In this series on thought leading investors, the MOI Global Editorial team has selected a series of quotes from past interviews that are representative of the investor’s approach.

Strategy

“To me, the most important single question at a point in time with regard to strategy. I’m not talking about tactics. I’m not talking about what’s going to go up tomorrow. I’m not talking about eternity. But for the middle term, let’s say three to five years, the most important thing at a given point in time is how you’re balancing offense and defence.”

“Basically speaking, we want to have a lot of offense when prices are low, psychology is depressed and the outlook is bad to most people but we don’t think it’s so bad. And we want to have defence when prices are high, psychology is buoyant and everybody sees a brilliant future, and we don’t think the future may live up.”

“One of the things I said in the book is that when there’s nothing clever to do, the mistake is in trying to be clever. I don’t think that this is a time when there are compelling clever things to do, big picture-wise. Hopefully, we can always find some bargains, but of course in a difficult market when everybody’s combing the markets and willing to spend money, the bargains tend to be fewer and further between.”

“Now, you asked about this dichotomy. I don’t know so much about their thinking. But number one, Buffett of course takes the longest view because number one he’s the largest. Then number two, his assets are so illiquid when you own whole companies.”

“What does it mean to pick a long-term view? What it primarily means is we have long term trends, secular trends. We have modest cycles around the trends when measured in decades or longer. Then we have short term cycles around the long-term trends. And taking a long-term view means ignoring the shorter-term fluctuations.”

“Probably, Buffett is saying that he’s willing to ignore the short-term fluctuations and part of it is because he has to being as big and as locked-in as he is. Part of it is his nature and that he’s very happy owning good companies at share prices that he thinks have moats and good management, good people, and less concerned about profiting in the short term where the other, Watsa, may be more concerned about what the next year or two holds.”

“Since I started Citibank’s high yield bond fund, we went from high yield and converts to international converts and European converts to and European high yield to distressed debt to distressed for control to distressed mortgages to mezzanine finance. So a lot of what we have done although not all has been credit based, we consider that to use your term, certainly one of our greatest circles of competence. And we emphasize the thing that have a high probability of paying off for us. I bet there are other people who are better at us at investing in things that have a low probability of paying off but with a very high pay-off.”

“I believe that the most important, single, tactical question for an investor is at any given point in time whether to be emphasizing offense or defence, aggressiveness or caution. I think if you get that right, the other stuff doesn’t matter that much – picking managers, picking strategies, picking individual securities – and if you get it wrong, the other stuff doesn’t help that much. I think that the single best way to augment performance in general is to be right on the question of offense versus defence.”

“If you have value as an analyst, you should concentrate and get some mileage out of your successes. If you don’t have any value, you can diversify, but then shouldn’t you just as well have gone into an index fund?”

“Do you want to know everything about a micro-specialty or a fair bit about a broad number of things? I think what you’re referring to about Buffett is different. I think what you’re referring to is the importance of taking whatever knowledge you have and understanding the context and having knowledge which is not limited to your area of specialization.”

“If you have offense and the markets turn good, you make a lot of money. If you have defence and the markets turn bad, you avoid losing a lot of money. But of course, the reverse is true as well. It’s very important to have the appropriate mix of offense and defence at a given point in time.”

 

Psychology

“I don’t think that prices are so low or psychology is so depressed, or the outlook is so good that it’s time to be aggressive. But I also don’t think that prices are so high or psychology is so buoyant, or the outlook is so bad that it’s time to be defensive. The other thing of course today is that if you’re entirely defensive then you have to go into things that yield pennies on the dollar or fractions of pennies perhaps.”

“Most equity investors are optimistic by temperament and they tend to think how much money can I make if everything goes right? The bond investor thinks only about what can go wrong. The fusion of the two is an improvement and the equity investor should think about I know the bold case but what can go wrong and how would it affect me?”

“Now contrarianism itself is a very, very important virtue among investors and especially value investors. The goal of investing is to buy things for less than they’re worth. How do you buy things for less than they’re worth? You need somebody to sell it for less than its worth. Who wants to do that? The answer is people who are disheartened, afraid, disillusioned, depressed, unduly negative. These are the people we want to buy from and it’s when these opportunities become available that we want to turn up the wick and be more aggressive. On the other hand, when everybody’s optimistic, confident, comfortable, sanguine, complacent, they’re unlikely to want to sell things and especially to sell them at prices below their worth. This is not a good time for us to be aggressive, when there are no bargains available and perhaps only things that are too high. That’s the basic issue and I have felt over the last, let’s say, three and a half years. I seem to date it back to the spring of ’11. That most people have been if not optimistic, then willing to invest optimistically because they could not get the returns they want by being conservative given the low levels of rates that the central banks have mandated. I hope I’m not being too complex in this discussion, but I think it warrants it.”

