Distinguished Speaker Series: Howard Marks, CFA

I'm here to talk to you today with my host send and I selected a presentation that I'll use to kick off today's session entitled investing in a low return world and hopefully you might find some of it interesting and hopefully it'll set the scene for some good QA to follow and we will have time so I hope you'll all work on your questions while we speak what has been the dominant characteristic of the financial environment over the last ten years and the answer is low interest rates generally speaking I mean the all-time lows of interest rates were hit during that period and interest rates while having been raised in recent years are still extremely low the effect the impacts of that is to raise Davout the discounted cash flow of most businesses to increase the value of businesses to provide a wind at the back of many businesses to encourage economic results all those things that's why the central banks of the world lowered interest rates ten plus years ago to fight the global financial crisis and of course it did work but that has left us with an investment Virant characterized by low interest rates and that's the reason for talking about them today so I've been saying for some time I still believe that today the uncertainties are unusual in terms of number scale and in solubility things like geopolitics etc the prospective returns in many asset classes are historically low because of the low interest rate environment asset prices range from full to high depending on which asset category you're talking about and pro risk behavior is widespread they taught me at Chicago 50 odd years about go about the importance of risk aversion in terms of causing the positive correlation between risk and return and when people are risk-averse they'll do thorough due diligence and the market will be a safe place but sometimes they forget to do that they engage in pro risk behavior and the environment becomes more risky the bottom line I think has been and is that we're living in a low return high-risk world some of the environmental indicators over the last couple of years include the tenth year of an economic recovery the longest bull market in history the ascendant super stocks the fangs strong demand for corporate credit money flows into emerging market debt record fundraising for private equity the onrush of capital for tech and VC investing and interest in crypto currencies and I think that these are the important hallmarks of the last couple years and what do they mean we were talking about that before right what does it mean what it means to me is that the markets over the recent years have been shaped by optimism trust in the future faith in investing and investors a low level of skepticism and risk tolerance not risk aversion so the first question is do you agree you should ask yourselves this guy know what he's talking about or is the exaggerating risk has he left out a bunch of things to color his presentation these are the things that I think are reflected in these things these things have to be present for these things to happen in my opinion the point my point is that attributes like these do not contribute to a positive climate for prospective returns and risk the increase of optimism the increase in risk tolerance the low level of skepticism contribute to asset appreciation but of course that asset appreciation does not render the world safer we have to be cognizant of that why are prospective returns low the again at Chicago it all starts here at Chicago for me back in 67 and I learned about the capital market line and it begins over at the left with the risk-free rate with zero risk and it proceeds up into the right to offer investors a potential risk premium as an incentive for barring incremental risk that's how the market works now I'm gonna take a minute out since I think I have plenty of time today to say you asked most people what does this slide mean think about it for a minute ask yourself what does this slide mean okay times up what most people would say in my opinion is two things number one riskier assets have higher returns and number two if you want to make more money the way to do it is to take more risk everybody agree I don't get any agreement okay and I think that both of those are terrible formulations for the simple reason that if riskier assets could be counted on for higher returns by definition they wouldn't be riskier so that's a fallacy and if you are guilty of that fallacy or have been consciously or unconsciously guilty of that fallacy I think you should check your reasoning riskier assets cannot be counted on for higher returns in my opinion what this relationship means is different what it means is that assets that appear riskier have to appear to offer higher returns they don't have to deliver so the important thing is to keep that distinction in mind but anyway most of the time the market does look like this the you know longer bonds have higher yields than shorter bonds low quality bonds have higher yields than safe bonds stocks have higher expected returns than high-quality bonds and alternative investments offer higher returns than equities they merely don't have to deliver so we get a dialogue and it goes like this and let's go back 20 years to 1999 I wrote a memo about this back in O four I'm still quoting from it I've gotten a lot of mileage from it it's called risk and return today and what I observed in O four is back in enforced today I believe so people would say well I can get 4% with no risk in t-bills if I'm gonna buy the five-year Treasury and tie up my money for five years I need 5% if I'm gonna buy the ten-year I need 6% if I can get 6% with no risk in a ten-year Treasury I need a hundred basis points more to buy corporates with credit risk so that's seven if I can get six in ten year Treasuries I need I'm not gonna go into high-yield unless I can get eleven and that's the fixed income world and if I can get those kind of returns on fixed income I'm not gonna buy quality stocks unless I think they'll return nine Nasdaq I need 10 and by the way if I can get those returns from public securities I'm not gonna buy I'm not gonna develop real estate unless I think I can get make 14 or go into public private equity unless I think I can make 20 or venture capital unless I can think I can make 30 so all along the line you get people saying in order to take incremental risk I need the expectation of incremental return nothing could make more sense and that is the way the world was back in 1999 then we had this thing called the global financial crisis and the central banks pulled down the risk-free rate from 4 in 99 to about zero in some countries of course short-term rates went negative in order to stimulate economies recapitalize financial institutions and