We Study Billionaires - The Investor’s Podcast Network - TIP497: Lessons from Billionaire Howard Marks

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to The Investors Podcast. I'm your host, Clay Fink. And on today's episode, I'm going to be doing a deep dive on Howard Marks' book, The Most Important Thing. I'll be covering some of my biggest takeaways I had from going through his wonderful book. Howard Marks is the co-founder of Oak Tree Capital, which has 159 billion in assets under management. Studying from a fantastic investor like Howard reminds me of how much I don't

Starting point is 00:00:30 know as an investor, and that the world is very uncertain and unpredictable. In a world that's ever changing, it's important to have the humility to challenge your own beliefs and continually upgrade our level of thinking. During this episode, I'll be discussing some of the biggest lessons I learned from reading Howard's book, The Most Important Thing. More specifically, I'll be talking about the role of psychology in markets, how Howard thinks about the efficiency of markets, the role market cycles play in Howard's investment strategy, why he only looks for bargains when investing, how Howard thinks about investing in a low interest rate environment, why we should put an intense focus on investing defensively, and why trying to predict where the macroeconomy

Starting point is 00:01:12 is heading is a fool's errand. I've really enjoyed reading Howard's book as I learned quite a bit from his thoughtful insights on investing intelligently. With that, I hope you enjoyed today's episode covering the investing wisdom of billionaire Howard Marks. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Starting point is 00:01:46 What is the most important thing in investing? This is the question that Howard Marks, would be challenged with when investing for clients and developing a philosophy, except there is not just one thing when it comes to investing. There is a multitude of different things that are really important, and if we misassess any of them as investors, then we run the risk of having suboptimal outcomes in the end. As Mark states, quote, successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit anyone, and the result is likely to be less and satisfactory."

Starting point is 00:02:26 In quote. Marx also states that his book isn't a step-by-step guide for learning how to invest, but rather a book that covers the investment philosophies that he uses in his own process. The ideas presented in his book are intended to be timeless in a world that is constantly changing. Ironically, Marx's goal isn't to simplify investing, but rather make it clear just how complex it actually is. Mark says that the most important key to his successful investment career has been an effective

Starting point is 00:02:57 investment philosophy developed and honed over time for more than four decades and implemented consciously by highly skilled individuals who share his culture and values. He also outlines in the introduction the importance of experience in developing that philosophy. Experience is a poor teacher during the good times because we believe that investing is easy and that anybody can make a lot of money in the markets. Now, chapter one in his book is titled Second Level Thinking. I wanted to read the very beginning because I just don't think I could say this any better myself, so here it goes.

Starting point is 00:03:32 Quote, few people have what it takes to be great investors. Some can be taught, but not everyone. And those who can be taught can't be taught everything. Valid approaches work some of the time, but not all. And investing can't be reduced to an algorithm and turned over to a computer. Even the best investors don't get it right every time. The reasons are simple. No rule always works.

Starting point is 00:03:57 The environment isn't controllable and circumstances rarely repeat exactly. Psychology plays a major role in markets and because it's highly variable, cause and effect relationships aren't reliable. 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. Investing, like economics, is more art than science, and that means it can get a little messy, end quote. Note that he said that investing is more of an art than a science.

Starting point is 00:04:32 This is why he isn't going to outline a specific formula or specific method to being a successful investor. Because if the formula was so successful and easy that you could just put it into a book or put it into a podcast episode, it would become widely known and arbitrage by the overall market, thus making it ineffective. To Marx, successful investing consists of receiving a return above that of the market, such as what is achieved through a low-cost index fund, which is really available to anyone and requires no skill or particular insights to achieve that return. The way to outperform is either through luck or through insight, and since luck isn't something we can really rely on, we must develop superior,

Starting point is 00:05:15 insights relative to others. So superior insights are required to earn above average returns, and superior insights really come from what Marks calls second level thinking. First level thinking says that it's a good company. Let's buy it. Second level thinking says that it's a good company, but the market thinks it's a great company and it's not. So the stock is overrated and overpriced. Let's sell it. First level thinking says that, quote, The Outlook calls for low growth. and rising inflation. Let's dump our stocks." End quote. Second level thinking says, The outlook stinks, but everyone else is selling in panic. Buy. First level thinking is so simple, so everyone can do it. Anyone can have an opinion based on first level thinking. Second level thinking

Starting point is 00:06:03 is deep, complex, and convoluted. The second level thinker takes many big ideas into account, such as the range of likely potential outcomes, the most likely of the potential outcomes, the probability that I'm right, how my expectation differs from the consensus, how does the consensus think about the particular asset, etc. Given how complex investing can be, anyone who tells you that it's very simple and that anyone can do it, you should just simply ignore. Those who believe investing is simple probably aren't using second level thinking. Luckily for us, the good news is that the prevalence of first level thinkers increases

Starting point is 00:06:44 the returns available to second-level thinkers. Obviously, in order to beat the market average, we must deviate from the holdings the average person has. And Marx lays out a two-by-two matrix to help show how things shake out for unconventional investors. In the first column, it shows the two outcomes for the average and the conventional investor. For the average investor, a favorable outcome produces average good results, and an unfavorable outcome produces average bad results. Then in the second column for the unconventional investor, it shows that for the favorable outcome, this leads to above average results, and for the unfavorable outcome, this leads to below average results, which is very simple and straightforward.

