Howard Marks's Investing Philosophy: Risk, Psychology, and Second-Level Thinking

Deep Dive

The discussion begins by celebrating the 35th anniversary of Howard Marks's memos, highlighting their institutional status and readership across the finance industry, including notable figures like Warren Buffett. The memos are described as charting impactful financial events and, more importantly, Marks's investment philosophy, standing apart from any other comparable body of work.

Marks explains that the first memo, written in 1990, was not part of a grand plan but stemmed from an interesting event that illuminated his and his firm's approach, designed for clients. He emphasizes a conscious decision to focus on clarity rather than industry jargon and numbers, aiming to write the way he speaks to make complex topics simple, which he considers a mission accomplished when readers convey this.

A surprising detail revealed is that Marks received no response to his memos for a considerable time, for about ten years. This was during an era of physical mail, requiring significant effort for a reader to respond. Despite the lack of feedback, Marks continued writing because he enjoyed it and found it a creative and artistic outlet, valuing the process of drafting and refining.

The conversation then shifts to the bubble com memo, written in January 2000, which marked a turning point and brought the memos to wider attention. Marks recounts reading Edward Chancellor's book "Devil Take the Hindmost" in the fall of 1999, which detailed past financial speculation like the South Sea Bubble. He observed parallels between historical speculative frenzies and the TMT (tech, media, telecom) bubble, particularly the idea that the internet would fundamentally change the world, leading him to question the valuations of internet stocks. He notes the trepidation involved in issuing such a skeptical view when the market was experiencing extreme exuberance, likening it to standing in front of a freight train.

Marks elaborates on the TMT bubble, stating that while the internet did change the world, most stocks from that era became worthless. He reflects that being too far ahead of one's time can be indistinguishable from being wrong, requiring a willingness to be perceived as incorrect for an extended period. The bubble com memo gained traction because its predictions proved correct relatively quickly, and Marks's definition of a bubble, based on investor psychology rather than traditional metrics like P/E ratios or spreads, resonated widely.

The discussion moves to the Global Financial Crisis, seven or eight years after the bubble com memo. Marks references a memo from February 2007, "Race to the Bottom," which warned of investors readily accepting significant risk through leverage, untested derivatives, and weak deal structures. He highlights that while he warned of the impending crisis, his message also shifted to identifying buying opportunities when the market became excessively negative, framing it as a contrarian approach.

Marks explains his contrarian philosophy as akin to jujitsu, using the excessive force of other investors' optimism against them. He emphasizes that mistakes are made at market extremes, with investors becoming too excited during booms and too depressed during busts. His internal message at Oaktree during the crisis was to remain calm and recognize that if the situation was as dire as feared, the world would be over regardless, and if not, missing the buying opportunity would be a failure.

A central theme emerges: risk. Marks states that risk is the most important concept in investing, with understanding, recognizing, and managing it being crucial for distinguishing excellent investors. He argues that making money is not the primary challenge, especially in a generally upward-trending market, but rather making it with risks under control to survive downturns. This emphasis on risk management is identified as a cornerstone of Oaktree's investment philosophy, distinguishing the firm by its relative outperformance during difficult market periods.

Marks notes that Oaktree does not aim for extreme gains during boom times but believes its best relative performance comes during downturns. He stresses the importance of having defense embedded in all actions, not just switching to a defensive posture when a crisis hits. He describes the period after the financial crisis (roughly 2010-2019) as a "fairly odd period" characterized by low defaults and readily available financing, making it a quiet and frustrating time for Oaktree, which thrives on taking advantage of others' mistakes and distress.

He explains that in such an environment, where the economy and markets grew gradually, and overleveraged companies were not tested, there was relatively little for Oaktree to do. This required patience, likening it to waiting for a good pitch at bat, as suggested by Warren Buffett. The concept of "waiting for a good pitch" is directly linked to the inability to find great bargains when the market is sanguine and everyone is confident, leading to periods where opportunists have little to act upon.

The conversation then turns to the COVID-19 pandemic, described as the "ultimate illustration of uncertainty." Marks references his memo "Uncertainty One," emphasizing intellectual humility as an essential investor trait. He quotes Mark Twain, stating, "It ain't what you don't know that gets you into trouble. It's what you know for certain that just ain't so." He posits that people who are 100% sure they are right are often wrong and are not enjoyable to be around. Saying "I don't know" or "I could be wrong" is presented as less dangerous than making bold bets based on unfounded certainty.

Marks contrasts the "I know school" of thought, which sounds confident and takes bold action that can lead to ruin if poorly timed, with the "I don't know school." He uses the analogy of a six-foot-tall person drowning in a stream that is five feet deep on average to illustrate the danger of overconfidence when dealing with averages and variability, particularly for companies that take on excessive debt.

Regarding generating alpha, Marks states there is no sure-fire way beyond executing decisions with superior insight and skill. He introduces the concept of "second-level thinking," which involves thinking differently and better than others, acknowledging that competitors are not unintelligent, making this a daunting but necessary task for superior performance.

Another significant belief discussed is the inability to judge the quality of a decision solely by its outcome. Marks argues that one must examine the process behind a decision, recognizing the role of luck. He criticizes those who take full credit for successes and attribute failures to bad luck, advocating for an understanding of the limits of intellect and foreknowledge. He reiterates that outperforming requires thinking better than others, buying what they are wrong to sell, and vice versa, in what is essentially a zero-sum game.

Marks acknowledges the role of luck in his own career, citing early career steps influenced by others' decisions and a job application that he did not get, which he initially perceived as bad luck but later recognized as fortunate. He mentions Nassim Nicholas Taleb's book "Fooled by Randomness" in relation to understanding luck and the illegitimacy of short-term performance records in fields affected by randomness.

The discussion then addresses the productive period during the 2020 pandemic, attributed to having nothing else to do and the rapid pace of developments. Marks found it fascinating to interpret unprecedented events, noting the lack of past data or analogous experiences, leaving only supposition for decision-making. He contrasts this with normal decision