Howard Marks' Latest Memo

http://www.oaktreecapital.com/MemoTree/Ditto.pdf

I admire Howard Marks' ability to articulate and rationally take the market's temperature; it's always important to know about where in the cycle we are and whether investor sentiment is getting ahead of itself.  Most of his latest memo (a great read as always) is focused on the cycle in relation to the credit markets, where it's clear that we're far closer to a top than a bottom, so caution is definitely warranted for anyone adding to a fixed-income position (especially high-yield, or long term bonds).

The other aspect of Marks' memo I found incredibly insightful was his discussion on investment risk (starting on page 3, his emphasis):

Much (perhaps most) of the risk in investing comes not from the companies, institutions or securities involved.  It comes from the behavior of investors.  Back in the dark ages of investing, people connected investment safety with high-quality assets and risk with low-quality assets.  Bonds were assumed to be safer than stocks.  Stocks of leading companies were considered safer than stocks of lesser companies.  Gilt-edge or investment grade bonds were considered safe and speculative grade bonds were considered risky.  I'll never forget Moody's definition of a B-rated bond: "fails to possess the characteristics of a desirable investment."

All of these propositions were accepted at face value.  But they often failed to hold up.

• When I joined First National City Bank in the late 1960s, the bank built its investment approach around the "Nifty Fifty."  These were considered to be the fifty best and fastest growing companies in America.  Most of them turned out to be great companies... just not great investments.  In the early 1970s their p/e ratios went from 80 or 90 to 8 or 9, and investors in these top-quality companies lost roughly 90% of their money.

• Then, in 1978, I was asked to start a fund to invest in high yield bonds.  They were commonly called "junk bonds," but a few investors invested nevertheless, lured by their high interest rates.  Anyone who put $1 into the high yield index at the end of 1979 would have more than $23 today, and they were never in the red.

Let's think about that.  You can invest in the best companies in America and have a bad experience, or you can invest in the worst companies in America and have a good experience.  So the lesson is clear: it's not asset quality that determines investment risk.

The precariousness of the Nifty Fifty in 1969 - and the safety of high yield bonds in 1978 - stemmed from how they were priced.  A too-high price can make something risky, whereas a too-low price can make it safe.  Price isn't the only factor in play, of course.  Deterioration of an asset can cause a loss, as can its failure to produce profits as expected.  But, all other things being equal, the price of an asset is the principal determinant of its riskiness.

The bottom line on this simple.  No asset is so good that it can't be bid up to the point where it's overpriced and thus dangerous.  And few assets are so bad that they can't become underpriced and thus safe (not to mention potentially lucrative).

Perfectly stated, this is an important concept as an investor needs to determine when the price of a security is materially out of line with the intrinsic value of the company, many times this is due to irrational investor sentiment.