Stronger for Longer

"The Tortoise and the Hare" is a famed fable, which is most commonly associated with the dictum slow and steady wins the race. This dictum has given rise to my new philosophy: stronger for longer. In this post, I will explain why investors should always have this at the forefront of their minds. 

In a recent gym session, I pushed myself particularly hard. Consequently, my left quadricep froze, causing inflammation around my knee. A few days later, my lower back muscles went into spasm. I am now using compression, a foam roller and ice-packs to help my leg and back heal. This is the second time my knees have become irritated, and the third time my back has gone into spasm. Clearly, I have injured myself far too frequently in the gym. Thus, I have decided that I must be more careful in the gym, and dedicate more time to post-workout stretching. 

My repeated experiences in the gym have finally reminded me of "The Tortoise and the Hare"; I have concluded there is no point attempting to go too far too fast, only to suffer from an injury. It is better to make slow and steady progress.

So, why should all this matter to an investor? Amongst athletes and active-types, making gains is a colloquialism used to refer to getting stronger, and building muscle mass. Too many people are in a rush to make such gains. Too many people get injured in this rush.

Investors are in the business of seeking gains - albeit of a different kind. And, surprisingly - or unsurprisingly - investors too are in a rush to make gains. Thus, it is important for investors to remember that the race is won through patience, and disciplined capital allocation - not by chasing quick money; it is always better to avoid an injury that will land you back at square one. Let us all seek to be stronger for longer.

Howard Marks on Investing

In my previous post, I criticised the decision of the Oaktree management Company to sell itself to Brookfield. I continue to believe that Mr. Marks did not act in the best interest of the minority shareholders. However, I have decided that it is still worth continuing to learn from Marks' investment approach. Thus, in this post, I have collected my thoughts relating to the following Howard Marks Investor Series Interview at Wharton. I have added my thoughts to Mr. Marks' comments. 

                                                   Source: Wharton School Youtube

What makes money?

Uncertainty is a money machine. As Wilbur Ross puts it, "Investors often find themselves running into burning buildings", or as Howard Marks puts it, in the investing world, you "have to be willing to catch a falling knife". Given that as an investor one is usually being bold in distressed situations, one must search for two things: A margin of safety and conviction. 

"The margin for error comes primarily from being able to use conservative assumptions and then still be looking at a generous rate of return; But, I must say that it it's not true that the the more conservative the better, because you can get to the point where you can make assumptions that are so conservative that you'll never lose money, but it will give you a target buying price which is so low that you'll never buy anything."

To be comfortable making a decision, you have to have a good idea about what a company is worth - come up with a conservative estimate - and buy it for less. The discount to valuation despite conservative estimates should provide you with a margin of safety. However, as with all things in life, moderation is key. This is because if you are excessively conservative, then you will simply be rationalizing inaction. 

Emotions are a roadblock to harnessing the power of uncertainty. This is partly what Warren Buffett may mean when he says that we must be greedy when others are fearful, and fearful when others are feeling greedy. In effect, when every one is greedy, they become less conservative - often without realising it - and when everyone is fearful, they become too conservative. Instead of thinking about it in black-and-white terms, perhaps it would be more appropriate to say that one must approach investing with a healthy balance of optimism and caution. What I understand from Mr. Buffett's statement is that when everyone is optimistic, it is important to tread cautiously, and when everyone is scared, it is important to be optimistic - whilst still remaining cautious.

"The knife falls until the dust has settled, until all the uncertainty has been resolved. But, the trouble is that once that happens then the price will have rebounded. So, we want to buy at a time of upset and while the knife is still falling, and I think that the refusal to catch a falling knife is a rationalization for inaction. It's our job to catch falling knives; that's how you get bargains; but, you have to do it carefully."

In effect, a big downmarket is when one is required to be bold. But, one must be eternally cautious. This can be emotionally difficult. In an environment in which it is instinctive to be scared, one must become emboldened; as an investor you must always be rational!

Be contrarian - and right - to "make the really big money". Catching a falling knife, requires you to go against the herd. You must be contrarian, and right to really generate a substantial return. 