 

Personality

“A couple of things. I was an equity analyst from 1968 to 1978. I was the Citibank Director of Research before I went into portfolio management on the bond side. The reason that high yield bond investing was good for me is because they both dealt with the uncertain future of companies, equities and high yield bonds.”

“I was lucky in ’78, I was asked to start up some bond funds in convertibles and high yield. I’m a conservative investor, it fit me very well to be investing in fixed income. If they would have said to me, “We want you to go out to Silicon Valley and start a venture capital fund. We want you to find Google when it gets invented,” I probably couldn’t have because I’m not a futurist and I’m not a dreamer. I’m probably better at sealing off the downside than finding the upside. Like they say in football, “Is he playing within himself? Is he doing the things he can do?” I think it’s extremely important for an investor, so I think the people we’re talking about are people who have these approaches, strongly held.”

“It fits my personality to think that for me the route to success is primarily through the minimization of mistakes. I try to project myself forward three or five years, look back and say will I be glad I did X or Y? If I’m not, what went wrong, and so forth? So jumping forward and looking back.”

“The first blush reaction is that when you’re younger and you’re just trying to get started, you can’t afford to be wrong because maybe you’ll never get any further if you lose your job. On the other hand, you could take the position that when you’re starting you don’t have much to lose, so you might as well take a shot. I think the conventional answer is that a person trying to get started will not have the mental resolve to take substantial risk of looking wrong and will tend to do more conventional things. I would think.”

“I think there are certain things that go with youth. First of all, you haven’t had much experience. Experience is very important. The extremeness of cycles and the way they can turn against you and the ease of doing things wrong in a cycle and because of the cycle, I think it’s a great help to have been through some. In the beginning, they’re terrifying. Hopefully, with time you realize that, “Oh, this is another of these cycles and now I know how to get through it.” 1) They lack experience. 2) One thing that is hard to have without experience is a strongly felt personal philosophy because I think that your philosophy comes from your experience. I imagine it’s very hard to set out as a beginner investor and have a fully formed investment philosophy and hold it very strongly because you just haven’t had the experience. Another thing, I would hope that for someone experienced like me that it’s easier to be unemotional than it is for somebody just starting out who hasn’t been educated by the market over some decades. I think that investing is an area where experience and age is a great advantage.”

“I want to say emphatically, Oliver, there are more than one way to skin the cat. I talk about the things you can’t do. You can’t make macro forecasts repeatedly successfully, you can’t trade algorithmically, so then what’s Stan Druckenmiller doing? What’s Renaissance doing? All the things I say you can’t do, there are people who’ve done them extremely successfully. Trade commodities, who’s Paul Tudor Jones? There are lots of ways to be successful. I always talk about the importance of risk-controlled investing. There are high risk investors who’ve been successful. I think the key is 1) to have an approach, well thought out, built out hopefully over some years or decades. Hold it strongly. As the memo says, be willing and able to hold through the periods when it’s not working because nothing works in every market, nothing works in every state of the cycle and nothing works every year. Even if you’re in an up cycle, it should work, it didn’t work.”

“Now Buffett and maybe even to a greater extent Charlie Munger…well, Charlie’s a Renaissance man, he’s a polymath. He knows a great deal about history, philosophy, science. We all have different ways of thinking about problems. Some of us learn or derive our conclusions through analogies. We see a process going on maybe in a company and we analogize it to something that might go on in nature. I think it helps to understand history, it helps to understand science. I think there’s a book out now called Investing: The Last Liberal Art, which talks about philosophy and psychology and metallurgy and psychics, whatever it might be and you can see in each of these disciplines lessons to be taken to the investment process. I read fairly broadly and I’m not a specialist in any one thing and I never really have ever been, ever since my days in 1969-70 when I started off as an analyst in conglomerates, but even that wasn’t specialized. I was a specialist in generalised companies. I think it helps to read broadly because what good does it do to know everything about one little thing if you don’t know how it fits into the world and how the world’s going to affect it.”

 

Insight

“Of course, you’re playing with the title. Because I wrote the book and I named it The Most Important Thing is because there is no most important thing in investing. There are twenty chapters and each one starts off the most important thing is and then it’s a different thing.”

