Memo to: Readers of this book

From: Howard Marks

Re: Memo 2020

This book is a collection of interviews conducted with a group of influential asset managers in China over the past year, some of whom quoted my views as originally expressed in my memos to clients. Although some of this information has previously been public, it is helpful and not repetitious to take them from the virtual world in which they were originally published and bring them together in book form in order to share views that are meaningful and worth sharing.

I often revisit my past memos. The Chinese say “温故知新” or “Wen gu zhi xin” which I’m told translates into “review the old and learn the new.” Indeed, a memo is not just for memorizing; it is also a tool to aid thinking and clarifying. The main content of this preface that follows below consists of my previously published views on the interwoven issues of coronavirus, investing and uncertainty. Our inability to know the future is a theme I’ve touched on repeatedly over the years, and 2020, full of great uncertainty, was an important chapter in which the relevance of this theme was repeated and re-examined. Because it highlights the memos of the past year, I give this preface title “Memo 2020.”

From the memo “Coming into Focus,” October 13,2020

A Different Kind of Crisis — One question I’m often asked nowadays is how the coronavirus crisis of 2020 differs from the past crises we’ve managed through:

· the high yield bond crisis of 1990-91, when many prominent LBOs of the ‘80s went bankrupt,

· the telecom/scandal company meltdown in 2001-02, and

· the Global Financial Crisis of 2008-09, brought on by the implosion of sub prime mortgages and marked by the meltdown of financial institutions.

The clear difference I want to cover here relates to the characteristics of the current go-round. The best way to start might be to describe the crises of the past:

· In each of the three crises listed above, recessions caused or exacerbated economic weakness.

· Negative economic and corporate developments, collapsing markets and rising fear caused a credit crunch in which financing became impossible to obtain.

· The combination of economic weakness and the unavailability of financing led to vastly increased defaults and bankruptcies.

· Asset prices cratered.

· Companies and investment entities marked by asset/liability mismatches and/or high levels of leverage experienced margin calls and meltdowns.

· The downward spiral seemed unstoppable.

· Pessimism ran rampant, leading to soaring risk aversion.

· This led to panic selling of assets and rendered most investors absolutely unwilling to buy.

· Because of all the above, it was possible to purchase assets at prices from which extremely high returns could be achieved, often with low attendant risk.

Now, contrast that with the events of 2020. In mid-February, developments regarding the coronavirus pandemic and the lockdown implemented to fight it began to hammer the markets. Prices for equities and credit fell, and the mood turned darkly negative. From the all-time high reached on February 19, the S&P 500 fell 34% in only 33 days. The prices of high yield bonds and leveraged loans were hard-hit as well. Security issuance stopped cold. The pieces were in place for a crisis just like those described above, and things were moving in that direction in March.

But as everyone knows, the Treasury and Fed announced rescue programs in mid-March and an enlarged Fed program during the week of March 23: zero interest rates, bond buying, grants, loans and significantly enhanced unemployment payments.The total ran to multiple trillions of dollars. And the authorities made it clear that there was more behind that: that the available resources were unlimited.

· People accepted that the recession would end and a recovery take its place in short order.

· With short-term interest rates near zero, investors lined up to buy bonds in the quest for return. Thus rather than a credit crunch, there’s been record amounts of capital available.

· Even though the rescue provided “liquidity but not solvency,” whole industries(like the airlines) were saved from sure bankruptcy.

· There were none of the spectacular implosions that mark most crises.

· Ditto for panic selling.

· Pessimism was replaced by willingness to think about better times ahead.

· With interest rates at zero, investors couldn’t aford to be risk averse. They had to embrace risk assets in order to have a shot at returns above the low single digits.

· Thus asset prices recovered.

To illustrate the effect, since April 1, investors in distressed debt have had opportunities to make large rescue loans to companies or entities needing a quick response to problems related to illiquidity or pending debt maturities, and there’s still a good pipeline. But with investor optimism reinforced, competition to lend has increased, and the ultra-low returns available on safe assets have made the possibility of double-digit returns something people compete to achieve. The sum of all this has kept prospective returns far lower than is usual in times of crisis.

Thus this is an unusual crisis: one marked by a non-financial, exogenous cause and a lack of lasting pain for most investors . . . and not by widespread opportunities for bargain hunters. Great investments are often made when an investor is willing to buy something no one else will touch at any price. We were able to do just that in past crises, because what you needed was money to spend and the nerve to spend it, and we had those things when most didn’t. Other investors’ lack of money and nerve in past crises made them great times for buying. Today, thanks to the Fed and Treasury,everyone’s got a lot of both. That makes things much tougher. . .

