Howard Marks is chairman and a a co-founder of the investment firm Oaktree Capital which specializes in distressed debt and has around 100 bn $ of assets under management. He is a true grandmaster when it comes to investment philosophy. His legendary memos to Oaktree clients are a must read for financial professionals. «When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something», says none other than Warren Buffet.
Marks is especially interesting when commenting on risk and risk management and the necessity to understand the risk/reward equation.
I post some excerpts here but the full article is worth your time.
- We’re in a very strange market. Most people are doing a good job of thinking and the consensus is not necessarily wrong today. On one side, the world is a very uncertain place and I think the average investor understands that. Most people are sober and sensitive to all the uncertainty. You don’t see many people who are massively bullish. Nobody is saying stocks are going to the moon.
- Security prices are not low. I wouldn’t say high, but full. So people are thinking cautiously but they’re acting bullish and they’re behaving in a pro-risk fashion. While investor behavior hasn’t sunk to the depths seen just before the crisis, in many ways I feel it has entered the zone of imprudence.
- (…) [investors] are forced to be buyers by the central banks.
- Most people think that there is a positive relationship between risk and return: If you make riskier investments you can expect a higher return. That’s total nonsense! Because if riskier assets could be counted on for higher returns than they wouldn’t be riskier. The reality is that if you make riskier investments you have to perceive that there will be a higher return or else you have no motivation to make that investment. But it doesn’t have to happen: If you increase the riskiness of your investments the expected return rises. But at the same time the range of outcomes becomes greater and the bad outcomes become worse. That’s risk and that’s what people have to think about.
- [the rising spreads on high yield bonds is] a good thing. If you’re a buyer you would rather buy at a high risk premium than on a low one, everything else being equal. Maybe the onrush of money was too strong, maybe the attitudes were too optimistic. Now people are a little more worried, especially since they already had a little bad experience in Ukraine, in Greece and in China over the summer.
- The riskiest thing in the world is the belief that there is no risk. When people think there is no risk, they do risky things. By contrast, when people think there is risk than they behave in a safe manner and the world becomes a safer place. That’s why I welcome the recent developments. They remind us that today the risks are substantial and they should be undertaken only with considerable forethought. My dad used to tell the story of the gambler who went to the race track and said: “I hope I break even because I need the money.” The market is not an accommodating machine. It will not go where you want it to go just because you need it to go there. So if you’re talking about money that you can’t afford to lose then you can’t say: “Just give me the highest yield.”
- In the United States, we had seven years of super low interest rates to try to stimulate. That has never happened before. What are the long term effects on the economy? What’s the effect on lending behavior? And, how will that go now that the Fed has started to raise rates? What will that do to the world? The answer is very simple: We don’t know. And anybody who thinks he knows is kidding himself.
- Everybody would like to know what’s going to happen a year from now. What the economy, interest rates, exchange rates, earnings and all that stuff is going to. But it’s very, very hard to know. My favorite quotation on this subject comes from the economist John Kenneth Galbraith: “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”
- The most important thing to do is to assess not the future but the present. Awareness and understanding of cycles is an essential tool for investment survival. That’s why I always say: “We may never know where we’re going, but we’d better have a good idea where we are.”
- There will always be cycles and that means there will always be a recession coming. But is it one year away or five? That’s the question! I think we’re going to limp along in a slow growth mode. There is always a possibility of some acceleration. But there is no boom so there is no need for a bust. Booms usually create overexpansion and when it turns out that it was excessive it turns into a bust. Today, I don’t see boom and I don’t see bust. So I don’t see anything that could cause a recession in the short term, at least not in 2016 – and I’m not characterized an optimist.
- if you need a culprit for a future recession in the US then it’s likely China will contribute.
- For me, the definition of a great investor is one who performs well in the good times and doesn’t get killed in the bad times. In other words: When the tide goes out he’s prepared because he has a margin of safety in his portfolio. (…) That would describe a terrific money manager: Consistent and not too much excitement, no big ups and downs – and that’s what we try to do at Oaktree Capital.
- you have to think different from the crowd because if you think the same you act the same and you perform the same. That’s what I call second level thinking. A first level thinker says: “It’s a great company so I should buy the stock”. In contrast, the second level thinker says: “It’s a great company. But it’s not as great as everybody thinks so the price is too high and I should sell.”
- I don’t see things that are dirt cheap or crazy high, except the possibility of social media stocks and technology IPOs. But other than that I don’t see anything glaringly wrong. I just think the whole world is priced for a better future than we have.
- The outlook today is not so bad and prices are not so high that they demand complete caution and defensiveness. But at the same time prices are not so low and the outlook is not so good that we should be aggressive. So our strategy is not maximum defensiveness, not aggressive. It’s somewhere in between, but with a significant emphasis on caution. And that means you have to select your investments carefully.