"You make the really big money in this world by unhooking from the market when everybody's happy, and nobody could think of anything that could ever go wrong, and everybody thinks that the trees are going to grow to the sky, and so you should sell up here. And then, the market collapses and nobody can think of anything that could ever go right again, and every stock price is devoid of any optimism at all, and that's a great time to buy. But to be [able to do] that you have to be a contrarian, and you have to be able to diverge from the crowd."

Being contrarian requires you to use what Howard Marks frequently refers to as "second-level thinking." In today's world, where information is instantaneously and universally available, second-level thinking means interpreting facts differently, thinking differently, and reacting differently.

"Everybody receives the same inputs. We [all] read the same newspaper [...] but some of us see the news and the prices as a buy signal, just when most people see the news and the prices as a sell signal, and vice versa. And you want to be in the minority. [You know,] there are three stages of a bull market. The first stage is when only a few unusually perceptive people believe that there could be some improvement. The second stage is when most people accept that improvement is actually taking place, and the third stage is when everybody and his brother believes that things can only get better. You make a lot of money if you buy in the first stage. You lose a lot of money if you buy in the last stage. You buy the same things as everyone else, but what matters is when you buy them and at what price."

We have said that contrarianism is an indispensable ingredient for investing success. However, we must not be contrarian just for the sake of it. There are thousands of investment professionals, who are usually - on average - right; thus, if we are to hold a contrarian view point with conviction, we must question our interpretation and views to make sure we are right. There is, after all, no prize for being contrarian and wrong - indeed, being contrarian and wrong yields nothing but punishment.

The past, the present and the future.

The past is a good indicator for the future. Cycles repeat themselves, and learning from past experiences is a good way to prepare yourself for future experiences; being able to effectively compare and contrast the present with the past enables us to make better decisions. 

Mark Twain once said, "History doesn't repeat itself but it often rhymes".

As is almost always the case in the investment world, we must tread cautiously when we compare with the past. This is because our comparisons are often flawed. Firstly, the past can be viewed through an array of lenses, which makes it difficult to determine what really constitutes the past. Moreover, history only rhymes, and cycles cannot be counted upon; there is no such thing as market timing! Marks also makes a point of reminding new entrants into the investing world, that it has not been boom-crash all the way through; there may well be periods of low, steady growth, or even just stagnation.

Yet, there is little doubt, that a detailed, far-reaching study of the history of financial markets is likely to make everyone a better investor. It is also likely that past management decisions of a company are an indicator of forthcoming decisions.

Today is on the way to tomorrow. Businesses must survive this year before making it to the next. Thus, it is important to consider the ability of a business to navigate the present business environment; this may require financial ability, technological ability, or execution skills. Moreover, decisions today will affect the company's future; indeed, Jeff Bezos says that "[a quarter's results were] baked three years ago," so surely what a company is doing today could also be a pretty good indicator of where it might be three years later!

Investors can't escape dealing with the future. This is because what you are willing to pay for a business today is a function of what you think its earnings will be in the future. However, the future is inherently uncertain, and so people's opinions of the future change continuously. These changes are reflected in asset prices. This is what allows contrarian investors to generate returns.

Building an investment team.

In Pioneering Portfolio Management, David Swenson says that investing requires “a rich understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events”. Thus, investing is a challenging, interdisciplinary field.

"Hire rational grown-ups with a long-term orientation. [As a contrarian investor] you only really make money in downturns. That is less than 20% of the time." 

Consequently you need partners who possess integrity, and an ability to "[grind] it out". You need people who are curious, investigative, and contrarian. And of course, you need people who are extremely patient and humble. 

The future of the investing world

Passive Investing dominates. In recent years, low cost ETFs have gained in popularity. This is likely the result of three things. Firstly, these funds have low costs. Second, actively managed funds can be mismanaged. And, third, during the long economic recovery after the financial crisis, alternative asset managers have struggled to generate alpha. This  has two particularly significant implications. Firstly, asset managers are being forced to be more competitive on price. Secondly, asset managers with poor performance are being eliminated from the industry. Thus, this is a relatively 'tough' time for asset managers, who previously received extremely high compensation. Whilst it is unlikely that the active asset management industry will return to its glory days, I believe it is possible that alternative strategies will come back into favour following a downturn.