“I can’t tell your beginning investor a secret formula, but I think a thought-out approach held with discipline, unemotional behavior, sticking to your last, these are some of the fundamental things I think will lead to success, but none of it matters if you don’t have superior insight.”

“Value, value to price, psychology, risk, contrarian, counter-cyclical, defensive investing, etc., in general, there is no one thing. All of the elements that I discuss in the book are essential elements in putting together a solid foundation for investing.”

“Peter Vermilye, my boss at Citi, used to say that only 5% of analysts add any value. This is not a business where everybody has the same insight or above average insight, only a few people and so you have to do all those other things I talked about, but you also have to be able to think different from the crowd and better.”

“I think it helps to be highly intelligent. Buffett says, “If you have a 165 IQ, sell 30 points because you don’t need them.” I don’t think that’s true. I think that high intelligence is very important and I think the people that I’ve mentioned are extremely intelligent. Those are some of the criteria for success.”

“This is not a business where everybody has the same insight or above average insight, only a few people and so you have to do all those other things I talked about, but you also have to be able to think different from the crowd and better. The first chapter in the book says, “The most important think is second level thinking – different and better.””

“When I was a kid, 1970, 24 years old, I was an analyst and I had an orange piece of paper, so I knew it came from the FT posted above my desk and it said that an analyst is someone who knows a great deal about a few things and learns more and more about less and less until he knows everything about nothing. A portfolio manager is somebody who knows a little bit about a lot of things and learns less and less about more and more until he knows nothing about everything. A client is someone who starts off knowing a reasonable amount about a fair number of things, but through an association with analysts and portfolio managers learns less and less about more and more until he knows nothing about anything.”

 

Markets

“The biggest single change in the investment markets in the last three decades, and you know I started in this business 45 years ago and started managing money 35 years ago, the biggest single change over that period is that at the beginning of that period there were whole asset classes that people either didn’t know about or didn’t consider seemly, or didn’t’ consider proper, or even asset classes that were against the rules – (inaudible, 16:16) are an example.”

“And 35 years ago or 25 years ago, there were a lot of easier games. Now, we have something called the internet which spreads the information. We have most people who are willing to play in any game and it’s easier to find them, and so easy games have become less easy. That’s the biggest single change. When markets become efficient, we should acknowledge we ignore reality at our own peril.”

 

Second level thinking

“Oil, you would tend to say oil is a necessity of life. They’re not making any more oil. There’s a fixed amount in the ground, we can’t change the amount we take out that rapidly. We can’t change the amount we use that rapidly, so the existence of oil, the supply and the demand, then thus the price should be stable. Then you look at oil prices and they go crazy – up and down, up and down. Somebody sent me a report yesterday on the subject. I haven’t gotten to read it yet, but it was ’99, March 4th, The Economist, 15 years ago. What do you think the prices of oil was? Ten bucks, so the point is in recent years, in the last decade we’ve seen it at $35, we’ve seen it $147. We’ve seen it at $50, we’ve seen it at $110. Now we see it at $45. It’s a crazy thing, it fluctuates like mad. Anyway, #1, it is unstable. If the existence and the supply and the demand are so stable, why should the price be so unstable? I guess it’s priced at the margin, but in part it’s because it’s not a free price. It’s manipulated and sometimes it’s manipulated high and sometimes maybe the manipulators run out of the ability to keep it high, so it falls down and then maybe it falls further than it should because people are disillusioned.”

“The answer is I don’t know. I would tend to think the price of oil is not predictable and if that’s true, then we should acknowledge it and accept it. Now you might say, “I can’t accept that because I have to know because my oil investments and so many other investments are so highly dependent on the price of oil,” and maybe everything’s dependent on the price of oil, but no matter how important it is to know something, if it isn’t knowable, you have to admit it. I’m not here to tell you how to know the price of oil, I’m trying to convince you that maybe you shouldn’t try to know the price of oil. Not Buffet this time, but I always go back to Mark Twain on this subject and Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true.” Strongly held beliefs that turn out to be wrong, well, that’s the main way you lose money in the investment business. If you can’t know something, like in my opinion the price of oil, then you should not bet on it, period.”

