The Economics Hub Newsletter: Week 7
Howard Marks' latest memo, contrarian investing, second-level thinking, investment philosophy and other article recommendations
Happy Sunday!
Welcome to another issue of The Economics Hub Newsletter! I hope you are well.
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Here’s what we cover this week. As per your interest and convenience, please click on the specific topic to jump directly to that section!
Ready? Let’s dive in!
1. Howard Marks’ Latest Memo: I Beg to Differ
Howard Marks, the founder of Oaktree Capital Management is widely considered as one of the most successful investors of all time. He particularly specializes in high-yield and distressed debt investing opportunities. In the investment world, he is famously known for his client memos, sharing his wisdom and perspective on the macro-economic and investment landscape and more general insights. He published his first memo to clients on October 12, 1990, and since then, his memos are periodically sought out by some of the best investors in the world. You can check the complete list of his memos here.
“When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.”
Warren Buffet, Chairman and CEO, Berkshire Hathaway
On a similar note, I am currently reading his “The Most Important Thing” book and I cannot recommend it enough! The book dives deeper into the time-tested key investing strategies backed by his fundamental investment philosophy. He also outlines the pitfalls that can destroy your capital or ruin a career. He utilizes passages from his memos to illustrate his ideas and demonstrate the development of an investment philosophy that fully acknowledges the complexities of investing and the perils of the financial world. It doesn’t matter if you are a beginner or a professionally trained investor, the book offers broad takeaways. It is a short, accessible and qualitative book, please consider getting a copy!
Okay, back to the topic.
In his latest memo, he argues that investors seeking superior performance must have the courage to depart from the pack, even though doing so means accepting the risk of being wrong. Thinking differently and better than others is key to outperformance, he explains, because in investing, it’s not enough to be right. You have to be more right than most. This means being able to tell when the investment crowd is focused on all the wrong things.
He begins his memo by presenting a simple two-by-two matrix to illustrate the importance of “unconventionality” in investing. Unconventionality, as he puts it, is required for superior investment results, especially in asset allocation. To distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently. The bottom line is, that you can’t take the same actions as everyone else and expect to outperform.
The matrix presented above can be summarized as:
If your behaviour and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if the behaviour is unconventional is your performance likely to be unconventional . . . and only if the judgments are superior is your performance likely to be above average.
He proceeds to assert that to make returns above average, you have to depart from consensus behaviour. You have to overweight some securities, asset classes, or markets and underweight others. You need to make active bets. However, every active bet placed in the pursuit of above-average returns carries with it the risk of below-average returns. Okay, what does it mean? It essentially means that you cannot expect to earn more than average returns if your “active bets” are wrong and if they are wrong, your return will simply be below average. As easy as it sounds on paper, this is extremely difficult to accomplish in reality. As he puts it:
Anyone who thinks there’s a formula for investing that guarantees success (and that they can possess it) clearly doesn’t understand the complex, dynamic, and competitive nature of the investing process. The prize for superior investing can amount to a lot of money. In the highly competitive investment arena, it simply can’t be easy to be the one who pockets the extra dollars.
So what can you do as an investor to prevent your “active bets” from being wrong? He advises that you have to depart from the pack, and by departing from the pack, the difference will only be positive if your choice of investing strategies and tactics are correct and you’re able to execute them better. He then proceeds to summarize his key investment strategies, some of which are discussed below:
Second-Level Thinking
Contrarianism
The Decision to Risk Being Wrong
Second Level Thinking
The idea of second-level thinking is built on his memo titled, “Dare to Be Great.” The concept of Second Level Thinking has been instrumental to Howard Marks’ success. It builds on the foundation that most investors are exposed to the same level of information and assuming that these investors are smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.
You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others ... which by definition means your thinking has to be different.
How can first-level thinking be different from second-level thinking? Let’s see some examples:
First-level thinking says, “It’s a good company; let’s buy the stock.”
Second-level thinking says, “It’s a good company, but everyone thinks
it’s a great company, and it’s not. So the stock’s overrated and
overpriced; let’s sell.”First-level thinking says, “The outlook calls for low growth and rising
inflation. Let’s dump our stocks.” Second-level thinking says, “The
outlook stinks, but everyone else is selling in panic. Buy!”
The difference in workload between first-level and second-level thinking is
massive, and the number of people capable of the latter is tiny compared to the number capable of the former. Second-Level thinkers need to take into account:
What is the range of likely future outcomes?
Which outcome do I think will occur?
What’s the probability I’m right?
What does the consensus think?
How does my expectation differ from the consensus?
