Fewer Losers, or More Winners?

0:05This is the memo by Howard Marks. Fewer losers or more winners

0:16My memos got their start in October 1990, inspired by an interesting juxtaposition between two events. One was a dinner in Minneapolis with David Van Benskoten, who was the head of the General Mills Pension Fund. Dave told me that in his 14 years in the job, the fund's equity return had never ranked above the 27th percentile of the pension fund universe or below the 47th percentile. And where did those solidly second quartile annual returns place the fund for the 14 years overall? Fourth percentile. I was wowed. It turns out that most investors aiming for top decile performance eventually shoot themselves in the foot.

0:59But Dave never did. Around the same time, a prominent value investing firm reported terrible results, causing its president to issue an easy rationalization. If you want to be in the top 5 % of money managers, you have to be willing to be in the bottom 5 % too. My reaction was immediate. My clients don't care whether I'm in the top 5 % in any single year, and they and I have absolutely no interest in me ever being in the bottom 5%. These two events had a strong influence on me and helped define my, and what five years later became Oak Tree's, investment philosophy, which emphasizes risk, control, and consistency above all.

1:43Here's how I put it 33 years ago in that first memo titled The Route to Performance. I feel strongly that attempting to achieve a superior long-term record by stringing together a run of top decile years is unlikely to succeed. Rather, striving to do a little better than average every year, and through discipline to have highly superior relative results in bad times, is less likely to produce extreme volatility, less likely to produce huge losses which can't be recouped, and, most importantly, more likely to work. given the fact that all of us are only human. Simply put, what General Mills' record tells me is that in equities, if you can avoid losers and losing years, the winners will take care of themselves.

2:30I believe most strongly that this holds true in my group's opportunist niches as well, that the best foundation for above-average long-term performance is an absence of disasters. As you can see, my dinner with Dave was a seminal event, His approach was clearly the one for me. Incidentally, I want to share that after decades of not having been in touch, Dave was among the many kind people who wrote in recent months to encourage me vis-a-vis my health issue. This is a great example of the many personal dividends my career has paid. Putting it in brief. That first memo, and the bit cited above, include a phrase you've likely heard from Oaktree.

3:15If we avoid the losers, the winners will take care of themselves. My partners and I consider this phrase so fitting that we adopted it as our motto when Oak Tree was formed in 1995. Our reasoning was simple. If we invest in a diversified portfolio of bonds and are able to avoid the ones that default, some of the non-defaulters we buy will benefit from positive events, such as upgrades and takeovers. That is, the winners will materialize without our having explicitly sought them out. We thought that phrase was innovative, but in 2005, while working with Seth Klarman to update the 1940 edition of Benjamin Graham and David Dodd's Security Analysis, The Bible of Value Investing, I read something that indicated we were late by about 50 years.

4:06In the section Seth asked me to edit, I came across Graham and Dodd's description of fixed value or fixed income investing as a negative art. What did they mean? At first, I found their observations cynical, but then I realized what they were saying. Let's assume there are 108 % bonds outstanding. Let's further assume that 90 will pay interest and principal as promised, and 10 will default. Since they're all 8 % bonds, all the ones that pay will deliver the same 8 % return. It doesn't matter which ones you bought. The only thing that matters is whether you bought any of the 10 that defaulted. In other words, bond investors improve their performance not through what they buy, but through what they exclude.

4:54Not by finding winners, but by avoiding losers. There it is. A negative art. One more anecdote concerning the origin of the phrase. I've always been interested in old books. A few years ago, while walking through a Las Vegas convention center, on the way to meet with a client, I came upon a rare book fair. I stopped at the booth of a book dealer I know, and my eye immediately fell on a book he had for sale, How to Trade in Stocks, by Jesse Livermore. Here's the quote the dealer had highlighted. Winners take care of themselves. Losers never do. You may be tempted to believe Livermore borrowed my idea until you realize that, like Graham and Dodd, he published these lines in 1940.

