Howard S. Marks, CFA: Thoughts on working through a dramatic Down Cycle

The 73rd CFA Institute’s annual conference started yesterday, virtually this year from CFA Institute studio in Charlottesville, Virginia. Mark Franklin, President and CEO of CFA Institute, gave a welcome note and started the conference. 

The first speaker, Howard S. Marks, CFA discussed his thoughts on working through a dramatic down cycle. His discussion on different components of the market fascinated me. I tried to summarize his speech below so that many finance and investment enthusiasts can learn from it.  

Howard Marks said how glad he is in taking part in the CFA Institute event. He has been involved with the CFA ecosystem for 50 years. Some of his discussions are:

Market Cycles

We look to the Historic patterns as a way to understand and hopefully get a handle on the future and be able to think about what it holds. I put out a memo this week entitled uncertainty with a bunch of my favorite quotes about how uncertain the future is. we look to past patterns to get a handle on the future, the greatest of which is something called the cycle. And the cycle is, generally speaking, it’s a series of up and down oscillations around a central trend-line. Now, it could be a stable phenomenon like the average P/E ratio, or it could be a growth phenomenon like GDP. But GDP doesn’t grow in a straight line. And PE ratios don’t hold at a given level, there are oscillations around them. And I think, and most people think of those in terms of ups and downs, I think of them more productively as accesses and corrections. We move away from the line, and those are accessed in either direction, and then eventually regress back toward the line, but usually carry through it to another access in the opposite direction. So we think about cycles. 

Current Market Scenario

We have had an outside influence which to which I would argue that the markets have been vulnerable for some time. But finally it arrived in the first quarter of 2020. And it is unprecedented in its power. And it has knocked the market for a loop. And, of course I’m talking about the virus but this was all complicated by the fact that in order to combat the virus, we put the economy into a deep freeze. And so the combination of the virus and the economic damage done by the Deep Freeze caused unprecedented declines. Then we have the Fed coming in with the Treasury to support the economy in again, unprecedented ways. We have the battle between these two forces, the disease and the economic impact of fighting it, the Fed and Treasury programs which will win. We have no way to know and we’re not going to get the answer anytime soon. This will play out over the next several quarters If not years.

Past Market Crisis compared to Current Crisis

I’ve been in the high-yield bond world for the last 42 years and below investment grade credit, and I’ve lived through three debt crises in those markets in 1990/91, 2001 and 2007-08. In all three of the cases, financial events are the raw materials of the crises. The accelerator was a Recession. This is very different because the raw material for the crisis is the disease. This is not a financial reason. This didn’t start off as a financial crisis. It starts with really a health crisis. And the financial aspects are the ramifications of the health crisis. Investors are not epidemiologists, and they don’t know the science. One theme of the memo of this week was, you say, intellectual humility, which means knowing what you don’t know. And it’s so silly for an investor to build his investment conclusions around his view of what the disease holds when he knows nothing about it. 

Intellectual Humility

This week’s memo says that, to be a good investor, you have to have confidence. You have to have confidence in your views. You have to be able to put them into action. If you buy things that decline you have to be confident enough to re-investigate. Hopefully revalidate the thesis, continue to hold, maybe even buy more now that they’re cheaper. And, and so confidence plays an important part. I asked the question, when does competence become hubris and stubbornness? There is no clear line of demarcation. But I think that part of part of it is, as you say, from Lynch, knowing what you don’t know. And the other thing is that I believe that it’s important to build in a margin of safety and, and margin of safety comes from many different places. 

Margin of Safety

Margin of Safety might come from the quality of the company, the stability of the industry, the predictability of the industry in the company, the firmness of the documentation service. The investment and the lowness of the price, because for any given investment that you consider making you event, you evaluate the investment relative to the underlying fundamentals. And then whatever the relationship between price and fundamentals, the lower the price goes, the more margin of safety you have assuming that the actual outlook for the fundamentals didn’t change. So, the point is the in the discussion of intellectual humility, it I quote, people much smarter than me as saying that the expert calibrates his expression of his opinion based on how firm the evidence is.

I think that the investor should calibrate his confidence in his investment based on how, how much margin of safety there is. And I can tell you that at Oaktree we become more aggressive when we believe we have a greater margin of safety. And as I say that margin of safety comes from the quality of the company the predictability of the industry, the quality the documentation, but largely from the discount of the price from the entrance. value. And you know, when we get when we start seeing things that are selling well below their intrinsic value, in our opinion, that’s when we that’s when we turn aggressive with I would describe Oaktree as a cautious company where in risk asset classes we have been for all of our careers and normally we take a very cautious approach to our risk asset. classes. But when they when we go through these crises that I described, and the prices collapse relative to what we think is the long term intrinsic value, we throw off our caution, and we become incredibly aggressive. And I think that that toggling between aggressive and defensive is the greatest single thing that a new investor can do. If they do it appropriately.

Shifting during Extreme periods

My book about market cycles basically talks about being able to shift at the extremes. In between the extremes, this is not too much smart to do because on normal days when we woke up, wake up, we don’t know if the market is going to be strong or weak, or know if offense or defense is cold for but as you say, when the market cycle goes to an extreme when it’s super high. 

