Howard Marks talked to the CFA Society Chicago last week and streamed it live via Youtube. The video is embedded below (with links).
The entire talk is worth watching but the Q&A portion is what stood out most (his answer to why the market collapsed in the fourth quarter is brilliant @ 55:22). The Q&A starts around 31:35.
Three things stood out in the Q&A, which I transcribed below. The first question was on finding the line between market efficiency and inefficiency. The short version is markets are efficient but some inefficiency exists but it’s hard. Much of it is psychological and tends to be more pronounced at certain points in the market cycle. Marks explains what it takes to take advantage of those periods.
Later, Marks was asked about the right structure for capturing inefficiencies, which is where contrarianism comes in and he circled back around to the contrarian mindset at the end of the talk. He offers a great example on second-level thinking. And finally, he points out that it’s not about always being a contrarian but being an intelligent contrarian only when an opportunity exists that be taken advantage of.
I described my history, which was high yield bonds in ’78, distressed debt in ’88, emerging markets in ’98. So the key is that there were things people would do and things people wouldn’t do. There were markets that people didn’t understand, didn’t have full data on, maybe there wasn’t any performance history, the markets were not fully — they didn’t have the infrastructure and institutions, and, of course, there were biases…
Moody’s — venerable credit rating institution — if you took down the 1978 edition of the Moody’s Manual off your shelf and you looked up the definition of a B rated bond, it said, “Fails to possess the characteristics of a desirable investment.” In other words, you can not prudently invest in a B rated bond. That’s a bias. And if there’s an asset and 99% of people will not buy it at any price, then it makes sense that the people who will buy it might get a bargain.
So these things — not knowing about it, not understanding about it, not being willing to buy it, not thinking its a professional fiduciary — these are the kinds of things that create inefficiency. What I call structural inefficiency. Where are they today? Almost negligible.
Believe me, forty, fifty years ago — for those of you not practicing this profession then — the world was a stupid place. Nobody knew anything. I mean, there was all this data and maybe the data existed or maybe it didn’t exist, but if it existed, maybe it was over there and maybe you were over there. And you had no idea where it was or how to get it or the people who had it, wouldn’t give it to you.
And today, everybody knows everything. You’re out to dinner with your date or your spouse and you have an argument about when a certain movie came out, you google it, you find out. There’s no such thing anymore of us not knowing anything. And so, if today everybody knows about every asset class, has data on it, and feels they understand it and feels comfortable with it, then where are you gonna find structural inefficiencies? And the answer is: It’s tough. It’s really tough.
And so, in my opinion, I wrote a Memo in January of ’14 called “Getting Lucky”… I talked about a process I call efficientization. Which is if inefficiency is really — To sum it up and oversimplify it, inefficiency is the result of ignorance and today there’s much less ignorance. So markets become more efficient over time. And I believe most markets have become more efficient over time. And it’s very hard to find anything about which there is ignorance.
By the way, back in 1978 people would say to me, “Young man,” and I was a young man at the time, “I’m sure you can make a lot of money doing that but it wouldn’t be proper. It wouldn’t be fiduciary.” Now, look around this room. Today, anybody will do anything to make a buck. So that bias does not exist. And that’s the bias that gave people like me opportunity forty years ago.
We talk about efficient markets. The economists talk about perfect markets. And there are certain criteria for perfect markets, which are obviously the same. One is knowledge, one is objectivity, and one is the willingness to substitute. So in other words, oil and gas will be priced in a standard relationship to each other, as long as everybody is willing and able to go from oil to gas and gas to oil. They will equilibrate their prices. That’s what efficient markets do. And today, people are willing to invest in any market. So it’s really hard to think of where you’re gonna get a free lunch.
However, I do go on in the memo to say that while structural inefficiency is hard to locate, from time to time we get cyclical inefficiency. Which is to say, from time to time people lose their objectivity and they value assets too low, in which case we can get bargains if we resist the error of their psychology, and sometimes they like assets too much and prices are too high and we can make easy money by shorting them, if we can resist the error of the common psychology.
So I think it’s really hard to find structural inefficiency today. From time to time we find cyclical inefficiency. And I can’t tell you where the dividing line is and it’s never the same.
By the way, one of my — I’ll say competitors came out with a very clever statement about four years ago. He said everything with a CUSIP is overpriced today. So what he was saying is that all public securities are overpriced because they’re too easy to invest in but, by implication, private investments are not overpriced. But if everybody hears that and everybody responds and everybody dumps their public securities and buys in the private markets, then maybe the inflow of capital to the private markets makes private investments too expensive and their desertion of the public market makes those too cheap. So there’s no rule that always stands. And when everybody says, “The secret to getting rich, the secret to superior risk-adjusted returns is to make private investments,” if everybody believes it and all the money flows to private investments, then it will no longer be underpriced and attractive.
What does that mean: taking advantage of inefficiencies. Well, Mark Twain, I think it was, said, “The definition of a profession is a conspiracy against the laity,” because professions tend to use big words to describe the things they do. And the academics at the University of Chicago came up with this word inefficiencies as the things we should try to capitalize on back in the early ’60s.
I use the word mistakes. If you can find a security which is underpriced — relative to its intrinsic value and relative to other securities relative to their intrinsic values — then what you’re really doing is you’re finding a mistake. And if you really have done what you think you’ve done, then that means that the person who’s selling you that security is making a mistake.
So do you think that mistakes are made? Do you think that you’re smart enough to be the one who finds them rather than the one who commits them? And obviously, in order to find and take advantage of the mistakes of others, you have to have what I call a contrarian way of thinking.
My first book…called The Most Important Thing…the first chapter says the most important thing is second level thinking. If you think the same as everybody else, you’re gonna act the same. If you act the same as everybody else, you’re gonna perform the same. That’s not a very good formula for being a superior investor.
If you want to be a superior investor, you have to think different from others, you have to act different, and maybe then you can have different performance. Then the only question: Is you’re performance different and right or different and wrong, relative to the average? But clearly, if you think the same as everybody else, you can’t outperform…
So when my son was studying investing, and he would come to me and say, “Dad, I think we should buy Ford stock cause Ford is coming out with a great Mustang and they’re gonna make a lot of money.” And I would say to him — my answer was always the same because I feel by repetition you can get your lessons across — so my answer to him was always the same, “Who doesn’t know that?”
If Ford is gonna come out with a great Mustang and it’s gonna be a killer car and it’s gonna make a lot of money but everybody who follows Ford knows that, then that piece of knowledge is not profitable. So, in order to outperform others, you have to know something they don’t know. You have to look at things in a different way then they look at them. Second level thinking: different and better.
And just one brief example. The first level thinker says this is a great company, we should buy the stock. The second level thinker says it’s a great company but it’s not as great as everybody thinks, we should sell the stock. And that’s the thing I hope you’ll think about.
It’s important to be a contrarian. Except, that it’s not always the right thing to do. There are a lot of people that say…what contrarian means is you do the opposite of others. No. To be an intelligent contrarian, you have to know what others are doing, know why they’re doing it, know what’s wrong with what they’re doing, and then figure out if there’s appropriate action to be taken on that.
My first book…had a second edition called The Illuminated edition, in which some notable investors and I added commentary to the first edition… Joel Greenblatt who was a great equity investor, one of the greatest who nobody has ever heard of… Joel put in [The Most Important Thing Illuminated] on the section on contrarianism, “Just because five other people will not stand in the path of an oncoming Mack truck, doesn’t mean you should.”
So contrarianism is not just a matter of doing the opposite of others, it’s a matter of taking advantage of mistakes and it has to be done on an understanding.