Howard Marks, co-founder of Oaktree Capital Management, is widely admired within the value investing community. According to Warren Buffett, ‘when I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something.’
Although Warren Buffett's Chairman’s letters are well worth the read, no single investor has a monopoly on investment wisdom, as Buffett himself readily admits. This means investing is a life-long pursuit that involves reading widely and learning from as many successful investors as possible.
To that end, I was browsing through Marks’s memos and came across Random Thoughts on the Identification of Investment Opportunities. I’ve summarised Marks’s seven thoughts on this topic below with a few comments of my own.
1. No group or sector in the investment world enjoys as its birthright the promise of consistent high returns.
Marks uses the example of real estate – he wrote the memo in 1994 – and this is also the example that springs to mind today.
Even six bedroom mansions with pools and tennis courts located in Toorak or Point Piper could prove a bad investment if you pay too much, perhaps because you believe the canard that ‘you should buy real estate because they're not making any more.’
2. What matters most is not what you invest in, but when and at what price
There are two ways you can obtain a margin of safety: either though the quality of the business you buy or the price you pay for that business (and ideally both!).
Even a great company can be a poor investment if you pay too much. Similarly, even a bad business – such as a mining service company – can be a good investment if you buy it for a song at the bottom of the cycle.
3. The discipline which is most important in investing is not accounting or economics, but psychology.
Anyone with an average intelligence or above can learn accounting principles, study economics and learn the theory of competition between firms.
However, what distinguishes the best investors is their understanding that investing is a popularity contest and that the best opportunities come in buying what is unpopular.
To do so, you need to understand investor psychology and how the collective views of investors are reflected in the price of the stock.
In other words, before you buy, always ask: ‘What is in the price?’
4. The bottom line is that it is best to act as a contrarian.
While the collective wisdom can be correct, as Marks has noted elsewhere, ‘you can’t take the same actions as everyone else and expect to outperform.’
A current example of where it may be wise to act as a contrarian is the discretionary retailer sector, which has been decimated on fears of Amazon’s (NASDAQ:AMZN) impending arrival and slowing consumer spending. This is why colleagues Alex Hughes and James Greenhalgh are currently sifting through the retail sector looking for bargains.
5. Book the bet that no one else will.
Investing is like the pari-mutuel system used at the track: the favourites in a horse race have the shortest odds and the most popular stocks are usually the most expensive. In other words, betting on them is usually an unfavourable proposition from a risk/return perspective.
You have more chance finding a favourable risk/return proposition investing in stocks – or betting on horses – that everyone hates.
6. As Warren Buffet said, “the less care with which others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when others are unafraid, you'd better be.
The property section of the AFR has listed countless examples in recent times of private investors purchasing service stations, Bunnings Warehouses, childcare centres, pubs and other commercial property at mid-to-low single digit passing yields.
These investors seem to be unafraid that interest rates may rise materially from their current low levels, that their tenants may encounter financial difficulty and thus perhaps be unable to meet their rental obligations, or even that they as owners might have to invest material amounts in capital expenditure to maintain these properties or even to attract replacement tenants.
7. Gresham's Law says "bad money drives out good." When paper money appeared, gold disappeared. It works in investing too: bad investors drive out good.
When the market or a particular sector is doing well and is perceived to have a bright future, investors tend to pile in indiscriminately. This makes it difficult for more demanding investors to find appropriately-priced stocks.
With Australian stocks in general fairly valued, this is why we only have nine stocks on our Buy list at the moment.
As Marks notes, ‘demanding investors must be willing to be inactive at times’ and this is advice we follow, even if, as we acknowledge, it can be frustrating for members waiting for new Buy ideas to appear.
However, while I don’t know when they will appear, appear they will. They always do.