when the risk-free rate was pulled down to zero everything else followed and now it goes like well if I if the return on cash is zero I'm not gonna tie my money up my money up for five years unless I can get one ten years I gotta have one and a half and so forth I'm not gonna I wouldn't buy high grades unless they paid three I wouldn't buy high-yield unless it paid six and so forth so you can see that the demanded returns all all investing is relative the decisions are relative decisions and so all of the decisions are still saying in relative terms but taking place at lower levels in terms of prospective return so this is the the reason why prospective returns are low today and this is of course as I say I think the most important single characteristic of the financial environment over the last decade well now investors in many markets have taken on increased risk in order to access returns above those on safe assets so the person who used to like me all the money I had you know six seven I was concerned about the environment so I took all the money that I had outside of oaktree and I put it into Treasuries one two three four five six year Treasuries it's called the later'd portfolio for those of you who are in the bond business and it is the dumbest form of investing known to man you have this progression of year of maturity z' the the closest in one matures it goes to the back of the line you always have a portfolio which has one two three four five six year maturities you always have some money coming to within a few months and you know you can't make much but you can't lose and the yield on that portfolio was over six back in oh seven and of course today it would be over two so in peat most people you know I meet with pension funds and endowments and insurance companies and they can't invest for two three four percent many of them need seven or eight so that means you can't do much in the low return safe assets that you used to invest in so people have had to push out the capital market line in pursuit of tolerable returns in the low return world that has caused there to be a lot of money chasing limited opportunities in the risk markets the safe closed in markets the government bond market high-grade bond market even the stock market are by definition much larger than the alternative markets of real estate private equity venture capital and so forth and and and even private credit and so you've had a lot of money moving from the safe asset classes to the risk asset classes and when a lot of money hits a small asset class we know what happens and I believe that as a result of the demand for returns well let me say this you know 7 february o 7 i wrote a memo called the race to the bottom and i tawt i said in there that the market for for buying investments or making loans is like an auction house and when something when an opportunity goes up at an auction house it goes to the person the highest bidder the highest bidder is by definition the person who was willing to accept the least for his money and the same is true of the securities markets i want to buy some stock i want to pay 30 to josh says you'll buy it at thirty two and a quarter and and tom says he'll pay thirty two and a half I don't get any Tom gets the stock he's the highest bidder but of course he gets a worse deal than I would have got at thirty two but if he makes the investment the trouble is that when there's a lot of money in investors hands and they're hot to trot to put it to work then the bidding maybe goes too far and in the credit markets people bid up the price which means they bid down the yield and they bid down the safety that's the way the auction goes and I believe that the race to the bottom has been under way in the credit markets and that is to say investors are competing for the limited opportunities in the risk markets by volunteering for low returns weak structures and high risk again next question do you agree or do you not agree that's as we go along that's that's a question that you should all be asking so I believe that we have seen over the last few years what I call the seven worst words in the world too much money chasing too few deals and that was the title of my September memo the seven worst words in the world when that's going on is that going on do you think it's been going on when it's going on that's troublesome and you should recognize it and act accordingly how our return high returns achieved high risk adjusted returns how do you get high returns with low risk the answer in my experience is investors make money most safely and most easily when they do things that other people are unwilling to do that's the history of my career I started city banks high-yield bond portfolios in 1978 when nobody else would do it and it was considered unfair II and imprudent to buy an investment grade bond we started the distressed debt fund at the TCW in 1988 when people said are you crazy you're gonna buy the debt of bankrupt companies how can that end nobody else would do it that's how you get bargains when investors are unworried and glad to make risky investments or worried but investing anyway because the low-risk alternatives are unappealing which is more descriptive of the last ten years asset prices will be high risk premiums will be low and markets will be risky that's the result of too much money and Eaton investors who are too eager what will help us avoid the extremes of the markets and the keys to avoiding mistakes are simple awareness of history belief in cycles rather than unabated on unidirectional trends skepticism regarding the existence of free lunches you know there just aren't that many opportunities to make a lot of money without risk regardless of how often they are pandered insistence on low purchases prices that presume that provide lots of room for error and attention to all these things a variable will cause you to miss the most feverish parts of bull markets you can't have everything which is when prices go from fair to extreme but they will also make you a long-term survivor and I think that's very important you can't have it both ways you can't guarantee participated participation in the appreciation in a heated bull market and be prepared for its reversal so I wrote my first really cautionary memo of this cycle in July of 17 and I got the the rare treat of turning on the TV and watching it being debated and these are some of the things people said on TV one guy said the story from Howard Marks is it's time to get out and I said to him there's only two things I would never say number one is get out and number two is it's time because because you know our industry our field of endeavor does not permit that level of certainty I would never say those thing then you can read for yourself the other things that people said about the