Published in: 2018
Howard Marks, co-founder of Oaktree Capital Management, sums up his 28 years in his current role and 22 years before that as an asset manager: the trick is not to be the hottest stock picker. The trick is to survive. We will be wrong more often than we expect. The future is not ours to know. Being wrong comes with an activity whose outcome depends on an unknown future. However, we can calibrate the portfolio after the cycle – and thereby improve our odds.
THE PILLARS OF LONG-TERM GROWTH. Output of an economy is the product of hours worked and output per hour. As the population grows, hours worked tend to grow, and so does GDP. The growth in the population means that there are more people working every year to manufacture and sell products (as well as more people to buy and consume them). Productivity changes occur gradually and require long periods to take effect. They stem mainly from advances in the production process. Long-term growth is determined by fundamental factors such as the birth rate and increase in productivity (but also by other changes in society and the environment). These factors usually change relatively little from year to year, and only gradually from decade to decade.
SHARE OF INCOME FOR CONSUMPTION. Consumption fluctuates more than employment and income. Residents can choose to spend a higher proportion of their income on consumption when: (1) the daily headlines are favorable, (2) they believe that the election result supports a stronger economy, (3) higher income or lower taxes, (4) consumer credit has become more accessible, (5) an increase in asset prices has made them feel richer, or (5) their team won the World Cup.
2-3% IS THE NORMAL GROWTH RATE. The normal growth rate of US GDP appears to be around 2-3% per year. Growth can be 1% or hit 4-5% (during boom times or during a recovery from a slowdown). The annual growth rate can be negative by a few percent and if it remains negative for two quarters in a row, it is called a recession.
PRODUCTIVITY. Population growth and productivity have declined in the United States and other developed countries. This indicates a slower growth in the coming years than in the years after the Second World War. Emerging markets – and China in particular – have been growing rapidly in recent decades, and although their growth is slower at the moment, they may well outgrow the developed world in the coming decades.
OPERATIONAL LEVERAGE. A company’s profit is often far from stable from year to year. Profits are significantly more volatile than GDP. Sales and costs vary for many reasons, and different types of costs vary in different ways, especially in response to changes in sales. If a company’s revenue increases by 20%, its rental costs will not increase initially, its expenses for machinery will probably not increase initially and its expenses for purchasing goods will increase immediately and proportionately. Thus, total costs may increase less than revenues. The second form of leverage is from debt financing. Companies vary in operational and financial leverage.
VALUATION PENDULUM. Markets rarely go from “underpriced” to “fairly priced”. Usually, it continues from “fairly priced” to “overpriced”. For the 47 years from 1970 to 2016, the average annual return was 10%. Only 3 out of 47 years, however, the stock market closed + -2% from normal, ie between 8-12%. In 13 of the 47 years, the stock market closed more than 20 percentage points from normal – either up more than 30% or down more than 10%.
BUY WHEN PRICE < VALUE. All you need is (a) an estimate of value, (b) emotional strength to continue, and (c) eventually your estimate of value will prove to be correct. However, asset classes move in a pendulum. Risky assets outperform when valuations are penalized too much. Then they underperform until they again have adequate risk premiums. Not only are good times followed sooner or later by bad times, but often good times give bad times (unwise debt issuance or over-expansion).
IT’S ALL PERSPECTIVES, NO FULL PICTURE. There is a story about a group of blind men who walk on the road and meet an elephant. Everyone touches different parts of the elephant and has different explanations for what they have encountered. We are the blind men. Although we have a good understanding of events we have witnessed, we do not get the overall perception we need.
PROBABILITY DISTRIBUTION. The future is not a single fixed outcome that is intended to happen, but a series of possibilities. At best, we have insight into the respective probability of the outcome. Investment success is like choosing a lottery winner: a lottery ticket (outcome) is drawn from a bowl (the whole opportunity set). A result is chosen from many possibilities. To win this game more often than you lose, you must have a knowledge advantage. The ball selector who knows the 70:30 ratio has an advantage. It is only if we know more than others (whether it consists of having better data, doing a superior job of interpreting the data we have, knowing what actions we should take) that our forecast will lead to our excess return.