I believe it’s possible to figure out that a preponderance of defense is called For when it goes to the bubble busted low, I think it’s possible to conclude that more offenses gold for I mentioned when I was working on the book I mentioned to my son that I thought my calls had basically been correct. And he said, Yeah, dad, that’s because you did it five times in 50 years. At the extremes, I think the logic is compelling. The probability of success is high, but in between, not so. We have learned and profited from the cycles. We’ve lived through the distressed debt. The world does reach extremes periodically, and we think we can profit from them.

Being Contrarian is enough?

Everybody wants to be contrarian and likes to think they’re contrarian, but it’s actually possible for everybody to be contrarian at once. What does it mean to be contrarian? plainly a lot of the time, you can lose a lot of money as an institutional investor, you can lose clients by going against the herd when the herd keeps going in the same direction. So I think another very useful broad point is how, what is contrarian means to you.

Our goal as investors is to be above average. It’s not, it’s kind of like golf. It’s not the goal can’t be to have a good score. The goal has to be to have a better score than the other person. So if you’re if you if what you need to do is outperform and we all get paid for outperformance then By definition, you have to think differently from other people that hopefully will permit you to behave differently from other people. And if you think and behave differently from other people, and you’re more right than they are, that’s a necessary ingredient, then you can have superior performance. It should be clear that if you think the same as other people, you’ll behave the same as other people. And if you behave the same as other people, you can’t outperform. That’s number one. So, superior and investing has to come from correct idiosyncratic decisions. Number two; everything in our body conspires to make us do the wrong thing at the wrong time. Everything in our psychological makeup and in the environment conspires to make people become more excited, more optimistic the higher things go and more depressed and more pessimistic the lower things go. So it’s natural because of the motion and herd following to buy high and sell low. Now I think the right goal is to buy low and sell high. So again to do so you have to depart from the crowd. And that’s the importance of contrarians and David Swensen, who runs the endowment at Yale has as one of my favorite quotes, also in the uncertainty memo, and he says that active Investment Management requires the adoption of uncomfortably idiosyncratic portfolios. And I think uncomfortably idiosyncratic are two beautiful words. You have to be idiosyncratic, that is you have to depart from the norm. If you’re going to outperform, and it has to be uncomfortable because by definition, you’re doing things that other people aren’t or you’re refusing to do what they’re doing. And the day when you say no, that’s a mistake. And many times it doesn’t work for months or maybe years. And one of the most important advantages in our business is that being too far ahead of your time is indistinguishable from being wrong. And that’s where the discomfort comes from. But I believe that every great investment begins in discomfort. That is you’re buying the things everybody else hates, and how do we know they hate him because they’re cheap. if they didn’t hate him, it wouldn’t be cheap. Okay, so that’s either point number two or maybe that’s a separate point.

As an investor, if you’re not confident you can perform well. But if you’re overconfident, you can’t perform well.

While being a contrarian is a necessary condition for outperformance, it is not sufficient. And in order before taking a contrary approach on an issue, it’s not enough to say I’m going to do the opposite of what everybody else is doing. Well, here’s what you have to do. You have to look at what they’re doing. You have to understand what they’re doing, and why they’re doing it. You have to figure out what’s wrong with what they’re doing. And you have to depart from what they’re doing for a reason. So knee jerk contrarianism is certainly not a successful strategy.

Central Bank Independence

It seems obvious that Govt and FED working together which suggests a non independence. And, you know, the Treasury prints money and gives it to the Fed and the Fed can put it out through the banking system with a multiplier effect. And so, you know, certainly we’re working hand in glove. Many things are going on now that are unprecedented.

Just because something can have an unforeseen negative consequences, doesn’t mean it’s a mistake. I believe that, that that a fair bit of what the Fed and Treasury are doing now can and maybe will have unforeseen negative consequences but I still think they have to do because to to not take these actions would be too permit the possibility of a depression.

Obviously there’s some risk of inflation but people seem to be more concerned with The notion of financial repression where you get persistent government intervention to keep bond yields low, arguably a less painful method than inflation of forcing people to pay for the paper that all the money they’ve spent dealing with the Coronavirus.

We all believe that the free market is the best allocator of resources. And I would say in general that since the global financial crisis, and perhaps before we have not had a free market and money, that there have been great efforts to inject liquidity, which has the effect of driving down the price of money. I like to believe that the Fed would like to move back in the direction of a free market in money by no longer keeping rates artificially low. They think that they are going to keep them low until they believe that the disease and resulting economic crisis are under control. Because one of their most important goals is to keep credit flowing and available to needy borrowers at a reasonable price. And so I think there’ll be leaning on rates. I’d like to believe they’re not going to do it forever.

So, you know, clearly my, my desire to see the Fed get out of the business of administering rates was unrewarded. I like to believe that when they can, they will, I think that the Fed was slow in letting rates rise. 

My job is to outperform and regardless of what the prevailing level of returns is, oaktree will be successful if we produce better returns than our peers. And so, you know, the market is what it is, rates are what they are, the return environment will be what it will be. I think that you know, superior investors who make periodic decisions, control their emotions, are able to deviate from the herd will still be able to outperform. So I don’t worry too much about that.

Source: 73rd CFA Institute’s Annual Conference

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