Starting point is 00:07:28 The unconventional approach really comes down to buying something for less than its worth in the market eventually agreeing with you that the asset was undervalued at the time of the purchase. I'm going to be getting into this later when I discuss his thoughts on looking for bargains when buying a company. Now, Marks does have a chapter on the efficient market hypothesis, so I did want to cover this as well. I didn't want to dive too much into the theory as I think the audience is fairly well versed with what it means. It's not that markets are either fully efficient or fully inefficient. The truth is likely somewhere in the middle. Since the market is largely efficient, it makes investing, you know, really difficult. But there are some inefficiencies for us to have the

Starting point is 00:08:13 opportunity to find them and have the opportunity to beat the market average as well. Given that markets are widely efficient, when you make a purchase based on mispricings in the market, we should consider the following questions. 1. Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that's cheap? 2. If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk. Three, why would the seller of this asset be willing to part with it at a price from which it will give you an excessive return? Four, do you really know more about the asset than the

Starting point is 00:08:53 seller does? And five, if it's such a great proposition, why hasn't someone else snapped it up? Mark says that market inefficiencies are a necessary condition for superior investing, and that attempting to outperform in a perfectly efficient market is like flipping a fair coin, the best odds you can hope for is 50-50. Since markets are largely efficient and Marx realizes that the advantages are to be gained when assets are mispriced and inefficient, this led him to want to put more focus on the relatively inefficient markets where hard work and skill would pay off best. When Mark's co-founded Oak Tree in 1995, the firm largely focused on high-yield debt,

Starting point is 00:09:35 distressed debt, and private equity, which I'll be touching on a little bit later. I also think there is a happy medium we can find between thinking about these theories and hypotheses and utilizing them within our own frameworks. It makes sense that markets are largely efficient, but it's important to remember that markets are made up of humans that are largely driven by emotions such as fear, greed, and envy. And they're also driven by many psychological biases. Because of this, I believe there are times when markets are pretty inefficient and

Starting point is 00:10:08 there are a lot of times where they are efficient. So I guess the point I'm trying to make is that markets are fluid and ever-changing. It's not really black and white. In regards to the efficient market hypothesis, I love this short, made-up story that Marx tells where a finance professor that believes these theories takes a walk with a student. The student notices that there is a $10 bill on the ground, and the professor says, that can't be a $10 bill, because if it were, someone would have picked it up by now. The professor walks away and the student picks it up and goes to buy a beer. And the story reminds me so much of Buffett. He puts in so much work into understanding a great company. Then when the market overreacts to bad news related to the company or the market is just largely ignoring it,

Starting point is 00:10:55 he scoops up a bunch of shares to own, while the efficient market people would rather state that it's simply impossible to beat the market and earn outsized returns. Next, I wanted to transition to talk about Marx's comments on risk. The essence of investing consists of dealing with the future, and because the future isn't certain at any point, then risk is inescapable. Thus, understanding risk and handling risk effectively is essential to being a successful investor. When you're considering an investment, you shouldn't just analyze the potential returns, but also the risk as well. Risk obviously isn't preferred, so if two investments have similar return profiles, but one has more risk, then we'd obviously prefer the investment that has less risk. On the same line of

Starting point is 00:11:40 thinking, the return of a portfolio doesn't tell us whether the investment manager did a great job or not. If a fund manager achieved a 10% return, but only held two stocks, applied leverage, or only invested in microcaps, then a 10% return might not be sufficient for the level of risk that was taken. This would mean that the manager actually did a poor job of allocating capital when taking into consideration the risk that was taken. The theory behind risk and return for an investment is that for a riskier investment to be deemed investable, it must offer prospects of higher returns. So those that believe they don't mind taking on more risk may think that the secret to receiving higher returns is just to simply

Starting point is 00:12:25 increase your risk, and that's really not the case either. If riskier investments reliably produced higher returns, then they wouldn't actually be risked. A better way to think about it is that the future is far less certain for a riskier investment. A high-flying growth company that is growing at 50 or 100% per year, the bull case says that there is so much upside, it will be significantly larger many years down the road. That's what happened to a company like Amazon. They just really never quit growing. The bare case for a high-flying growth company is that because they are growing and there's

Starting point is 00:13:00 a lot of money to be made, this encourages competition to come in. and eat at those profits and try and steal market share. So eventually the growth slows and the optimistic prospect doesn't pan out and the stock price really suffers. You know, the example here is a company like Peloton. Now let's compare the high-flying growth company to something like a 10-year U.S. Treasury. The U.S. Treasury is perceived as less risky because it's extremely likely that you will get your coupon payments that you agree to over the length of that investment. The outcomes are very very certain. Whereas with the high growth company, there is a wide range of potential outcomes. Either it does really, really well and grows for a long time, or the growth stalls and the stock

Starting point is 00:13:44 price goes nowhere or way down, or somewhere in the middle. Now, when looking at a spectrum of all investments we could put money in, you have the U.S. Treasury on the very low risk, highly certain area, and then you have the high-flying growth company, which is higher risk and, you know, wide range of potential outcomes. And then you have all these investments in between where you know, you have your value stocks, your deep value, and your regular growth stocks. So there's kind of a spectrum of risk and return and how certain we can be about the future for all these investments. Mark states that when riskier investments are priced fairly, they should have higher expected returns, as well as the possibility of low returns and in some cases the possibility of losses.