Is the consensus psychology that’s incorporated in the price too
bullish or bearish?How does the current price for the asset comport with the consensus
view of the future, and with mine?What will happen to the asset’s price if the consensus turns out to be
right, and what if I’m right?
Again, as easy as it sounds, it isn’t in reality. There are no simple formulas or cheat sheets. As Charlie Munger once said:
It’s not supposed to be easy. Anyone who finds it easy is stupid.
The majority of investors work with the same information, data, reports, portals, etc. as everyone else and are subject to the same psychological influences, which in turn, makes it very difficult to have a second-level thinking perspective on the markets. Furthermore, it is not only important to have different thinking from the consensus, but your line of thinking or analysis has to be correct or closer to being correct.
Howard Marks and his son Andrew described a few factors that distinguish second-level thinking in the 2021 memo titled, “Something of Value.” Their superiority essentially stems from their ability to:
better understand the significance of the published numbers
better assess the qualitative aspects of the company, and/or
better divine the future
In the end, the whole concept of Second_level thinking can be summarized as follows:
For your performance to diverge from the norm, your expectations— and thus your portfolio—have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
Howard Marks in his book “The Most Important Thing”
Contrarianism
It is obvious from the above discussion that the key to superior investing cannot be achieved by following the “investment herd” — masses of people (or institutions) that drive asset prices one way or the other. It’s their actions that take prices to bull market highs or market bubbles driven by the psychological trap of “something will always go up.” And on the other hand, the actions of the investment herd can also lead to bear market territory and occasional crashes — these are particularly driven by the collective notion of “Oh no, this is the end. I need to sell everything to get at least a part of my initial investment.”
Clearly, following the judgement of the crowd cannot be the key to successful investing as joining in the market swings of highs or lows tricks people to own or buy assets at high prices and selling or fail to buy at low prices. This is where the need for being a contrarian arises. For attaining more than average returns, following the herd wouldn’t be enough. We need to bet against the consensus view, the trend and most importantly, we need to do it correctly. We need to be contrarians. As Howard Marks put it well in his 2002 memo titled, “The Realist’s Creed”:
It's easy to make guesses about the future but hard to be consistently more right in those guesses than your fellow investor, and thus hard to consistently outperform. Doing the same thing others do exposes you to fluctuations that in part are exaggerated by their actions and your own. It's certainly undesirable to be part of the herd when it stampedes off the cliff, but it takes rare skill, insight and discipline to avoid it.
The thing I'm surest of is that the solution doesn't lie in making guesses about the big-picture future. Rather, it lies with investors who possess skill, insight and discipline.
In the same memo, he outlines some of his desired characteristics:
contrarianism, scepticism, modest expectations, humility and defensiveness
eschewing macro forecasts
attention to the cyclical nature of things (always remember the pendulum never goes in one direction forever but rather swings.)
consciousness of timeframe
concentration on valuation
awareness of prevailing investor psychology or market consensus
concentrate on avoiding pitfalls
face up to the uncertainty that surrounds the macro future
invest in a few areas of specialization based on in-depth analysis, conservatively
estimated tangible values and modest purchase prices
For being an effective contrarian, you should be aware of the following things:
what the investment herd is doing or preaching
what is the rationale behind it
what’s wrong, if anything, with what it’s doing; and
what you should do about it
Again, intelligent contrarianism is hard, deep and complex. It involves much more than simply doing the opposite of the crowd. It is challenging, uncomfortable and requires superior judgment, a trace of wisdom, etc. Nevertheless, being a contrarian enables us to “buy when everyone else is selling — and if our view turns out to be right — that’s the route to the greatest returns earned with the least risk.”
The Decision to Risk Being Wrong
So far, we have discussed enough on improving our ability, insights, mindfulness, aptitude, etc. for having second-level thinking, being contrarian and indifferent to the consensus of the crowd — all for aiming to achieve superior or more than average level of returns, consistently. However, Howard Marks also compels us to account for the risk of being wrong. The would-be investors must understand that every attempt at success by necessity carries with it the chance for failure. The two are inseparable.
In a market that is even moderately efficient, everything you do to depart from the consensus in pursuit of above-average returns has the potential to result in below-average returns if your departure turns out to be a mistake. Overweighting something versus underweighting it; concentrating versus diversifying; holding versus selling; hedging versus not hedging – these are all double-edged swords. You gain when you make the right choice and lose when you’re wrong.
