Winning the Impossible Game

Sometimes, in trying to impress a reader, a writer can create the wrong impression. Howard Marks, the veteran Chairman of Oaktree Capital Management and author of a widely-read client memo, tightly defines an investment philosophy that he's developed over four decades in his book, "The Most Important Thing".

While he strives to show the reader that long-term investment success requires psychological discipline (second-level thinking, as he terms it), in doing so, he re-affirms something the thoughtful investor knows already: it's nearly impossible to sustain outperformance in money management.

Investment managers, we learn, must overcome many common emotions that undermine consistent success: greed, fear, the willingness to suspend disbelief, the tendency to conform to the herd, envy, ego, and capitulation. They function in markets that are neither efficient nor inefficient, and must constantly mitigate risk exposures where they often have no clue what those exposures are.

He argues that, because cycles are unpredictable and the future is unknowable, the best an investor can do is determine where he is at present, in terms of market conditions. But even that realization is often impossible to achieve, especially if, as is usually the case, one or more negative emotions overwhelms an investor's psyche. (By implication, the clear-sighted folks might as well be needles in haystacks.)

What's more, Mr. Marks advocates Nassim Taleb's concept of alternative histories—where events that already transpired are, in fact, just small subsets of events that could have happened. In supporting this view, he dismisses, for example, an investor's great performance if that investor has assumed unnecessary risk, and luckily skirted harmful events.

Taken together, it's a miracle anyone can outperform the market for any length of time at all.

Why, after reading his book, would anyone trust his or her hard-won earnings with any individual or investment group?

To be sure, examples exist of folks who, over decades (the total time a person might buy and sell investment funds), have beaten the market, but you can probably count the number on one—maybe two—hands. Plenty more individuals have excelled over shorter time periods, but their performance showcases a small sample size (a few years) or may feature substantial losses, or both.

In either case (the long- or short-term period of outperformance), the shareholder entering and exiting a fund makes a critical timing decision that can dramatically affect his wealth's appreciation—or depreciation. Take Mr. Marks himself. He won't retain his position at Oaktree indefinitely, and his eventual departure presents considerable uncertainty to whomever purchases his funds today. (The same holds true for folks investing in Berkshire Hathaway and Warren Buffett.)

Past performance, Mr. Marks reminds us, does not guarantee future success. The shareholder, it would seem, could just as well visit the nearest casino, and claim the same chance for wealth improvement.

If investing in a money manager constitutes mostly luck—or a skill for timing (something Mr. Marks dismisses outright)—then why not create a money management operation instead? That career choice has produced vast riches for many, many different people—often far greater wealth than any of their shareholders.

Mr. Marks does not provide a model for building a money management operation. Instead, he delivers something more valuable—a complete investment framework, the operation's core competency and competitive advantage.

While investment groups can experience massive gains over short time periods, enough for its founders to enjoy a long retirement, most should plan for a long haul. Fat fees (management and, for some funds, performance) may not last forever, nor the ease of amassing assets under management—now especially challenging in the aftermath of the 2008 financial crisis.

The Graham-and-Dodd school of value investing, of which Mr. Marks is a disciple, perfectly fits a long-term approach. It produces a manager who applies patience, extreme diligence and a mental commitment to decades of work. The school—its espousal of frugality—doesn't demand that its students invest in costly trading infrastructure, super computers and complex algorithms, or ramp up risk exposure and deploy leverage and concentrated positions. Rather, it endorses in-depth, pound-the-pavement analysis, downside protection and margin of safety.

Farewell the retire-before-forty era. Pity the fool who expects to catch the next massive momentum wave, and trade his way to riches. Fads appear and disappear, back and forth Mr. Marks' pendulum swings, but steady goes the skeptical, value investor.

The long-term manager traverses the slow road of careful, defensive investing. Sexy, no. Successful business-building, yes.

Mr. Marks does not lack confidence. The book's title might well read "Everything I Have to Say is Important"; he manages, with eye-opening assertiveness, to identify each of his key statements as "the most important thing".

Of course, when it comes to money, we tend to use superlatives. And what could be more important than generating wealth-creating returns? We hope lots of things.

The first nineteen chapters explain different lessons he's learned—pearls of wisdom. Throughout the book, he interweaves excerpts from his client memo which he has published since the early 1990s. The twentieth, and final, chapter presents short outtakes from different issues of his memo, and summarizes his philosophy.

Early on, Mr. Marks distinguishes value investing from other investment styles, and cites the infamous Nifty Fifty of the late 60s and early 70s as a stark example of the perils of growth investing and misplaced risk taking. While certainly some of the companies bellied up, not only did many survive, they thrived: Eli Lilly, Coca-Cola, Philip Morris, Hewlett-Packard, Texas Instruments, and Motorola among the names he mentions. Had someone purchased and held on to equal positions in each company, that person today, forty years later, would have done quite well.

Even if Mr. Marks disparages the Nifty Fifty phenomenon, his repeated argument that patience pays is essential wisdom. An investor's career inevitably spans multiple market cycles—often extreme conditions. Confidence in long-term results contradicts our age of escalating portfolio turnover rates. For Mr. Marks and other contrary-minded investors, it's an obvious opportunity.

Finding and investing in a hot-handed fund manager may well be impossible for most people. Many more could opt to play the game themselves. Now, a manual—replete with enough catchy aphorisms to post as quotes-of-the-day for years to come—exists from which to make a business of it.