“I write in the memo and if you want to see my thinking, go back to a memo in late ’10 called All that Glitters on the subject of gold. I believe assets that do not produce cash flow cannot be priced. Oil doesn’t product cash flow and anything that you might say about oil today in terms of justifying either a price above or below the current level, everything you’re going to say about oil like they’re not making, like that the demand and supply are relative and stable, like that a lot of it is in the hands of countries that are hostile to the interest of the US and so forth, all those things were true when oil was $110. They were true when it was $35 and true at $147 and they’re true today, but how do you turn them into a price? If there’s no methodology for turning the outlook into a price, then it’s not something that you can invest in from a value point of view, so I can’t give you much help on that score. You can gamble on oil, just like I think you can gamble on gold and lots of people do it. You might argue to me that some element of gambling on gold or oil is a reasonable part of a portfolio. Do it if you want, but don’t fool yourself into thinking it’s value investing, in my opinion.”

“The point is when people turn pessimistic on something and it crashes like the price of an E&P company, then maybe an emotionally stable analyst can incorporate a range of prices from – who knows – 20, 30, 40, 50, 60 and say, “At each level, how will this company operate? What will its revenue be? Does it have hedges? What will its expenses be? What will its cash flows be? Will it stop drilling? Does it have to drill to maintain leases?” The point is the answer it analysis and the fact that you can’t know something doesn’t mean you can’t invest in it. You can make a very wide range of assumptions and maybe in theory you can find a company where no matter what you assume for oil prices, they still attract them, but maybe all the other investors have thrown the baby out with the bathwater and it’s selling at an unjustifiably low price or maybe you can say, “Well, I can assign a 10% probability to $10 oil and a 20% probability to $20 oil, 30, 40, 50, 60, 70 and I still find it attractive on balance.””

“If you look at my memo, Risk Revisited, I argued for treating the future as a probability distribution. This business of predicting the price of something is BS. How about predicting what the shape of the distribution of possible prices will look like? What you do is you make a distribution, 10, 20, 30, 40, 50, 60, 70. You assign a probability to each number and let’s say if you think there’s a 10% probability, it’s 10 and a 20% probability is 20 and a 30% probability is 30 and so forth, 30% probability is 40, 40% probability is 50, whatever. It shouldn’t add up to more than 100. Then you model the company under the different prices and then you wait the outcomes by the probabilities and then you come to something called an expected value. You might say, “Well, the expected value is 60 and the price is now 30.” That expected value includes some very unattractive probabilities, possibilities. You say, “I’m going to buy it anyway.””

 

Risk, probability

“The fact that the expected value, given the range of possibly outcomes, is attractive doesn’t mean that the outcome is guaranteed to be attractive because some of those outcomes you’re modelling may be unattractive and have a small, but non-zero probability and they may happen. In which case, you may lose some or all your money. There a professor at the London Business School called Elroy Dimson. He said, “Risk means more things can happen and will happen,” and that’s very important to keep in mind always, but then I turned it around in the memo to say, “Even though many things can happen, only one will.””

“If you accept that the world is a random place, a place full of randomness, then clearly the person who had the highest return last year didn’t necessarily do the best job and one year is a very short time for evaluating results. There are people who do good work, which doesn’t succeed because of randomness. There are people who do bad work, which succeeds because of randomness. Einstein said, “Not everything that counts can be counted and not everything that could be counted counts.” If you believe that, then you wouldn’t do short-term, individually, highly quantitative conversations. Our people don’t have individual balance sheets. Even the people who work on funds where we get a carry, like our distressed debt funds, real estate funds and so forth, everybody gets a share in the profits that everybody produces on the team and we think we get more out of them by encouraging them to have teamwork and help each other and we think that’s the best way to do it.”

“Like any statistical process, it takes a substantial amount of experience to draw a reliable conclusion, so it probably takes at least ten years for somebody reliably to be able to say, “I have superior insight or I don’t.” I think it’s very important that people be honest with themselves and really mark your portfolio of the market at the end of the year and say, “Which of the things that I thought would happen happened? Which of the things I thought would happen didn’t happen? Where was my mistake? Do I really have a superior ability to figure out which companies will succeed, which stocks are inexpensive, which risks are worth taking?” There’s no magic answer, there’s formula.”

“I’m a fan of the Nassim Nicholas Taleb’s book, Fooled by Randomness, which talks about how random the world is. There are people who see the world as there’s a future out there, if only I could predict it. I don’t think the future exists yet. I think there’s lots of potential futures out there and the best any analyst or any investor can do is assemble a probability distribution and have a superior graph for what it holds and that’s what we try to do.”

“I would define reaching for yield or stretching for yield or stretching for return as doing things that go beyond what you normally would do, that are riskier than what you would normally do because you can’t get the kinds of returns that you want and traditionally have gotten in doing the things that you traditionally have done, and especially in doing the things that are of the riskiness that you have traditionally borne.”

