Howard Marks from Oaktree Capital is one of my favorite investors. He is very smart so I always like to watch his interviews. He also regularly publishes memos which are great reads if one is interested in the topic of investing. This post is a summary of his investing philosophy as gathered from his presentation at Google. I started writing this post in October, but did not have time or the mental focus to finish until now. But here it is, just in time for Christmas!
Howard wrote a book in 2011 called The Most Important Thing. The reason for the title of the book is that he often found himself saying "the most important thing in investing is". But actually there was not a single most important thing, but up to 19 different things which were all important. He got a letter from Warren Buffett in 2009 or 2010 who told him that if he writes a book, Warren will give him a quote. The foreword warns that the book is not designed to tell you how to make money, to tell how easy investing is or how to make it easy. In fact, it is designed to make it clear how hard it is. Investing is difficult because it is counterintuitive in many ways. In the book he tries to teach people how to think, not what to think. What to think should change as times change, but how to think should stay the same.
When he was getting out of graduate school at age 23 in 1969, he did not know what he wanted to do. He had studied finance at Wharton and accounting in Chicago. He knew he wanted to do something in finance but he wasn't very specific. So he interviewed in six different fields: large consulting firm, small consulting firm, accounting firm, corporate treasury, investment management, investment banking. He ended up in the investment business because he had a summer job in 1968 at Citi in the investment research department. There was nothing glamorous about working in the investment business at that time. The pay was the same as the rest. In fact all the 6 jobs he was offered had the same pay, between $12,500 to $14,000 a year (adjusted for inflation, about $110,000 to $125,000 in 2024). There were no famous investors at the time and there were no TV shows on investing. He liked it because it was intellectually interesting.
There are a few books that were fundamental in shaping his investment philosophy. First is Fooled by Randomness by Nassim Nicholas Taleb. He said it is either the most important badly written book, or the worst written very important book that you'll ever read. The basic theme is that in investing there is a lot of randomness. If you look at investing as a field without randomness, where everything is determinative, you will get confused and will not make the proper conclusions. For example, you see an investment manager who reports a great return for the year. Someone might conclude that he is a great investor. In truth it may be somebody who took a crazy shot and got lucky. Taleb's second book is called The Black Swan which became more famous but is not as good in Howard's opinion. Taleb has also written a third book called Antifragile.
The first book Howard learned in Wharton was called Decision Making Under Uncertainty by C. Jackson Grayson who became America's first energy czar. The most important lesson from that book was that you cannot tell from the outcome whether the decision was good or bad. So in investing you can make a bad decision but get lucky and win. Or you can make the right decision but get unlucky and lose. Totally counterintuitive and opposite to many other professions. For example, consider an engineer who builds a bridge. If the bridge falls down, you must assume that the engineer made a mistake. But in the investing world where randomness is involved, good decisions fail to work all the time. And bad decisions work all the time. Investment business is full of people who are right for the wrong reason. They made a bad decision but got lucky and were bailed out by events.
Taleb's book is all about the role played by luck:
Even if you know what is most likely, many other things can happen instead
In investing, you should not act as if the things that should happen are the things that will happen. Unlike the electrical engineer, who knows that if he turns on a light switch, the light will go on every time, because the laws of physics don't change. But in investing it is important to think about a range of possible outcomes. Therefore investors should think about probability distributions when making an investment.
Same thing from Elroy Dimson at London Business School:
Risk means more things can happen than will happen
In the economic world, people often make their decisions on something called expected value. You take every possible outcome of an investment, and multiply it by the likelihood that it will happen, and finally you sum the results together and you get expected value. Then you choose your course of action based on the highest expected value. That sounds like a totally rational thing. But what if the course of action includes some outcomes that you absolutely cannot withstand? Then you will not take the course of action with the highest expected value because it has some outcomes that you cannot accept. Who is ready to be the skydiver who is right 98% of the time? After learning all of this, Howard realized that should does not equal will. Lots of things that should happen fail to happen. And even if they don't fail to happen, they fail to happen on schedule. The thing that the economist thinks should happen this year may happen in three years.
