Bonus Episode: Howard Marks on “In Good Company”

0:00Hello, and welcome to The Memo by Howard Marks. I'm Anna Schemansky, and today we have a special treat for you. Howard recently joined the In Good Company podcast with Nikolai Tangen. They discussed Howard's investment philosophy, risk management, and how to determine the quality of a decision. We hope you enjoy the discussion. Hi, everybody. I'm here in Oslo with the co-founder of Oaktree Capital, the investment guru, Howard Marks. Great to have you here.

0:37You are one of the world's most impressive and respected investors and also very famous for writing various kinds of memos. Now, we'd love to start off by just asking you, what got you started in finance in the beginning? You know, I was very fortunate. I went to the public schools in New York, and schools were crowded and difficult. but one day one of my buddies said, they're teaching a course in accounting. We should take it. And I took it. I loved it. Not many people love accounting. Not too many. But, you know, it has a symmetry that a certain kind of mind responds to. So I took it and I loved it.

1:19And, you know, I decided to become an accountant. Excuse me, what is that certain kind of mind? what is that? Well, I think very left brain, logical, literal, mathematical. But it's really the symmetry. It's the balance between the left and the right. When I walk through Oslo and I see the very symmetrical architecture, I enjoy it. Some other people might think it's boring or too regular but you know I responded very strongly and so I went off to Wharton to become an accountant and then I was introduced to finance which is actually of course much more interesting and switched to finance. It's interesting because most places they say finance but at Wharton they say finance.

2:11I think that's right. Yeah very good. Now what is your investment philosophy now? What is it?

2:21My philosophy is, I guess it's Oaktree's philosophy, six very simple points. Number one, risk control. I believe it's easy to make money in the market. That's especially true in the good years. And most years are good years. The challenge, the real skill is to make money with the risk under control so that if it turns out to be a bad year, instead, you won't do too badly. Number two is consistency. My clients don't want results that are all over the lot. And at the top, one year and at the bottom, the next. So we try to be just consistently a little bit above the middle. But then thanks to risk control in the really bad years, we do bounce up to the top.

3:07Number three, I believe there's such a thing as market efficiency. And we target only the less efficient markets. Number four, high degree of specialization. You can't be a successful generalist, in my opinion. You have to know more than everybody else about a few things. Number five, we don't rely on macro forecasting to drive our investments. And number six, we don't expect much from market timing. So that's the philosophy right there. Has it changed over time? I knew all those things 50 years ago, but I think my adherence to them has grown stronger, my conviction. Which ones in particular? Well, first of all, I think market efficiency is a very important concept.

3:58my experience as an investor over the years showed me why and introduced me to to the limits on knowing more than others and that leads into non-market timing and then my experience with forecasters basically in my opinion showed me that it doesn't work macro forecasting all the macroeconomists are useless well you said that no no i'll do as a question I'm sorry. My intonation was wrong.

4:34I would say they're not right consistently enough to follow. And, you know, when I started at the bank 55 years ago, we used to say that an economist is a portfolio manager who never marks the market. And I think that's true. You know, if you were an active investor, you wouldn't hire somebody without looking at their record. But no economist ever presents his record. No, they can't because they wouldn't be hired. Now, which of these rules have been the most difficult to adhere to? Have you never been tempted to break some of them? I mean, you must have been. I've never been tempted to break from them because I think that what they all emphasize, in my opinion, is the limits on knowledge.

5:19And the longer I live, the more I understand the limits on knowledge, the more convinced I am. What are the limits of knowledge? Well, number one, randomness or luck is every place in our business. You're not dealing with physical laws like in physics or in engineering. You're dealing with, in large part, people. I mean, what are markets? It's a collection of people. How is history made? Through the actions of people. And the world is governed through the actions of people. So processes which are basically built around people can't be predicted. The physicist Richard Feynman once said that physics would be much harder if electrons had feelings.

6:10People have feelings. And so their behavior is unpredictable. And randomness plays a very big part. Yeah, you often talk about that, how you judge the quality of a decision. Yes. Tell me about that. Well, thanks to randomness, a good decision doesn't always work. And a bad decision doesn't always fail. The first book I read when I got to Wharton 61 years ago was Decision-Making Under Uncertainty in Oil and Gas. And the greatest lesson I remember learning from that book is that you can't tell the quality of a decision from the outcome. Now, this is a concept that many, many people wouldn't get.

6:55Well, of course you can. But if you think about how random the world is, you know that in the short run, randomness alone can produce just about any outcome. Is that because also some stupid people get rich? Well, that's right. We all know people. We say, oh, he was right for the wrong reason. Yeah. and there are stupid people who get rich, of course. You know, one of the things I say is that the ingredients in success are aggressiveness, timing, and skill. And if you have enough aggressiveness at the right time, you don't need much skill. Now, that can make you write once or twice, but to be right repeatedly over an entire career, now you're talking about skill.

