Together with Buffett’s annual letter to shareholders, another investors writing I have really come to enjoy is Howard Mark’s memos, one of the founders of Oaktree Capital Management. The clarity the perception the memos are written with is unparalleled in this era of one-liner’s on X or Instagram.
Oaktree is a distressed debt investment vehicle, which makes bets on distressed assets being turned around, or upgraded. Risk control is at the centre of its investment philosophy. In simple parlance, avoid losers, and winners take care of themselves.
Applied to bond markets, if Oaktree invest in a diversified portfolio of bonds, and they can avoid the bonds that default, some of the non-defaulters will benefit from positive events such as upgrades and takeovers, such that winners will materialize without having specifically identified them. Graham and Dodd, in their famous book Security Analysis, talk of this approach as a negative art, in which superior performance is not which securities are bought, but which are NOT bought.
The philosophy can be applied to many forms of life and investing: one of our highly respected advisors at SSCG used to say, when you are managing a team of employees, you don’t focus on your weakest players, you focus on your strongest players (by definition avoiding losers). Big corporations rarely hire from outside the corporation, they promote from within, as there is a pool of candidates to choose from who understand the company’s culture and thus likely to be a less risky hire. When choosing equities, superior risk adjusted returns come more from avoiding picking losers, than by explicitly focusing on picking winners. I think of my own portfolio of shares on the ZSE. Having invested in a wide basket of shares over the past few years, I have come to realise that there are literally a handful of stocks to own, and most are worth avoiding. One stock in particular I’ve become really disappointed with, as it’s performance continues to dwindle, even as other shares recover. It becomes cheaper and cheaper but never seems to recover. And the shares which seem expensive continually seem to do better. And applied to deal making, one of Donald Trump’s quips, is that your best deals, are often the ones you don’t do.
“Winners take care of themselves; losers never do.”
Howard Marks
Risk control versus Risk avoidance
Risk avoidance is not doing anything where the outcome is uncertain and could be negative. But in investing, this is not going to produce attractive returns. For example, if one buys government issued treasury bills, the returns will be low. US 1-year T-bills currently pay 5.4% which is actually a lot higher than it has been for years. Some level of uncertainty is required in the pursuit of attractive returns. Whereas Marks defines risk control as declining to take risks that exceed the quantum of risk you want to live with and/or you wouldn’t be well rewarded for bearing.
Successful investing then is not about having losers, but rather how many losers you have compared to your winners. Buffett is widely regarded as only having 12 great winners in this career, whilst his partner Charlie Munger says actually it is only four (American Express, Bank of America, Coca-Cola and Apple). Marks puts Berkshire Hathaway’s success down to three key ingredients:
- A lot of average performing investments;
- A relatively small number of winners that they invested heavily in and held for decades;
- Relatively few big losers
Tennis as an analogy to risk – unforced errors, aces, winners
I can relate closely to Marks analogy of tennis for risk, since I have recently got back into tennis after many years away from the sport.
He talks of there being two types of tennis games: Professional’s play a winners game, whereby they win by hitting winners (unplayable shots which take skill to make), but amateurs play a loser’s game, whereby the winner is usually the person who hits the fewest losers (my school coach always used to tell us to just keep returning the ball over the net and inside the lines).
To win a winners game is a higher risk endeavour than to win a losers game, since you have to take much riskier shots which are more likely to lead to unforced errors. And too many unforced errors lead to losses, both in tennis, and in investing.
He compares Alcaraz and Eubanks, two up and coming tennis players who play an aggressive winners game, with the top three tennis players from the past 20 years (Djokovic, Federer and Nadal), who all play more of a defensive game (playing consistently well for several hours at a time, controlling unforced errors, and waiting for the other player to make a mistake). Taking the stats from the recent Wimbledon quarter-finals tournament, it was clear Eubanks approach was high risk (aiming for winners), whereas Medvedev was more defensive, and ultimately Medvedev won.
Equities – why active managers seldom beat the market
Often a small number of stocks account for a disproportionate large share of market gains, such as the “magnificent seven” recently, comprising Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta, which have performed well this year, compared to the rest of the 493 companies in the S&P 500 index which are flat, in aggregate.
The common reasons purported why active investors struggle to keep up with equity indices, is due to market efficiency, management fees and investor error. Marks adds one more reason, being active investor’s need to pick winners.
If you didn’t own the magnificent seven, you would be far behind the indices, and also, if you owned them but in a different weightings to the index, you would also lag. Apple, which traded at a split adjusted price of 0.37 per share in 2003, and currently trading at 180, has gone up in price nearly 500 times. Bitcoin went from around $13 per share in 2012, to around 65,000 in 2021, a multiple of 5,000 times. Most investors would have sold part or all of their shareholding in Apple (or Bitcoin) at some point along the meteoric rise, to take profits, and avoid regret. But if they sold their shares and the index constructors didn’t, they would not have kept up with the index as the price continued to rise.
“Selling your winners and holding your losers is like cutting the flowers and watering the weeds”
Peter Lynch, “One Up On Wall Street”
Risk
Marks concludes his memo by illustrating risk on the traditional risk/return graph, where risk is shown along the x-axis, compared to return on the y-axis. As the theory goes, the more risk you take, the more return you should be rewarded with. However, as Marks points out, this is not true, else by definition there would not be increased risk. Rather, he cleverly superimposes a series of bell-shaped probability distributions turned on their side – as shown in the graphic below.
This graph doesn’t include “Frontier Markets” which would be further along to the right, and then of course you have the “fragile” markets such as Zimbabwe, Venezuela etc.
As you move from left to right in the graph, three things happen:
- the expected return increases (higher risk, higher return);
- the range of possible outcomes becomes wider (standard deviation increases)
- the bad possibilities become worse
Where is the best place to be along the spectrum as an investor? Nearer the low risk/low return intersection, or further up the higher risk/higher return curve? As the Efficient Market Hypothesis (EMH) suggests, in theory, there are no better or worse places to be, because security prices should be priced such that it factors in the risk associated, hence the popular phrase you can’t beat the market (and, certainly in developed markets, most active investors fail to beat the market after fees).
However, he says there are times when markets, sectors, or securities are overpriced or underpriced, and being on some parts of the risk curve compared to others can offer better returns. In periods of excessive risk aversion, it often is better to be on the riskier part of the curve, and in periods of excessive risk bearing, the safe part of the curve can offer a better proposition.
How is alpha generated?
Alpha is the measure of an investors ability to beat a benchmark, e.g. if an index achieved 10% return whilst a fund manager achieved 12%, the alpha is 2%. To generate alpha year after year, such as Buffett has done, is remarkably difficult.
Investors generate alpha by either reducing risk whilst giving up less return, or by increasing potential return with a less than commensurate increase in risk. In the second method, I can think this is done by simply paying a very low price for a security than its intrinsic and risk adjusted value. This is often achieved in hard economic times when markets are down, investor confidence is low, and there are very few buyers around.
Marks posits that investors who possess alpha can alter the shape of the distributions in the graphs so that’re not symmetrical, in that the portion of the distribution representing the less desirable outcomes is smaller than the portion representing the better ones. Put more succinctly, it’s the ability to put yourself in a position where the upside potential offered far exceeds the downside risk. This is the area where ultra-successful investors play.
In closing, professional investors (Buffett, Marks, Soros, Druckenmiller etc. etc.), play a winners game of investing, where they actively select particular securities that end up being winners, or avoiding losers, but most amateur investors are better off playing a losers game of investing, where they put their money into index funds. This way, they will avoid disasters, and the winners will take care of themselves. It’s also the type of tennis I will play.