memo on TV but I'll read you the last one and one guy said I appreciate Howard Marx's message but I think now is no more a time to be cautious than any other time skip a little it says this means that durable portfolios hedges cash reserves etc there is no better or worse time for any of these things that we can foresee in advance that's what he said and I take issue with all the statements up there now but most importantly with the last one we're all I assume everybody here is in the investment business what do we do what do you do what is your job oh it's to manage money know what is the job of the money manager and the answer I think is that everything we do falls into one of two categories asset selection and cycle positioning asset selection is trying to hold more of the things that will do better and less of the things that will do worse and cycle positioning means trying to hold a more have more money invested more aggressively when the time is right and less money invested more defensively when the timing is wrong positioning for the cycle those are the two things we do I don't think there's anything we do that doesn't fall under one of those two headings and accepting that there is no better or worse time for defense versus offense means giving up on the ladder tying one hand behind our back and I think it's a mistake I think we can at the especially at the extremes increment our poor performance by being aggressive at the right time and defensive at the right time there are times for aggressiveness and there are times for caution when prices are low pessimism is widespread and investors flee from risk that's the time to be aggressive when prices are high and enthusiasm is rampant and investors are risk tolerant that's the time for caution which is this that's the question very simple question not always easy to answer but a very simple question do you agree that sometimes it's better to be on offense or sometimes on defense do you agree that these are the things that determine those times which is this very simple so the decision today these are the questions to ask to try to figure out which this is our investments rich or cheap where do we stand in the market cycle that's what the book is all about how should we be positioned versus our normal risk posture every one of you and every client and every institution should have a normal risk posture based on your financial condition your aspirations your ability to stand pain your emotional Constitution your needs etc that's your normal position where should we be today visa vie our normal position should we be emphasizing offense or defense today should we worry more about losing money today or worried about missing opportunity now this is very important every one of us in this room faces two risks every day the obvious risk that everybody knows about and nobody likes is the risk of losing money the more subtle risk which not everybody thinks about is the risk of missing opportunity now you could say Howard I want to be sure that I don't ever lose a penny I don't want to ever have a down day in my portfolio I couldn't take it I say okay we put you all in 30-day bills you'll never have a down day and you'll miss all the opportunities but if you say look I'm a young guy I have a big risk tolerance I know what I'm talking about here I don't want to make sure I don't miss any opportunities then we say okay no Treasuries for you and now you were a hundred percent exposed to the risk of losing money so the point is you can eliminate either risk which puts you entirely at the mercy of the other risk or you can balance them and what do most people say well I don't want to lose a lot of money but on the other hand I don't want to miss all the opportunities so I'm gonna operate in the middle I'm gonna I'm gonna have some risk of losing money and some risk of missing opportunity and most of us maintain a balance somewhere in the middle hopefully as is appropriate for our circumstances and our clients circumstances and then the next question is these are V your normal balance of the two risks what should your balance be today do you believe in trying to change the balance as the environment changes or you just to buy and hold investor and it's not necessarily wrong because changing it with the is is not easy to do or do you want to give it a try and lastly if you go back 10 years ago it's a great time to be here because February 22nd of onine if you wanted to make a lot of money you only needed two things money to invest and the nerve to invest it that's all you needed you didn't need a lot of brains you didn't need selectivity caution conservatism select the discipline patience agility all you needed was money and nerve and if you had those things over the last ten years you've made a ton of money does that mean that money and nerve is the formula for success in the investment business no because if you had money and nerve in April of oh seven you lost a lot of money you bore the full brunt or more of the global financial crisis maybe you got knocked out of business that's when you needed caution conservatism risk control patience selectivity and discipline so the point is there are different tools for different climates which is this money and nerve today caution and conservatism today an oak trees mantra over the last several years has been move forward but with caution I don't think that asset prices are so high I don't think the outlook is so bad that you should practice maximum defense and the return for being an ultra-safe assets is unacceptably low so for most of us but on the other hand I don't think the prices are low enough or the the outlook is good enough to be practicing sheer aggression I don't think it's as any place for aggressiveness in today's market so that's where we came up with this balance a move ahead but with caution we're investing every day we're basically fully invested and trying to stay that way but with a portfolio that is biased toward defense not offense biased v's of the our norm so how should you invest in a low return world and I've come up with six possibilities I put them up here and I am not aware that there are any others number one invest as you always have and expect your historic returns well that's actually a fake because nothing in my opinion offers the return that it has starkly has offered so that's a red herring I just want to make sure I had your attention the second one invest as you always have and settle for today's low returns that's more like it that's more realistic that's more prudent it's just not much fun and for many organizations it doesn't fit the business plan the third is to reduce your risk to prepare for the market correction and accept still lower returns and that's even less fun the fourth is to go all the way towards defense go to