Starting point is 00:14:26 I think a lot of people have been fooled on taking on more risk in their investments without recognizing the potential for really bad outcomes, such as what we've seen with many companies in 2022. In actually defining risk, Marx has the same view as Warren Buffett. While academics view risk purely as volatility, Marx views it as the permanent loss of capital. If you're almost certain that a company is trading below its intrinsic value, then they don't really care too much about the volatility of the investment as long as you have a long time horizon, and you're certain that you won't lose any money if your thesis is correct.

Starting point is 00:15:04 Now, risk of loss does not necessarily come from weak fundamentals. Even the worst companies can make great investments, as we know from studying the early days of Warren Buffett or Benjamin Graham. Another risk with investing is having psychological biases when making the decision to purchase a particular investment. For example, investors tend to believe that exciting stories and stocks that have performed well as of late will continue to be high performance of the future. Many times, the investments that have had the best recent performance are actually the riskiest stocks or companies to own because of the potential irrational exuberance associated with the company or sector. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:19:38 trial today at Shopify.com slash WSB. Go to Shopify. shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. I think the most difficult thing when it comes to risk is how we quantify it. If you ask 10 people what the risk of a particular stock was, you'd probably get 10 different answers. And I think this is a big reason why academia decided to define risk as volatility. And it's because you can just put an actual number on it. While some investors might say risk is your chance of losing money over the holding period, that's practically impossible to quantify. Risk is subjective, hidden, and something we just can't quantify, which can make investing really difficult. Mark says that, quote, skillful investors can get a sense

Starting point is 00:20:32 for the risk present in a given situation. They make that judgment primarily based on A, the stability and dependability of value, and B, the relationship between price and value. Other things will enter into their thinking, but most will be subsumed under these two." This reminds me of the example Nassim Taleb uses in his book, The Black Swan. He uses the example of a turkey that is at a farm. The turkey gets fed day after day. It probably doesn't think its life is very risky. It's got a fence around it, and it gets fed every day, and, you know, there's no predators

Starting point is 00:21:08 to go out and eat it. Then Thanksgiving inevitably comes every year, and the turkeys are taken to the slaughterhouse, So the Turkey's situation was much riskier than it appeared. And the volatility of its day-to-day life wasn't very high, but the risk for its life was actually very high. So I wouldn't say you can necessarily look at past results to see how risky something truly is. To put this into a real-world example like the stock market, I can't help but think of a company like Boeing. Prior to March 2020, Boeing stock was fairly stable and was probably perceived as not very risky to most investors. Then March 2020 hit, and the stock just dropped off a cliff from $340 per share to under $100 per share, a drop of over 70% in just one month.

Starting point is 00:22:01 These Black Swan type events like the coronavirus can show us just how risky some assets might be, and just how uncertain our world really is. This is one reason why I like to have a little bit of extra cash on the sidelines ready to be deployed. Odds are the cash won't end up doing well and gets devalued away slowly by inflation, but if a tail risk event happens, such as what happened in March 2020, then you have the cash available to buy when many people are just for sellers. In March 2020, people were selling assets because they had to, not because they wanted to. This was a liquidity crisis, and during liquidity crises, the dollar becomes extremely valuable

Starting point is 00:22:44 relative to financial assets that people are being forced to sell. In addition to understanding risk, it's also really important to be able to recognize risk. Investment risk comes primarily from too high of prices, and too high of prices often come from excessive optimism and inadequate skepticism and risk aversion. As an investor, it is critical. to be skeptical when analyzing a particular company. Prior to the great financial crisis, people believe that home prices only go up and that the mortgage-backed securities were very likely to pay off. Risk is the highest when people foolishly believe there is little to no risk. Buffett says that, quote, it's only when the tide goes out that you find out who's been swimming naked, end quote.

Starting point is 00:23:33 And it's only a matter of time before the tide stops coming in. After an investor is able to recognize risk, it's critical that they're also able to control and manage risk. The greatest investors have a knack for selecting investments, but an adequate rate of return relative to the risks taken. This might bring them to a portfolio with higher expected returns with a similar level of risk to the market or similar expected returns to the market with lower risk. I don't have much to add in regards to controlling risk. Other than that, risk is a necessary part of investing. If we wanted no risk with investing, we would all just go out and buy U.S. Treasuries and call it a day. But we're here to receive an adequate return as well.