5:41So much for my innovation. At the time I adopted that saying, my partners and I were primarily high-yield bond investors. And since non-convertible bonds have little upside potential beyond their promised yield to maturity, It truly was the case that our main job was to avoid the non-payers, with the assumption that some subset of the payers would likely give us exposure to positive developments that occurred. It was an appropriate way to sum up our approach as bond investors. But fortunately, I joined up with Bruce Karsh in 1987, and in 1988 we organized our first distressed debt fund. Now we were investing in bonds that had defaulted or seemed likely to do so.

6:28We thought we might be able to buy them at bargain prices because of the cloud they were under, giving us the possibility of capital appreciation. Bruce has since become well known for his investing acumen, and certainly his returns since 1988 can't be attributed to the mere avoidance of losses. When you aspire to returns well above those available on bonds, it's not enough to avoid losers. You actually have to find or create winners from time to time. The returns generated by Bruce and his group show that they've done so. Oak Tree now has a number of what I call aspirational strategies, meaning they need winners.

7:11So, why do we still use the previously mentioned phrase as our motto, and why is the primacy of risk control still the first tenet of our investment philosophy? The answer is, we want the concept of risk control to always be top of mind for our investment professionals. When they review a security, we want them to ask not only, how much money can I make if things go well, but also, what will happen if events don't go as planned? How much could I lose if things get bad? And how bad would things have to get? Risk control is still number one at Oak Tree. 70-plus years ago, UCLA football coach Henry Russell Red Sanders said, Winning isn't everything, it's the only thing.

7:58The saying is also attributed to Vince Lombardi, legendary football coach of the Green Bay Packers. While I haven't figured out exactly what that phrase means, I'm firmly convinced that for Oak Tree, risk control isn't everything. It is the only thing. Not risk avoidance. Understanding the distinction between risk control and risk avoidance is truly essential for investors. Risk avoidance basically consists of not doing anything where the outcome is uncertain and could be negative. And yet, at its heart, investing consists of bearing uncertainty in the pursuit of attractive returns. For this reason, risk avoidance usually equates to return avoidance.

8:44You can avoid risk by buying treasury bills or putting your money into government-insured deposits. But there's a reason why the returns on these are generally the lowest available in the investment world. Why should you be well-paid for parting with your money for a while if you're sure to get it back? Risk control, on the other hand, consists of declining to take risks that A. Exceed the quantum of risk you want to live with and or B. You wouldn't be well rewarded for bearing. I've written in the past about what I call the intelligent bearing of risk for profit. Here's the backstory. I got my start managing money in 1978, when Citi asked me to run portfolios of convertibles and high-yield bonds.

9:31The farmer were mostly non-investment-grade securities issued by companies that had no alternative when seeking to raise capital, and the latter were, according to the terminology of the day, low-rated junk bonds. Clearly, they both entailed significant credit risk. Around 1980, a reporter from one of the first financial news networks asked me a provocative question. How can you buy high-yield bonds when you know some of the issuers are going to default? My response captured the essence of intelligent risk-bearing. How can life insurance companies insure people's lives when they know they're all going to die?

10:10The point is simple. These functions can both be performed in an intelligent, risk-controlled way. For that to be the case, the risk has to be risk you're aware of, risk you can analyze, risk you can diversify, and risk you're well-paid to assume. Risks like this needn't be avoided. If you have real insight, such risks can be borne prudently and profitably. I know several investors who take much more risk than Oak Tree does and whose bad years are much worse than ours. But the few who possess genuine skill, what I call alpha, more on that later, produce jumbo returns in their good years, such that their long-term returns are exceptional.

10:57Their clients are well rewarded, assuming they have enough intestinal fortitude to hang in through the bad years. Thus, risk-taking isn't unwise per se, and risk avoidance is appropriate only for investors who feel they can't survive tough times. Building a good record Since A, all but the most cautious investing entails risk, and B, the presence of risk means results will be unpredictable and inconsistent, very few, if any, investors are able to have only good years or to assemble portfolios that contain only winners. The question isn't whether you're going to have losers, but rather how many and how bad relative to your winners.

11:45Warren Buffett, arguably the investor with the best long-term record, and certainly the longest long-term record, is widely described as having had only 12 great winners in his career. His partner, Charlie Munger, told me the vast majority of his own wealth came not from 12 winners, but only four. I believe the ingredients of Warren's and Charlie's great performance are simple. A. A lot of investments in which they did decently. B. A relatively small number of big winners that they invested in heavily and held for decades and C. Relatively few big losers. No one should expect to have, or expect their money managers to have, all big winners and no losers.

