When looking for stocks, most of us create a list of potential candidates, then whittle it down using one or more criteria, including intrinsic value and risk. Howard Marks (Trades, Portfolio) started chapter 12 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor” with such a list.
But the author wanted investors to take a different path, one that is reminiscent of Benjamin Graham, Warren Buffett (Trades, Portfolio) and “cigar-butt” investing (buying really cheap and beaten-down stocks). That’s regardless of asset quality. He went on to write:
“It’s not what you buy; it’s what you pay for it.
“A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.”
Getting more specific, he argued:
- A good buy is one in which the price is low relative to value.
- The potential return is high relative to risk.
To explain how bargains get to be bargains, he began by explaining the conventional approach to finding “an objectively attractive asset.” Because it is attractive, it is also in demand, and that demand pushes up its price. Other investors interpret the rising price as a sign of even greater attractiveness. Thus, capital flows in and a virtuous circle emerges; pushed too far, of course, it turns into a bubble, as happened with tech stocks in the late-1990s.
A bargain-seeking process works in roughly the opposite way. It looks for securities with these types of characteristics:
- A potential bargain normally has some sort of defect; that can be an asset class, a company or an industry. For example, a balance sheet with too much leverage.
- Investors don’t do enough research and so fail to see beyond the defect.
- “Orphaned assets” like these are ignored by the media and other influencers.
- The price has been retreating, and investors make the mistake of extrapolating the current performance well into the future. That also implies that they also failed to consider potential reversion to the mean.
Summing up, a bargain asset is unpopular, capital avoids or leaves it, and there are no obvious reasons to own it. That led to another set of criteria for narrowing the field of bargain stocks:
- Largely unknown and only partially understood.
- In appearance, “fundamentally questionable.”
- Seems “controversial, unseemly or scary.”
- Not appropriate for “respectable” portfolios.
- Unpopular, not appreciated and not loved.
- A record of poor returns.
- Shareholders are divesting, not investing.
Marks added, “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.”
Two examples from his own investing career were listed: convertible securities and junk bonds in the late 1970s and 1980s. He cited one rating agency’s description of some B-rated bonds “generally lacking the characteristics of a desirable investment.” As we know in retrospect, Marks made his reputation — and a lot of money — by buying unpopular asset classes like these.
Of that agency’s description, he also observed that it was foolish to dismiss a whole class of investments without referring to their prices. In addition, investment bargains need not have any connection with high quality.
Think of unloved asset classes, and even individual stocks or securities, as potentially the Holy Grails of investing. They offer value at exceptionally low prices and therefore outstanding ratios of risk to return. Such good opportunities should not exist in efficient markets, but, “The forces that are supposed to eliminate them often fail to do so.”
Like Graham and the young Buffett, then, Marks shopped for low-priced assets, including stocks. But he also had something young Buffett and Graham did not, which was access to new and complex instruments such as junk bonds, distressed debt and possibly convertible securities. Not that Buffett would want them; after all, he made a practice of only buying securities he understood.
Quality is not an issue for Marks, just deep-value opportunities. In this chapter he did not explain how he managed the losers that come with this type of strategy, but presumably there were fewer of them than there were of winners.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