In my view, the low interest rates represent the dominant characteristic of the current financial environment, creating the dominant consideration for investors:the lowest prospective returns in history. Thus I’ve dusted off a presentation I’ve been giving in recent years called “Investing in a Low-Return World.” At its end, I conclude by enumerating the strategic alternatives for investors:

· Invest as you always have and expect your historic returns. Actually, this one’s a red herring. The things you used to own are now priced to provide much lower returns.

· Invest as you always have and settle for today’s low returns. This one’s realistic, although not that exciting a prospect.

· Reduce risk in deference to the high level of uncertainty and accept even lower returns. That makes sense, but then your returns will be lower still.

· Go to cash at a near-zero return and wait for a better environment. I’d argue against this one. Going to cash is extreme and certainly not called for now. And you’d have a return of roughly zero while you wait for the correction. Most institutions can’t do that.

· Increase risk in pursuit of higher returns. This one is “supposed” to work, but it’s no sure thing, especially when so many investors are trying the same thing. The high level of uncertainty tells me this isn’t the time for aggressiveness, since the low absolute prospective returns don’t appear likely to compensate.

· Put more into special niches and special investment managers. In other words, move into alternative, private and “alpha” markets where there might be more potential for bargains. But doing so introduces illiquidity and manager risk. It’s certainly not a free lunch.

None of these alternatives is completely satisfactory and free from downside. But in my view there are no others.

To put it into the terms I’ve been using over the last several years, how should the balance be set today between aggressiveness and defensiveness? How should you“calibrate” the riskiness of your portfolio? Should it be at your normal level; titled toward offense to try to wrest high returns from a low-return world; or tilted toward defense in deference to the uncertainties, requiring you to settle for lower returns?

As I’m sure is my bias, I lean toward defense at this time. In my view, when uncertainty is high, asset prices should be low, creating high prospective returns that are compensatory. But because the Fed has set rates so low, returns are just the opposite. Thus the odds aren’t on the investor’s side, and the market is vulnerable to negative surprises. This is how I described the prior years, and I’m back to saying it again. The case isn’t extreme — prices aren’t grievously high (assuming interest rates stay low, which they’re likely to do for several years). But it’s hard in this context to find anything mouth-watering.

From the memo “Knowledge of the Future,” April 14,2020

I’ve been thinking about the coronavirus and its relevance to investing. In the past, I’ve defined investing as the act of positioning capital so as to profit from future developments. I’ve also mentioned the challenge presented by the fact that there’s no such thing as knowing what future developments will be. This is the paradox we must deal with in our world of investing:

· there are few if any facts regarding the future,

· the vast majority of our theorizing about the future consists of extrapolating from past patterns, and

· a lot of that extrapolation — and just about all the rest of our conclusions — consists of opinion, speculation or guesswork. George Bernard Shaw said, “All professions are conspiracies against the laity.” Thus the rules of the investment profession seem to require that its members describe their views about the future using high-sounding terms like “analysis,” “assessment,” “projection,” “prediction” and “forecast.” Rarely do we see the word “guess.”

These days everyone has the same data regarding the present and the same ignorance regarding the future. There’s practically no such thing as meaningful knowledge regarding the future investment environment.

We use extrapolation from the past as the best way to deal with the future. If not for the ability to research past patterns and apply them to decisions regarding the future, we’d have to reach a new conclusion every day about every future possibility.So, for example, in investing we study typical past cycles, the exceptions from the norm, and details like the up-and-down pattern that’s part of most rallies. But blind faith in the relevance of past patterns makes no more sense than completely ignoring them. There has to be good reason to believe the past can be extrapolated to the future and that brings me to the current episode.

What did the U.S. see in 2020?

· one of the greatest pandemics to reach us since the Spanish Flu of 102 years ago,· the greatest economic contraction since the Great Depression, which ended 80 years ago,

· the greatest oil-price decline in the OPEC era (and, probably, ever), and

· the greatest central bank/government intervention of all time.

The future for all these things is clearly unknowable. We have no reason to think we know how they’ll operate in the period ahead, how they’ll interact with each other,and what the consequences will be for everything else. In short, it’s my view that if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out.

I came across something that I think supports my view that most people reach conclusions for reasons that are questionable:

An ignorant mind is precisely not a spotless, empty vessel, but one that’s filled with the clutter of irrelevant or misleading life experiences,theories, facts, intuitions, strategies, algorithms, heuristics, metaphors,and hunches that regrettably have the look and feel of useful and accurate knowledge. This clutter is an unfortunate byproduct of one of our greatest strengths as a species. We are unbridled pattern recognizers and profligate theorizers. Often, our theories are good enough to get us through the day,or at least to an age when we can procreate. But our genius for creative storytelling, combined with our inability to detect our own ignorance,can sometimes lead to situations that are embarrassing, unfortunate, or downright dangerous — especially in a technologically advanced, complex democratic society that occasionally invests mistaken popular beliefs with immense destructive power. (“We Are All Confident Idiots,” David Dunning, Professor of Psychology, University of Michigan, Pacifc Standard magazine, October 27,2014)

In other words, we may not be able to know the future, but that doesn’t keep us from reaching conclusions about it and holding them firmly.

