Howard Marks' Memo: Timely investing lessons from one of the all-time greats

Investing legend Howard Marks recently released his latest memo, Mr. Market Miscalculates, addressing the volatility seen in early August. He begins by referring to Mr. Market, a concept first introduced by Benjamin Graham in his book The Intelligent Investor (first published in 1949).

For those unfamiliar, the concept of Mr Market is explained as follows:

Imagine that in some private business, you own a small share that costs you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth, and furthermore, offers either to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

When he’s overenthusiastic, you can sell to him at prices that are intrinsically too high. And when he’s overly fearful, you can buy from him at prices that are fundamentally too low. Thus, his miscalculations provide profit opportunities to investors interested in taking advantage of them.

The full memo unpacks the entire episode of August volatility and for anyone interested in reading it in full, you can do so here. What we’re more interested in for this wire, however, is Marks’ compilation of writing on Mr Market over the years, “along with some priceless investing cartoons from my collection, and add a few new observations”, says Marks. 

Please note that the highlights from the memo below have been replicated and are his original words. 

Mr Market Miscalculates highlights

In the real world, things fluctuate between ‘pretty good’ and ‘not so hot,’ but in investing, perception often swings from ‘flawless’ to ‘hopeless.’ That says about 80% of what you need to know on the subject.

If reality changes so little, why do estimates of value (that’s what security prices are supposed to be) change so much? The answer has a lot to do with mood changes. As I wrote over 33 years ago, in only my second memo:

The mood swings of the securities markets resemble the movement of a pendulum. . . between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.” (First Quarter Performance, April 1991)

Mood swings do a lot to alter investors’ perception of events, causing prices to fluctuate madly. When prices collapse as they did at the start of this month, it’s not because conditions have suddenly become bad. Rather, they become perceived as bad. Several factors contribute to this process:

• heightened awareness of things on one side of the emotional ledger,
• a tendency to overlook things on the other side, and
• similarly, a tendency to interpret things in a way that fits the prevailing narrative.

What this means is that in good times, investors obsess about the positives, ignore the negatives, and interpret things favourably. Then, when the pendulum swings, they do the opposite, with dramatic effects.

When psychology is swinging radically, meaningless statements can be given weight. Thus, during the three-day decline earlier this month, it was observed that foreigners sold more Japanese stocks than they bought, and investors reacted as if this meant something. But if foreigners sold on balance, Japanese investors must have bought on balance. Should either of these phenomena be treated as more significant than the other? If so, which one?

Further complicating things in terms of rational analysis is the fact that most developments in the investment world can be interpreted both positively and negatively, depending on the prevailing mood.

Another classic cartoon sums up this ambiguity in fewer words. It’s highly applicable to the market tremor that inspired this memo.

One more source of miscalculation is investors’ tendency toward optimism and wishful thinking. Investors in general – and equity investors in particular – must, by definition, be optimists. Who other than people with positive expectations (and/or a strong desire for increased wealth) would be willing to part with money today based on the possibility of getting back more in the future?

For years, I quoted Buffett as having warned investors to temper their enthusiasm: “When investors lose track of the fact that corporate profits grow at 7% on average, they tend to get into trouble.” In other words, if corporate profit growth averages 7%, shouldn’t investors begin to worry if stocks appreciate by 20% a year for a while (as they did throughout the 1990s)? I thought it was such a good quote that I asked Buffett when he said it. Unfortunately, he answered that he hadn’t. But I still think it’s an important warning.

That inaccurate recollection reminds me of John Kenneth Galbraith’s trenchant reference to one of the most important causes of financial euphoria: “the extreme brevity of the financial memory.” It’s this trait that allows optimistic investors to engage in aggressive behaviour, untroubled by knowledge of what such behaviour led to in the past. Further, it makes it easy for investors to forget past errors and invest blithely on the basis of the newest miraculous development.

Finally, the investment world might be less unstable if there were immutable rules – like the one governing gravity – that could be counted on to always produce the same results. But there are no such rules since markets aren’t built on natural laws, but rather the shifting sands of investor psychology.

An example of the absence of meaningful guidelines can be seen in this excerpt from one of the oldest clippings in my file:

A continuing pattern of consolidation and group rotation suggests that increasing emphasis should be placed on buying stocks on relative weakness and selling them on relative strength. This would be a marked contrast to some earlier periods where emphasising relative strength proved to be effective. (Loeb, Rhoades & Co., 1976)

In short, sometimes the things that have gone up the most should be expected to continue to go up the most, and sometimes the things that have gone up the least should be expected to go up the most. To which many of you might respond “duh.” Bottom line: there are few effective rules for investors to follow. Superior investing always comes down to skilful analysis and superior insight, not adherence to formulas and guidelines.

My bottom line is that markets don’t assess intrinsic value from day to day, and certainly they don’t do a good job during crises. Thus, market price movements don’t say much about fundamentals. Even in the best of times, when investors are driven by fundamentals rather than psychology, markets show what the participants think value is, rather than what value really is. Value is something the market doesn’t know any more about than the average investor. And advice from the average investor obviously can’t help you be an above-average investor.

Fundamentals – the outlook for an economy, company or asset – don’t change much from day to day. As a result, daily price changes are mostly about (a) changes in market psychology and thus (b) changes in who wants to own something or un-own something. These two statements become increasingly valid the more daily prices fluctuate. Big fluctuations show that psychology is changing radically. (What Does the Market Know?, January 2016)

The market fluctuates at the whim of its most volatile participants: those who are willing (a) to buy at a big premium to the former price when the news is good and enthusiasm is riding high and (b) to sell at a big discount from the former price when the news is bad and pessimism is rampant. Thus, as I wrote in On the Couch, every once in a while, the market needs a trip to the shrink.

It’s important to note that, as my partner John Frank points out, in comparison to the total number who own each company, it takes relatively few people to drive prices up during bubbles or down during crashes. When shares in a company that was worth $10 billion a month ago trade at prices implying a valuation of $12 billion or $8 billion, it doesn’t mean the whole company would change hands at these prices; just a tiny sliver. Regardless, a few emotional investors can move prices much more than should be the case.

The worst thing you can do is join in when other investors go off on these irrational jags. It’s far better to watch with bemusement from the sidelines, buttressed by an understanding of how markets work. But better still to see Mr. Market’s overreactions for what they are and accommodate him, selling to him when he’s eager to buy regardless of how high the price is, and buying from him when he desperately wants out. Here’s how Ben Graham followed the introduction of Mr. Market that I included on page 1:

If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view of the value of your $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

In other words, it’s the primary job of the investor to take note when prices stray from intrinsic value and figure out how to act in response. Emotion? No. Analysis? Yes.