12:31In fact, not having any losers isn't a useful goal. The only sure way to achieve that is by not taking any risk. But as I said earlier, risk avoidance is likely to result in return avoidance. There's such a thing as the risk of taking too little risk. Most people understand this intellectually. But human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success. Having watched some great tennis this summer, right through the U.S. Open this past weekend, I'll recycle a tennis analogy I first suggested in my memo, Dare to be Great 2, April 2014.

13:13What if I went out to play tennis and said, Today, I'm not going to commit any service faults. My serves would have to be so meek that my opponent would likely destroy them. Tennis players have to take some risk if they hope to succeed, as we will soon discuss. If none of your serves fall outside the service box, you're probably serving too cautiously to win. The same is true of investing. As my longtime partner Sheldon Stone puts it, if you don't experience any defaults, you're probably not taking enough credit risk. Winner's stats Looking back, it turns out I devoted an entire memo to analogies between investing and sports once per decade in the 1990s, the 2000s, and the 2010s.

14:01This time, in my fourth decade of memo writing, I'm going to devote a few more paragraphs to tennis. As just mentioned, tennis makes for very apt comparisons to investing. Hit safely and get blasted? Or try for shots you can't make consistently and beat yourself? Charles D. Ellis' article, The Loser's Game, the Financial Analyst's Journal, July-August 1975, was truly seminal in my development as an investor. He pointed out that there are two kinds of tennis players, actually two different types of tennis games. Professionals play a winner's game. They win by hitting winners. In tennis, that means shots the opponent can't return.

14:46Since their game is so much within their control, they can usually produce the shots they want, the best of which win points. But amateur tennis is a loser's game. The winner is usually the person who hits the fewest losers. If you can just keep the ball in play long enough, eventually your opponent will hit it off the court or into the net. The amateur doesn't have to hit winners to win, and that's a good thing, because he or she generally is incapable of doing so dependably. A quick look at some statistics from this year's Wimbledon provides a great deal of food for thought. I look first at the men's quarterfinal match between Daniil Medvedev, the number three seed in the tournament, and unseated Christopher Eubanks.

15:32Eubanks, 6 feet 7 inches and highly athletic, surprised everyone with his rush to the quarterfinals. But in Medvedev, he was playing someone who spent years trailing just behind the big three of men's tennis. Novak Djokovic, Rafael Nadal, and Roger Federer. As a pronounced underdog, Eubanks probably recognized that he wasn't likely to outlast or outsteady Medvedev. Thus, he had to go for winners. If that was Eubank's plan, he succeeded in executing it. He achieved 74 winners to Medvedev's 52, and he aggressively rushed the net 67 times for 44 winners compared to Medvedev's 8 for 4 winners. These are great offensive stats.

16:19The problem is that, as I've experienced firsthand many times, if you're up against a player who's better than you are, You have to attempt shots that aren't firmly within your competence in order to have a hope of winning. Thus, along with his 74 winners, Eubanks was guilty of 55 unforced errors, mistakes that aren't forced by good shots from one's opponent. The easy way to make an unforced error is to go for a winner and miss. In comparison, Medvedev committed only 13 unforced errors. Bottom line, Eubanks had considerably more winners than Medvedev, but he had three unforced errors for every four winners, whereas Medvedev had only one per four.

17:05Medvedev won 53 % of the points played versus Eubanks' 47%, and thus he won the match. The lesson is that it's not enough to have more winners. To win, in tennis as in investing, You have to have a favorable relationship between winners and losers. You can win by having a few winners, but fewer losers, or by having a lot of losers, but more winners. Neither maximizing winners nor minimizing losers is necessarily enough. It's all in the balance. And that leads me to the Wimbledon men's final. This exciting match pitied Djokovic, who had won the most Grand Slam championships in history, 23 combined at Wimbledon, the U.S.