7:43You can't rely on luck for decades. What does age do to your investment process? I think that for the most part, age mellows you. I think you, I hope that in time you understand things more deeply. That's the key. Why are we more patient when we get older or are just about to die? Well, hopefully it's because we learned that quick action is not the answer. Hopefully we develop the wisdom to understand that if you want a good result, you're more likely to get it if you take a little time to think about the question rather than act on a whim. Yeah. Now, you're very dismissive of economic forecasting, as we talked about, but you are a strong believer in cycles and knowing where we are in the cycle.

8:42Why is the understanding of market cycles so important? Well, the world is cyclical. And everybody knows that the market and the economy and politics move cyclically. And nothing moves in a straight line where human behavior is involved. And if you were to account on it doing so, you would get into big trouble. I've been thinking about writing a memo. Lately, people have been asking me, what is the biggest mistake that you've seen? Or what is the mistake that people make most often? And I think it is that once the market is moving in one direction, that it will always continue to do so. In truth, regression toward the mean, or the correction of excesses, is much more dependable than continued movement in a straight line.

9:44Why do things revert back? Because I wrote a book in 2018 called Mastering the Market Cycle. And I'm a great believer in cycles. I'm a student of cycles. I've lived with cycles for a long time. And yet, when I got about two-thirds of the way through writing the book, I said to myself, why do we have cycles? The economy grows at 2 % a year. Why doesn't it just grow 2 % every year? Why sometimes one and sometimes three and sometimes minus one. So what's the answer? The answer is that people go to excess. And for example, if the economy is growing well for a few years, business heads say, oh, well, we have to build a new factory to get our increased share of the growth in our industry.

10:37And so they do. But so does everybody else. Now there are too many factories. And now the factory utilization falls and the companies go into decline. So then they pull back and they stop building factories. So straightforward greed and fear. Greed and fear is a good way to put it. And you mentioned the memos. The second memo I wrote in 1991 was called The Pendulum. Greed and fear, optimism and pessimism, credulousness and skepticism. Now, you dismiss forecasting, yet you are a great believer in trying to figure out where we are in the cycle. Isn't that kind of counterintuitive? It sounds it on the face.

11:21But I think there is a time when forecasting becomes more useful, and that is when we're at an extreme. Now, think about what I said a minute ago, that the biggest mistake people make is to believe that a process once in operation will continue nonstop forever. That's what takes markets to extreme highs, which we call bubbles, and lows, which we call crashes. But when we're extremely high and people get excited and say, hey, this is going to go on forever, usually it will collapse eventually of its own weight. So when the market is crazy high or crazy low, I think we can make a profitable forecast.

12:11The only thing is, Nikolai, that we don't get too many opportunities. I was speaking with my son when I was writing that book on cycles and I said, you know, I think my market forecasts have been about right. He says, yes, dad, that's because you did it five times in 50 years. Five times the market has been at such an extreme that regression toward the mean has been dependable. Not in terms of when it will happen or what will cause it or how fast it'll happen, but the fact that it will. Where are we now? I think we're in the middle ground. I think we're a little bit above fair value, but not so high that a decline is predictable or dependable.

12:59Are you talking about credit cycle now or stock markets? No, I'm talking right now about the stock market pretty much. And I'm not involved in the stock market directly. Most of Oak Tree's activities are in the credit markets. But I think the stock market is a good barometer. Because it's very obvious. We get a reading in the stock market every day. We don't get frequent readings in the credit market. And in private credit, we never get readings. It all takes place behind closed doors. So I take the stock market, and particularly the S &P 500 stock index in the US, as a very good indicator of what's going on in psychology.

13:42How many more good years do you think we have? Well, see, now you've crossed the line. Are we going into prediction now? Well, but not only that, but you've crossed the line into asking me to make a prediction as to time. Right. One of my Oak Tree colleagues in his quarterly letter to his clients stated his rule. If you name a price, don't name a date. If you name a date, don't name a price. Yeah. And then you can never be wrong. Yeah. Here's the important thing to think about, which I don't think many people do. Let's say that you and I can agree that the S &P is 20 % overvalued today, which I think is probably a good estimate.

14:26The P-E ratio is 21. The post-war norm is 16. So 20, 25 % overvalued. Let's say we agree on that. And let's say we're right. The next question is, what is the probability that it's going to decline in the next year? It's modest. It's probably a little better than 50-50, but it's not 100 or 90. If you've lived as long as you and I have, we've seen markets that were overpriced become more overpriced, and then more overpriced, and then get into a genuine bubble. If it was true that every time the market's overvalued, it corrects, then you wouldn't get bubbles. But do you see any bubbles within the market now?