Starting point is 00:24:18 I did want to mention one quote this discussion reminds me of, and it's a George Soros quote. It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong. So I just encourage the listeners to have a good idea of the probabilities and potential outcomes. If the thesis doesn't play out the way you'd expect, what does the downside look like? What do the other scenarios look like for you? If your thesis is correct,

Starting point is 00:24:48 then what does the potential upside look like as well? So you're weighing the probabilities and looking at, okay, what's my best case, what's my worst case scenario, and maybe what's a more middle-of-the-road outcome. Next, I wanted to turn the topic to cycles. cycles. Cycles are so important to understand because when we recognize them, we'll be able to take advantage of them as investors. Eventually, I'm going to be covering Ray Dalio's work. Dallio is someone who popularized the idea of the long-term debt cycle. Marks has a chapter in his book dedicated to

Starting point is 00:25:23 cycles because of the big role cycles play in our overall economy. Markets don't move in a straight line up or a straight line down. They move in cycles. Optimism is followed by pessimism. Companies rise and companies fall. People in human emotions are a big driver of cycles. When people are optimistic about the future, they spend more, they save less, they borrow more, and this all stimulates the economy. Thus, this can push up the prices of stocks, the price of homes, and the price of other assets. And this leads people to feeling wealthier. It's this idea of the wealth effect. And this can be a reinforcing cycle which pushes upwards and upwards and upwards and, you know, creates bubbles. Because things can't be perfect

Starting point is 00:26:07 and good forever, eventually the cycle reverses the other way. People become cautious, they start to save more money, spend less, borrow less. This decrease in spending can lead to the economy contracting and potentially even to a flow of bankruptcies as the economy ends up not being as strong as some anticipated. Marks states that cycles will never stop occurring, in that every decade or so, People will decide that cyclicality is over. They think either the good times will roll on without end or the negative trends can't be finished. At such times, they talk about virtuous cycles or vicious cycles, self-feeding developments that will go on forever in one direction or another,

Starting point is 00:26:49 where people will say this time's different. This bull market's not going to end for quite a while or this bear will never end. He also says that, quote, Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever and vice versa. Instead, it's the opposite that's more likely to be true, end quote. All of this reminds me so much of 2020 and 2021.

Starting point is 00:27:22 Stocks went up so fast after the Federal Reserve provided a massive boost. to the markets, that many people just assume that this could go on for quite some time, and it really couldn't be further from the truth. This isn't to say that we should have known that markets would decline after 2021. We just shouldn't be surprised when they do eventually cool off. When things seem too good to be true, they usually are. Marks also covered six reasons that investors make mistakes and influence market cycles. He says that the biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. He actually stated in his interview with William Green that emotion is the greatest enemy of superior investing. The first emotion

Starting point is 00:28:10 that serves to undermine investors' efforts is greed. The desire for money is fine, as it's a core driver of our economy, but greed can be a dangerous emotion as it can lead to us making irrational decisions. Greed can lead us to pursue strategies that lead us to hoping for high returns while overlooking any of the potential risks. It can also lead us to holding onto an asset that has appreciated tremendously well above its fair value, but we hold onto it because we have that greed that says, you know, further gains are to come. During Howard's interview with William Green again, he says that when you start hearing people say there's no price too high for a particular investment, that is the hallmark of being a bubble. No price too high. That's when you know that the herd is

Starting point is 00:28:59 getting greedy and they're likely overpaying for something they believe is so good that any price is justified. The counterpart to greed is fear. Rather than selling when times are really good, fear is what keeps people from buying when things are really bad. The third logic, Marks mentions is the tendency to dismiss logic, which I believe is tied to both greed and fear. People will naturally dismiss the facts that are right in front of them because their emotions are just so strong they just can't seem to overcome them. Fear and greed are what lead people to believing that no, this time is different than all of the previous times. The 2008 financial crisis was the end, people believed. And it wasn't the time to buy things.

Starting point is 00:29:46 financial assets on the cheap. That's what people thought. In 2021, this was supposedly a new paradigm, you know, the bull market melt up where the COVID winners were only going to grow to the sky. This is what the herd believed. The fourth psychological contributor is the tendency to conform to the view of the herd rather than resist, even when the herd's view is clearly misguided. Whether we like it or not, most people are heavily influenced by what the crowd is doing, especially those that are relatively new to investing, and it takes a tremendous amount of temperament to be able to shy away from the actions of others. The impact the herd can have on our actions really cannot be overstated, because it's likely we've all been influenced by the herd at some point in our journey. I know I certainly

Starting point is 00:30:34 have, and I've definitely learned from those experiences. The fifth psychological influence is envy. Envy is what happens when we start comparing ourselves to others, and people's natural desire is to want more in life. If someone keeps messaging you about the gains they're making in the hot stocks, it is incredibly difficult to simply stick to your own process and investment plan as your peers are buying into the hype and for the time being making a boatload of money. I know this is difficult to overcome because I was somewhat experiencing it myself after COVID. Funnily enough, I know a number of people who made a good amount of money simply by betting on meme stocks at the right time before they really exploded and then crashed.