17:52Open, the French Open, and the Australian Open against up-and-coming 20-year-old Carlos Alcaraz, who had a grand total of one. Like Eubanks, Alcaraz plays a big athletic game and goes for a lot of winners. You can see that in his serving. Alcaraz had seven double faults, more than twice Djokovic's three. But again, a single statistic tells us very little. since Alcaraz's attempts at big serves gave him nine aces. Serves his opponent couldn't even get his racket on. More than four times Djokovic's two. This is an indication of the players' respective styles. In the end, Alcaraz won the match with 66 winners, whereas Djokovic had only 32.

18:37So Alcaraz beat Djokovic with a bigger, high-risk game, while Medvedev beat Eubanks with his steadier, risk-controlled style. Neither approach is better than the other per se. Style alone never determines outcome. It's a matter of style plus execution. My tennis teacher, Jordy Ballister, explains, Alcaraz plays a more aggressive game. Given his high level of talent, as he showed at Wimbledon, if he has a good day, he can beat Djokovic or any other opponent. If he's off, he may well lose. It's interesting to note that tennis' big three presided over an incredible era. In the 19 years leading up to Wimbledon 2023, they won a combined 65 or 87 % of the 75 Grand Slam championships.

19:30Notably, none of them was a big hitter in Alcaraz's mold. Their ability to hit at a fabulous level for four or five hours without committing many errors was usually enough. The need for winning stocks There have been several times over the course of my career when a small number of stocks have accounted for a disproportionately large share of the market's gains. In this regard, a lot has been written about the so-called Magnificent Seven. Apple, Microsoft, Alphabet, owner of Google Amazon, NVIDIA, Tesla, and Meta, owner of Facebook At various points in time this year, these seven stocks accounted for most or all of the gains of various equity indices Here's how the Financial Times put it in June Seven of the biggest constituents have ripped higher, gaining between 40 % and 180 % this year The remaining 493 companies in Standard & Poor's 500 Stock Index are, in aggregate, flat.

20:36Big tech companies dominate the index to an unprecedented degree. Just five of those seven stocks represent nearly a quarter of the market capitalization of the entire index. The seven companies driving the U.S. stock market rally. Financial Times, June 14, 2023. The extent of these stocks' outperformance for much of this year may be unique, but the phenomenon is not. It was also the case in 2017 that a few stocks were largely responsible for carrying the market upward. Then it was the FAANGs – Facebook, Amazon, Apple, Netflix, and Google Alphabet. The Financial Times highlighted this history as well.

21:17Top heaviness, particularly in U.S. markets, is not new. The big tech stocks in the S &P now are the same situation as oil companies were in the past Or the nifty fifty in the 1960s Says Frédéric Leroux, head of the cross-asset team at Carminiac in Paris A nod to the craze that swept shares in a small number of fast-growing companies Such as IBM, Kodak and Xerox higher before a heavy decline set in It's a problem, but it's a recurring problem For as long as most of us can remember, active investors have had a tough time keeping up with the equity indices. For this reason, in recent decades, passive investing has taken a substantial share of equity capital invested.

22:04Active investing's shortfall has been attributed primarily to the combination of market efficiency, management fees, and investor error. I think there's another reason active investors need for winners. What if you didn't own the Magnificent Seven earlier this year? Clearly, you'd be far behind the indices. What if you owned them, but in smaller proportions than their weightings in the indices? You'd still lag, but by a smaller amount. So, by definition, keeping up with the indices requires having exposure to the big winners that is at least equal to their representation in the indices. That much seems clear.

22:46Now, think about that representation. Let's say you started off 20 years ago, in the summer of 2003, with an index-sized helping of Apple at a split-adjusted price of 37 cents. The key question is simple. Would you have held on as it rose? As I described in my memo selling out, January 2022, most investors subscribe to the conventional wisdom of taking profits. taking some money off the table, or topping the trees. After all, as the old saying goes, no one ever went broke taking profits. Investors often sell off some of their winners for the simple reason that they're afraid to watch as they give up their gains, which can lead to regret, criticism from clients, and or lost accounts.

23:38Most people would have sold part or all of their Apple holding by the time the price reached$15 in the summer of 2013. What would you have done when it hit 40 times your original cost after 10 years? Today, another 10 years later, Apple is around$180, up 12x since 2013, and up by almost 500x since 2003. The point is, in the face of these gains, very few investors would still hold all they'd originally bought. But if they sold Apple stock when the constructors of the index didn't, they've probably failed to keep up with the index. The situation can be summed up as follows. The performance of the equity indices is often dominated by a few stocks or groups of stocks.

