So the first thing that we learn from Marks is not to risk losing money by seeking outsized returns. It rarely ends well.
This is perfectly aligned with Warren Buffett’s two golden rules:
Rule #1 ~ don’t lose money
Rule #2 ~ don’t forget rule number one
“If you want to avoid high risks, you have to be willing to accept lower returns. Investing is not about beating the market. It's about controlling risk. If you can do that, you'll be a successful investor.
The best foundation for above-average returns is the absence of disaster. While most people seek phenomenal returns that outshine every other investment, a little above average is the secret.
Investing is a long-term game. It takes time to build wealth. Don't expect to get rich quick. Be patient and disciplined, and you will eventually be rewarded."
“Prioritize the downside of every investment. With limited downside, the upside will take care of itself.”
Howard Marks
Interestingly, Marks argues that it is important to have a diversified portfolio and to be prepared to sell assets when they become overvalued.
This is a very different approach to that deployed by Warren Buffett who believes in a concentrated portfolio and holding stocks for the long term regardless of market price. Buffett sees a holding in a listed company in the same light as ownership of a private business. He doesn’t allow himself to be unduly influenced by the often irrational behaviour of participants in the market which manifests itself in price swings either side of fair value.
I prefer Buffett’s approach of concentrating a portfolio over diversification, but I prefer Mark’s approach to not holding on to an investment for too long. I shall deal with each of these in turn.
(a) Diversification Strategy
In a 2014 interview, Buffett said, "If Charlie Munger and I think we have an edge, we should be concentrating our bets. We should be putting all our eggs in one basket and watching that basket very carefully."
Munger has made similar comments, saying, "I think diversification is a protection against ignorance. If you don't know what you're doing, then you should probably diversify. But if you do know what you're doing, then you shouldn't be afraid to concentrate your bets."
Buffett and Munger have said that there are very few wonderful companies out there. Most are mediocre at best, either due to poor unit economics, poor management or both. As such, when one stumbles across a great investment opportunity it is wise to swing hard.
In his 2023 shareholder letter he stated “In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so... Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years.”
If good opportunities are so few in number, it is wise to bet heavily when they arise.
In a 2007 interview, Buffett said, "If you can identify six wonderful businesses, that is all the diversification you need and you're going to make a lot of money. Why put money into your tenth favorite idea instead of allocating capital to your first favorite idea?"
It is very difficult to argue against this logic unless you are a poor sniper and so default to a scatter-gun approach to hunting for investments. If this is indeed the case, you may be best advised to trust someone else to look after your money.
(b) Hold Forever Strategy
One of the advantages of investing in a publicly listed company is that such investments come with the benefit of a liquid market. So why not exploit that benefit? Exiting an investment is quick and easy to achieve.
Consider this: between 1988 and 1994 Buffett accumulated a stake in Coca-Cola KO 0.00%↑ that cost him a total $1.3 billion. Berkshire’s position in Coca-Cola at the end of 1998 was valued by the market at $13.4 billion. That’s over a 1,000% return. Not bad in a decade!
Coca-Cola had grown in value to such an extent that in 1998 it accounted for 40% of Buffett’s stock portfolio, how’s that for concentration? The problem was that it was trading for nearly 50x earnings. If there had ever been a time to sell his stake in Coca-Cola, that was it. But Buffett didn’t sell. He still holds that position today.
All of the gains in the first decade of ownership have been diluted down. Multiple contraction from 50x to 25x, together with little business growth, yielded a mediocre result for what was by far Berkshire’s largest holding - a compound annual growth rate (CAGR) of 8.5% over a 30+ year period doesn’t look so impressive.
The moral of the story is that there is nothing wrong with concentration risk, but holding a position for too long is rarely the right move. So why did the Sage of Omaha not sell?
Buffett didn’t make a mistake by not selling, but had it been you or me, it would have been a mistake not to sell. Confused? Allow me to explain.
Buffett knew that Coca-Cola was vastly over priced in 1998. In fact, the entire Berkshire Hathaway stock portfolio was over priced. The problem that Buffett faced was that crystalizing the gain would have given rise to a huge tax liability running into the billions. He didn’t want that kind of capital bleed on the equity of Berkshire Hathaway. So what he did was pure genius.