cash accept they return closer to zero and wait for a better environment to put that cash to work it's very challenging because you know going to the cash is an extreme action for an active investor and not only do you have to be right but you have to be right quick because if it takes you two years to be right you'll you'll have dug a hole that you if the market keeps going up in those two years and you were wrong to go to cash you will have dug a hole so deep you may never get out of it and by the way you may not have a shovel anymore because you may have you may have lost your job so that's number four then there's number five which is to do the opposite to take on more risk in the low return world in order to try to get the returns that you used to get with safety that has obvious merits and demerits and number six is to put more into what you would call special niches and special people that has bet more on alternatives non market private and hopefully skilled managers now the important thing is that none of these alternatives is completely satisfactory everyone has a downside including number six because you go into special asset classes with hope what you believe is our special managers and you expose yourself to manage your risk the risk that you thought you were finding somebody with alpha but he or she actually turns out to have negative alpha and underperforms so as I say none as completely satisfactory but I think there are no others so now let's talk about pursuing superior returns through number 6 according to the efficient market market hypothesis which I was taught here at Chicago there are no miss pricings to find and no such thing as the skill to find them that is to say you can't beat the market you can't have alpha you can't contribute through active management and that means that an investor's return will be nothing but the product of the markets performance and the portfolio's degree of sensitivity to that market performance systematic risk or what we call beta market times beta you know performance is alpha manager skill plus beta times the markets return efficient market hypothesis there is no such thing as manager skill so it's all beta times the market and if that's true then the only way to try for a higher return in an efficient beta market is to take on more risk and for the reasons described earlier today's beta markets are generally offer unusually low prospective returns you have to decide for yourself whether you accept these as the premises there are really only three ways to strive for high returns in a low return world increase your risk as just described rely on getting lucky or locate in efficient markets where it's possible to profit from alpha or personal skill and of course locate managers who have that alpha the mere fact that a market is an inefficient market and I'm by the way I believe that a there are no markets which are perfectly efficient and B there are markets which offer inefficiency that's the ones we try to work in but people say oh I'm going into X Y Z because it's an inefficient market merely going into an inefficient market does not mean they hand out money it doesn't mean that everybody goes into that market and makes an above-average return or an above-average risk-return risk-adjusted return what it means is that unlike the efficient markets where there is no such thing as lock a skill or unskilled and as a consequence everybody performs about the same in the long run in the inefficient markets there their prices deviate from fair value so there is scope for a superior manager to do above-average through the application of alpha or an inferior manager to perform below average due to the presence of what you might call negative alpha so these are the ways to have superior returns and I believe that in order to participate in active management which is why I suppose we're all here who here manages an index fund not too many okay so we're all active managers we all think that that we can make value a creative decisions in order to do an active investing it has to be based on the belief that a markets exist that are less than fully efficient that offer the possibility of superior risk-adjusted returns and B there are people with the skill to identify the bargains and add value by actively managing assets if you don't believe both of those two things then you shouldn't be an active manager but pursuing alpha is not risk-free engagement in active management has to be based on the belief that those two things exist but pursuing alpha is not risk-free in efficiency only means that asset classes as I'd mentioned are able to deviate from fair value not that they're always bargains assets can be overpriced as well as under priced in an inefficient market clients count on alpha managers abilities to tell the cheap ones from the expensive ones the potential for choosing the wrong managers introduces manager into the equation in the Alpha in the inefficient market categories thus there is no surefire way to access high returns in a low return world even in alpha markets as should be expected one of the underlying beliefs of my philosophy and I hope of yours is that most of the time they don't give away money for nothing that's what the if the efficient market hypothesis really says and but the question is will you try and that's what I wanted to tell you today and kick off the discussion and that only took a half an hour so we have half hour for questions if you're if you're loaded who's got the first one yes wait wait I think there's a mic coming wait a second Thank You Kim Thanks where exactly do you find that line between efficiency and inefficiency in today's asset classes and how is it evolved with ETFs well I described my history which was high-yield bonds and 78 distressed death in 88 emerging markets in 98 so the key is that there were people things people would do and things people wouldn't do there were markets that people didn't understand didn't have full data on maybe there wasn't any performance history the markets were not fully they didn't have the infrastructure and the institutions and of course there were biases as I described there were people who said no it's you know Moody's venerable credit rating institution if you took down the 1978 edition of the Moody's manual off your shelf and you looked up the definition of a B rated bond it said fails to possess the characteristics of a desirable investment in other words you cannot prudently invest in a berated bond that's a bias and when if there's an asset and 99% of people will not buy it at any price then it makes sense that the people who will buy it might get a bargain so these things not knowing about it not understanding about it not being willing to buy it not thinking it's it's a professional fiduciary these are the kinds