24:29The gains of the leaders can make them seem expensive, arguing for profit-taking. Human nature, especially the desire to avoid regret, adds to the motivation to sell. By definition, if you reduce your holdings of the winners relative to their representation in the indices, and these winners continue to outperform, you'll have a tough time keeping up. In my memo Liquidity, March 2015, I included an insight from my son Andrew. To paraphrase, he said, If you look at the chart of a stock that's been up for 25 years and say, Man, I wish I'd owned that stock, think about all the days you would have had to talk yourself out of selling.

25:11I doubt many people watched Apple go from$0.37 to$180 without selling any. How many active investors would allow Apple shares to constitute nearly 8 % of their portfolios, which is its current weight in the S &P 500? But, to oversimplify, if they sold Apple, they've lagged. The bottom line is that winners aren't entirely dispensable. If you hope to at least keep up with the indices, you probably have to have an average representation in them. This isn't entirely inescapable. You might also achieve that goal by holding fewer of the losers. The Role of Risk-Bearing I'm going to conclude this memo using my favorite graph.

25:58When I attended graduate school at the University of Chicago, 55 years ago, I was taught to view the relationship between risk and return as linear. But the more I thought about it, the more unhappy I was with the way the linear presentation of the purported relationship tells investors that they can count on achieving higher returns as a result of taking more risk. After all, if that were really the case, risky investments wouldn't be riskier. Thus, in my memo, Risk, January 2006, I suggested a different way of depicting the relationship by superimposing on the line a series of bell-shaped probability distributions turned on their side.

26:41Rather than implying that taking more risk, moving from left to right in the graph, assures higher returns, this new way of looking at the relationship suggests that as you take more risk, A. The expected return increases, as per the original version. B. The range of possible outcomes becomes wider. And C. The bad possibilities become worse. In other words, riskier investments introduce the potential for higher returns, but also the possibility of other less desirable side effects. That's why they're described as being riskier. Since writing that memo, I've concluded that this way of thinking about things has a great many applications.

27:26Please download the PDF to view these. This all brings me back to the subject of this memo. As the graphs indicate, a high-risk approach introduces the potential for huge returns, as well as the possibility of loss. So, where is the right place to be on this spectrum? Where can one find the best risk-return bargains? The short answer is that, according to investment theory, particularly the efficient market hypothesis, there are no better or worse places to be. The EMH says markets price securities such that A, their price equals their intrinsic value, and B, bearing incremental risk is rewarded fairly.

28:13Thus, bargains and overpricings can't exist. This is why, according to the theory, you can't beat the market. The theory also suggests that if a market is at equilibrium, each change in prospective return is fair relative to the change in risk-borne, such that all positions on the curve are equivalent in attractiveness. Move to the left and you avoid some risk, but your prospective return drops. Move to the right and your prospective return increases, but so does your risk. No position on the spectrum is superior to any other. It's like a coin toss, which the EMH suggests active investing is. Neither heads nor tails is the smarter call.

28:59What about in practice? One of my favorite quotes is attributed to Albert Einstein and Yogi Berra, among others. In theory, there is no difference between theory and practice. In practice, there is. If markets are efficient and securities are always priced correctly, there can be no value in active investing. The truth is that many active managers, especially in developed market equities, have failed to demonstrate the ability to add value, or to add enough value to justify their management fees. This is largely why index funds were created and why a significant amount of equity capital has migrated to index and passive investing in recent decades.

29:46And yet, I firmly believe there are times when the markets are overpriced and times when they're underpriced. There are also times when particular markets or sectors are overpriced or underpriced relative to others. In these instances, some securities can be priced too high or too low, and thus, some positions on the risk curve can offer better bargains than others. The theory assumes investors are rational and objective, but psychological excesses violate that assumption. Take, for example, the investment environment during the global financial crisis. As I described in my July memo, taking the temperature, in late 2008, investors were so worried about a financial sector meltdown that they panicked and sold securities aggressively as their prices collapsed.