Starting point is 00:31:16 to follow. The sixth key influence is ego. Oftentimes, many of the best investors will slightly underperform in bull markets, but outperform in bare markets. This requires setting one's ego aside, knowing that it's unlikely for anyone to continuously beat the market year after year after year. Oftentimes, there will be a period of underperformance for the greatest investors, and that's just a fact. Marks ended this section of his book by stating, quote, the desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd, and the dream of the sure thing. These factors are near universal, end quote. Most of us probably just believe that we are immune to these forces and emotions. But remember that

Starting point is 00:32:04 we are all human and we're all highly influenced by our emotions. If we see a giant crash in the months to come. It's easy to say now that we won't give in to the massive panic and fear, but actually feeling and experiencing that sort of downturn is entirely different. We may watch our portfolios drop and we buy more. And then the next month, they fall further. And then the next month, they fall further. You know, this is what it was like during the great financial crisis. I believe it was Toby Carlyle on our podcast said that two-thirds of a bare markets drop, like what happened in the great financial crisis, two-thirds of the drop occurred in one-third of the time period. So for quite a long time period, it's just a slow grind downwards,

Starting point is 00:32:48 and then there's just that capitulation where, you know, people just give up, they're just going to give up and just sell everything. Markets have a way of really defying logic and have us begin to really doubt ourselves. So being highly aware of your decision psychologically when the pendulum swings to these extremes is very critical because that's when the emotions really kick in. I believe a lot of money is either made or lost at the extremes based on the decisions we end up making. Now with this discussion of cycles, this begs the question of, what do investors do about cycles? We know that the vicious cycles up and down are truly inevitable and that human emotions will always be part of the markets. And we know that timing the top and

Starting point is 00:33:32 timing the bottom is nearly impossible. So what do we do? First, we have to accept the fact that we can't predict how long the ups will extend upwards and how long the downs will keep falling. The only thing we know for certain is their inevitability and eventually they will turn. Now, the buy and hold approach would just say to just to completely ignore the market cycles because they're unpredictable. But Marks takes a slightly different approach. His approach is to get a good idea of where we stand in terms of the cycle and react accordingly. For example, earlier he talked about the idea of there's no price too high to pay. Well, when people start saying that, that might be a good indication that we are getting into pretty frothy markets. We can't know how far a trend will go

Starting point is 00:34:19 and when it will turn, but we do know that it will turn eventually because nothing goes up forever. I do think there are times when we can see things are getting towards the extreme. When a major bank fails and the Fed has taken unprecedented action to prevent other banks from failing, that is probably a good sign that we are somewhere in the extreme of the downturn. When NFTs of a tweet are selling for millions and millions of dollars a year after the Fed printed all this money, that may be a sign that things are getting a bit frothy and start selling when everyone is excited about all their massive investment gains. Of course, NFTs were not the only signal that things were pretty frothy and overvalued.

Starting point is 00:34:58 You could have looked at the stats on new IPOs. You could have looked at the meme stocks, the cryptocurrencies exploding in value, spacks, etc. So it really comes down to this contrarian view in that the crowd is usually wrong. They are too enthusiastic when markets are particularly high and too pessimistic when markets are too low. Mark says that, quote, when others are recklessly confident in buying aggressively, we should be highly cautious. When others are frightened into inaction or panic selling, we should become aggressive, end quote. It's just like Buffett's quote, where we want to be greedy when others are fearful and fearful when others are greedy. Now, when Marks invests, he's looking for things that he believes are bargains, meaning that the price is

Starting point is 00:35:45 trading well below what he believes is the underlying value. He's never looking for something he believes is trading at simply a fair value. To find something that's underpriced in a bargain, Here are the attributes in an investment that Marx is looking for. 1. It's little known and not fully understood. 2. It's fundamentally questionable on the surface. 3. It's controversial, unseemingly or scary. 4. It's deemed inappropriate for respectable portfolios. 5. It's unappreciated, unpopular, and unloved.

Starting point is 00:36:21 6. It has a trailing record of poor returns. And seven, it's recently the subject of disinvestment, not accumulation. Like I just mentioned, finding these investments that are trading at bargain prices, by definition it requires you to be a contrarian. You're one of the very few people that are purchasing that investment, while everyone else is selling or bearish on it. Large companies that come to mind today are companies like Facebook or Meta or Alibaba. These are down tremendously, and some well-known value investors are,

Starting point is 00:36:55 bullish on these companies, and they appear as contrarians to the overall market because most people aren't bullish on them because their stocks have done so poorly. Marks made a career out of investing in high yield and junk bonds, and he made a killing in this field. Most investing institutions had a minimum requirement of owning bonds that were investment grade or single A grade or better. At a high level, this makes a little bit of sense. Why would someone like a pension fund or an endowment want to hold junk bonds if there is a high risk of default. You know, that's looking at the risk side. Well, because junk bonds were highly overlooked at the time, Marx was able to buy bargains in this specific sector because he was able to get them at the right price, which reminds me a bit

