Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.
You can contact Brent at [email protected] and on Twitter at @donnelly_brent.
As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.
Today, I’m writing about Howard Marks’ most recent memo, which you can find here: Oaktree Capital – Something of Value.
Major bonus: I sent my note to Mr. Marks as a courtesy in case he had any feedback (because he is a legend and I’m scared of authority figures). He was kind enough to get back to me. He didn’t just reply with a one-line email, he gave me almost an hour of his time. So herein, I combine the original piece I wrote with my notes from a 60-minute phone call with Howard Marks. Enjoy!
Howard Marks has been a great investor and one of the best finance writers in the business for decades. He has been writing must-read investor letters since I was in high school. His latest memo “Something of Value” contains much insight, particularly about why traditional value investing is likely permanently impaired as a strategy and why Growth vs. Value is a false dichotomy.
The Marks letter spans 18 pages so my piece today will scratch the surface. If you have time, go read the memo from Howard Marks first, then come back.
Here is my quick review + summary + partial rebuttal + phone interview excerpts. Just so it’s clear: the indented quotes are from the memo and the left justified, larger font quotes are from our phone call.
Howard Marks on value and efficient markets
With unlimited computing power widely available to most investors in the world, stocks that are cheap on simple metrics like price/earnings etc. are probably cheap for a reason. Unlike pre-internet, when you had to scour annual reports in a library to find company metrics, everyone now has access to detailed company financials. If you want to be a value investor, more imagination is required than simply running a P/E or P/S screener on Yahoo! and buying whatever pops out.
In ye olden days, it was hard to get timely and accurate corporate information and so simply buying cheap things worked because not everyone knew what was cheap. There is no reason to think that should work going forward.
Here is the key quote from Marks’ note:
In the past, bargains could be available for the picking, based on readily observable data and basic analysis. Today it seems foolish to think that such things could be found with any level of frequency. If something about a company can be easily read in an annual report, or readily discovered by a mathematically competent analyst or computer, it stands to reason that, in most cases, this should already be appreciated by the marketplace and incorporated in the prices of the company’s securities. That’s the essence of the Efficient Markets Hypothesis.
Thus, in the world we live in today, investing on the basis of rote formulas and readily available fundamental, quantitative metrics should not be particularly profitable. (This is not necessarily true during market downturns and panics, when selling pressure can cause prices to decouple from fundamentals).
That last sentence is the key—and it should also be stated in reverse. That is: growth can also outperform value during manias and bubbles as buying pressure can cause prices to decouple from fundamentals.
Essentially what this all comes down to is that markets are mostly efficient but efficiency breaks down at times due to behavioral factors. Markets defy EMH and decouple most aggressively from fundamentals during manias and crashes. Despite the wide availability of home computers and financial data, for example, value still outperformed from 2000 to 2007 as the NASDAQ bubble unwound and mean reversion following the dotcom mania (and crash) eventually brought things back into balance.
Value and growth cycle back and forth… Each time value underperforms (like now), prognosticators find a new explanation for why that might be permanent, not cyclical. If anything, though, what stands out to me is that the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.
I initially read the memo as a bit of an assertion that “value is dead”, but that’s not right. Marks explained to me on the phone that that is not what he meant.
“Market inefficiency is mostly cyclical now. In the past it was structural.”
What he meant was that structural inefficiencies that once existed are gone and will never come back. Pre-internet, there was alpha sitting around all over the place. Anyone with a calculator, a basic understanding of DCF, and a strong work ethic could scoop up that alpha because markets were structurally inefficient. Now, markets are structurally efficient and veer into inefficiency only during cyclical periods of extreme emotion. You either need to use a behavioral approach, or you need to understand the companies, industries, and technologies way better than anyone else. That level of understanding requires a much deeper knowledge than one can glean by scrolling through publicly-available data.
Howard Marks on growth
The memo avoids declaring a new paradigm to justify current record-high valuations … but it definitely feels like it wants to declare a new paradigm! For example:
It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.
The last line is definitely debatable and the entire paragraph is kinda debatable, but not quite the language you see from #truebelievers in presentations for various NEWECONOMYDISRUPTORS™ ETFs. “The shares of frictionless businesses are reasonable to own at any price, multiple, or valuation because super long duration assets have nearly infinite cash flows!” While this sort of 1999ish statement has now made its way into the mainstream narrative, Mr. Marks stops just short of making it.