“What it means to a fixed income investor, by the way, everything is a little clear cut in fixed income because fixed income is so mathematical, but the lessons, the themes are the same for investors in all asset classes. But anyway, reaching for yield in fixed income means moving out the risk curve, investing in lower quality assets, riskier assets because you can’t get the return you want in assets or the risk you normally have borne.”

“But the point is that eliminating the return on T-bills made the T-bill investor or a high-grade bond investor go into high yield bonds. The high yield bond investor used to get twelve and now can get six, he may want to go further out the risk curve to try to get back to twelve. But it’s very dangerous because you must be aware of the incremental risk you’re taking and it takes you into waters that you may not be familiar with and expert in.”

“On the other hand, I describe the math of bonds, bonds can only produce disappointment. The upside of it is not (inaudible, 28:22), only the downside. What the equity investor can learn from the bond investor is to worry about what can go wrong.”

“Well, I think the only thing you can do is you can review. Look, I’m proud to say I always repeat the fact that the first thing I learned at Wharton 51 years ago was you can’t tell from the outcome whether a decision was a good one or not. Lots of good, well-thought-out decisions fail to work and lots of poor decisions get lucky. You can’t tell from the outcome whether a decision was a good decision. The only thing you can do is go back and review it and review your assumptions.”

“When you go from paying bonds that you expect to pay to non-paying, Chapter 11 candidates, you take on new risks in the pursuit of new returns. Our idea was to do what we call a step out and introduce a new product and let the client pick which they want instead of change the character of the exiting fund or product.”

 

On the business of investing

“What we’ve tried to do is build a business, serious business, which has business aspects that satisfy the client and not just good investment performance. We deal with institutions that want things other than just good performance. They need transparency, they need reliability. They need integrity and all those things. There are people – I call them three guys in a desk – who can just bring in money, sit around the desk, have a mysterious non transparent process and put out a statement every year which says, “We’re up 40%.” They don’t need the other stuff. Probably they won’t get sovereign wealth funds and state funds of the world because they don’t satisfy their need for things like transparency, but they can be quite successful assuming that they really earned 40% when they put out a statement that says they did. I came up the institutional side of the business and I’m used to dealing with pension funds and endowments and sovereign wealth funds and they want other things.”

“The other thing is that it all depends on your personal approach. To me, it’s very important to not only have excellent investing, but also take the high road. I’m proud of Oaktree’s performance, but I’m proud of the fact its financial success has been accomplished on the high road. I guess there are probably some people out there who don’t care that much. We make certain ethical statements in our business principles that probably other people are indifferent to, but we wanted to go that way.”

“Our approach, again, living in the world of the institutional investor, the pension fund or the endowment that does something called asset allocation, we got hired to do high yield. Then when we thought, “Well, maybe distressed would be a good idea,” we thought it would be bad for our business to do distressed in the high yield portfolios because that wasn’t what the client was expecting and that would introduce confusion and it involved different skills, certainly a different risk level. Hopefully, a different return, but the possibility of a lot worse.”

“I think that the outstanding thing that we’ve done on the business side and that has persisted most strongly for the longest period is sticking to the mission. Back in 1978 when I started Citibank’s convertible bond fund, one of my bosses there said to me, “Well, why don’t you put in some common stocks?” I said, “Why would we do that? It’s a convertible bond fund.” He said, “Well, that way you can get higher returns.” I said, “Well, that sounds like a great idea. Then why don’t we put in some oil, some gold and some old master paintings, too?” My approach was always to tell the client what you’re going to do and then do it. I think that if you do that, you eliminate 80% or 90% of dissatisfaction. If you’re not clear about what you’re going to do or you’re clear about what you’re going to do, but you don’t stick to it, then you can to have a lot of problems with that client.”

“To me, we’ve never had a client say, “I was surprised to see in my portfolio. I didn’t think that was what you were going to do.” To me, if the client says that, that’s the death nail. That means you either weren’t clear about what you were going to do or you didn’t stick to it, but if you tell them what you’re going to do and do it, you’ve solved a lot of problems. It happens to be a feature of the institutional world that if you try to do what you said you were going to do and mess up, that’s bad, but if you try something else and mess up, that’s many times worse, if you go outside your territory. Again, by saying what you’ll do and sticking to it, you’ve avoided one of the big problems, reasons for client dissatisfaction.”