323 pages; Rs 699
There is cyclicality in life, as encapsulated in adages like “History does not repeat itself, but it does rhyme” (attributed to Mark Twain) and “What goes up must come down”. The central proposition of Howard Marks’ book is that stock markets, too, tend to be cyclical. Investors cognisant of this phenomenon can position their portfolios in a way that they are able to benefit from it.
Mr Marks is the co-founder of Oaktree Capital Management. The memos he writes for his clients, in which he offers insights on the markets and the economy, are widely read. Perhaps his memos are rivalled in popularity only by Christopher Woods’s “Greed and Fear” reports. Warren Buffett has said that when he receives one of Mr Marks’s memos, he sets everything else aside to read them. Sankaran Naren, chief investment officer of ICICI Prudential Mutual Fund, has acknowledged Marks’ influence on his investment style.
Market valuations tend to fluctuate. Sometimes the markets become excessively expensive and sometimes excessively cheap. Naive investors believe that the markets are uni-directional. When they have been rising for two or three years, they believe they will continue to do so forever. And when the markets have been depressed for a couple of years, they abandon all hope of them ever rising again. The smart investor, on the other hand, understands cyclicality and seeks to profit from it. He invests only when the odds favour him and abstains when they do not. When valuations become expensive, he books
profits and waits for the markets to correct. With this approach, he tilts the odds of success in his favour. Awareness regarding the market's position in the current cycle also enables him to alter his portfolio stance from aggressive to defensive, and vice versa.
Investor psychology is the key contributor to market cycles. When things are going well, investors turn overly confident. Their continuous buying drives the markets up, way beyond rational levels. Similarly, when the environment turns negative, investors turn excessively pessimistic and see nothing but a risk all around.
According to Marks, the smart investor can get a good idea of where the market is positioned in the cycle by gauging investors’ collective attitude towards risk. In bull markets, investors become too risk tolerant. Widespread risk tolerance, he says, is the best harbinger of a subsequent market decline. In such times, the intelligent investor should turn cautious. On the other hand, when the bulk of investors turn excessively risk-averse, and see only possibilities of losses everywhere, the wise investor should enhance his exposure to equities. This is when the risk of further losses becomes minimal and the payoff from bearing risk is the highest. Being contrarian and going against the wisdom of the crowds pays off richly in the markets.
Mr Marks suggests that investors should ask one question when evaluating any investment: How much optimism is already factored into the price? A high level of optimism usually means that favourable future developments have already been priced in and the possibility of further gains are low. But if optimism is low or absent, it is likely that the price is low, expectations are modest, and even a slight turn for the better will result in price appreciation.
Having experienced a market cycle or two, one would imagine that investors would turn wiser. But this does not happen to most. Sometimes, investors begin to believe that this time it is different and the old rules no longer apply. Most investors do not read financial history. American economist John Kenneth Galbraith said that there are few fields of human endeavour in which history counts for so little as the world of finance. Past experiences, he added, are dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. Also, new investors enter the markets who have not experienced previous downturns. They serve as cannon fodder for the next correction.
While market cycles will occur, it is nearly impossible to predict their duration and turning points. So, awareness about cycles needs to be combined with patience.
Indian readers will find the chapter on credit cycles interesting in the light of the recent IL&FS crisis. Those whose money was stuck in the recent downturn will glean useful insights from the chapter on real estate cycles. Among stock investors, fundamentals-based, buy-and-hold investors will especially benefit from the wisdom in this book. An ability to estimate a stock’s intrinsic value correctly, combined with an awareness of market cycles, should provide them with just the edge they need to outperform in a market that is becoming more efficient with each passing day.