The idea that some companies have infinite cash flows discounted at a near-zero interest rate means valuation no longer matters for some companies is the same numerator mistake everyone made in 2000 (near-infinite growth of the World Wide Web… For, like, ever!). To be clear, a) the denominator story now is different from 1999 and b) Mr. Marks never says valuation doesn’t matter, but he gives more than a passing nod in that direction as he suggests there may be a few companies out there right now where almost any valuation could be seen as reasonable. One other note: just because US government yields are at 1.5% or companies can borrow at low rates, that doesn’t mean company WACCs are 1.5%. Take a look at the WACC for a few of your favorite companies. It’s not zero and it’s not even close!
Anyway, I found Marks’ arguments against value more compelling than his arguments in favor of growth, but the whole memo got me thinking.
One big message I took from the memo is that investors should not get married to one style. Trade and invest flexibly using the logic of what style makes sense at any given moment in the regime you find yourself. That does not mean you have to chase the current fashion, it just means you should think for yourself and be flexible. Don’t rigidly declare yourself a value investor or a growth person.
Another takeaway for me is that even the smartest people in the world (like Howard Marks) risk overweighting recent information. This is not a criticism of Mr. Marks, just a hard-to-avoid fact for all human beings. Recent news, information and performance are easier to remember than prior (or future!) performance. I could also be wrong and there is something truly new and different about today’s crop of tech companies. I’m open to that possibility, but I also doubt it. There have always been companies perceived to be dominant and expected to achieve rapid, durable growth as far as the eye can see. As Marks says:
John Templeton warned about the risk that’s created when people say, “It’s different this time,” but he also allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today.
Personally, my guess is that the number is still well below 50%. On the phone, I tried to press Mr. Marks on this topic because it’s the most interesting aspect of the letter. When a “value guy” who correctly identified 1999 as a bubble in real time and sidestepped it nods to the idea it might be different this time … that’s interesting!
When I pressed him on the phone he said:
“Yes, you could say I’m struggling with a partial conversion.”
“Drill down and be open-minded.”
His defense of a more open-minded position on “highly-valued” tech is rooted in the idea that you cannot make blanket statements about entire industries without having an intimate knowledge of the firms themselves. The quip he used was:
“All generalizations are flawed, except this one.”
So his feeling is that now, given the enormous growth rates and very low interest rate environment, you need to keep an open mind and understand each individual company, industry and technology. This clearly doesn’t square with the 1999 experience. Even the very best companies in 1999 were terrible investments. For example, if you bought Amazon in 1999 or 2000, you were underwater for 10+ years!
“Sure it’s like 1999, but it’s not 1999, it’s 2021“
Mr. Marks says we are experiencing something similar to the Internet Bubble in some ways but 2021 is vastly different in other ways. Rates are low and the Fed is not hiking. Some assets are overvalued and in a bubble, but some are not. To make blanket statements like: “stocks are too high” or “tech is overvalued” is not the right approach. He believes you need to drill down and make more granular assessments, whether it’s crypto, tech or old economy stocks.
He did make it abundantly clear that he still believes that valuation always matters. He spent about 10 minutes emphasizing and reiterating that he does not currently believe and will never, ever believe that valuation does not matter.
“Value vs. growth is a false dichotomy.”
Marks said his grandmother used to joke: “What do you like better: summer or the country?” Value vs. growth is not a spectrum, it’s two sides of the same coin.
“It’s not what you buy, it’s what you paid.”
He said: “I’m going to sell you my car, do you want to buy it?” I mumbled for a second and he clarified: “The question makes no sense.” Every asset you buy is a combination of the intrinsic worth of the asset and the price you pay. Looking at one or the other in isolation is dumb. People define “value” as cheap, but they are often talking about price, not worth.
… “carrying low valuation parameters” is far from synonymous with “underpriced” ….
Traditional capital-V Value Investing is all about numbers: ratios, book value, cash flow, price-to-earnings, etc… Meanwhile, Growth Investing is all about the company: Tell me the story, what a great product, DISRUPTION!, huge moat, revenue growth, innovators!, viral founder, and so on. Again, this is a false dichotomy. Good investors should be looking at both, not one set of variables in isolation from the other.
