What’s Missing From Howard Marks’ “Something Of Value"

Howard Marks is a legendary value investor whom I greatly admire. I have been a long-time reader of his memos, which I find to be insightful, and this one, titled “Something of Value” was no different. In fact, I think this was one of Marks’ best memos. There was a lot of wisdom in it, and a lot of thoughtful introspection from a value investor trying to improve his understanding of the world as the environment evolves. And yet, there were also several important things missing, which if not discussed are likely to leave the readers with an incomplete understanding of the subject.

Before you dismiss this statement as reactionary grumblings by a member of a dying cult, value investing, hear me out. Let’s start with the premise of what Marks wrote in “Something of Value,” and what was right with it. Then, let’s talk about what’s missing, and what the potential biases are that can cause someone reading his memo to walk away with the wrong conclusions.

The premise of the memo is that Marks had to spend much of 2020 living in the same household as his adult son, who is an early-stage growth investor. Their debates and discussions prompted Howard Marks to reassess some of his long-held beliefs about value investing, and update them for the new economic reality that we currently face.

So, what points did I agree with in the memo?

• The markets have gotten to be a lot more efficient over time. There is more competition in investing, and therefore one has to do something differentiated to beat the stock market over time
• Value investing defined simply as buying stocks based on low multiples of past profits is not likely to add much value, if any
• Just like a statistically cheap stock is not necessarily undervalued, a statistically expensive, high Price-to-Earnings ratio (P/E) stock is not necessarily overvalued
• There are businesses whose economics either 1) mask their true current economic profitability, thus inflating their P/E or 2) have the long runway and an impenetrable competitive moat that will make their future profits so much higher than the current levels as to make the stock a bargain at almost any ratio of current profits
• If the high-growth, high P/E technology companies are now such a large part of the stock market, it’s difficult to have an informed opinion on whether the stock market is overvalued or not without having a bottom-up view on the value of these tech companies
• Value investors sometimes overestimate the predictability of historically stable businesses because they underestimate the increased pace of business disruption
• Informational advantage enjoyed by value investors decades ago has been competed away with the advent of computers and the internet

Now, to what was missing from Howard Marks’ “Something of Value”:

Analytical Advantage Doesn’t Just Apply to High-Growth Stocks

With the informational advantage largely gone, the next obvious source of advantage is analytical advantage. This means processing the same information that everyone has access to in a way to arrive at a superior investment conclusion. However, I disagree with Marks’ implicit premise that analytical advantage necessarily benefits those analyzing high-growth companies more than those analyzing steady, mature companies.

The stock price asks the question. What do I mean? The current stock price is a lens on the long-term expectations about the company’s fundamentals that market participants are embedding in the current price. So yes, you can use your analytical advantage to see the long-term future of a high growth company better than most market participants. That might lead you to buy it at a high P/E and still realize above-average rates of returns, while investors buying similarly high P/E stocks of lesser companies end up with sub-par rates of return.

However, analytical advantage applies to mature companies just as much as it does to earlier stage ones. A value investor might successfully use her analytical advantage to find those among low-expectations stocks whose fundamentals don’t deserve such low expectations. In other words, it takes nuanced fundamental analysis to find which of many low P/E stocks are actually mis-priced as opposed to deservedly statistically cheap. So just because informational advantage is no longer a major factor in investing doesn’t necessarily favor investing in high growth vs. more mature companies.

Importance of Behavioral Biases

Marks didn’t really address a major source of occasional mis-pricing in the market: behavioral biases. So if the investment markets were populated by purely rationally actors (think Commander Data from Star Trek), then analytical advantage is all that would be left. However, we are humans, and we are all biased in many ways. Some of us are better at using various techniques to reduce the impact of these biases on our investment decisions than others, and that can be an advantage.

Furthermore, market participants are prone to consistently repeating behavioral biases that cause them to shun certain companies en masse at points in time, and heavily favor others. You don’t have to be free of all behavioral biases. Nobody is. However, if you can be significantly better than the typical market participant in this respect then you have a competitive advantage as an investor.

Importance of Temperament

Just because your analysis leads you to the right decision on what you should do as an investor, doesn’t mean that you will actually do it. Peter Lynch used to say the mark of a great investor is in his stomach, not his brain. What he meant is that few have the fortitude to act when the analytical conclusion is pretty clear, but it’s very scary because nobody else is willing to buy what you have concluded is an attractive investment. Incidentally, my two decades of experience and working with various investors have led me to conclude that temperament really can’t be learned. You are either wired to act independently on your insights or not. Most are not.

At least twice in his memo, Marks’ mentioned that outside of major market dislocations there are no longer any obvious bargains to be had. I think that’s true if you are managing tens or hundreds of billions of dollars. I do not think this is nearly as true if you have a more nimble pool of capital which can take advantage of inefficiencies in pockets of the market. So some of the areas that Howard Marks mentioned in his memo, like special situations, are still a source of occasional great ideas for those looking. It just doesn’t make sense to spend your time looking at those if you have $100B to manage – these ideas are rarely large enough to allow you to make an investment that will make a material impact at that size.