Starting point is 00:37:41 of Benjamin Graham's cigar butt approach where he's buying these companies that were just in the doghouse and largely ignored by the overall market. Marks' big picture thesis was that if practically nobody wants to own these bonds. And even if they go from taboo to just slightly tolerated by the market, then they can perform quite well. In a way, this sort of flips Buffett's idea of buying quality companies on its head because of the fact that these junk bonds aren't high quality really at all, nobody wanted to touch them. Thus, this is how they became really attractively priced in Mark's view. One of my favorite Howard Mark's quotes is, quote, good investing comes from buying things well, not buying good things, end quote. And this quote ties directly to his approach

Starting point is 00:38:27 on purchasing junk bonds. It's not about buying the highest quality assets. It's about purchasing at the right price in whatever field you're playing in. I think I'll also add that, you know, we as investors, we need to play a game that we believe we are well equipped to win. Just because somebody says that you should only purchase bargains, you should always make sure you're paying the right price. We should also be mindful that we want to play games that we feel that we are equipped to win. So I feel in my position, I am just more comfortable, you know, focusing on some quality companies when I do purchase individual stocks that, you know, I'm not equipped to win the junk bond market game. You know, it's not a game I want to play. It's not something I feel like I'm well

Starting point is 00:39:09 equipped to win. So I feel like it's also being mindful of, you know, what your favorite approach is and, you know, learning from all these smart investors and just kind of applying what you believe, will work well for you. So that's just another comment I wanted to make. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI powered platform. So whether you're prepping for a SOC2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and

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Starting point is 00:42:40 fundrise.com slash income. This is a paid advertisement. All right. Back to the show. Next, I wanted to transition to talk about investing in a low-rate environment. One of the greatest challenges during my time as an investor is that interest rates have been suppressed so low, which in turn elevates the prices of all financial assets. In his book, Marx discusses how one should go about investing when they can't find opportunities. He personally recommends what he calls patience opportunism, in which you wait pitch after pitch until the right opportunity or right bargain comes along. Given the low-rate environment we're in,

Starting point is 00:43:21 I liked how in Chapter 13 marks outlined how we can approach investing in a low-rate environment. One option is just to invest anyways and almost be forced to accept lower expected returns because of the elevated prices. Because most of us aren't super sophisticated investors and don't do this full-time, most of us probably fall into this camp, including myself. Another layer of this is that you've recognized that we're in a low-rate environment, so you just have to commit to having a long-time horizon. And the long-holding period will help make up for that low-rate environment at the time of the purchase. Amazon might be an example of a company that is a great company trading at a fair price today in 2022. Although the price may be elevated currently because of the

Starting point is 00:44:07 environment we're in, I believe that there might be some catalysts for Amazon to continue to grow their earnings power substantially far into the future, say 10 to 20 years. So today, you pay a relatively high price because of the environment and the company successfully executes on that business strategy. So having that long-term approach and buying quality can maybe make up for paying a high price at the time. This approach of just investing anyway also accepts the fact that market timing is incredibly difficult. Alternatively, you could invest like Marx does and not be afraid to hold some cash on the sidelines while you wait for the right opportunities to come your way. He cautions against investors reaching for returns by investing in riskier assets, which is what

Starting point is 00:44:52 a low-rate environment leads most people to do. You want to take risk when others are fleeing from it, not when they're competing with you to do so. Preston Pish actually talked about the concept of four sellers on my interview with him on our millennial investing show, so I was glad that Marks covered this in his book as well. Every once in a while, like I mentioned, and there will be a mass sell-off in the markets, and many large institutions with large positions are in a spot where they become forced sellers. This is also known as a liquidity crisis. Liquidity crises are incredible buying opportunities, in my opinion, because the entities that are forced to sell have to come up with the currency or U.S. dollars. It's like they have no choice

Starting point is 00:45:35 and they have a gun to their head and they just have to sell no matter the price. And Mark's talked about this in his book. And this liquidity crisis and forced selling can quickly become a reinforcing cycle where one round of selling leads to margin calls on some companies, and then that leads to more selling, which leads to more margin calls, and it's just reinforcing on the way down. Then this is exactly what happened in March 2020, and a similar event happened during the great financial crisis. When this type of event happens and there just isn't enough dollars to meet the demand, then the Federal Reserve is inevitably forced to step in to prevent many firms from failing and then, you know, the potential total collapse of our economy.

Starting point is 00:46:16 The key to successful investing in such a crisis is first to be insulated from the forces that might require selling, and second, to be positioned to be a buyer instead. And to satisfy that criteria, you need a strong understanding of value, little or no use of leverage, capital that's ready to be invested for a long period of time, and finally, a strong stomach to weather through the volatility. Marks states that, quote, patient opportunism, butchrist by a contrarian attitude, and a strong balance sheet can yield amazing profits during meltdowns, end quote. Now, the last piece I wanted to cover from the book was Chapter 17, which covered investing defensively. He says when friends ask him for personal investment advice,

Starting point is 00:47:04 He tries to understand their attitude towards risk and return. If you ask most people if they care more about making money or avoiding losses, most would tell you they care quite a bit about both. The problem is that you can't chase profits without risking losses at some point in your investment timeline. So it's all about finding the right balance between the two. Targeting a reasonable rate of return with an acceptable amount of risk. Oak Tree puts a high priority on playing defense when they invest.