Since the entire stock market was over priced in 1998, so too was Berkshire Hathaway stock. He knew that it was worth close to parity to book value, but it was being priced by the market at circa 3x book. So Buffett took a page out of the Henry Singleton playbook and used his over priced stock as currency to acquire Gen Re. By doing so he achieved a wonderful pivot. He acquired a great Gen Re business together with its huge fixed income portfolio. He avoided the need to pay tax by effectively swapping his over priced equity for something that had a more attractive valuation. Genius.
Unfortunately, as individual investors operating on a smaller scale than Warren Buffett, this kind of strategy would never work for you and me. So while this approach worked well for Berkshire Hathaway and it explains why Buffett didn’t sell his Coca-Cola position in 1998, if you or I had held Coca-Cola stock between 1988 and 1998, selling at the end of that decade would have been the correct thing to do.
So Howard Marks is absolutely correct, but Buffett was not wrong!
Contrarian Thinking
Marks graduated from Chicago in 1969 and went to work for Citigroup. Eventually he found himself in the bond department of Citibank where he was asked to figure out the high yield bond market and to start a fund.
While studying Marks had been indoctrinated with academic nonsense such as the efficient market theory. For those not familiar with it, essentially it states that asset prices reflect all available information and so those prices reflect the true value of the asset.
Most of what we learn while in academia we need to unlearn in the real world and the same was true for Marks.
He made some astute observations and discovered a dichotomy in the market. On the one hand the Moody's Manual defined high yield (B-rated) bond as “fails to possess the characteristics of a desirable investment”. Moody’s were effectively stating that these bonds are not suitable investments, regardless of price. How could that be? On the other hand, Marks observed that the darling stocks of the time, known as the Nifty Fifty, were considered to be the best and fastest growing companies in America and were so good, that there was no price too high. Many were being capitalized at between 60x and 90x earnings. It was almost as though the market assumed that nothing bad could ever happen to these companies. That was patently wrong because from their 1972–1973 highs to their 1974 lows, Xerox fell 71%, Avon 86%, and Polaroid 91%.
Marks knew that price mattered. He had no interest in putting money into overpriced stocks, but was perfectly happy allocating capital to underpriced debt.
He was interviewed on a financial TV show in the early 1980s and the anchor asked “How can you buy these low grade bonds?” Marks responded by stating that the most conservative companies in America, life assurance companies, invest in the knowledge that every one will die. Investing is a probabilistic endeavor. It is all about risk adjusted returns and so any risk, at the right price, would make a good investment. The point was well made.
This was a pivotal moment for Marks. So while the rest of the professional investment community shunned high yield bonds (perhaps on the advice of Moody’s), he effectively had the market to himself. It was like shooting fish in a barrel. He found value hiding in plain sight, and so it was relatively easy to make good money.
This is contrarian thinking at its best. The lesson is not to follow the herd. Be different.
Marks believes that investors should understand the psychology of the market. He argues that markets are often driven by emotions, and that investors who can understand these emotions will be better able to make successful investment decisions.
Marks points out that most investors are irrational and lack any understanding of the psychology of the market. He goes further and suggests that they neither possess the requisite skills nor the expertise to succeed. They get overexcited and frustrated in equal measure and this results in making poor decisions which prove costly.
He suggests that most investors, both retail and professional, lack confidence in their own ability (primarily due to their investment ineptitude) and so seek confirmation from the market. This results in a herding mentality where they all follow like sheep.
This is particularly pertinent to today’s investment mentality. Consider those that jump into crypto-currency because so many others on social media appear to be doing it. Think about investors (I use this term in the loosest possible sense because they are better classed as speculators) and the day traders who base their decisions entirely on momentum, which is blindly following the herd. Last, but by no means least, what about passive investing? It is now larger than active investing and is all about allocating money based not on fundamentals, but based on what others are doing.
Understanding psychology is important and it often trumps simply running numbers.
Investing is the activity of forecasting returns over the life of an asset; speculation is the activity of forecasting the psychology of the market. Most people are concerned, not with making superior long-term forecasts of the probable yield of an investment, but with foreseeing changes in the market price a short time ahead of the general public. They are concerned, not with what an investment is really worth as a business, but with what the market will value it at, under the influence of mass psychology, tomorrow.
The best investors are contrarians. They think for themselves and make their own decisions. They understand businesses and hold for the long term.
“Investing is not a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.
Buy when others are selling and sell when others are buying… don't follow the crowd.”
Howard Marks