Howard Marks Shareholder Memo Will Make (or Save) You Money!
The Most Important Things From The Author Of The Most Important Thing
In my new investment book The Millennial Advantage, I cited and quoted The Most Important Thing by Howard Marks, in my view one of a handful of books every serious investor should read. As he explains in the book’s Introduction, the title is a bit of an inside joke. In meetings with current or prospective clients, he constantly found himself emphasizing a key principle by saying, ‘The most important thing is X,’ or ‘The most important thing is Y.’ So he put together a memo collecting the most important of those most important things, ending up with 18 of them. He has modified the list somewhat over the years, but it formed the basis for the book and for his core philosophy. What hasn’t changed is that there is no one most important thing.
They’re all important. Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is likely to be less than satisfactory. That is why I have built this book around the idea of the most important things—each is a brick in what I hope will be a solid wall, and none is dispensable.
Aside from his book (about to be plural), Marks publishes one of the most informative shareholder letters in the industry (beating Buffett, in my opinion). This quarter was no exception. Coming in at 24 pages (double the length of his average letter), there’s so much to take from this letter that I think it’s tremendously valuable to highlight what I consider to be “the most important things.”
In addition to the topics I will discuss here, Marks spends some considerable time discussing other important topics such as Private Equity, Emerging Market Debt, High Yield ETFs, Credit, and M&A. I’ve chosen to leave these out of this article because I don’t think they’re as relevant to individual investors. However, if you’re only going to read one article this week, I highly suggest that it be Marks memo.
First is his summary of the current investment environment. Like Marks, I don’t believe in market timing or the traditional buy and hold approach. Instead, I think investors are best taking the temperature of the market, identifying if there is extreme behavior, and then deciding the investment implications for them personally.
The Current Environment
In the memo, Marks addresses four of what he deems the “most noteworthy” characteristics in our current market:
o The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
o In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
o Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.
o Pro-risk behavior is commonplace, as the majority of investors embrace higher risk as the route to returns they want or need.
Marks is a big believer that history tends to repeat, so he quotes one of his articles written before the great financial crisis and notes how it’s just as relevant to today.
Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so… Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best.
In my book, I mention the characteristics of what I believe identifies extreme behavior in equity markets. It’s a relatively long list and, to access it, you’ll have to purchase my book. One the things I mention is the ease of access to capital (e.g. low interest rates and lenient borrowing conditions), which fuels investors to have more money than ideas. This is nothing new, as economists in the late 1900s wrote about this often. When investors, especially institutions, are pressured to put money to work (since investors don’t like to pay managers for holding cash), they invest in things they probably shouldn’t. Eventually, these investments turn sour and money is lost. Another characteristic that defines what most investors would consider “extreme behavior” is when they recognize when there is a risky environment but don’t change their strategy accordingly.
This is prevalent today. You can’t spend more than a few minutes on a financial news site without reference to inflated valuations (the CAPE is twice the historical average) or an article about how the FAANG stocks are well overvalued. Yet, you see investors pour money into equities (and FAANGs, in particular) regardless of high market prices (aka Risk). It’s the fear of missing out or what Millennials call FOMO! FOMO is identified by psychologist Daniel Kahneman (he calls it something else) as a behavioral bias that pushes investors to think that the overwhelming fear is missing out on potential returns, rather than the fear losing money. Investing is a “losers game”, where you win by NOT LOSING! That means that the thing that every investor should fear is the fear of losing money (FOLM), not the fear of missing out (FOMO).
Another characteristic of today’s market is low volatility, represented by the reduced level of the volatility index, better known as the VIX. Marks explains how investors are extrapolating a low VIX into the future, or assuming it will remain low for an extended period of time. While the VIX shouldn’t be used to forecast the future, as it only represents the current environment, long periods of low volatility cause investors to become complacent, bidding up low quality assets and making other bad financial decisions which eventually come back to bite them in the ass (and increase volatility). In other words, a lower than average VIX isn’t sustainable and it’s just a matter of time until volatility increases. A rise in volatility means almost always means a reduction in market prices. Also note that the index doesn’t simply creep up – but often increased rapidly, accompanying a steep decline in market prices.
Facebook, Amazon, Apple, Netflix, Nvidia, Google
The FAANG stocks, or what Marks calls “Super Stocks,” are composed of Facebook, Apple, Amazon, Netflix (or Nvidia) and Google (now named Alphabet). These companies are well run, cash flow generating beasts of capitalism, and there’s no doubt about that. But investors are treating them like they’re invincible and that they’ll continue to grow like they have, in perpetuity.
Will they? Likely not! Look back throughout history and not one company has ever been able to break the business life cycle. Oil stocks in the 70s, tech companies in the 90s - what these asset classes have in common is that the environment changes in unexpected ways; competition becomes fiercer; success breeds complacency; large firms become inefficient. High stock prices can lead to capital losses, regardless of company fundamentals.
This is a clear case of investors suspending disbelief (like how we suspend disbelief of reality to believe a protagonist like Walter White could pull off what he did)of their knowledge of the future and believing that there is no price that’s too high for a piece of these companies! Today FAANG stocks are priced for perfection and we all know better than to believe these companies will be perfect going forward. Investors who allocate a large portion of their capital into the FAANGs will eventually suffer the consequences.
