Interpreting Seth Klarman quotes using Howard Marks Memos

Couple of years back I tried to compile Howard Marks memos from 2001-2011 in a 75 page document. It was quite a learning experience for me to go through this document again. You can download this document from here.

I have generally found it difficult to understand many of the Seth Klarman quotes. Few of my friends says I am trying to read too much into it 🙂 . May be they are right? But nevertheless I have found it very helpful to read couple of Mr. Seth quotes along with Howard Marks memos. Find below two of such quotes.

Please share your interpretation of below quotes, more so if you disagree with my interpretation.

Seth Klarman says

“The investment challenge of providing liquidity to out-of-favor asset classes is more complex than simply identifying areas that others are avoiding. First, it is important to never be blindly contrarian, betting that whatever is out of favor will be restored. Often, investments are disfavored for good reason, and investors must consider the possibility that recovery may not occur. Second, it is important to gauge the psychology of other investors. How far along is the current trend, what are the forces driving it, and how much further may it have to go? Being extremely early is tantamount to being wrong, so contrarians are well advised to develop an understanding of the psychology of the sellers. Finally, valuation is extremely important in reducing risk. Investors must never mistake an investment that is down in price for one that is bargain-priced; undervaluation is determined only by a security’s price compared to its underlying value.”

I found the quote highlighted in bold quite interesting. Isn’t it same thing as timing? With the same question, I was struggling during demonitisation led crash too. Something unprecedented had happened and I really could not understand what to do more so with some of my stocks which were directly hit by demonitisation.  Ofcourse prices fell by 30-40%, but in absence of adequate information this means nothing. I was not waiting for consensus but wanted to wait atleast for 2 quarters to see the impact of event and then take a call. I have asked this question to many investors and except for couple of answers found most not to be satisfactory. I think finally I got answer to this in Howard Marks memo. This is what Howard Marks says in his January 2008 memo

“Nevertheless, I do think we’re in the early going: the pain of price declines hasn’t been felt in full (other than perhaps in the mortgage sector), and it’s too soon to be aggressive. Things are somewhat cheaper (e.g., yield spreads on high yield bonds went from all-time lows in June to “normal” in November) but not yet on the bargain counter. Thus, I’d recommend that clients begin to explore possible areas for investment, identify competent managers and take modest action. But still cautiously, and committing a fraction of their reserves.

“Don’t try to catch a falling knife.” That bit of purported wisdom is being heard a lot nowadays. Like other adages, it can be entirely appropriate in some instances, while in others it’s nothing but an excuse for failing to think independently. Yes, it can be dangerous to jump in after the first price decline. But it’s unprofessional to hang back and refuse to buy when asset prices have fallen greatly, just because it’s less scary to “wait for the dust to settle.” It’s not easy to tell the difference, but that’s our job. We’ve made a lot of money catching falling knives in the last two decades. Certainly we’ll never let that old saw deter us from taking action when our analysis tells us there are bargains to be had.

In the period ahead, cash will be king, and those able and willing to provide it will be holding the cards. This is yet another of the standard cyclical reversals, and it will afford bargain hunters a much better time than they had in 2003-07.  Some of those who came to the rescue of troubled financial firms in 2007 may have jumped in too soon. There’s a fair chance they didn’t allow maximum pain to be felt before acting, (although the prices they paid eventually may turn out to have been attractive). I’d mostly let things drop in the period just ahead. My view of cycles tells me the correction of past excesses will give us great opportunities to invest over”

In his book “The Most Important Thing Illuminated“, Howard Marks added more on the same topic of catching falling Knife:

Investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.

Investor sentiment was extreme in October 2008. Valuations were incredibly cheap, and stocks offered wonderful returns looking forward. In fact, over the next two years returns were spectacular. Unfortunately, stocks first fell another 20 percent from the already low October 2008 levels before they eventually turned around (in March 2009). As contrarians it’s our job to catch falling knife with a view on intrinsic value.

