Do we make our own luck? It is a question tackled with great insight by Oaktree Capital Chairman Howard Marks, one of The Value Perspective’s favourite investors, in his excellent memo to the firm’s clients, Getting lucky. We will pick out a few of his points on the way to making our own but, if you have not read it already, the whole memo really is worth a look.
Before addressing the role of luck in investment, Marks spends some time considering the part it plays in our lives in general. Using himself as an example, he notes all the ways “demographic luck” has contributed to his success – not least in winning what Warren Buffett has memorably described as “the ovarian lottery” as a result of being born in the US in the first place.
Marks reflects too on the impact of luck on his being born to middle-class parents at the very start of the baby boom, on the timing, location and circumstances of his education and employment, on teaming up with his fellow Oaktree founders and so forth. “Pull out a few of the steps on this progression and where would I be today?” he asks.
Finally, Marks remembers the job he wanted more than any other after gaining his MBA in 1969. Only recently he discovered he had indeed got the nod but the partner who was supposed to call him had arrived at work hung-over on the relevant morning and so failed to deliver the good news. “Just think,” he says, “but for that bit of ‘bad luck’ I could have spent the next 39 years at Lehman Brothers!”
The context of investing, Marks believes the idea “you make your own luck” might more usefully be expressed as “luck is what happens when preparation meets opportunity”. “This way of looking at life is in line with my formulation regarding investment results,” he adds. “Performance is what happens when events collide with an existing portfolio.”
Marks goes on to quote the observation of the London Business School’s Elroy Dimson that “risk means more things can happen than will happen”, before touching on Nassim Taleb’s view of the world, set out in his book Fooled by randomness, as an uncertain place. “Things that should happen may not happen,” adds Marks.
“And other things may happen instead – for any of a variety of reasons, many of them extraneous, unpredictable and even nonsensical. those things can be described as random: the result of luck, either good or bad. the point is that we assemble our portfolios, and future events determine whether our performance will be rewarded or punished.”
Reading this memo, the thought kept occurring that it might be possible to depict some of its ideas by way of a graph. What underlies Dimson’s brilliantly pithy line is the idea you cannot judge the correctness of a decision by its outcome – since more than one thing could happen, it must follow that what does happen will not necessarily have been the thing with the highest-probability.
So there are a set of different paths for everything in life that could happen – some of whose potential outcomes we can know about but, equally, others we cannot even envisage. To put that in investment terms, the way we value a business is with reference to the level of free cashflow it generates over time and clearly, over time, there will be a number of different possible outcomes for that cashflow.
What value investing acknowledges is the cheaper the price at which you buy an asset, the more of those outcomes will be beneficial to you. This is what the graph below illustrates – the vertical axis being a business’s free cashflow, the horizontal axis time, the arrows a range of good and bad outcomes and the dotted line the price you pay – and therefore the marker of whether or not you make money.
Here on The Value Perspective, we often talk about how a lower valuation increases the margin of safety on the downside but the other side of the coin of looking to minimise the number of events that will have a negative effect on the share price is looking to maximise the number of events that will have a positive effect.