I’ve written about the natural consequences of passive investing in previous articles and spend a considerable amount of time discussing the topic in my book. In my opinion, index funds are currently an inefficient way to allocate capital but they’re valuable if used in the right way. Most investors confuse low cost with low risk, and these ultra-risky vehicles (composed of mostly high price stocks, including a large allocation to FAANG) will mimic or exceed the market’s volatility once it corrects. In my opinion, investors should hold more concentrated portfolios of less popular, smaller companies as, if done properly, can exhibit both higher return and lower risk. Expect 40-60% drawdowns at some point in the future with index funds. In addition, the more people who throw capital into these funds the higher the magnitude of potential drawdowns once the market corrects. As Marks says, “it’s one big momentum trade.” Honestly, I’m a little tired of writing about it so take it from Marks himself.
Like all investment fashions, passive investing is being warmly embraced for its positives:
Passive portfolios have outperformed active investing over the last decade or so. With passive investing you’re guaranteed not to underperform the index. Finally, the much lower fees and expenses on passive vehicles are certain to constitute apermanent advantage relative to active management. Does that mean passive investing, index funds and ETFs are a no-lose proposition? Certainly not: While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming. The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds. Here are a few more things worth thinking about: Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective… Finally, the systemic risks to the stock market have to be considered. Bregman calls “the index universe a big, crowded momentum trade.” A handful of stocks – the FAANGs and a few more – are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated.
I was recently quotes in a Forbes article explaining the risks of Cryptocurrency investments and stated that no investor should allocate more than 5% of his or her discretionary assets into these investments, as it’s more than likely a huge bubble. Now, like Marks I’m no crypto expert, but I do consider myself an expert on capital markets and human psychology, in regards to money. I spend a large portion of my book discussing cognitive bias and emotion and, if you’re completely unaware that our brains aren’t meant for us to prosper financially, you really should pick up a copy.
At the foundation, cryptocurrency isn’t tangible and there’s no central institution in charge of managing the growth of this currency (most investors consider this an attractive quality, I don’t). If you’re not familiar with cryptocurrency, here’s a few quotes from a NY Times article published in June:
The sudden rise of Ethereum highlights how volatile the bewildering world of virtual currency remains, where lines of code can be spun into billions of dollars in a matter of months.
Ethereum was launched in the middle of 2015 by a 21-year-old college dropout, Vitalik Buterin . . . Mr. Buterin was inspired by Bitcoin, and the software he built shares some of the same basic qualities. Both are hosted and maintained by the computers of volunteers around the world, who are rewarded for their participation with new digital tokens that are released into the network every day.
Because the virtual currencies are tracked and maintained by a network of computers, no government or company is in charge. The prices of both Bitcoin and Ether are established on private exchanges, where people can sell the tokens they own at the going market price
Many [new currency] applications being built on Ethereum are also raising money using the Ether currency, in what are known as initial coin offerings, a play on initial public offerings.
These coin offerings, which have proliferated in recent months, have created a surge of demand for the Ether currency. Just last week, investors sent $150 million worth of Ether to a start-up, Bancor, that wants to make it easier to launch virtual currencies.
Marks leverages the NY Times article to prove his overall point that Crypto is a bubble. “Bottom line: you can use the imaginary currency Ether to buy other new imaginary currencies, or to invest in new companies that will create other new currencies” he states. In a former letter from the late 90s, he highlights “illogical aspects of e-commerce” that are appropriate for the Crypto movement.
Two guys meet in the street. Joe tells Bob about the hamster he has for sale: pedigreed and highly intelligent. Bob says he’d like to buy a hamster for his kid: “How much is it?” Joe answers, “half a million,” and Bob tells him he’s crazy.
They meet again the next day. “How’d you do with that hamster?” Bob asks. “Sold it,” says Joe. “Did you get $500,000?” Bob asks. “Sure,” says Joe. “Cash?” “No,” Joe answers, “I took two $250,000 canaries.”
One of my very favorite quotes concerning the market’s foibles, from John Kenneth Galbraith, says that in euphoric times, “past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”
Maybe I’m just a dinosaur, too technologically backward to appreciate the greatness of digital currency. But it is my firm view that the ability of these things to gain acceptance is just one more proof of the prevalence today of financial naiveté, willing risk-taking and wishful thinking.
In my view, digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people will pay for it. But this isn’t the first time. The same description can be applied to the Tulip mania that peaked in 1637, the South Sea Bubble (1720) and the Internet Bubble (1999-2000).
Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future.
It isn’t unreasonable for someone to use Bitcoin to pay for something – or for a seller to accept Bitcoin in payment – based on an agreement between the parties: barter takes place all the time. But does that make it “currency”?
The price of Bitcoin has more than doubled since the start of the year. Can something that does that seriously be considered a “medium of exchange” or “store of value,” rather than the subject of a speculative mania? Maybe not, but Bitcoin looks staid in comparison to Ether, which has appreciated 4,500% so far this year. The outstanding Ether is now worth 82% as much as all the Bitcoin in the world, up from 5% at the beginning of the year.
Investors should choose their risk posture based on an assessment of what’s being offered in terms of absolute return, absolute risk, and thus absolute risk-adjusted return. But today – on that famous other hand – investors generally don’t have the luxury of holding out for absolute returns and safety like they enjoyed in the past.
Overall, the future is extremely uncertain and many of the characteristics that define “extreme behavior” are clearly visible in today’s market. Do I think there will be a crash soon? The truth is I don’t know… No one does. But what I do know is that investors aren’t giving themselves enough chance for sufficient compensation (upside) for the risks that they’re taking (downside) and I myself, as an investment advisor, choose to remain patiently on the sidelines until prices come closer to historical averages.