Picture the scene. The date was 1955. November 12, 1955 to be precise. And there was a buzz in the air in Hill Valley, California that evening. Goldie Wilson was gaining support for his mayoral campaign. There had been a high-speed car chase around the town square that ended in car being covered in manure. And the local high school was hosting its Enchantment Under the Sea dance. There was a lot to be excited about in Hill Valley. But there were also some signs that there could be a storm on the horizon.
Luckily for Marty McFly and Doc Brown, they had a flyer that helped them know exactly what the future would bring. And they set in motion a plan that ultimately allowed them to navigate through the storm and have a happy ending (albeit with a few minor bumps along the way). They knew that at precisely 10:04 pm, lightning would strike the clock tower and that they could channel the 1.21 gigawatts they needed to power the flux capacitor and send Marty home to 1985 (and to do so without unraveling the very fabric of the space-time continuum).
Now if we put aside the fact that clock towers of 1955 likely didn’t track the second hand and that the space-time continuum is more about gravity than it is time travel, the key to executing this master plan was precise knowledge of the future. The concept of knowledge of future is the subject of Howard Marks’ recent memo titled “Knowledge of the Future” (Howard is the Co-Founder and Co-Chairman of Oaktree Capital Management, which is the largest distressed debt investor in the world). As usual, he doesn’t disappoint.
Before we go any further, let me say that Howard Marks’ memos should be at or near the top of any investor’s regular reading list. His ability to cut through complex topics and to frame them in eloquent yet simple terms is unmatched. This memo is no different.
In this memo, Howard frames the timeless investment challenge of projecting the future but does so through the lens of the current pandemic crisis and prospective recovery. I’ll view Howard’s memo through the lens of Back to the Future. Because, why not, it is a fun movie. To introduce his memo, Howard writes..
I was impressed by the observation of Marc Lipsitch, Harvard epidemiologist, that there are (a) facts, (b) informed extrapolations from analogies to other viruses and (c) opinion or speculation. He said it in connection with the novel coronavirus, but I’ve been thinking about its relevance to investing.
Howard Marks, Knowledge of the future
The title of Howard’s memo, “Knowledge of the Future” is an intentional reference to the eternal paradox that, as investors, we have very little if any knowledge of the future. Investors, unfortunately, don’t have the luxury of having a “save the clock tower flyer” or a Sports Almanac with results of every sporting event over the next 50 years. Instead, investments are often made with hopes that our extrapolations of past patterns may, in time, resemble what comes to pass and that our wagers will seem wise.
In the past, I’ve defined investing as the act of positioning capital so as to profit from future developments. I’ve also mentioned the challenge presented by the fact that there’s no such thing as knowing what future developments will be. This is the paradox we must deal with.
Howard marks, knowledge of the future
In fact, Howard has written at length in his memos about the concept that investing successfully is not about predicting one future outcome. That is an impossible task. Instead it is dependent on understanding that there can be a wide range of potential outcomes (a distribution). And investors should seek to understand how much risk they are assuming for that range of outcomes. There is no such thing as ‘high risk, high reward.’ The fact that something is ‘high risk’ actually means there is a lot of uncertainty around what outcome may occur. To assume the risk of heightened uncertainty of outcome, a prudent investor should require that at least some of those possible outcomes result in high reward. But make no mistake those ‘high reward’ outcomes are uncertain if not unlikely. In fact, it is far more probable statistically speaking that one of the non-high-reward outcomes will occur. That is what makes something high risk. Nobody writes about this paradigm better than Howard Marks.
Going back to Howard’s take on current conditions..
What does the U.S. see today?
– one of the greatest pandemics to reach us since the Spanish Flu of 102 years ago,
– the greatest economic contraction since the Great Depression, which ended 80 years ago,
– the greatest oil-price decline in the OPEC era (and, probably, ever), and
– the greatest central bank/government intervention of all time.
The future for all these things is clearly unknowable. We have no reason to think we know how they’ll operate in the period ahead, how they’ll interact with each other, and what the consequences will be for everything else. In short, it’s my view that if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out.
howard marks, knowledge of the future
In this memo, Howard provides his thoughts on the uncertainty we currently face. He also discusses other topics including the potential shape of a recovery (V-shaped vs. something more drawn out), government stimulus and its long term impact, and interestingly what key questions you can pose to yourself to help evaluate the range of potential paths to recovery. As an aside, I have capture some interesting real-time metrics to monitor using geo-location data.
I won’t spoil the ending of Howard’s memo. You should read it in its entirety. However, since we already know how Back to the Future ends, I will continue with a few final comparisons.
Howard provides a number of open-ended questions around the potential moral hazard of the current 1.21 gigawatts worth of fiscal stimulus and monetary stimulus. After all, the Fed through both its Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) is now buying a “broad and diversified portfolio of corporate bonds” which includes high yield bonds via ETF wrappers.
In Back to the Future speak, could the Fed’s effective backstopping of risk markets ultimately backfire and rip the very fabric of the space-time continuum, causing dire future-altering repercussions? Is this stimulus merely encouraging poor risk-management and rewarding bad behaviors, akin to Old Biff handing Young Biff the Sports Almanac for him to profit from? The indiscriminate buying of risk assets, including non-investment grade debt, could certainly create another market where all ships rise (or continue to rise) on the back of the wave of federal stimulus. In this case, active management isn’t rewarded. However, I believe the nature of this crisis will create a recovery with more dispersion where there will be winners and, unfortunately, losers who cannot adapt to the new normal. Clearly this is some really heavy stuff to ponder.
So what is an investor to do if we cannot know the future? There are a few points to make. First, it is a generalization to say we cannot know the future. After all, we do know the sun will rise and set tomorrow. But that knowledge of the future is not going to yield you much return investment-wise. It is priced-in so to speak. A second point to make is that not knowing the future doesn’t mean one shouldn’t invest. Instead, my point (and Howard’s) is that you should be thoughtful about how you invest, when you invest and over what time frame you will measure your success. There are select investors and managers who have delivered above average returns over long periods of time. They have an edge. I prefer to find managers’ whose edge is a function of active, hands-on intervention in their investments (private equity for example). If these managers have a proven track record of improving the profitability of companies they buy, the remaining question remains one of purchase price, which itself is a byproduct of price discovery and timing. And in an environment of such uncertainty, price discovery is difficult. Therefore, prudence may call for patience. There is no better case example than Warren Buffett, who has chosen patience during this downturn.
The bottom line is that, now more than ever, we should acknowledge that we do not have facts about the future. Therefore, in these most uncertain times we should all proceed with humility about what we know and more importantly about what we do not know. We should measure twice and then cut once. Because if we don’t proceed thoughtfully and if my calculations are correct, when this baby hits 88 mph, we’re gonna see some serious s**t!
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