15:18On the positive side, there are people who believe that the AI stocks, for example, are in a bubble. And most bubbles do surround something that's new. And this one does. and something that everybody's very impressed by. I don't know enough about AI to know if this is excessive or justified. But you would look at the things that are most exciting to most people and largely at the things that are new. Now, in terms of excesses on the downside, you would have to wonder about China. I mean, China has been marked down by everybody. Many people describe it as uninvestable. It has declined a lot, that Chinese market.

16:15Is it too cheap? Is it? Well, again, I don't know. I suspect that it may be, but I don't know enough about it to make a statement. And one of the rules, as you know, is that it's okay to have an opinion on these subjects. It's just not okay to bet the client's money. Yeah, that's an important principle in your firm, right? Right.

16:44Which brings us on to risk management. And what you say is that your goal is to deliver superior investment results with risk under control. Now, to you, what is sound risk management? sound risk management first of all importantly is not risk avoidance risk avoidance usually results in return avoidance yeah um if you want to make a good return you have to take risk i put out a memo last week on the subject and i said it uh you know if you want to make money uh you have to take risk but you should not expect to make money just for taking risk you have to do it skillfully. So there is a process that I call the intelligent bearing of risk for profit.

17:30We try to engage in that. It has to be risk you're aware of, risk you can analyze, risk you can diversify, and risk you're highly paid to take. If those four necessities are satisfied, then it pays to take risk. When you talk about probabilistic outcomes, what do you mean by that?

17:59Because we're not dealing with the physical sciences, because we're not dealing with physics, there can always be a variety of outcomes. The future is never so certain that only one thing can happen. In fact, there was a professor at the London Business School named Elroy Dimson, and he said, risk means more things can happen than will happen. It's a very simple statement, but it's very true. And so you have to appreciate the fact that under any set of circumstances, a variety of outcomes are possible. And you should always allow for the vagaries of the future. uh mark twain the great american humorist once said it ain't what you don't know that gets you into trouble it's what you know for certain that just ain't true in other words excessive certainty is the enemy acknowledging your limitations is your friend it keeps you from getting into trouble what is the common wisdom now which you think may be wrong in December, what I thought might be wrong, well, you saw, you know, in December, there was a high degree of consensus that the Fed would cut rates six times this year.

19:22And I said, I thought that was excessively optimistic. I described it as Goldilocks thinking. Remember Goldilocks, not too hot, not too cold. Everything's, it's just right. Everything's going to stay good forever. That kind of thinking is dangerous because it assumes an optimistic future. I thought that was too optimistic. Now, most people now say two or three rate cuts this year. So that error, I think, has been corrected. One of the reasons I think that you can't predict the direction of the stock market in the short term. Excuse me, just one thing. Are you surprised that the market hasn't reacted more negatively on that pretty big adjustment in expectations?

20:00Yes, I am a little bit surprised. It's kind of like calculus and the second derivative. I think that the market is still governed by optimists, just they're a little less optimistic. But the optimist is still holding sway. But if you look at the S &P, it's kind of flattened out in the last six weeks and it hasn't gone down but it also stopped going up so i do think that the level of optimism is is down so how do you work with risk at oak tree well separate risk people or just no how do you structure the process no uh i've always uh resisted having a risk management department. I think it's everybody's job to control risk.

20:54And the person who advocates for a given investment and studies it should be the person who not only thinks about the return, but also the risk. And the concept that I am the investor, my job is to make money. I think about the upside. There's somebody who sits over there in the corner. His job is to think about the risk. I think that gets you into dangerous territory because everybody says, well, I can count on somebody else to limit the risk. I think that's not a good idea. I think that risk control is everybody's responsibility. And in fact, I listed our investment philosophy before, risk control is number one.

21:37And by the way, Oaktree and I and my colleagues started off doing straight fixed income. When you buy bonds, you buy an 8 % bond, in the long run, the best you can do is 8%. There's no upside. There's only downside. So the proper fixed income investor has to think about and avoid the downside. It doesn't have to worry about the upside. Graham and Dodd in the Bible of security analysis, well, the title of the book is Security Analysis, and Graham was Warren Buffett's teacher. They said in that book that fixed income investing is a negative art. The art is in avoiding the downside, not in capturing the upside.

22:19There is no upside in fixed income investing beyond the promised return. So when bonds had negative rates, what did you think then? I thought it was unsustainable. But negative rates were not a market phenomenon. They were administered by the central banks. And of course, in the short run, the central banks can do what they want. There's an old saying in America, don't fight the Fed. And by the way, if you think about it, in December, I mentioned that the consensus was that there would be six rate cuts. The dot plot, which is the expression of the Fed executives' opinions, said there would be three.