Starting point is 00:47:34 In the good times, they just want to be able to keep up with the markets or the indexes. During the bad times, they are positioned to outperform. Many other investors might end up getting too aggressive, hoping they will make a lot on their winners and not give it back on their losers. Marks uses the analogy of soccer. Each team has 12 guys on the field. They can focus on being aggressive and scoring, or they can put more focus on defense and ensuring that their opponent doesn't score.

Starting point is 00:48:02 I'm no soccer expert, but this is the example that Marx uses in his book, so I'm just going to run with it. He says, quote, what's more important to you, scoring points or keeping your opponent from scoring on you? In investing, will you go for winners or try to avoid losers? Or how will you balance the two? Great danger lies in acting without having considered the consequences, end quote. With regards to investing, offense consists of using aggressive tactics and increasing risk to try to achieve, above average returns. Defense consists of putting a big emphasis on ensuring you're not doing the wrong thing or purchasing the wrong security. Playing defense in investing means ensuring you don't have any losing positions, which comes down to doing proper due diligence, applying high standards,

Starting point is 00:48:52 demanding a low price, and having a generous margin for error, as well as avoiding being too generous in your forecasts of future growth due to the uncertainty of the future. To add to that, Marx says that proper diversification is another element of playing good defense. Concentration and leverage are two levers that can be pulled on the offensive end, so it makes sense that being diversified is a form of playing defense. Concentration adds to your returns when you're right, but it's really harmful when you're not right. This essentially gives investors a potential for higher highs and lower lows. Mark says that the critical element of defensive investing is what Buffett would call the margin of safety or margin for error.

Starting point is 00:49:35 It's not hard to make investments that will be successful if the future unfolds as expected. Certain targeted investments can be highly successful if the future turns out how you hoped. But we should also be aware of the possibility that the future might not play out as we expect. How will we fare in that scenario? What could our returns look like? It's a matter of considering the worst-case scenario, as well as the best case. Marks states that, quote, of the two ways to perform as an investor, racking up exceptional gains, or avoiding losses, I believe the latter is more dependable.

Starting point is 00:50:10 Achieving gains usually has something to do with being right about events ahead, whereas losses can be minimized by asserting that tangible value is present. The herd's expectations are moderate and prices are low. My experience tells me the latter can be done with. greater consistency. A conscious balance must be struck between striving for return and limiting risk, between offense and defense. So I think it all comes down to just finding that right balance between offense and defense, which really comes down to our temperament as an investor and really what our goals are. Investing is a game where a lot of people want to make big gains, and people want to be that

Starting point is 00:50:50 one guy that found the next Amazon or found the next Tesla. Very few investors are able to have a good investment career over a long time period, though. Some will find winners over a short time period, but finding those big winners isn't really a sustainable approach when you zoom out over a 30-year or 40-year time period. You need an approach that is much more reliable, that applies some defense and a margin of safety to your approach. Constantly swinging for the fences on your investments inevitably leads people to having a portfolio full of losers because they're taking too much risk. They consistently try to hit home runs so they end up striking out and have lousy outcomes. They bet too much when they think they have a winning idea or believe they have the

Starting point is 00:51:34 correct view. They're concentrating rather than diversifying. They incur excessive transaction costs and taxes through trading too much or trying to time the market. And they position themselves for the outcome they hope will happen rather than considering the possibility of being wrong or having a stroke of Remember that playing offense can be a double-edged sword. There aren't any free lunches in investing, so any potential benefits that playing offense gives also has its potential pitfalls as well. And I think many people see this as a give-and-take sort of approach. I think it's important for people to understand that you can achieve good in reasonable results consistently over a long period of time with the right amount of defense, but playing too much offense and taking too much

Starting point is 00:52:20 risk may lead to dreams that really never come to fruition, which may mean never achieving the destination you'd like to achieve or something like not living the comfortable retirement that you really want to live. Now, those are the main points I wanted to hit from Marx's book. I also went through his last few memos as well, as they're more related to what's currently happening in the world of high inflation and stocks currently in a bare market. His September 2020 memo was titled The Illusion of Knowledge. This memo went into explaining why he believed that making helpful macro forecasts is just so difficult.

Starting point is 00:52:59 He starts with a quote that says that, quote, there are two kinds of forecasters, those who don't know and those who don't know they don't know, end quote. Mark states that he recently attended an investor event where people were asked on their opinions regarding the recession, inflation, the rest of Ukraine war. Taiwan, China, everything going on, the U.S. elections, each person on stage had their particular views, but Marx was sitting there thinking that nobody was an expert on foreign affairs, politics, macro, and he was convinced that none of them were capable of improving investment results based on what their view of the macro environment was.

Starting point is 00:53:41 This is what led Marx to writing this particular memo. And he adds a quote from Daniel Borestein, The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge. He says that, quote, in order to produce something useful, be it in manufacturing, academia, or even arts, you must have a reliable process capable of converting the required inputs into the desired output. The problem, in short, is that I don't think there can be a process capable of consistently turning the large number of variables associated with economies and finance.