I don’t believe the famous value investors who so influenced the field intended for there to be such a sharp delineation between value investing, with its focus on the present day, low price and predictability, and growth investing, with its emphasis on rapidly growing companies, even when selling at high valuations. Nor is the distinction essential, natural or helpful, especially in the complex world in which we find ourselves today.
“A high P/E stock can still be cheap.”
Real value investing is not about buying cheap things. It’s about buying assets for less than they are worth and waiting for the market to agree with your judgment. This might mean buying a stock at 70X earnings when it’s worth 250X earnings. Or it might mean a stock at 0.8X earnings is expensive because it’s going bankrupt. Good investors understand and study the relationship between price and intrinsic value and do not buy assets based on value metrics or growth stories in isolation.
Even famous so-called value investors like Ben Graham and Warren Buffett made as much or more money in growth as they did in value. I did not know that! Super interesting.
Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long-term investment in a growth company, GEICO, than in all his other investments combined.
Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns.
This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential. While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks. Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful.
“Don’t place arbitrary or artificial constraints on your portfolio. It’s not about being best at a particular game, it’s about choosing the game you can win.”
Unless you are forced by mandate, don’t corner yourself into a particular style. Just like in trading I say it’s best not to be a breakout trader or a mean reversion guy or anything similar… In investing, it’s best not to pigeon-hole yourself as a value guy or a growth woman etc. Intellectual flexibility and adaptation lead to long-term outperformance, not the expert application of a single investing style.
This is relevant right now with regard to the bullish ESG story. ESG investing might be the best thing to do ethically, but from an investment point of view it’s hard to imagine the thing that everyone in the upper echelons of finance loves (and is actively and publicly signaling it loves) will outperform the things that everyone thinks are icky. I mean, Philip Morris is one of the best-performing stocks of all time, and a big part of this is because for much of its existence, people would not touch it.
“No asset is so good that it can’t be overpriced.”
Marks started at Citicorp in 1968, in the midst of the Nifty Fifty bubble [1] and that experience (like my 1999 experience) puts him always on alert for bubbles. Here’s a quick excerpt from a 2018 Wharton piece:
Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.
Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.
Formative experiences shape behavior for decades. Everyone forms strong bonds to salient early-life experiences, whether those experiences involve investing or life outside finance. If you grew up in the Great Depression, you reuse aluminum foil. If you grew up in the 70s, you scrimp on gas.[2] If you came of age in 1999, you might find the smell of highly-valued tech particularly pungent. As a general rule, these sorts of bias are bad.
Marks noted in our conversation that this predilection for bubble detection can be both a blessing and a curse. While it might save you from going all-in levered long at the most egregious moments of euphoric overvaluation, it can also lead you to be too cynical. It can lead to gigantic missed opportunities.
While the idea that some companies can be good investments at what appear to be sky-high valuations didn’t resonate much with me because I feel the same thing was said in 1999, it did resonate with me big time when Marks said his partial conversion on the 2020 disruption economy is in some measure motivated by this realization:
“I was too skeptical in the past. Skepticism can lead to knee-jerk dismissiveness.”
When he said those words, my brain lit up a bit because I have suffered from the same bias of excess dismissiveness many times. Healthy skepticism is great. Reflexive cynicism and dismissiveness is bad. Marks’ comment hit home for me and the conversation may have influenced my less skeptical view of NFTs a few weeks later (see AM/FX: The metaverse contains infinite Pop-Tart® cats). If I was wrong about the iPhone and I was wrong about bitcoin (and Twitter… Who’s ever going to use that???)… Maybe next time I should be more open minded? And perhaps less wrong?
The risk, of course, is you end up on the other end of the spectrum—that’s not good either!
| Reflexive cynic | Highly skeptical | Healthy skeptic | Rational optimist | Unrealistically optimistic / gullible | Pollyanna |
I have been too far left on this spectrum, and so has Howard Marks
While I want to be less knee-jerk dismissive overall, my observation right now is that there is a large swath of the investment community wearing the Growth Investor blinkers and that has put them too far to the right on the spectrum from cynic to unrealistic optimism and beyond.