of things that create inefficiency what I call structural inefficiency where are they today almost negligible today you know the believe me 4050 years ago for those of you who were not practicing this profession and the world was a stupid place nobody knew anything I mean there was all this data and maybe the data existed or maybe it didn't exist but if it existed maybe it was over there and maybe you were over there and you had no idea where it was or how to get it or the people had it wouldn't give it to you and today everybody knows everything you know you're out to dinner with your date or your spouse and you have an argument about when a certain movie came out your googled you find out everybody there's no such thing anymore that's not knowing anything and so if today everybody knows about every asset class has data on it and feels they understand that and feels comfortable with it then where are you going to find structural inefficiencies and the answer is it's tough it's really tough and so in my opinion I wrote a memo in January of 14 called getting lucky by the way all the memos unlike the book the the memos are available free I highly recommend that and they're all available at WWE capital calm under click on insights and you'll see a thing there about the Chairman's memos or maybe it says memos from Howard Marks but so I wrote this memo called getting lucky and I talked about a process I call efficient ization which is if inefficiency is really there to sum it up and oversimplify it inefficiency is the result of ignorance and today there's much less ignorance so markets become more efficient over time and I believe most markets have become more efficient over time and it's very hard to find anything that is about which there is ignorance and by the way back in 1978 people would say to me well young man and I was a young man at the time I'm sure you can make a lot of money doing that but it wouldn't be proper it wouldn't be fiduciary now look around this room today anybody will do anything to make a buck so that bias does not exist and that's the bias that gave people like me opportunity 40 years ago and if nobody's if everybody's willing to you know with the economists we talk about efficient markets the economy talks about perfect markets economists talk about it and there are certain criteria for perfect markets which are obviously the same and one is knowledge one is objectivity and one is the willingness to substitute so in other words oil and gas will be priced in a standard relationship to each other as long as everybody is willing and able to go from oil to gas and gas to oil they will equilibrate their prices that's what efficient markets do and today people are willing to invest in any market so it's really hard to think of of where you're going to get a free lunch however I do go on in the memo to say that while structural inefficiency is hard to locate from time to time we get cyclical inefficiency which is to say from time to time people lose their objectivity and they value assets too low in which case we can get bargains if we resist the error of their psychology and sometimes they like assets too much the prices are too high and we can make easy money by shorting them if we can resist the error of the common psychology so I think it's really hard to get fine structural inefficiency today from time to time we find cyclical inefficiency and I can't tell you where the dividing line is and it's it's never the same and by the way one of my I'll say competitors came out with a very clever statement about four years ago he said everything with the Q sip is overpriced today so what he was saying is that all public securities are overpriced because they're too easy to invest in so but but but by implication private investments are not overpriced but if everybody hears that and everybody responds and everybody's dumps their public securities and buys in the private markets then maybe the inflow of capital from the private markets makes the private investor to the private markets makes private investments too expensive and they're desertion of the public market makes those too cheap so these there's no rule that always stands and when everybody says the secret to getting rich the secret to superior risk-adjusted returns is to make private investments if everybody believes it and all the money flows to private investments then it will no longer be under priced and attractive hi mr. Marx thanks to all for speaking to us my name is Alex I have a quick question so how do you distinguish between mining the cycle and market timing because everyone says you know you can't time the market but it seems I just want to hear your well that's a great question and my initial reaction is to say okay you got me because and and and the reason I say that is one of the six tenets of oak trees investment philosophy is that we're not market timers but I do think that mark I had the way I try to weasel out of that vice that you put me in is that is that I think that market timing means raising and lowering cash based on a prediction of what the markets going to do and I don't we don't usually raise or lower cash and we never make a prediction of what the market's going to do and what what what both my first book the most important thing in the second book mastering the market cycle say on the subject is we never know where we're going but we sure as hell or to know where we are I do not believe in forecasts and you know my my hero John Kenneth Galbraith said we have two kinds of forecasters the ones who don't know and the ones who don't know they don't know so one of the tenets of oak trees philosophy is that our investment decisions are not driven by macro forecasts we don't have an economy on an economist on staff we don't invite economists in to tell us what GDP is going to do next year we base our decisions on where we are in the cycle in the cycle of that business in the cycle of the economy in the cycle of the market psychology and attitudes towards risk and in the capital market cycle there are a lot of cycles that bear on our decisions we have a we try to have a sense of where we are very important but everybody recognized the book is fully open on this subject knowing where we are doesn't tell us what's going to happen tomorrow because from any for example as we've seen in recent months from any point on the on the cycle the market can go up down or flat the fact that mark that securities are overpriced doesn't mean they're going down tomorrow the fact that they're under priced doesn't mean they're going up tomorrow from any point on the cycle they can go up down or flat does that mean that all three are equally likely no where we are in the cycle determines the odds or what I call in the book the tendencies and so by understanding where we are