From the memo “Uncertainty,” May 28,2020

Since we know nothing about the future, we have no choice but to rely on extrapolation of past patterns. By “past patterns,” we mean what has normally happened in the past and with what severity. And yet, there’s no reason why (a) things can’t happen that differ from those that happened in the past and (b) future events can’t be worse than those of the past in terms of severity and thus consequences.

While we look to the past for guidance as to the “worst case,” there’s no reason why future experience should be limited to that of the past. But without reliance on the past to inform us regarding the worst case, we can’t know much about how to invest our capital or live our lives.

Many years ago, my friend Ric Kayne pointed out that “95% of all financial history happens within two standard deviations of normal, and everything interesting happens outside of two standard deviations.” Arguably, bubbles and crashes fall outside of two standard deviations, but they are the events that create and eliminate the greatest fortunes. We can’t know much in advance about their nature or dimensions.Or about rare, exogenous events like pandemics.

In 2001, I wrote a memo titled You Can’t Predict. You Can Prepare. At first glance, that seems like an oxymoron. How can we prepare for something if we can’t predict it? Turned around, if the greatest extremes and most influential exogenous events are unpredictable, how can we prepare for them? We can do so by recognizing that they inevitably will occur, and by making our portfolios more cautious when economic developments and investor behavior render markets more vulnerable to damage from untoward events. That line of reasoning suggests a glimmer of good news: we may not be able to predict the future, but that doesn’t mean we’re powerless to deal with it.

From the memo “You Bet,” January 7,2020

Decisions Under Uncertainty — I have an indelible recollection of the first book I read as a Wharton freshman in 1963. The book was Decisions Under Uncertainty:Drilling Decisions by Oil and Gas Operators by C. Jackson Grayson, Jr. (who in 1971 would take on the role of “price czar” in the Nixon administration’s efforts to get inflation under control).

The best and most lasting thing I took away from Grayson’s book — and the first thing I remember learning in college — was the observation that you can’t tell the quality of a decision from the outcome. This revelation had a profound influence on me as a 17-year-old and represented the first critical building block in my understanding of how the world works.

As Grayson explained, you make the best decision you can based on what you know, but the success of your decision will be heavily influenced by (a) relevant information you may lack and (b) luck or randomness. Because of these two factors,well-thought-out decisions may fail, and poor decisions may succeed. While it might seem counterintuitive, the best decision-maker isn’t necessarily the person with the most successes, but rather the one with the best process and judgment. The two can be far from the same, and especially over a small number of trials, it can be impossible to know who’s who.

By my stage in life — if not well before — one should have figured out his strengths and weaknesses and tilted his activities toward the former. I’ve concluded that my strengths include the ability to:

· frame questions,

· logically organize data and weigh pros and cons,

· know what I don’t know,

· accept that future outcomes aren’t predictable,

· think about the future probabilistically, and

· make decisions incorporating all of the above (although far from always correctly).

Also very important has been the ability to internalize Grayson’s point about decision quality (and thus live with my unsuccessful decisions from time to time).This set of attributes equipped me for a career in investing . . . and for finding enjoyment in games of chance. . .

Investing comes down to Jack Grayson’s title: Decisions Under Uncertainty. As I’ve learned in the 57 years since first reading his book:

· You have to be able to understand which companies or assets are favored and the attractiveness of the proposition.

· You need a sense for whether your holding is a good one and for the chance the competition — the market, which you’re playing against — might have better.

· You need the discipline to follow a process and the wisdom to accept that no process is sure to produce good results.

· You have to understand the significance of the information you have, as well as that which you don’t have. You need the nerve to bet heavily based on what you think you know and a healthy respect for what you may not know.

· You need to control greed and fear, hopefulness and despondency. You have to resist making an unwise bet just because it could enable you to catch up with the indices or the competition. . .

Investing is a game of skill — meaning inferior players can’t expect to be above average winners in the long run. But it also includes elements of chance — meaning skill won’t win out every time. In the long run, superior skill will overcome the impact of bad luck. But in the short run, luck can overwhelm skill, and the two can be indistinguishable. These are the things that make investing both challenging and stimulating. They’re the reason I feel good about the way I chose to spend my career.

The world will be back to normal someday, although today it seems unlikely to end up unchanged. What matters most — in terms of both health and finances is how we do in the interim.

For 2021, stay safe!