Investing requires skill - but also luck. As larger numbers of skilled asset managers have entered the field, the market has become more efficient. This - coupled with the low interest rate environment [in the US] - has produced a low return world. In addition, owing to the paradox of skill (Success Equation, Micael Mauboussin), luck has become a more important determinant of returns. 

Fear not for there is hope. Whilst asset management is harder, and perhaps not as financially rewarding as it used to be, it remains an intellectually stimulating field, which continues to reward its successful players handsomely. Indeed, it is also possible that in light of the aforementioned challenges, people will seek alternative opportunities and careers. This will only increase the opportunity available to those who continue to seek stakes in high quality, well run businesses which are available at a (discount to) fair value.

Oaktree's decision to sell itself does a disservice to minority shareholders.

I generally endeavour to follow Mr. Buffet's recommendation that we "praise by name, and criticise by category". However, in this post I shall knowingly disregard this advice. This is because I feel  particularly strongly about this matter.

I have been a shareholder in Oaktree Capital Management for over a year now. There were a few reasons I chose to make an investment in the company. The most important ones are outlined below:

A. I thought Oaktree was a good quality business:

1. Good quality, trustworthy management with long-term orientation.
2. Good investment return track-record and cautious approach to investing.
3. Serious focus on its philosophy and fiduciary responsibility.
4. 1, 2, and 3 make it a leader in distressed debt investing. 
5. 'Firms', 'Capital', and 'Credit' will always exist in some form.

B. I thought Oaktree was undervalued:

In recent years, as the financial markets have rebounded after the Great Financial Crisis, and achieved new highs, Oaktree has been able to exit positions and 'book' returns. However, as optimism has increased, the number of bargains has fallen. Hence, Oaktree has been unable to redeploy all of this capital. Consequently, they have returned money to some investors in the funds, or have chosen not to raise capital. The 'reduced' AUM, and unavailability of bargains has resulted in lower management - and performance fees. Consequently, earnings of the management company have been low.  

As and when the next crisis occurs, Oaktree's reputation will enable it to raise capital, and the circumstances will present bargains. Thus, as the markets recover, Oaktree would - again -  be able to deliver strong financial performance to its investors. This in turn would enable Oaktree - the management company - to generate greater profits. At least, that is the business story Mr. Marks and his firm have long presented.

As of today, my thesis for Oaktree Capital Management remains largely unchanged. Thus, I am confused by Oaktree's sudden decision to sell itself. Firstly, I fail to understand why you would sell the company at a time when earnings are lower than they will likely be in the future. Oaktree itself says that "[its IPO] has not been a great success. Maybe [we] are not suited for public ownership." It is difficult for me to swallow that a firm full of long-term value investors has chosen to judge how much the market likes asset management firms within a six-year 'long' time period since its IPO. Furthermore, it is my view that the firm should not sell itself simply because the stock has not performed well. Moreover, this statement by Oaktree's management, that Oaktree is undervalued provides proof that the 'premium' to market value paid by Brookfield is meaningless. Also, in selling itself to Brookfield, which is itself listed, Oaktree doesn't necessarily resolve this issue; perhaps Oaktree is simply hunting for excuses for selling itself. Secondly, I feel cheated by the fact that Oaktree's management will continue to own and operate the company independently. When I initially purchased my stake, internal ownership gave me confidence that I was in the same position as Mr. Marks. Now I find that is not quite true. I am able to understand why Brookfield may insist on the managers' owning a stake in Oaktree. However, this raises concerns over the conflict of interest facing Oaktree's executives: by selling the public's shares at a discount to fair value, Oaktree could secure a better price for its managers in the future. This would directly place management's interests before those of the minority public unitholders. 

I am sure that Oaktree has the legal grounds for their actions. Yet, Mr. Marks and his team are wrong to sell. They were certainly not capable of negotiating the best possible deal to benefit minority public unitholders, who do not have significant voting rights.  I have suffered a great personal loss - lost a role-model - if Mr. Marks has chosen to place his personal interest above what is morally right. Thus, I should be delighted if Mr. Marks were to directly address these concerns in an explicit manner. Perhaps he could start by publicising the terms of his future liquidation. Otherwise, people should take note; if Mr. Marks' firm is willing to put itself above minority shareholders, someday Oaktree will be willing to place itself above investors too.

