One Way to Diverge from the Pack
An except from Howard Marks's latest memo, I Beg to differ...Mr. Marks is always essential reading for a greater understanding of both ourselves as investors and the market's behavior in general...
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To conclude, I want to describe a recent occurrence. In mid-June, we held the London edition of Oaktree’s biannual conference, which followed on the heels of the Los Angeles version. My assigned topic at both conferences was the market environment. I faced a dilemma while preparing for the London conference, because so much had changed between the two events: On May 19, the S&P 500 was at roughly 3,900, but by June 21 it was at approximately 3,750, down almost 4% in roughly a month. Here was my issue: Should I update my slides, which had become somewhat dated, or reuse the LA slides to deliver a consistent message to both audiences?
I decided to use the LA slides as the jumping-off point for a discussion of how much things had changed in that short period. The key segment of my London presentation consisted of a stream-of-consciousness discussion of the concerns of the day. I told the attendees that I pay close attention to the questions people ask most often at any given point in time, as the questions tell me what’s on people’s minds. And the questions I’m asked these days overwhelmingly surround:
the outlook for inflation,
the extent to which the Federal Reserve will raise interest rates to bring it under control, and
whether doing so will produce a soft landing or a recession (and if the latter, how bad).
Afterwards, I wasn’t completely happy with my remarks, so I rethought them over lunch. And when it was time to resume the program, I went up on stage for another two minutes. Here’s what I said:
All the discussion surrounding inflation, rates, and recession falls under the same heading: the short term. And yet:
We can’t know much about the short-term future (or, I should say, we can’t dependably know more than the consensus).
If we have an opinion about the short term, we can’t (or shouldn’t) have much confidence in it.
If we reach a conclusion, there’s not much we can do about it – most investors can’t and won’t meaningfully revamp their portfolios based on such opinions.
We really shouldn’t care about the short term – after all, we’re investors, not traders.
I think it’s the last point that matters most. The question is whether you agree or not.
For example, when asked whether we’re heading toward a recession, my usual answer is that whenever we’re not in a recession, we’re heading toward one. The question is when. I believe we’ll always have cycles, which means recessions and recoveries will always lie ahead. Does the fact that there’s a recession ahead mean we should reduce our investments or alter our portfolio allocation? I don’t think so. Since 1920, there have been 17 recessions as well as one Great Depression, a World War and several smaller wars, multiple periods of worry about global cataclysm, and now a pandemic. And yet, as I mentioned in my January memo, Selling Out, the S&P 500 has returned about 10½% a year on average over that century-plus. Would investors have improved their performance by getting in and out of the market to avoid those problem spots ...or would doing so have diminished it? Ever since I quoted Bill Miller in that memo, I’ve been impressed by his formulation that “it’s time, not timing” that leads to real wealth accumulation. Thus, most investors would be better off ignoring short-term considerations if they want to enjoy the benefits of long-term compounding.
Two of the six tenets of Oaktree’s investment philosophy say (a) we don’t base our investment decisions on macro forecasts and (b) we’re not market timers. I told the London audience our main goal is to buy debt or make loans that will be repaid and to buy interests in companies that will do well and make money. None of that has anything to do with the short term.
From time to time, when we consider it warranted, we do vary our balance between aggressiveness and defensiveness, primarily by altering the size of our closed-end funds, the pace at which we invest, and the level of risk we’ll accept. But we do these things on the basis of current market conditions, not expectations regarding future events.
Everyone at Oaktree has opinions on the short-run phenomena mentioned above. We just don’t bet heavily that they’re right. During our recent meetings with clients in London, Bruce Karsh and I spent a lot of time discussing the significance of the short-term concerns. Here’s how he followed up in a note to me:
...Will things be as bad or worse or better than expected? Unknowable ...and equally unknowable how much is priced in, i.e. what the market is truly expecting. One would think a recession is priced in, but many analysts say that’s not the case. This stuff is hard…!!!
Bruce’s comment highlights another weakness of having a short-term focus. Even if we think we know what’s in store in terms of things like inflation, recessions, and interest rates, there’s absolutely no way to know how market prices comport with those expectations. This is more significant than most people realize. If you’ve developed opinions regarding the issues of the day, or have access to those of pundits you respect, take a look at any asset and ask yourself whether it’s priced rich, cheap, or fair in light of those views. That’s what matters when you’re pursuing investments that are reasonably priced.
The possibility – or even the fact – that a negative event lies ahead isn’t in itself a reason to reduce risk; investors should only do so if the event lies ahead and it isn’t appropriately reflected in asset prices. But, as Bruce says, there’s usually no way to know.
At the beginning of my career, we thought in terms of investing in a stock for five or six years; something held for less than a year was considered a short-term trade. One of the biggest changes I’ve witnessed since then is the incredible shortening of time horizons. Money managers know their returns in real time, and many clients are fixated on how their managers did in the most recent quarter.
No strategy – and no level of brilliance – will make every quarter or every year a successful one. Strategies become more or less effective as the environment changes and their popularity waxes and wanes. In fact, highly disciplined managers who hold most rigorously to a given approach will tend to report the worst performance when that approach goes out of favor. Regardless of the appropriateness of a strategy and the quality of investment decisions, every portfolio and every manager will experience good and bad quarters and years that have no lasting impact and say nothing about the manager’s ability. Often this poor performance will be due to unforeseen and unforeseeable developments.
Thus, what does it mean that someone or something has performed poorly for a while? No one should fire managers or change strategies based on short-term results. Rather than taking capital away from underperformers, clients should consider increasing their allocations in the spirit of contrarianism (but few do). I find it incredibly simple: If you wait at a bus stop long enough, you’re guaranteed to catch a bus, but if you run from bus stop to bus stop, you may never catch a bus.
I believe most investors have their eye on the wrong ball. One quarter’s or one year’s performance is meaningless at best and a harmful distraction at worst. But most investment committees still spend the first hour of every meeting discussing returns in the most recent quarter and the year to date. If everyone else is focusing on something that doesn’t matter and ignoring the thing that does, investors can profitably diverge from the pack by blocking out short-term concerns and maintaining a laser focus on long-term capital deployment.
A final quote from Pioneering Portfolio Management does a great job of summing up how institutions can pursue the superior performance most want. (Its concepts are also relevant to individuals):
Appropriate investment procedures contribute significantly to investment success, allowing investors to pursue profitable long-term contrarian investment positions. By reducing pressures to produce in the short run, liberated managers gain the freedom to create portfolios positioned to take advantage of opportunities created by short-term players. By encouraging managers to make potentially embarrassing out-of-favor investments, fiduciaries increase the likelihood of investment success.
Oaktree is probably in the extreme minority in its relative indifference to macro projections, especially regarding the short term. Most investors fuss over expectations regarding short-term phenomena, but I wonder whether they actually do much about their concerns, and whether it helps.
Many investors – and especially institutions such as pension funds, endowments, insurance companies, and sovereign wealth funds, all of which are relatively insulated from the risk of sudden withdrawals – have the luxury of being able to focus exclusively on the long term ...if they will take advantage of it. Thus, my suggestion to you is to depart from the investment crowd, with its unhelpful preoccupation with the short term, and to instead join us in focusing on the things that really matter.
July 26, 2022
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