Endpoint Bias

Let’s ask the question that I suspect was on many readers’ minds as they read Howard Marks’ memo: would he be writing or thinking these thoughts if the stock market darlings, many of them tech-related, weren’t up so much over the last few years? You might say “Ah, but that’s the point! They are up so much.” You would be right. However, you would also be wrong.

Consider Marks’ own point that with high growth tech companies, it’s wrong to be too focused on valuation. He asserts that as long as fundamental business momentum is positive and valuation is not at a complete extreme, you should hold on to your shares. (Let’s put aside for a second that the disclaimer about “extreme valuation” reads a bit like what it is– a little disclaimer placed there to cover all bases. Readers are never told how to determine what’s extreme and what’s not.) Implicit in Marks’ argument is that there is a very wide range of prices justified by the same fundamentals. Therefore as he was writing his memo his own logic should also lead him to agree that the prices of most of these tech giants could easily be much lower than they are even without any changes to fundamentals.

So if the current fundamentals could have translated to a much lower set of stock market prices if market sentiment, interest rates, fund flows or any number of exogenous factors outside of the companies’ control or your ability to predict were different, then it’s very plausible that the same bottom-up insight about these companies would have mapped to far less spectacular recent market success. Imagine many of these companies’ stocks declining 50% or more tomorrow, to still quite rational prices relative to their fundamental prospects. If that were the case, do you think that Howard Marks’ son’s arguments would have prompted Howard to write the same memo that he did at current prices? I will posit that in the absence of the stock market action of the last few years Howard might not have been writing this exact memo even if company fundamentals were exactly the same.

This Time Is Different. But It Also Isn’t Different

Howard Marks argues that this time is different than the three best known stock market bubbles of the 20th century: the late 1920s, the late 1960s and the late 1990s. The main difference he sites it that this time we have an emergence of companies with real cash flows, durable competitive advantages and a long runway for growth ahead of them. Those things are clearly true in many of the market leaders. These are not, in many cases at least, the structurally money-losing companies bid up to absurd levels in the 1990s.

So what isn’t different? Think about those 3 periods for a second. The Nifty Fifty bubble of the late 1960s was also very different from the mania of the late 1920s. These were real companies with strong franchises. Kodak. Walmart. Polaroid. Xerox. The conglomerates. Some called them “one decision stocks” – you find them, and then you never have to sell them at any price because the business is so strong. Sound familiar?

Now think of the late 1990s. It was different again. These were new business models that were going to ride the wave of new technology to massive profitability. Traditional valuation metrics don’t apply here! We need to focus on early-stage metrics, like the ratio of Enterprise Value to Eyeballs (don’t ask). I was graduating from MIT during this period and remember the lavish recruiting events some of these new-age companies threw for us with their air of sophistication and invincibility. Which companies am I referring to? Don’t ask – they are long gone so the names probably won’t mean much to you. The future is harder to predict than it seems.

My point is that each time is different. That’s why these manias reoccur. It would be too dark a view of human nature to think that having bid up tulips to insane price levels once, we humans are going to do so again and again every few decades. For new bubbles to appear, the details have to be different. Then the argument cannot be debunked simply by pointing to the ruins of financial fortunes of the past, because the believer can thoughtfully explain the important differences between tulips and radio companies of the 1920s, conglomerates of the 1960s or internet and telecom stocks of the 1990s. What isn’t different is human nature. And human nature causes investors to react emotionally far more than rationally in financial markets, which in turn causes it to price securities, even of very deserving companies, at highly irrational levels from time to time.

Conclusion

It’s of course possible that Howard Marks is exactly right on everything that he wrote, and that my points above are mistaken. That investors in the stock market as a whole and in the glamour stocks of the day in particular will continue to enjoy high returns. It’s possible. However, it’s also possible that I am right, and that many of the glamour stocks being bid up to ever-higher levels are priced at the edge of rationality or beyond. In that case the returns that await the true believers of the theory that price (mostly) doesn’t matter for good businesses is not going to be that different from the financial disasters of the past. So investors face a choice. Risk missing out on the growth stocks going ever higher and settle for good but (for now) less spectacular results that traditional value investing, when practiced properly, is capable of. Or risk your hard-earned capital on the bet that this time is sufficiently different, and if it isn’t different enough then stand to realize large losses. I choose the former, even if it risks being out of step with the market for a long time.

I believe that Howard Marks is 100% right that investors need to continue to evolve and to improve their craft rather than to blindly rely on dogma or simple formulas. How you should evolve your investing is not a function of how I or Howard Marks do it, but it should be based on your own strengths, weaknesses, circumstances and circle of competence. Learn from others, but don’t worry about whether where you come out as an investor is the same or different than where they do. Think from first principles, and if you aren’t reasonably sure of something in investing, wait for something better. It will come.

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This article previously appeared on Behavioral Value Investor