23:00Now, what sense does it make for market participants to say there will be six cuts if the Fed itself is saying there will be three. So I think that - So how do you read that? Well, I think that was a mistake. I think that was an excess of optimism. But because risk control is job one, in my opinion, because we started off as straight fixed income investors, we came up with the motto for Oak Tree, if we avoid the losers, the winners take care of themselves. Yeah. Now, that was good for the first 10 plus years. After that, we started getting into what I call aspirational strategies, where we're trying to make not 8%, but 15 or 20.

23:50Avoiding the losers is not enough in that case. You have to actually find some winners. But we have kept risk control as tenant number one of the investment philosophy, because we do think it's extremely important. And I want every analyst and portfolio manager to be thinking about risk and not counting on the person in the risk department to do so.

24:16You often talk about various types of games. Yes. Card games, poker, bridge, and you backgammon and you compare them and talk about how you taught your son to play and why it's so much fun. Just what kind of learnings have you drawn from this field? Well, I think that card games, backgammon, chess are all very helpful for investing. And many, many of the investors I know play one or more of them. First of all, it's risk-taking. You put up money in the hope that you'll end up with more, but you could lose your stake. So it gets you used to the concept of risk-taking. Secondly, it's all probabilistic.

25:10There's almost nothing you can do that will always work, in part because luck is involved, and in part because you're playing against an opponent who is skillful. So assessing probabilities is very, very important. Structuring your bet, knowing when you have an advantage, knowing when you don't have an advantage. Do you look at financial markets as a game? Well, not as a game as in ha-ha, but as a gamble. I don't use the word gamble negatively, but our job for our clients is to take the money they've entrusted to us and try to turn it into more. There are very few ways to do that risklessly, and the riskless ways don't have much reward.

25:59So ever since 1978, when Citibank asked me to move into the bond department and start up portfolios in convertible bonds and high-yield bonds, I have been involved in market niches that are considered risky. Never anything as comfortable as high-grade bonds or S &P stocks. These are real risk markets. And so I've had to develop what I call the intelligent bearing of risk for profit and implement it in a consistent way. Now, another person who shares your love for games is Annie Duke. why do you uh and i i think her work is great but why do you why do you like her work well annie duke for the benefit of your listeners was uh at one point in time the best woman poker player in the world she was world champion not just for the women but for everybody in the world uh she most people don't know it but she uh well when i first met her five years ago, she had completed all the coursework for a PhD in decision analysis, and now she has earned her degree.

27:16And so she approaches poker professionally, analytically, and with discipline. And that's what my job is to do for my clients, your job for your clients here at the bank. And she wrote a book in 2019 called Thinking in Bets. First of all, I just love the title, that we can reduce our analytical process to structuring things as bets. And I met her at that time, was really impressed. The last memo I published before the pandemic in January of 2020 was entitled You Bet. It was really about Annie and her approach. And then I did a podcast with her that a lot of people have told me that they enjoyed.

28:10And I think it helps a great deal to think about the process of structuring bets. And most people don't really understand it. They think that, well, for example, let's say there's a basketball game and the Lakers are playing the Knicks. There's usually a very broad agreement which team is better, which team is favored in that game. But if you bet on the underdog, you get odds. If you bet a dollar and they win, you get two or three. So now the question changes. It's not what outcome is likely to happen, but it's, is the payoff better for investing in the team that will probably win? Sometimes the payoff is better for investing in the team that will probably lose.

29:07And even the improbability of their success is overcome by the fact that you're offered sufficient odds. This is the way the markets work too. Absolutely. Which brings us to the whole contrarian investing field. So how important is it to be contrarian in finance? Well, I think it's essential. Contrarianism merely means betting against the consensus. On every subject, there's a consensus. There's what most people believe is the case. When the consensus is too strong and there's too much optimism that the consensus outcome will apply, maybe the odds for betting on the improbable outcome are so high that it's a compelling bet.

29:57The consensus, if you take that into the investment markets, the knowledge consensus is already embodied in the price of every asset. Maybe you can find times when you think the consensus is wrong and you can do better by betting against it. Usually because the payoff is so high for doing the thing that is considered unlikely. Now, I want to stress that I don't think it's a good idea to routinely say, well, what does the consensus think? Let's do the opposite. it. The process has to be much deeper than that. You have to say, what does the consensus think? What do I think? What's wrong with the consensus thinking?

30:47Why did they think that way? What could make the error of their ways exposed? So it's a very deep question. But you don't usually make much money by betting on the thing that everybody else loves. The big money is made by betting on the things they hate, which as a result are cheap, if you're right. Does it take a certain amount of personality to be good at this? It does take a certain personality because number one, you have to be a contrarian person. You have to be comfortable existing outside the mainstream. And what type of people is that? I think analytical and relatively tough because it's not pleasant.