In his report Alpha and the paradox of skill, Michael Mauboussin, one of The Value Perspective’s favourite thinkers on value investing, talks about a successful US chief executive who spent his youth trying to become a better poker player – working hard to learn the odds of any possible hand, how to spot giveaway ‘tells’ in other players and so forth.
After a while, an uncle pulled the man aside and offered him the following advice: “I wouldn’t spend my time getting better – I’d spend my time finding weak games.” Mauboussin uses this story to illustrate that there are two aspects to successful investing. “The first is skill, which requires you to be technically proficient,” he writes. “The second aspect is the game in which you choose to compete.”
Picking one’s battlegrounds, so to speak, as carefully as one’s battles are clearly an idea that goes straight to the heart of what we on The Value Perspective are trying to do. We are always hunting for mispriced business in areas of the market made inefficient by the behavioural inefficiencies – at base, the fear or greed – of other investors.
It is not altogether surprising then that Mauboussin’s anecdote also crops up in Getting lucky, the excellent memo sent out to clients of Oaktree Capital by the firm’s chairman Howard Marks, another of our favourite investors. Interestingly, Marks goes on to argue the presumption should be that markets are generally efficient and investors should always work to disprove that idea.
“Everyone is aware of [markets], basically understands them and is willing to invest in them,” he says. “In general, everyone gets the same information at the same time … I had markets like that in mind in 1978 when, on going into portfolio management, my rule was ‘I’ll do anything but spend the rest of my life choosing between Merck and Lilly’.”
Three and a half decades later, of course, those two remain titans of the global pharmaceutical industry – both pored over by an army of brokers and other analysts – and Marks’s point is there seemed little to be gained by joining their numbers and trying to add value in such an efficient market. Far more to his liking, it turns out, was the high yield bond market that was still in its infancy in the late 1970s.
It was, says Marks, little-known, little-researched and little-traded, with limited reported performance history, no centralised trading and no reported data on prices. “Most importantly,” he adds, “high yield bonds were viewed as unseemly and investing in them was considered improper. I’ll never forget Moody’s definition of a b-rated bond – ‘fails to possess the characteristics of a desirable investment’.”
As a consequence, most professional investors had to stay away from high yield bonds, leaving Marks to make hay – after all, a game becomes so much easier when most of your opposition are barred from playing against you. Then, switching from history to the future, Marks draws the distinction between what he calls ‘structural’ and ‘cyclical’ inefficiencies.
Structural inefficiencies do still exist in comparatively less scrutinised parts of the market – smaller companies versus large stocks, for example, or emerging markets versus their developed counterparts – but, as a result of greater information, increased competition and so on, they are not nearly as abundant as when Marks began his investment career.
What does remain in abundance, Marks argues – and The Value Perspective wholeheartedly agrees – is cyclical inefficiency, which springs from the idea markets can veer from rational to irrational. As we said earlier, this is the core of value investing – taking advantage of those ‘behavioural inefficiencies’ that exist in markets to buy very cheap stocks for when they recover.
“Just five years ago, there were lots of things people wouldn’t touch with a ten-foot pole,” Marks concludes, “and as a result they offered absurdly high returns. Most of those opportunities are gone today, but I’m sure they’ll be back the next time investors turn tail and run. Markets will be permanently efficient when investors are permanently objective and unemotional. In other words never, unless that unlikely day comes, skill and luck will both continue to play very important roles.”