Mastering the Market Cycle is the second (and last) book from Howard Marks, founder of Oaktree Capital Management. This book comes seven years after Marks’ first written work “The Most Important Thing”, which lays out Marks’ investment philosophy and financial wisdom. First of all, a warning for those who read “The Most Important Thing”: this book relies heavily on what was written in the first book and thus might appear repetitive in more than one instance. Moreover, the book draws a lot of examples and concepts from “Fooled by Randomness” by Nicholas Taleb. In my opinion, “Mastering the Market Cycle” is still an interesting read, but its “added value” is greatly reduced if one has already read either “The Most Important Thing” and/or “Fooled by Randomness.”
Mastering the Market Cycle Marks’ investment philosophy can be described as value-oriented, with particular attention to downside risk. One of his cardinal points, which is reiterated more than once in the book, is that “the focus should be on the price of the assets relative to its intrinsic value, rather than on the quality of the asset itself”. This means that, if the investor manages to maintain emotional discipline in face of uncomfortable investments (e.g. distressed securities), he or she can find bargains where other investors refuse to “catch a falling knife”, that is when they are excessively pessimistic towards distressed securities. Indeed, Howard Marks and Bruce Karsh were among the first professional investors in distressed securities in the World with a dedicated investment fund.
“Mastering the Cycle” means taking the “temperature of the market” to understand in which phase of the cycle we are in, rather than predicting future macro developments. Marks is indeed a firm believer in the impossibility of predicting macro development with certainty over time. In the book, Marks identifies various economics cycles which impact financial markets:
The Economic Cycle: the broadest of the cycles, which involve fluctuations in economic output as measured by GDP (with breakdowns in labor and capital inputs), taking into account the influence of short and long-term economic trends and the effects of Central Bank and Government policies.
The Cycle in Profits: the ups and downs of corporate profitability. This cycle differs from the economic cycle (it is more volatile) mainly because of the effects of leverage of business. The leverage here is defined by operating leverage (increase or decrease in operating profits larger than the increase or decrease in sales because of fixed costs and economies of scale) and financial leverage (using a proportion of debt to finance the business vs equity).
The Cycle in Investor Psychology: a favorite of Marks, this cycle describe the mood swings of investors, which tend to go from “very good” to “very bad”, while staying a little time in what Marks called” Happy Medium” in one of his investment Memos to Oaktree clients. For example, the author finds it interesting that while the SP500 returned around 10% on average, the index returned between 8% and 12% only three times in 47 years.
The Credit Cycle: arguably one of the most important cycles, the credit cycle depends on the availability of capital, which grows in expansion times and contracts in recessions. The intuition of Marks as a distressed debt investor here is to step in to provide capital while the credit window is shut, in order to reap outsized risk/reward investments produced by lack of supply of capital. While the credit window is open, providers of capital will bid down returns for a unit of risk, thus paying more and receiving less (“Too much money chasing too few deals”).
The Distressed Debt Cycle: a subset of the credit cycle, this is the cycle in which Howard Marks built his expertise as founder of Oaktree. Distress investment is becoming increasingly popular in recent times but Marks and Karsh were pioneers in the sector at the beginning of the nineties. Again, analyzing companies for their intrinsic value allows the wise distress investor to step in while other providers of capital are fleeing at the bottom of the cycle, thus harvesting assets with outsized risk/return profiles.
The Real Estate Cycle: arguably one of the most important cycles, it has a longer span than other cycles mainly because of the long lead time required for new building development to take place. This long lead time might be counterproductive as new construction starts in expansionary periods but the completed building might be available only when a recession hit. This makes Real Estate a risky business (the nature of which was ignored during the Financial Crisis of 2008). A wise distressed investor would wait for projects to be started and or completed and then buy the assets for low prices from bankrupt over-leveraged developers when a recession strikes.
The bottom line - skepticism is important when things look too good to be true but also when things look too bad to be true. In both cases, the investor must exercise discipline in selecting the right investment and gauging market sentiment, without being caught in the fad of the moment. Another favorite quote of Marks is: “What is wise to do at the beginning, the fool does at the end”. Thus the importance of understanding where we stand in the market cycle at any given time.
Written by: Edoardo Cicchela
Comentarios