in the cycle I believe we can get the odds on our side but not provides perfect certainly that we're right so to me the distinction is tilting to what we think is the right behavior based on an understanding of where we stand in the markets in the cycle today as opposed to raising and lowering cash based on predictions of what's going to happen tomorrow and I hope I've exculpated myself Tom in in setting up an organization is there an optimal structure for for capturing market and efficiencies well I would say that number one you I I think there are more and less efficient markets and so if you if you believe everything I said here I should get this boilerplate off the screen if if if you believe everything I said then it tells me that if you're going to be an active manager you should try to get into markets which are less efficient and that they exist and that you can sometimes figure it out which they are that's number one number two that means that you should direct most of your efforts at taking advantage of in inefficiencies and you should have people who are contrarians sceptics and who tend to think that way now what does that mean taking advantage of inefficiencies well mark twain i think it was said that the definition of profession is a conspiracy against the lady because professions tend to use big words to describe the things they do and the academics at university of chicago came up with this word inefficiencies as the things we should try to capitalize on back in the early 60s I use the word mistakes if if if you can find a security which is underpriced relative to its intrinsic value and relative to other securities relative to their intrinsic values then what you're really doing is you're finding a mistake and if if you really have done what you think you've done then that means that the person who sell you that security is making a mistake so do you think that mistakes are made do you think that you you're smart enough to be the one who finds them rather than the one who commits them and obviously in order to find and take advantage of the mistakes of others you have to have what I call a contrarian way of thinking my first book the first chapter in the first book said there the first book is called the most important thing and I would find myself in my clients offices saying the most important thing is to not lose money and then five minutes later I would say the most important thing is to buy cheap and then five minutes after that I would say the most important thing is to understand the risks you're taking so I wrote this book called the most important thing and there are 21 chapters and each one starts off the most important thing is and then it's a different thing because there are many many things in our business which are not only most important but absolutely essential and you have to do them all it's like a brick in the wall you can't dispense with any of them but the first chapter says the most important thing is second level thinking if you think the same as everybody else you're going to act the same if you act the same as everybody else you're going to perform the same and that's not a very good performance of formula for being a superior investor if you want to be a superior investor you have to think different from others you have to act different and maybe then you can then you can have different performance and then the only question is your performance different and right or different than wrong relative to the average but clearly if you think the same as everybody else you can outperform so you have to have an organization which is based on what I consider second level thinking which is thinking different from others and better so when my son was studying investing and he would come to me and he'd say dad I think we should buy Ford stock because Ford is coming out with a great Mustang and they're gonna make a lot of money and I would say to him my answer was always the same because I feel by repetition you can get your lessons across so so my answer to him was always the same who doesn't know that if Ford's gonna come out with a great Mustang and it's going to be a killer car and it's going to make a lot of money but everybody who follows Ford knows that then that piece of knowledge is not profitable so in order to outperform others you have to know something they don't know you have to look at things in a different way than they look at them second level thinking different and better and and just a one brief example the first level thinker says this is a great company we should buy the stock the second level thinker says it's a great company but it's not as great as everybody thinks we should sell the stock and that's the thing I hope you'll think about yes there's one over there yeah hi my name is jean coleman and i would like to ask you a question it's only your personal opinion if you can answer it do you think Fed will raise interest rates if he has how many times this year next year and what do you think GDP will be this year and also next year only based in your opinion I don't really care about it anybody else well you might have missed the part when I said I don't believe in in in forecasts not only do I not believe in forecasts I especially don't believe in my own that I lived through the 70s and in the 70s the America was victimized by hyperinflation and at times inflation was running at 16% a year the the the I had a loan out from as this happens the first Chicago Bank and it was three-quarters over prime we didn't have LIBOR then we had something called prime my rate was three-quarters over prime and I got a slip from the bank one day and it said your rate is now 22 and 3/4 so that was the 70s and into the early eighties and nobody could figure out how to get inflation under control and you know everybody was tearing out their hair and and we you know we had Jimmy Carter and we had Ford and we had these things called wind buttons when stood for whip inflation now and it turned out that putting on a button didn't do any good but but the thing is eventually Paul Volker was appointed the the Fed Chairman and he raised interest rates and he cooled off the economy and an inflation stopped and when Volcker was done when he left office which I think was 82 and he was considered the smartest man alive he went to his first event like this one and he and he was asked will interest rates go up or down and he said yes and that's my answer to you and and as I say I don't believe in forecasts and especially my own now having said that having said that six months ago everybody sure was sure that interest rates were going to go up a lot fast and now because Powell got some worries about the future of the economy he cooled it with the interest rate increases and now everybody thinks he's going to be a dog and