Starting point is 00:54:16 markets, the inputs, into a useful macro forecast, the output, end quote. Anyone who forecasts our economy has no choice but to do so using some sort of model, whether that be a complex one, an informal, mathematical, or intuitive one. There's some sort of model going into it, and models consist of assumptions. If A happens, then B will happen. The problem is that the global economy is just so insanely complex. The U.S. alone has 330 million people, and the U.S. economy consists of the individual actions of those 330 million people summed up. When you take that globally, you have billions of people and essentially

Starting point is 00:55:00 countless interactions with companies, suppliers, consumers, and all these touchpoints. What many macro analysts might do is look at the past to help determine what might happen in the future, which may work sometime, but the world changes during the world. dramatically over time, too. And when I think about an investor like Ray Dalio, he's looking at some events that happened centuries ago to determine how to invest in 2022. Mark states that, quote, the unpredictability of behavior is a favorite topic of mine. Noted physicist Richard Feynman once said, imagine how much harder physics would be if electrons had feelings, end quote. The rules of physics are reliable because electrons always do what they're supposed to do. They never forget to

Starting point is 00:55:46 perform. They never rebel. They never go on strike. They never innovate. They never behave in a contrary manner. But none of these things is true of the participants of an economy. And for that reason, their behavior is unpredictable. And if the participant's behavior is unpredictable, how can the workings of an economy be modeled? Honestly, I must say I'm quite surprised to see Howard Mark's opinion on this. I think of someone like Stanley Drive. Drunken Miller, who's more than four decades into investing in, he's never had a down year, and his fund compounded capital at over 30% per year. So obviously, he's one of the best of the best in terms of predicting these macro forces, but, you know, I'm definitely not saying

Starting point is 00:56:28 I can do what Drunker Miller can do, but I'm just surprised to see Howard Mark say that, you know, it's very unlikely people can predict what's going to happen. Regardless, I also know that predicting the future and assigning probabilities to particular outcomes is also very difficult, but I digress. Marx adds that clearly economic relationships aren't hardwired and economies aren't governed by schematic diagrams, which models try to simulate. Thus, for me, the bottom line is that output for a model may point in the direction much of the time when the assumptions aren't violated.

Starting point is 00:57:02 But it can't always be accurate, especially at critical moments such as inflection point. and that's when accurate predictions would be most valuable. Now, some models are going to be useful at times. So the economy isn't entirely unpredictable. But the bottom line from his point of view is that the forecasts aren't helpful. We don't really know which forecasts are going to be right and which forecasts are going to be wrong. To add to that belief that forecasts aren't reliable, he goes on to say that many of the forecasters are part of teams managing equity funds.

Starting point is 00:57:33 And what we know for sure is that actively managed equity funds are underperforming the market relative to the market indexes. He highlighted that the HFRI hedge fund index had a average 10-year return of 5.1% per year. And the HFRI macro total index had an average tenure return of 2.8%. Meanwhile, the S&P 500 averaged 13.8% over that study. So it's really not even comparable. And obviously, these forecasts don't help these funds. outperform the market. In the end, Marks has the same view as Warren Buffett that the macro future

Starting point is 00:58:09 isn't knowable, so it should be disregarded when making investment decisions. Now, that concludes my episode covering Howard Marks. I can't help admire Howard's intense focus on playing defense and ensuring you're not taking unnecessary risk, because I feel like that message is somewhat lost in the investing landscape today with so many people trying to hit the next big winner, learning from someone like Howard whose family experienced the tragedies of the Great Depression can give us a lot of insight to the potential downfalls of an overly aggressive portfolio. This is something I believe we can all learn from because the key to investing is ensuring we stay in the game for the long run and put us in a position to weather through any market

Starting point is 00:58:53 environment. Also, what I've really liked about all of this is that he doesn't give you the answer to investing success because he can't tell you what the right answer is. is because the game's always changing. He's essentially encouraging the readers to consider the principles he lays out in his books and his memos and then come to your own conclusion, and that's really what TIP stands for. We do our best to bring the truth to light, and then everyone can come to their own informed conclusions. And that's the beauty of it, because it encourages continuous learning and being open to accepting new information when it arises. If you're interested in checking out more content related to Howard Marks. You can listen to William Green's interview with Howard, which was

Starting point is 00:59:36 this year in 2022. I'll be sure to link that in the show notes. Trey Lockerbie also interviewed Howard last year, so I'll be sure to link that as well. That is all I had for you for today's episode. Really hope you guys enjoyed it. You can connect with me on Twitter at Clay underscore Fink, C-L-A-Y, underscore F-I-N-C-K. If you enjoyed this episode, I would love it if you shared it with just one friend who may enjoy this type of content. With that, thank you so much for tuning in, and we'll see you again next week. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment

Starting point is 01:00:25 purposes only. Before making any decision consult a professional, this show is Copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP497: Lessons from Billionaire Howard Marks

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