A reflection on the importance of probability, outcome, and expected return.

Why probability alone is useless, the challenges posed by tail outcomes, and our inability to determine distributions.

It’s All About Expected Return

I am currently reading Nassim Taleb’s Fooled By Randomness. Early on, Taleb makes an important distinction between probabilities, and expected returns. This is particularly key when there is an asymmetric distribution of outcomes. 

Here is a brief summary of Taleb’s example. Taleb considers the stock market. For the purposes of the example, say there is a 70% chance the market (index) will go up, and a 30% chance the market will go down. Using these probabilities - without considering the outcomes - we would arrive at the conclusion that one ought to invest in the index. Now let us take the same odds, and attach outcomes to each probability; there is a 70% probability that the market will go up by 1, and a 30% probability that the market will go down by 10. In the following table, expected return is calculated:

Probability	Outcome	Expected returns
70%	1	0.7
30%	-10	-3
	Total expected return:	-2.3

The expected return is -2.3, suggesting that it would be wiser to short the index. This is because if I were to make this decision - in the same theoretical conditions - an infinite number of times, I would only be able to generate a positive return by doing this.

Low Probabilities and Finite Deaths

Whilst I have just used Taleb’s example to show that expected return is a more useful metric than probability, I must strike a cautionary note. This is because in reality, we do not always have the ability to repeatedly make the low probability bet in this example. In effect, it is possible for you to make decisions that are correct on an “expected return” basis and still suffer an “unacceptable outcome”. This is because we can only make a finite number of ‘bets’. If the more likely outcome were to occur in each of your ‘bets' you could lose all capital. This would be a finite death. Thus, perhaps it is best to invest only when the probability and expected return are both in your favour.

We have now discussed how investing solely in low probability events that can be justified on an expected return basis could result in an indigestible outcome. However, it must be said that ignoring tail risks (of very low P) that have a great magnitude could have equally - if not more - devastating consequences. In my post about Confidence Game, I distinguish between improbability and impossibility. This is an important distinction, because events with very low probabilities can produce unacceptable outcomes when they do occur. 

Effectively, it is important to consider low probability events in a careful, balanced manner as they may be associated with unacceptable outcomes.

Imagining Odds and Outcomes

In the example Taleb refers to, there are two definite probabilities, and two specific outcomes. This serves the purpose of illustration; however, assuming that things are as easily predicted in reality, would be a grave mistake. 

In reality, we must begin by coming up with a range of outcomes. This itself is very challenging. Now, after we have determined a range of outcomes, it is important to attach a probability to each outcome. It is very difficult to attach accurate probabilities. People normally overestimate the amount by which things will change in a year, and underestimate the magnitude of change that can be achieved through slow, steady progress in a decade. This is just one systematic error we are prone to making. 

Imagining the outcomes, and then attaching probabilities to these outcomes is an art form. It must be undertaken with diligence, caution, and an awareness of the difficulty of the task. Investing does not reward ‘accuracy’ - indeed some say this is impossible. Instead, it pays you for (i) being right about the ‘story’ of a business, and (ii) seeking a margin of safety.

Value vs. Growth

Investing is often divided into value investing and growth investing. This is wrong.

Value investors “believe” in buying assets for less than they are worth today. Growth investors “believe” that investing in fast-growing companies is more important than investing in companies at a discount to real value.

Both schools of thought have some merit; you must own businesses which are trading below what they are worth to be able to generate any return. It is also important to own businesses which will, at the very least, exist in the future, if not grow, if you want to be able to generate returns over long time-periods. 

Indeed, as Howard Marks says, ‘All investors try to buy value – that is, to buy something for less than it’ll turn out to be worth’. One might say that Value investors are focussed on the present and can’t help having to deal with the future, whereas Growth investors are focussed on the future, and are compelled to consider the present. Marks believes that the choice isn’t one of value vs. growth but one of “value today” vs. “value tomorrow”.