Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 11 “The Most Important Thing Is…Contrarianism”

Trackrecord, Clients, Mistakes, Redemptions, Patience

“‘Once-in-a-lifetime’ market extremes seem to occur once every decade or so – not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach. Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom…And you must have the support of understanding, patient constituents. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.”

I wonder, if an investor was able to find a firm or client base with patient & long-term focus, could not profiting from “market extremes” be the basis of a very long-term & successful, albeit not headline-grabbing, wealth creation vehicle?

Marks also highlights a very costly mistake – one that has nothing to do with investing, and everything to do with operational structure and business planning. The “most typical” market victim of Marks’ description is one who has misjudged the nature of his/her liabilities vs. portfolio assets. Your patience is not enough. The level of patience of your capital base matters.

When To Buy, When To Sell, Catalyst

“Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers…If buyers didn’t predominate, the market wouldn’t be rising…figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further and the market is as high as it can go. Buying or holding is dangerous.”

“The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).”

“Accepting contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction. On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond)…Even when an excess does develop, it’s important to understand that ‘overpriced’ is incredibly different from ‘going down tomorrow.’ Markets can be over- or underpriced and stay that way – or become more so – for year.”

Tricky part is determining the timing when “the top is reached.” As Stanley Druckenmiller astutely points out: “I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…” Unfortunately, neither Druckenmiller nor Marks offers additional insight as to how one should identify the catalyst(s) signaling reversals of the pendulum.

I have also heard many value investors bemoan that they often sell too soon (because they base sell decisions on intrinsic value estimates), and miss out on the corresponding momentum effect. (See Chris Mittleman discussion). The solution involves adjusting sell decision triggers to include psychological tendency. But this solution is a delicate balance because you don’t want to stick around too long and get caught with the hot potato at the end when ‘the last person who will become a buyer does so” and “bullishness can go no further.”

When To Buy

“…one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.”

Gumption is rewarded during periods of uncertainty.

Mistakes

“You must do things…because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.”

In this business, mistake & profit are exact and opposite mirror images between buyer and seller. Frankly, at times, it’s difficult to distinguish between temporary impairments vs. actual mistakes.

Expected Return

“…in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.”

For Marks, future expected return is a probably-adjusted figure.