I’m a little frustrated at the moment as it is proving difficult to identify attractively priced businesses to invest in. My portfolio remains 100% in cash given the recent all-time highs reached in US equity markets, with the S&P 500 up nearly 11% for the year-to-date, and general exuberance in European equity markets – the Eurostoxx 600 is up about 5% year-to-date, which is also its highest level in nearly 5 years. So the contrarian in me is saying that now may not be the best time to invest in stocks, and my stock-screening and research to date appears to be confirming this also. However, rather than get impatient and get invested just for the sake of it, I’ve been taking the time to re-read The Intelligent Investor among other investment books and articles until more attractive investment opportunities start to appear. I recently came across an interesting interview with Howard Marks of Oaktree Capital Management on Manual of Ideas. In this interview, he re-iterates the importance of risk appreciation and general market awareness, which is definitely worth reminding ourselves of in the context of where stock prices are at present. I have extracted what I believe are the key points to take away from this interview, as I continue to wait for better investment opportunities than what present market price levels offer.
My key points are as follows:
1. Risk – the most dangerous thing to neglect:
• “The great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it.”
• “The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years …….. people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it.”
Independent Value takeway: risk according to Marks is a very simple concept, not defined by mathematical models that seek to measure and predict price volatility, or by a stock’s so-called beta factor – risk is about losing money, and money is invariably lost when the primacy of risk management is forgotten due to an over-emphasis on the secondary goal of making money. So, superior investing and investment performance is as much about not losing money as it is about making money. And this performance can be attributed a consistent and disciplined approach that is ALWAYS cognisant of what the real definition of risk is. Part of the challenge for investors in always appreciating risk is being consistent in one’s approach as markets rally higher, as they have been doing at present.
2. The Temperature of the Market:
• “If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated) … it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.”
• “I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.”
IV takeway: the above extracts carry resonate greatly in the context of where stock prices are at present. Interestingly, in the first point Marks makes mention of the macro-environment, what he calls the “temperature” of the market. Some value investors might claim that value is value, regardless of market level, and it is possible that even in a richly priced market, undervalued businesses can be found.
However, if we ignore the general market environment when making investment decisions, we are implicitly assuming that the prevailing environment has had no bearing or influence on the price that one is being asked to pay for a business that one may be about to invest in.This is an important point to consider. Value investing advocates investing at a margin of safety to a business’ intrinsic value; however during times of elevated general market prices, the margin of safety may be reduced, as if one’s estimate of intrinsic value is incorrect or flawed, at an elevated price level these is less headroom for error. Hence elevated price levels are hostile to the investor as they diminish the likelihood of acquiring a business at a favourable price while increasing the likelihood of capital impairment, in the event that one’s estimate of intrinsic value is incorrect.
The second point reinforces this concept of appreciating the market’s temperature – it is important to recognise when stock market prices have overheated, and the implications of this for safety of principal and investment returns. If one invests regardless of the stock market’s level or cycle, then one risks simply following the stock indices themselves, and surely one can only expect average results at best from this approach over time.
3. Adjusting your level of aggressiveness based on the environment
• “I would argue that you should adjust your activities based on the climate of the market. ….You have to be sensitive to conditions in your world, and you should adjust your tactics — offense and defense — based on conditions in your environment.”
IV takeway: This third point brings to a conclusion Marks’ preceding points. In his view it simply does not make sense to assume that one can find always find value and invest with satisfactory results in an expensive market. Yes undervalued stocks may be found, but finding them is firstly much harder, and secondly, carries greater risk, in that the margin of safety is potentially reduced – it must be remembered that an investor’s estimate of intrinsic value is just that, an estimate, and not an absolutely certain value.
My own view is that while value investors do not necessarily need to spend time analysing macro-economic variables in the same way a macro-oriented hedge fund manager would, value investors should still appreciate the general level or “temperature” of the market at a point in time, and understand the implications of this for investment. Such an appreciation will serve to reinforce discipline, patience and a consistent approach to resist investing regardless of conditions on the belief that a business is undervalued somewhere, and instead embolden the investor to wait for more favourable and advantageous conditions to take hold.
Each of these points provides a useful reminder to remain patient as I seek investment opportunities. The current market climate or temperature to use Marks’ nomenclature indicates to me that prices are clearly elevated and that there is nothing imprudent about holding cash at present. That said, I am also conscious of Buffett’s latest letter to shareholders, in which he appears to suggest (based on my own reading) that holding too much cash may effectively be a mis-allocation of capital (due to likely future inflationary pressures arising from recent QE). However, Buffett is a unique investor with unique investment objectives and circumstances very different to my own. So on that basis, I am comfortable with holding cash for the time being, and wait alertly and patiently for opportunities to arise.