Never forget the six feet tall man who drowned crossing the stream that was five feet deep on average
We cannot live by the averages. We cannot say: I am happy to survive on average. We have to survive on the bad days. And if you are a decision maker, you have to survive long enough for the correctness of your decision to become evident. You cannot count on it happening on schedule. Overpriced is not the same as going down tomorrow.
John Kenneth Galbraith was an economist and a diplomat who worked in government. He wrote some very good books such as A Short History of Financial Euphoria. He said this:
We have two classes of forecasters: Those who don't know, and those who don't know they don't know
Howard does not believe in macro forecasts. This means forecasts such as interest rates, performance of economies, performance of stock markets. He thinks the efforts of being a superior investor are not aided by macro forecasts. He is not saying that the forecaster is never right, quite the opposite actually, the forecasters are often right. For example, lets say the GDP grew last year about 2%. And now many forecasters forecast that GDP will grow this year about 2%. That is called extrapolation and usually in economics extrapolation works. Usually the future looks like the recent past. So usually people who forecast the continuation of the current situation are right. The only problem is that those forecasts do not make any money. Because the thing that everyone expects is already "priced in" and reflected in the prices of securities. So if the GDP will grow around 2%, everyone who forecasted it will be right, but the prices of securities will not move at all because it was expected. In this case those who are right do not make any money by being right. The forecasts that make money are the forecasts of radical change. If everyone predicts 2%, but you predict -2% or 6%, and turn out to be right, you can make a lot of money. Forecasts which are radically different from the recent past are potentially very valuable. But only if they are correct. Of course they are not of any value if they are incorrect.
He released two early memos called the Value of Forecasts, parts 1 and 2. In one of those he reviewed the history of a Wall Street Journal poll of economists forecasting GDP growth and other economic indicators. They ask around 30 people and do the same poll consistently every year. The results show that most of the time people who got it right predicted extrapolation and nothing changed. Once in a while something changes radically and invariably somebody predicted it. But the problem is that if you look at that person's other forecasts over the years, you will see that he always made radical forecasts and never was right any other time. The fact that he was right once does not tell you anything, and does not help for favorable investing outcomes in the future. The conclusion for Howard is that forecasting is not valuable.
Another book that Howard learned from was Winning the Loser's Game by Charles Ellis. Main themes from his book:
- The difficulty of getting it right consistently
- This is what makes defensive investing so important
Simon Ramo wrote a book about winning in tennis. He said there are two kinds of winning tennis players. The champion tennis players win by hitting winning shots. That is shots that the opponent cannot return. The amateur tennis players win by avoiding hitting losers. The amateur tennis player just focuses on getting the ball over the net and hoping for the opponent to make a mistake. Championship tennis is a winner's game but amateur tennis is a loser's game. This relates close to investing: amateur investors should focus on avoiding losers.
Charles Ellis thought that investing is a loser's game. Howard also believes that investing is a loser's game but for different reason. Charles believed that markets are efficient and securities are priced right. Howard believes there are inefficiencies, but it is difficult to consistently take advantage of them, and you have to be an exceptional person to do so.
In tennis they keep track of a metric called unforced errors. The reason is because there are so few of them. The professionals do not make many unforced errors. But amateurs do all the time. If you are going to be an investor, you have to decide: Am I good enough to go for winners, or should I emphasize the avoidance of losers?
Another lesson for Howard came from his meeting with Michael Milken in 1978:
- If you buy triple-A bonds, there is only one way to go
- But if you buy single-B bonds and they survive, the surprises are likely to be on the upside
Triple-A bonds imply that everything is perfect, so if there is a chance, it is likely to be for worse.
