If you had to choose a handful of letters to hone your value investing skill set, Howard Marks would easily fall near the top of our list. His most recent piece is no exception. We’ve attached it in full along with some of our favorite quotes (accompanied by various illustrations) which should prove to be timely as this bull cycle gets progressively longer in the tooth.
High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.
One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)
But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.
There’s nothing more risky than a widespread belief that there’s no risk . . . and, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
I recite all of this because I have no doubt that investors are making substantial movement back in the same direction . . . In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.
There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason . . . But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.
In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.
If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.
I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.
Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasuries or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.
Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.
Prudent Behavior in a Low-Return World
- Go to cash – not a real alternative for most investors.
- Ignore the lowness of absolute returns and pursue the best relative returns.
- Forget that elevated prices might imply a correction, and buy for the long run.
- Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
- Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.
Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:
- the so-so U.S. recovery;
- the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
- the economic impact of deleveraging and austerity;
- the over-indebtedness of peripheral eurozone countries;
- the possibility of rekindled inflation and rising interest rates;
- the uncertain outlook for the dollar, euro and sterling; and
- the instability in the Middle East and resulting uncertainty over the price of oil.
With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right.
We have a hard time finding anything to disagree with in Mark’s most recent letter and look forward to reading his most recent book.