I try to look at it logically. There are times to buy an asset that has been declining: on the way down, at the bottom, or on the way up. I don’t believe we ever know when the bottom has been reached, and even if we did, there might not be much for sale. If we wait until the bottom has been passed and the price has started to rise, the rising price often causes others to buy, just as it emboldens holders and discourages them from selling. Supply dries up and it becomes hard to buy in size. The would-be buyer finds it’s too late. That leaves buying on the way down, which we should be glad to do. The good news is that if we buy while the price is collapsing, that fact alone often causes others to hide behind the excuse that “it’s not our job to catch falling knives.” After all, it’s when knives are falling that the greatest bargains are available.

How do we resolve when to buy problem. Simple we buy when something is cheap. If it becomes cheaper, we buy more. If we see something attractive today, we never say we will wait another six months because It will be cheaper then. It never works that way.

He further added in his book that

” The one thing I am sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainly has been resolved, there will be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain. And the high volumes that accompany a sharp sell-off will also likely be over. Not only will prices be on the rebound, but buying a sizeable position will be much harder. 

A hugely profitable investment that does not begin with discomfort is usually contradictory. It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why we hold a view of value that enables us to buy when everyone else is selling and if our view turns out to be right – that’s the route to the greatest rewards with the least risk. “

 Seth Klarman another quote add a little more interesting perspective to above question. He says “This massive influx of capital, ironically has led to a market where almost everyone has wanted to reflexively buy the dips, where the market’s high have been higher, and lows higher too..”

 Second Quote

“What happens when you are wrong is everything is investing. You must construct a portfolio to survive those times”….

I was confused again by this quote. How can we construct a portfolio to survive all the risky scenarios? Some of them though possible, may be very low probability event. Again I think I got answer to these questions in Howard Marks memo.

“So What Do We Do Now (after Sept 11 bombing)?  We could assume that the combination of further weakening of the already-weak economy plus continued terrorism will make for a very difficult environment. If we then based our investment process on that assumption, we would hold cash and make very few commitments. I call this “single scenario investing.” The problem, obviously, is that arranging our portfolio so that it will succeed under a scenario as negative as that means setting it up to fail under most others. We do not believe in basing our actions on macro-forecasts, as you know, and we certainly don’t think we could ever be that right.

Thus Oaktree will continue to invest under the assumption that tomorrow will look a lot like yesterday – an assumption that to date has always proved correct. At the same time, we will continue to insist on an investment process that anticipates things not always going as planned, and on selections that can succeed under a wide variety of scenarios. As long-term clients know, this part of the story never changes. In the current environment, we will allow a very substantial margin for error. We will continue to work only in inefficient markets, because we feel it’s there that low risk needn’t mean low returns, and upside potential can coexist with downside protection.

And we will continue to strive for healthy returns in good markets and superior returns in bad markets. We do not promise to beat the markets when they do well, but we also don’t think that’s an essential part of excellence in investing.”

Howard Marks further elobaorated on this in his Dec 2008 memo

“One of my favourite adages concerns the six-foot-tall man who drowned crossing the stream that was five feet deep on average. It’s not enough to survive in the investment world on average; you have to survive every moment. The unusual turbulence of the last two years – and especially the last three months – made it possible for that six-foot-tall man to drown in a stream that was two feet deep on average. UShould the possibility of today’s events have been anticipated? It’s hard to say it should have been. And yet, it’s incumbent upon investors to prepare for adversity. The juxtaposition of these sentences introduces an interesting conundrum.

 If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008] that no one would ever invest in these asset classes, even on an unlevered basis.)

In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm (A) most of the time, but we know it’s not unusual to see outcomes that are better or worse (B). Although we should bear in mind that, once in a while, a result will be outside the usual range (C), we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never (D).

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a “black swan” will materialize. But if in the future we always said, “We can’t do such-and-such, because we could see a repeat of 2007-08,” we’d be frozen in inaction.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-08 prove there’s no easy answer…”

 In his October 2008 letter he further says that “But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability it will happen. During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. Since we never know much about what the future holds – and in a crisis, with careening causes and consequences, certainly less than ever – we must decide which side of the debate is more likely to be profitable (or less likely to be wrong).”