Howard Marks, chairman of Oaktree Capital.
I began to work in the investment management industry more than 46 years ago. Thus I’ve had lots of time to develop my investment philosophy. I’d like to describe some of the inputs that contributed to its formation.
During the decade that began in 1968, I served in Citibank’s Investment Research Department and eventually rose to the position of Director of Research. The approach the bank employed during that period was described as «Nifty Fifty Investing,» meaning the bank bought the stocks of what it thought were the best, fastest-growing companies in America – companies like IBM (IBM 160.38 -1.18%), Kodak, Merck (MRK 61.89 -1.06%) (MRK 104.1 1.07%), Texas Instruments and Coca Cola. But if you bought those stocks in 1968, by 1973 you’d lost a large proportion of your money. So that was my first big lesson: you can invest in high quality assets and lose a lot.
In 1978 I transferred to money management and was asked to start a fund of high yield bonds – also called «junk bonds» – for one of the bank’s clients. Now I was investing instead in some of America’s worst companies . . . and the fund made a lot of money. So not only did high quality investments fail to ensure gains, but low quality investments didn’t necessarily bring losses. That was my first important lesson: investment success isn’t a function of what you buy, but of the price you pay for it.
In the process of learning about high yield bonds, I had a pivotal meeting with Michael Milken in 1978. Among other things, Milken explained that if you buy AA- or AAA-rated bonds, they only have one way to go: down. But if you buy B-rated bonds and they survive, he said, they also have only one way to go: up. The lesson here was subtle but significant, and it lay in three little words: «and they survive.» I took away the conclusion that the right goal in managing high yield bonds isn’t finding companies that would get stronger and be upgraded or taken over. They most important thing was excluding from our portfolios the ones that wouldn’t survive. This provided the seed for Oaktree’s overarching motto: «if we avoid the losers, the winner will take care of themselves.» If we can put together portfolios of bonds that pay interest and principal as scheduled, some will have good things happen. Those things will bring us serendipitous gains. But the necessary precondition for enjoying them was the issuers’ survival.
Milken’s advice fit well with an article I read in the Financial Analysts Journal: The Loser’s Game by Charles Ellis. Sy Ramo – the «R» in the name of the company TRW – had written about the fact that, whereas championship tennis players win matches by hitting winning shots, amateur tennis players win by avoiding hitting losing shots. To win, the professional has to hit shots that his opponent can’t return. But if the amateur merely keeps the ball in play long enough, eventually his opponent will hit it into the net or off the court. Ellis adapted Ramo’s observation to investing, pointing out that most investors are like amateur tennis players, because market efficiency makes it quite hard to find bargains and beat the market . . . that is, to hit winners. If that’s true, victory goes to investors who avoid errors. In his view that meant investing passively, achieving strong diversification, and minimizing investment costs.
I believe there are markets that are quite efficient; my years spent researching prominent, large-cap stocks had convinced me that – perhaps above all else – I didn’t want to spend the rest of my life «choosing between Merck and Lily,» as I put it. But my experience managing money in more obscure market niches like high yield bonds convinced me that not all markets are efficient, and that it’s possible to find bargains and achieve superior risk-adjusted returns.
So I didn’t give up on «beating the market» as Ellis would have had me do. Rather, I concluded – in line with his article – that the route to success still wouldn’t come most dependably through finding incredible successes, but through investing in underpriced assets, enjoying a lot of satisfactory results, and avoiding big losers and bad years capable of scuttling our long-term record. Not hitting winners that would get our names into the newspapers, but avoiding losers that would cost us points and games.
Another pivotal input – with a profound impact on my philosophy comparable to Ellis’s – came from one of my role models, the late economist John Kenneth Galbraith. In his 1990 book A Short History of Financial Euphoria, Prof. Galbraith said simply, «We have two kinds of forecasters: the ones that don’t know and the ones that don’t know they don’t know.» In other words, forecasting can’t dependably be done correctly. Thus forecasts regarding the direction of economies, interest rates and investment markets can’t be counted on to deliver superior investment returns. My experience had suggested the fallibility of forecasts and forecasters, and Galbraith confirmed it. Non-reliance on macro forecasts has been an important component of my investment approach ever since.
It’s not that macro forecasts are never right. Most of the time the macro future is a lot like the macro past, and in those times, extrapolation is successful and simplistic forecasts are often right. But when you extrapolate the recent past and the future repeats it, a forecast of continuation is rarely profitable. What would be very profitable are correct forecasts of drastic changes in direction. But those changes are very hard to predict consistently. Someone usually gets it right on the occasion of each change, but no one gets it right consistently. Those isolated correct forecasts don’t prove that forecasting can be done successfully, consistently and profitable. The sum of my experience has shown these statements to be true.
The most recent of my seminal inputs came in another key book, Fooled by Randomness by Nassim Nicholas Taleb, published in 2001. Highlighting the difficulty of forecasting, Taleb made clear – among many other important things – that the future is composed of a distribution of possibilities, and even if you know what outcome is most likely, many other things can happen instead. Even the most likely outcome is only one of the possibilities. Even if it has the highest single probability, its likelihood rarely approaches 100%. The other possibilities introduce uncertainty. Elroy Dimson, a professor at the London Business School, capped it succinctly: «Risk means more things can happen than will happen.»