Howard Marks Memo Summary: You Bet

My favorite investor to follow is Howard Marks.  There’s some unique insight that can be taken from the works of most successful investors and I I specifically enjoy the quarterly memos published by Howard Marks with Oaktree Capital. Warren Buffet has called the quarterly memos required reading for him, so I took that endorsement and started doing the same.   Marks’ work between Mastering the Market Cycle and The Most Important Thing were also two favorite investment reads of 2019. This quarter Howard Marks wants to help investors think about investments based on probabilities.

January 2020 Oaktree Capital Memo: You Bet

There’s a reason there are top investors and there are top players in a game like poker.   Investing and gaming both involve three dimensions:

• Skill
• Luck
• Information Available

In investing, information availability is supposed to be uniform and the SEC delivers harsh penalties for insider trading.   Similarly, a known card counter in blackjack will be removed from the casinos because they possess information available that shouldn’t be available in that game.   Marks goes on in detail to describe numerous games and how they vary in luck, skill, and information availability. I’m not a gambler myself (we tried once, lost $10, and both myself and Mrs. Shirts were miserable for the rest of the day after the experience), so admittedly I couldn’t fully relate to all the games the gambling to discuss.  

However, one of my favorite games to play with the extended family is monopoly and I could relate to his discussion around skill, luck, and information available.  This is a game that involves luck and skill, but generally all the same information is available to everyone minus those pesky Chance and Community Chest cards. One particular family member almost always loses due to a failure in skill:  He refuses to keep enough cash in reserve to support liquidity while making “all-in” bets as soon as he can buy houses and hotels. I always think about asset allocation and the importance of keeping enough on hand for an investing downturn. 

The Memo: Key Takeaways:

Index Investing is Good!  Index investing requires no skill, yet allows the individual investor to receive the return of the total market.   This is my recommendation for everyone building their first $1,000,000. I believe doing anything other than index investing with the first million dollars presents a distraction from the fundamentals of financial independence:  Grow your income, reduce your expenses, and invest the difference in a high savings rate. There isn’t enough in invested assets yet to make appropriate gains to compensate you for your time.

Understand Odds and Probabilities:   Much about Financial Independence is about odds and probabilities.  Will the market average a certain return? What are draw down risks? Where are the odds better, doing pre-tax accounts now or saving in Roth accounts?  Will the 4% rule hold up? All of these things are uncertain, we just make the best decisions we can based on the odds. The same applies for probabilities when picking your investments.

I’ve never been able to invest in the technology sector.  It just didn’t fit with what I “wanted” for an investment, the probability of every investment I make increasing at a rate at least as good as the market.   I couldn’t and still struggle to come to terms with the odds for these investments. Marks goes on to compare sports betting with venture capital investing: The most successful Silicon Valley VC firm may make 20 small investments and recuperate everything based off one home run.   They do this by finding companies that have 20-1 odds of being successful but the payoff on the one successful one is 100-1. The firm earns a successful return from the one that succeeds that covers all the other losses. (Marks has acknowledged in interviews that not fully understanding the payoff in technology investing earlier in his career is one of his investing regrets)

I’ve personally struggled with this on the other side of investments I do understand.  There are often investments I see where the underlying company is okay, but has too much debt and therefore the common stock has a high likelihood of going to zero in bankruptcy.   However, if the company’s management can pull out from this burden of debt, the stock may triple, quadruple, or more in value. I’ve been tempted to invest in these situations but hadn’t fully wrapped my head around it.   Its the same odds based analysis that goes into the technology stocks I’ve avoided due to valuation.

This memo helped provide me with more clarity.  If the odds are right, it may be a good idea to make a smaller investment where the probability of a high return offsets the likelihood of loss. 

Don’t mistake a bad outcome for a bad decision:   This is both good investing and good life advice. This example would always come up in my old job.   I would see someone make a loan (and a credit officer approve a loan), then the loan would go bad.   The weaker credit officers would inevitably say “I shouldn’t have made that loan, how did I not see that, ect”. The stronger employees would say “I am confident I made the best decision I could at the time with the information provided”.

The memo discusses the top poker players still losing 40% of their hands.  The same applies if you choose to be an individual stock investor. Some of your choices will win, some will lose, and if you own too many individual stocks, you might as well just be an index fund investor.   However, you should not confuse a bad outcome with a bad decision. Did you make the best decision you could at the time with the information provided? Is there anything you can learn from your decision to help you with the next one?  I missed out on a once in a generation sale on real estate 8-10 years ago because I worked in a business that was constantly bombarded with bad the bad news. I will be willing to take the risk if I see that level of sale again.

Invest in what you know:   The best gamblers play the games they are most familiar with it.  Individual investors should do the same. If you are in technology, you probably have an edge on the average investor.   I personally enjoy investing in banking, real estate, activist investors, and distressed companies. That is where I have professional experience.   It may be different for you and it’s okay to say “I don’t know what I don’t know”. Peter Lynch was famous for telling investors to invest in what they know.

Look for Inefficient Markets:   When someone talks about inefficient markets, they are usually talking about the efficient market theory vs. non efficient markets or investing in emerging markets.   I view inefficient markets when some short term news effects an entire industry’s stock prices, but the news may not specifically harm a single company.   

The best example I can remember was in early 2016, the price of oil plummeted to below $30/share after a four month fall.   Reports were coming out talking about the contagion from this into the banking sector and all banks fell in price. I happen to take the opportunity to add shares in Bank of Hawaii, which had zero oil exposure.  I was rewarded well. I know others who were in the banking industry and understood the oil and gas concentrations and management talent of various banks, and bought a bunch of Texas based Frost Bankshares under $50/share and doubled their money in two years.  

Similarly, investors had an opportunity to buy Costco at $150/share in July of 2017 when Amazon announced they were buying Whole Foods and everyone in the investment community declared all grocery selling retailers dead.   Three and a half years later the investors who thought that might be an absurd thesis were rewarded with a 100% gain. It was one of my largest holdings at the time and I’m kicking myself for not adding more even though I knew it was absurd.  

Local real estate investors are a great example of finding an inefficient market. There are only so many people with the capacity to buy a stand alone rental property and willingness to deal with tenants.

Summary

I have binged Howard Marks work and can not recommend it enough for people once they approach financial independence and want to be more thoughtful in their investing.   Understanding the various types of investment risk and understanding risk relative to return has served me well in my investing career.   Understanding odds and the probability of outcomes is applicable to financial independence. I see people grinding to work an extra year, two years, three years, to try to offset a minimal probability of running out of money, but what’s the probability that you run out of life first?