These investors see booming top line growth and economic disruption and low rates as far as the eye can see but ignore the other side of the equation. They see a McLaren P1 and think: “Wow, I want that!” and then pay Howard Marks $22 million for it when it’s really worth more like $2 million.
Marks is worth around $2B, so I am assuming this is the car he drives. I could be wrong.
Meanwhile, value investors are looking for 1992 Toyota Tercels they can buy for $800 and resell for $2,000. The right philosophy is to look at all the cars and see which ones you can get for less than fair value.
Easier said than done in the stock market, obviously, but I think it’s a good framework.
In ten years, I bet we will look back at many of the outsized investment winners of 2020 and see them as flukes. Separating skill from luck is notoriously difficult in finance. Evaluating the performance of any strategy or fund manager by how it, he or she performed in 2020 could be the epitome of Taleb’s fooled by randomness. I think “persistent investing skill” and “performance in 2020” are more likely to be inversely than positively correlated.
Many fund managers who delivered stellar performance in 2008 left investors disappointed in 2009. It is the aggregate performance of managers and strategies over multiple years that matters, not 2020 outcomes.
Anyway, a lot to chew on here. I thank Howard Marks for the memo and for being so generous with his thoughts and his time. There is no reason he needed to spend an hour talking to me on the phone, and I sincerely appreciate that he did.
Finally, Mr. Marks suggested I check out this 1962 Warren Buffett interview, just for fun. It is fun!
[1] A year or so before man landed on the moon and 18 months before the letters “LO” were transmitted over the ARPANET in what is widely viewed as the birth of the internet.
[2]> See: Malmendier and Shen, Scarred consumption (2021) https://voxeu.org/article/scarred-consumption and Severen and Benthem, Formative Experiences and the Price of Gasoline (2019) https://www.nber.org/papers/w26091
Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.
You can contact Brent at [email protected] and on Twitter at @donnelly_brent.
Disclaimer
U.S. Global Markets Sales and Trading Commentary Disclaimer
Its a good piece. I think Howard owns a business that is dependent on the financial markets and to that extent he is not just an investor, he is also long in a structural way the industry. So is his family. I know he knows what the effect of a crash will be on his industry, net worth and team. I think he he is very right about what he says, but they are kind of generalizations, I think he is very moderate because he is very aware of career risk or better said business risk, or maybe reputation risk, knowing what weight strong statements from his side can carry. Whatever the case yes, there are a lot, too many on the right of that spectrum, many are no Howard’s and most have no clue what they are doing and investing money they cant loose and on record margin. true, governments will prop up anything, give away money, stretch out taxes grow huge debt balance, yes all true, in my mind it is the greatest mismanagement experiment of all times, it all makes a great recipe for a very fragile selfish system that is so vulnerable that at some poin can only collapse, the king is naked!
The reticence to explore the tails of the risks that are building, and instead gloss over them, “Yay! In the Long Run!” is part of the confidence game Wall Street plays with its clients. The siphoning of value to the managerial class in Wall Street and Corporate Street makes a huge difference in risk tolerance between the barkers and the muppets (the internal Goldman term for how it really felt about its clients). It matters to the US investor trying to scrape together $1 million to retire whether there is a drawdown again similar to the past two, right as they are about to live off of that pile of savings. The next drawdown means nothing to those already holding >$100 million in wealth.
And, Howard Marks doesn’t deserve being lumped into that cesspool of barkers.
That is an apology to Marks for my comment associating him, not a problem with Fabrizio’s comment!
Muppets? Us non-financial pack-members really appreciate that insight!
> the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.
The dichotomy between value investing and growth investing is simply a case of sliding percentages. Sliding percentages are well-known in the real world (e.g., tax brackets), and can be qualitatively modeled in a quantitative way via the expressions (r.x)/x and (x – r.x)/x, r.x being an abbreviation for log.(1 + x), for x positive, where log is the natural logarithm.
In the case at hand, x is the amount of your liberality (as opposed to conservatism), and (r.x)/x is the fraction of your investing that is value-based, and (x – r.x)/x is the fraction of your investing that is growth-based. (Being super-liberal myself, I’m investing in Esperanto!)