Fat Juicy Notes on Howard Marks Latest Memo

by Daniel Sparks

writer at

the Motley Fool

Howard Marks, Chairman of Oaktree Capital, recently published yet another incredible memo to clients. The memo, entitled On Uncertain Ground, discusses today’s investment environment in an uncertain global economy. The length of Marks memos can often be discouraging, so I’ve summed it up concisely.

Macro forecasts: Useful or not?

It’s important to note that Oaktree has never used macro forecasting as a tool to make better investments. In fact, he notes in the memo that one of the key tenets of Oaktree’s investment philosophy dictates that their “investing will not be governed by macro forecasts.”

If macro forecasting is irrelevant to investing, why examine the state of the economy? In his book, The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor, he offers a common sense explanation. There are many things in life that we can’t predict far in advance yet we still take note of in the current situation: Each day, we look at the weather to choose an outfit and we consider the traffic on the road to decide on the degree of our acceleration.

The investor should always do his or her best to attempt to understand the economic situation of today and position themselves accordingly.

Uncertain times

Marks doesn’t waste time getting to the point: Today’s economic environment is characterized by uncertainty.

Leading up to 2008, the United States was presented with 40 years of increasing availability of credit and increasing willingness to take advantage of it. Government became a victim too, as deficit spending increased. The result? Many people spending money they didn’t have–all over the world. Credit spending facilitated GDP growth across the globe. Then, in 2008, reality hit: Leverage was maxed.

In other words, much of the economic growth up until 2008 was based simply on increased availability of credit (and willingness to make use of it).

The result? Consumer savings are on the rise and austerity is making a comeback. Marks notes that this may be good for consumers in the long run but it results in a short-term reduced spending, which we’ve clearly witnessed since 2008.

Marks goes into plenty of detail on different economic factors that are influencing the economy today, including Europe, the US fiscal situation, the “depressing state of politics,” the growing income inequality, and China. If any of these specific areas interest you, I highly encourage you to read the memo (or at least the part you are curious about).

The Psychological Environment

Anyone familiar with Howard Marks knows his advice resounds with the truest sound when he talks about psychology and risk management. So when I see the heading “The Psychological Environment” in his memo, my ears perk up. Of course I was not disappointed.

“Psychology plays a huge role – perhaps a dominant and self-fulfilling one – in influencing economic growth.  In short, if people think things will be good in the future, they’ll spend and invest, and things will be good.  But if they turn pessimistic regarding the future and go into their shells, refusing to spend and invest, growth will slow down.” – Howard Marks

Interestingly Marks presents us with the idea that the economy really may not be any worse today than it was pre-2008. Think about it: The future seems more uncertain now than it did before, but it probably isn’t because things are more uncertain now. It’s because we were fooled by the illusion before the crash that things were better off than they were. In other words, Investors weren’t giving weight to the “apocalyptic” (or worst-case scenario) probabilities.

Positive psychology prevailed up until 2008, despite a few hiccups. Luck rewarded many “processes” in the 1990’s when stocks returned 20% annually. Investors interpreted favorable outcomes as evidence of skill in their investment process. In 2005-2007, recall the clarity with which people viewed the market: Things seemed certain. Economists, consumers, and investors all seemed to understand how the market worked. Cause and affect finally seemed scientific.

Unfortunately this positive psychological environment pre-2008 was not due to a “better economy.” It simply represented a lack of appreciation for the “apocalyptic” probabilities.

Post-crisis, a crashing stock market is still fresh in our minds. The overarching attitude toward the stock market is one of balancing caution with a search for higher returns. In 1999 the S&P traded at 30 times earnings and no one seemed to care. Marks argues that the case can definitely be made that, today, stocks might be cheap in relation to history. But he quickly questions the validity of such a statement with a more important thought: But are they cheap enough? Concluding stocks are a buy simply because the market has below average P/E’s represents naive thinking.

The psychological environment is fragile, and the balance is unique:

“Please note, however, that while investor ardor and risk-blindness are at reassuringly low levels today – and that may be the best single thing that can be said for the current environment – the actions of central banks to minimize interest rates have served to force investors out on the risk curve in search of return.”

It’s not time to hide

“It’s essential, however, to remember that it can be just as wrong to see things as hopeless as it is to consider an environment risk-free. One mustn’t overreact in either direction [bold added].”

Marks then ends with some straight-forward advice which I will end with.

“ Move forward, but with caution – that’s my mantra today. The environment is uncertain, but we shouldn’t find that paralyzing.”

  • frankiethepunk

    Interesting insights. Howard Marks gives very sound advice. The real trick is to figure out whether you are holding four aces or a handful of nothing. This can be a lot more difficult than it appears. Currently I am holding onto two companies that I am convinced are fantastic value plays with tons of upside potential. Decker Outdoor (DECK) and Ezcorp (EZPW). The problem is that both stocks have been a disaster for my portfolio. DECK is down by 60% and EPZW is down by 30%. So the question I keep on asking myself, is “am I the sucker here, or is the market assigning ridiculous valuations to these stocks?” One wants to be smart enough to buy a stock like APPLE before its goes on its big run, but not dumb enough to hold onto a stock like RIMM. Fortunately, Jae Jun’s amazing spreadsheets have given me a good insight into what I am holding, but I still find myself plagued with doubts. “Am I holding two aces here or a handful of nothing?” Incidentally, if any of your readers have any insights into these stocks they would like to share (positive or negative) I would be interested in hearing their views.

  • anon

    OSV is a guru when it comes to valuation. But it doesn’t create a story about the future and brand moat of a company. I find that OSV is just 1 tool within a set that you need to employ before making an investment decision. You need to combine valuation with others in order to make a well-informed decision. Otherwise, you will find yourself in a value trap as I have, directly following some of Jae’s picks.

    Combine it with Phil Town’s 4Ms – Meaning, Moat, Management, Margin of Safety. You will find that OSV only fulfills the Margin of Safety requirement. What about the others – Meaning (do you understand how the company makes money, and do you know how they will continue to make money 10years into the future?) and Moat (how will this company defend their brand, profit, and market share)?

    I haven’t followed DECK for several months, but I know its share price is propped up by hit brands like Uggs. But is Uggs here to stay, or is it a fleeting seasonal fashion trend? What kind of moat is there that protects their business from competitors? Can DECK continue their streak of hits? If you don’t have an answer to these questions, you’re just making a gamble.

  • Sorry to hear about your losses and what you say is true to some extent. I seem to have written about quite a few value traps this year.

    OSV will do the quantitative work for you easily. But the qualitative is up to each investor. Understanding the industry, moat and definitely management is a top priority.

    It’s why I go through the annual reports and proxy statements to get a better idea of what the company is like.

    Just like Murphy’s law, there are many companies I don’t write about that do well in my portfolio. Or I had written about it long ago and didn’t mention it again.

Ready to try Old School Value?