he's going to support the market the economy in the market by not raising interest rates and by guess the only thing I would say and answer your question is I think that that he will raise interest rates more than people think that's my guess because I think they're a lot I think there are a lot of reasons why we should have interest rates above today's so I hope I sidestepped that question hi hello sorry hi you mentioned that we're in a low return environment and I can certainly understand that with respect to bonds because any bond that by today as a yield of maturity that's quite a bit lower than it would have had 20 years ago but is that true of stocks because stock bees aren't demonstrably higher than they were twenty years ago the Saxon bonds have different cycles and where are we in each cycle well on the one hand of course they can diverge but and it's easy what you say is about bonds is true the low returns are wired in if you buy a 3% bond you shouldn't expect 6% return to maturity you might get lucky and have a 6% year but not to maturity stocks which do not have a wired return seem on the face to be freer to diverge from from their returns from from from from the to have a return different from that of bonds what you say has a lot to recommend itself the p/e ratio on the SP is 16 or 17 today the post-war average is 15 or 16 stocks are not priced much higher than they historically have been and historically the SP has produced a return of about 9% a year on average so is it possible that the treasure that the 10-year Treasury will yield to 75 for the next ten years but that stocks will return 9 is I think your question and or 8 and the answer is yes it's possible and that's there's good arguments to be made that's the case now most people don't think that that stocks are set up to return 8 or 9 in the coming decade I think one of the main reasons being that historically stocks have given 8 or 9 but in the old days the economy grew faster than it's growing today or then then the outlook calls for and you know it seems to me that in the 1945 tonight a 2002 95 or 2000 period the economy grew faster it had the benefit of the catch up from World War 2 the professionalization of a lot of industries and a lot of technological and productivity gains that are not going to be repeated in the coming decades but I might be wrong you know there's this there's this theory called secular stagnation and then there are the people who don't believe it and I lean to it a little more than I lean against it but so so it's true that stocks are not much overpriced relative to history relative to the p/e ratio but they might be you might be paying a slightly higher p/e ratio than history for slightly lower in history which is not that good a deal but anyway most people seem to think that stocks will return five six or seven in the coming years but if the ten-year pays three in stocks give five six or seven that difference of two three four hundred basis points a year is kind of in line with what most people think of as the what's called the equity risk premium so the real question is is it going to do five six or seven like most people think or is it going to do an eight or nine as your reasoning leads to in which case if you buy them you'll be the smartest guy in this room but you know you really can't tell but I guess the way to another way to look at the question is this if it's true that the ten year will give three and stocks will give 9 then stocks are too cheap and it's somebody who believes in an efficient market would say well that can't be so even though it looks to me like stocks will give 9 there must be some trap hidden which is going to prevent it that's the way an efficient market tear would think and maybe it's wrong you know back in when I was at and the Chicago campus we used to tell the story about the Chicago finance professor and the student who are walking through the campus arguing about the merits of the efficient market hypothesis and the student says oh look professor isn't that a ten dollar bill on the ground he says no it can't be a ten dollar bill could was $10 bill someone who picked it up by now and so this professor walked away and student picks it up and has a beer so the point is sometimes there are discontinuities in the market and you have a case for why this is one of them and I can't say you're wrong two more yes sir yes why why did the market collapse in the fourth quarter and the answer is people freaked out that's I mean I don't think anything really changed fundamentally you know I know the book came out on October 2nd and on I started to make a book tour that day and on October 3rd everything seems to be ok and on October 4th the market started to go down and it went down for the next October 7th two months no 80 days and you know it was the worst December since 1931 what changed well the first thing I was you know I was on the road so I wasn't getting all the inputs in real time as I normally might have been the first thing I was told was well the interest rates have spiked up and the ten-year hit 325 that day and my reaction was but but didn't everybody know that higher rates were coming and why if it's higher rates why would they be priced in today but not two days ago since everybody knew they were coming number two they said well oil is collapsing my reaction is that good or bad you know I mean oil prices bad for the oil companies but great for everybody else and great for the consumer and maybe even great for the economy so is is the is a collapsing oil price really a reason why stock should go down then of course there was concern over the the possible trade war with China but that was in the cards for months and you know so I I really don't see anything that changed that much fundamentally from October 3rd to October 4th and for my views on that subject I'll refer you to a memo I wrote in February of 16 which in in early 16 the markets got off to their worst start in history and I wrote a memo called on the couch because you know I said in the memo that once in a while the market needs a trip to the shrink and I said in the Mar in the memo and this is one of the things I hold most strongly and this is my only explanation for the fourth quarter is that in the real world things fluctuate between pretty good and not so high but in the market investors go from thinking that the outlook is flawless to thinking out that the outlook is hopeless and that's what happened I can't tell you why they did it maybe things were like you know I had that list of things where is it it was like the first slide I had that list of things that incorporated positive expectations and maybe some critical mass of investors said you know what maybe you've been too positive and they turn negative so all I can tell you doesn't make any