As opposed to passive investing, active investing carries a cost that goes beyond commissions and management fees: heightened risk of inferior performance. Thus, every investor has to make a conscious decision about which course to follow. The conscious decision can be based on various factors such as:
Your risk-taking ability and capacity
Your investment objective based on the ultimate goal and time-frame
Regular cash-flow/income streams
the amount of time you can dedicate to analyzing the markets and optimizing the portfolios
As you can see, it ultimately depends upon the investor and his objectives. The bottom line is that you need to figure out whether you wish to pursue superior returns at the risk of coming in behind the pack, or simply embrace the crowd consensus and aim for the average returns. You can follow either path, but clearly not both simultaneously. Here is how he summarizes his view:
Unconventional behaviour is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes. Thus each person has to assess whether he’s temperamentally equipped to do these things and whether his circumstances – in terms of employers, clients and the impact of other people’s opinions – will allow it . . . when the chips are down and the early going makes him look wrong, as it invariably will.
While his recent memo only discusses these three strategies, his investing philosophy also includes other tactics. I won’t go into their details but you can read more about them in his book “The Most Important Thing” and his memo “Dare to be Great.” These strategies are:
Bucking the Trend
Be a Pioneer
Up Against the Institutions
Avoiding the Agency Risk
Understanding the Price-Value relationship
Understanding, recognizing and countering different types of risks
Efficient Markets Hypothesis and inefficiency of markets
Being attentive to market cycles
Combating negative psychological influences
Patient opportunism
Appreciating the role of luck
He further proceeds to give his valuable insights on some of the most pertaining issues in today’s world of macro-economic and geopolitical uncertainty such as inflation, interest rate hikes and the imminent possibility of a recession. But again, discussions around these topics, although important, mainly revolve under the same heading: the short term. Even if you ignore all the elements of uncertainty, the economic forecasts depend on other factors such as geopolitical events, the competency of policymakers, etc. This makes it harder to:
predict accurate or closer to being accurate movements in the short-term future
Marks advises investors that even if we have an opinion about the short term, we can’t (or shouldn’t) have higher degrees of confidence in it.
If we conclude, there’s not much we can do about it – most investors can’t and won’t meaningfully revamp their portfolios based on such opinions.
In the end, Howard Marks advises investors to stay invested in the markets and not be bothered much about the short-term movements – after all, we’re investors, not traders. This is similar to what I had discussed in the last week’s report, where I summarized JPM’s mid-year investment report. If interested, please read it here.
He highlights the dangers of putting too much importance on short-term movements as follows:
No one should fire managers or change strategies based on short-term results. Rather than taking capital away from underperformers, clients should consider increasing their allocations in the spirit of contrarianism (but few do). I find it incredibly simple: If you wait at a bus stop long enough, you’re guaranteed to catch a bus, but if you run from bus stop to bus stop, you may never catch a bus.
His final piece of advice for both retail and institutional investors is brilliantly laid:
One quarter’s or one year’s performance is meaningless at best and a harmful distraction at worst. If everyone else is focusing on something that doesn’t matter and ignoring the thing that does, investors can profitably diverge from the pack by blocking out short-term concerns and maintaining a laser focus on long-term capital deployment.
Many investors – and especially institutions such as pension funds, endowments, insurance companies, and sovereign wealth funds, all of which are relatively insulated from the risk of sudden withdrawals – have the luxury of being able to focus exclusively on the long term . . . if they will take advantage of it. Thus, my suggestion to you is to depart from the investment crowd, with its unhelpful preoccupation with the short term, and to instead join us in focusing on the things that really matter.
What else I read this week…..
Fed Hikes 75 Basis Points Second Time, Signals Third Is Possible (Bloomberg)
Explained: Fed Reserve rate hike, US recession and impact on India (The Indian Express)
A hawkish Fed signals further rate hikes and sees a slowing economy – but not a recession (The Conversation)
What the Fed's Latest Interest Rate Hike Means for Mortgage Rates, Credit Cards and More (Money)
Fed rate hike: How will it impact your mutual funds? (The Economic Times)
SEBI notifies social stock exchange framework (The Economic Times)
Instagram rolls back changes after backlash (The Economic Times)
Instagram is fueling a thrifting boom in India, Bangladesh, and Nepal (rest of the world)
Two Weeks In, the Webb Space Telescope Is Reshaping Astronomy (Quanta Magazine)
IMF: Risk of crypto contagion to wider financial markets ‘limited’ (ETF Stream)
What about all the FUN debt gave you? (Budgets are Sexy)
Danger lurks behind the glamour of celebrity investors (Live Mint)
Integrating blockchain-based digital IDs into daily life (Cointelegraph)
Quantitative Finance Reading List (Quant Start)
Visualizing the World’s Largest Oil Producers (Visual Capitalist)
That’s all for this week folks, and thank you so much for making it this far! I hope you had lots of takeaways. Please subscribe if you haven’t yet and yes, subscriptions won't cost you a penny. It’s free!
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Have a great week ahead,
Shreyas