How do you make money as an investor? The people who don't know think that the way to make money is to buy good assets: a good building, stock in a good company. That is not the secret for success. The secret for success in investing is buying things for less than they are worth. What determines the success of an investor is not what he buys, but what he pays for it. If you buy a high quality asset but pay too much, you are in trouble. If you buy a low quality asset, but pay less than it is worth, chances are you will make money.
In those years, the Moody's guide for bonds defined a B-rated bond as something that fails to possess the characteristics of a desirable investment. In other words, it's a bad investment, regardless of price. Before working in high yield bonds, Howard was on the opposite side, buying the stocks of the best companies in America. If you bought them in 1968 and held until 1973, you lost most of your money. They were overpriced because investors falsely believed that no price was too high for the best companies.
After this Howard realized that his analysts should spend all their time trying to find bonds of companies that will not survive. So all analysts' time should be spent on looking at losers, not winners. This is counterintuitive to how most people approach investing.
Howard also refers to the book Security Analysis by Graham and Dodd as the Bible of Investing. The first edition was published in 1934. Howard was asked to update a chapter about bond investing in the book's new edition. To prepare for that task, he had to read the 1940 edition. It said that bond investing is a negative art. Bonds, also called fixed income, pay the agreed interest and principal. Unlike stocks, the upside of the investment is known in advance. All 5% bonds will pay 5%. Of the ones that pay, it does not mean which ones you buy. The only thing that matters is to exclude the ones that don't pay. That's why they called it a negative art. Your performance is defined not by what you buy, but by what you exclude.
Summarizing everything so far:
- Taleb says the future consists of a range of possibilities with the outcome significantly influenced by randomness
- Galbraith says forecasting is futile
- Ellis says if the game isn't controllable, it's better to work to avoid losers than to try for winners
- Milken says holding survivors - and avoiding defaults - is key in bond investing
These concepts created Oaktree's Investment Philosophy which Howard started in 1995:
- The primacy of risk control
- Emphasis on consistency
- The importance of market inefficiency
- The benefits of specialization
- Macro-forecasting not critical to investing
- Disavowal of market timing
The first one says that the most important thing is risk control. More important than beating the market. Other people place less emphasis on controlling risk and they have better results in the good times and worse results in the bad times. Secondly, Oaktree emphasizes consistency, so they don't reach for the moon at the risk of crashing. Howard's first memo in 1990 talked about a money manager who had a terrible year. He said it's very simple: if you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%. Howard has no interest in being in the bottom 5% and he doesn't care about being in the top 5%. He wants to be above the middle on a consistent basis over the long term.
One philosophy of Oaktree is that it is ok to have an opinion, but you should not act as if it's right. Mark Twain said:
It's not what you don't know that gets you into trouble. It's what you know for certain that just ain't true.
Finally all of this comes together in Oaktree's Motto which says:
If we avoid the losers, the winners take care of themselves
Another way to think about investment outcomes is the bell-shaped curve. Most investments will do ok and be in the middle. An occasional one will be exceptional (in the right tail of the bell curve). But goal of Oaktree is to try to exclude investments in the left tail. Instead many money managers tell their clients that they will try to be in the top quartile, the great right hand tail. Howard thinks that is difficult to do consistently. If you aim for the right hand tail and miss, you end up in the left hand tail. Oaktree simply attempts to cut off the left hand tail. If you cut out the terrible, the average of remaining results will be very good.
Finally Howard finishes with his three greatest adages that have been most helpful during his career:
- What the wise man does in the beginning, the fool does in the end
- Never forget the six feet tall man who drowned crossing the stream that was five feet deep on average
- Being too far ahead of your time is indistinguishable from being wrong
In summary, there was lots of wise words and concepts in this presentation. Most of the ideas are familiar to me because I have followed Howard for a long time. But I believe it is important to go over familiar ideas again and refresh your memory. And it is equally important to look at your own investment philosophy critically. If the results of the last years have not been up to par, it may be a good time to fine-tune your investment philosophy, especially by taking advice from one of the greats.