sense but that's the way that's what the market does oh by the way so so I put out that memo on a Thursday and on the next morning I went on Bloomberg to talk about it which is what I usually do when I put out a memo and they kept saying to me well the market is down isn't that a sell signal the markets down is not a sell signal and so I ran back to my office I wrote another memo entitled what does the market know which I put out I think three days later and the market doesn't know anything the market is just made up of a bunch of people and it is not any smarter collectively than the people are individually and the people went freaked out by the way what were the reasons for the declines in February 16 anybody have a good memory interest rate rise oil prices down and then there was a fund called the third Avenue fund that melted down and it turned out that they had had a portfolio of illiquid credit investments but had promised liquidity to their investors which is a combination that often ends in sorrow but it was it was quite similar and you know the point is you anybody who who takes his buy and sell signals from the market which is to say if prices are up that means it's a Buy and prices are down that's a sell I think it's really nutty because you know the point is as as my idol Warren Buffett says I like hamburgers and I bought a eat more hamburgers when they're on sale and anybody who thinks that low prices are a sell signal and high prices is a buy signal there's something wrong so the point is as as the memo what does the market know tried to point out don't count on the market for rationality and don't look for rational explanations it's all psychology if you could understand the the flaws of psychology or in much better shape than looking for rational explanations is that one more miss max I you know I think ever since the your paw came out and last October I have anecdotal evidence that it has become a consensus in the market when I listen watchin finance news media that everybody seems to agree that we are really in that late stage of a cycle and so that and before that I think I always can you know hear some people come you know we're you know we're only aware in the middle but seems right now everybody really is convinced that we are late in a cycle so that brings me to questions I mean if everybody's convinced that we are late in the cycle wasn't that awareness of the ladies ladies of cycle kind of prolonged us this cycle and make the anticipation of the cycle much orangy and the second related question is if this is really true that everybody's kind of cautious what not to make when a cycle returns would that make the the market reaction more pin higher let's say versus the last time around thank you well thank you I said one question I didn't say two but but anyway the answer is that if everybody holds a point of view by definition it's baked into prices so if you agree with that point of view it's not going to make you any money even if it's right the goal in investing with regard to understanding the environment or even the future is not to be right the goal is to be more right than others and correct forecasts which are commonly held don't make anybody any money so if everybody is now cautious that's a that's a favorable sign because that means that expectations are low and if things come in if you are more optimistic than the consensus and things come in better than the consensus expects then you will make money of course the problem is that usually the consensus is about right so-so correct idiosyncratic forecasts are potentially profitable but rarely correct but that doesn't mean you should try and by the way that's one of the reasons why I don't spend a lot of time making forecasts but I will say one thing about the people and the consensus that that we're in the late stages you'll recall that in December of seventeen the government passed the tax bill and people got very excited in stock market did very well and everybody thought that it would be very salutary for the economy and I started to get emails from people you know because we were in the tenth year of economic wealth at that time were in the ninth year and there's never been an economic recovery in the United States it went more than ten years and so most people were kind of getting a little cautious about late stages and then I started after the tax bill was passed I started to get emails from people saying things like Australia has not had a recession for 26 years and since this is the ninth year maybe we're going to go 17 more years without a recession which in my opinion is another form of saying this time it's different which is the four worst words in the world anyway so all these people started to think well maybe we're not gonna have recession maybe we'll never have a recession maybe it's not gonna come for 17 years or five years or ten or whatever it might be and then of course the market proceeded to do very well based on that optimism then the trouble was that in the fourth quarter all the people who said no recession for 17 years said next week and that's why the economy the market did so badly in the fourth quarter so the point is as I say forecasts swing much more radically than reality swings and it's it's desirable so that reads us the issue of being a contrarian and it's important to be a contrarian except that it's not always the right thing to do and there are a lot of people say oh the trillion well the contrarian means is you do the opposite of others know to be an intelligent contrarian you have to know what others are doing know why they're doing it know what's wrong with what they're doing and then figure out if there's appropriate action to be taken on that in my set my first book the most important thing had a second edition called the illuminated edition in which some notable investors and I added commentary to the first edition and told people what what they should think about what they had just read and Joel Greenblatt who's who was a great equity investor one of the greatest who nobody has ever heard of although he has some books out called the little book that will make you a mark a genius or something like that very good books and they and they have the merit of being short Joe put in on the section on contrarian ISM just because you think just because five other people will not stand in the path of an oncoming Mack truck doesn't mean you should so it's contrarian ISM is not just a matter of doing the opposite of others it's a matter of taking advantage of mistakes and it has to be done on an understanding and I hope that helps thank you for having me today it's been great being here

Channel: CFA Society Chicago

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Length: 66min 16sec (3976 seconds)

Published: Mon Feb 25 2019