The low risk high return genius

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Howard Marks, OakTree Capital

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High risk-high return is rubbish - because the prospects of high returns automatically means lower probability of risk. You got to either believe that an asset at a price represents high risk or high return prospects - not both. Investing, according to Howard Marks, is about identifying and investing in assets where the downside risk appears low and upside appears considerable - ie, low risk - high returns. The man who is famous the world over for his "OakTree memos" raised the highest amount anyone has for distressed assets funds in 2008 and delivered outstanding results for his clients - a great example of low risk - high return investing.

Howard Marks is an American investor and co-founder of Oaktree Capital Management. He graduated from the Wharton School, University of Pennsylvania and went on the Booth School of Business, University of Chicago for an MBA in finance and marketing. He is a CFA charterholder.Initially he worked for Citibank for about 16 years and moving on to TCW, found success and fame by creating the High Yield Convertible Securities in the mid-Eighties. He started Oaktree in 1995.

Investment Philosophy

"To be a successful investor, you have to have a clear philosophy and stick to it even under pressure. No one can profit from all opportunities. To be a disciplined investor, you have to be willing to stand by and watch others make money. Your process is more critical than the outcome. Talking about the investing profession, he said that no one can consistently forecast. Our industry is full of people who become famous by getting it right once. Investors would be wise to accept that they can't see the future and restrict themselves to doing things that are within their control. While we can't see where we are going, we ought to have a good sense of where we are." (Address at Flame University Mumbai, March, 2nd, 2017)

Investment Strategy

For Howard Marks, a first principle of investing is controlling risk. The emphasis is on avoiding losses rather than seeking profits. Anybody can do well in good times by taking higher than average risks. A good investment manager is one who performs well in bad times. Howard Marks's formula is "if we avoid the losers, the winners will take care of themselves."

The second principle is consistency. He says that he prefers a higher average performance than hitting soaring heights and plumbing dismal depths.

Howard Marks takes a markedly different approach to markets from the normal run of the mill investment manager. "We feel skill and hard work can lead to a "knowledge advantage," and thus to potentially superior investment results, but not in so-called efficient markets where large numbers of participants share roughly equal access to information and act in an unbiased fashion to incorporate that information into asset prices. We believe less efficient markets exist in which dispassionate application of skill and effort should pay off for our clients, and it is only in such markets that we will invest." (oaktreecapital.com)

Each and every portfolio ought to specialize in a particular investment area. It is critical to focus on one area and do it very well. At Oaktree Capital, a charter for each investment specialty is established as clearly and explicitly as possible. This makes all investment decisions transparent to the investors. Investors also get precisely what they want from an asset class. Portfolios can be combined to get the mix of assets an investor might desire.

Consistent superior performance is achieved through deep knowledge of securities and companies. This is more important than statistics about interest rates, predictions for the performance of the economy and markets. Oaktree Capital follows a bottom up approach relying on proprietary company specific research. The portfolio is structured to hold securities that do well.

Tackling Markets

Howard Marks is dismissive about timing the markets. However, when markets are choppy, portfolios may be rejigged to tilt defensively against losses. "Because we do not believe in the predictive ability required to correctly time markets, we keep portfolios fully invested whenever attractively priced assets can be bought. Holding investments that decline in price is unpleasant, but missing out on returns because we failed to buy what we were hired to buy is inexcusable."

The first step to an investments firm's success is to build up a team, whose members have the same investment framework and value system. Further, members' skillsets should be complementary.

Whenever there is over generalisation, such as that 'mortgages are risk free', or 'tech stocks are not expensive at any price', one can scent a bubble. If the market is high and effervescent then discipline in investing must go up. Markets can be inefficient. There is no guarantee that attractive bargains of the past will be around in the future.

Before investing, one should ask the question, "how much optimism or pessimism is already factored into this price." Buying 'good companies' is not the same thing as buying companies well. "The entry price is the most important criteria for making any investment decision, be it a high quality company or a junk bond. At the right price, even a junk bond is AAA."

Investment tips

Says Howard Marks, no one can be 100% sure of what will happen in the future. Therefore scepticism and doubt are actually strengths while identifying stocks for purchase. Further, markets are riskiest when in general investors believe there is no risk. In support of his view, he puts forward the 2007 meltdown.

"I am always worried when I make an investment decision. That's the only way there is. You can never be totally confident of a thesis", he said, explaining the state of mind of a good investor. "Investing is like being an airline pilot - hours of boredom punctuated by moments of terror."

He says that large gains accrue when the market consensus underestimates reality. According to Howard Marks, an investor should be aggressive at the bottom and defensive at highs. The key to outdo competitors is to think differently and to think better. "Superior returns come not from being right, but being right more than others. Superior results don't come from buying the right asset, but from buying assets at less than their worth. Investing is not about what you buy, but what you pay."

He is also emphatic that high risk does not mean high returns since that would mean it is not high risk by definition. He says one should go for low risk and high return. "One must always think of the downside or the worst case scenario. If one avoids the downside, the upside will take care of itself."

Mark's Memos

Howard Marks is famous for his 'memos' addressed to Oaktree clients. This contains his views on the state of the market. These are eagerly read by investors and market players alike for the sharp insights that they contain.

February 14, 2007

Any way you slice it, standards for mortgage loans have dropped in recent years, and risk has increased. Logic-based? Perhaps. Cycle-induced (and exacerbated)? I'd say so. This memo can be summed up simply: there's a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won't exceed that of the naysayers. But that is the usual pattern.

May 25, 2011

"I've commented about junk bonds that last year's weeds have become this year's flowers. I liked thembetter when they were weeds" This was by Warren Buffett. Marks alludes to this in his memo.

One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present,and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change.

We can never be sure what will happen -and certainly not when -but it's important to be prepared for what's likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed - from weeds to flowers and back - is an essential ingredient in being able to do so.

April 18, 2017

The key to financial security -individual or societal - doesn't lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialize. Has anyone thought through all the implications of closed-end funds 'increasing use of subscription lines?Are they all tolerable, for the individual parties and for the financial system?

Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.

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