Marks likens investment sentiment and mood swings of investors to the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.
Investment markets make the same pendulum-like swing:
- between euphoria and depression,
- between celebrating positive developments and obsessing over negatives, and thus
- between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium."
There are two important observations to be made concerning this 'movement'.
- We never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction.
- We can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond). Investors who believed that the pendulum would move in one direction forever -- or, having reached an extreme, would stay there -- are inevitably disappointed.
The ones who make money are the ones who understand this best and use it to their advantage. Marks explains the type of mindset required, which is obvious that it is a skill few investors have the mental discipline to implement. In his book he refers to it as second-level thinking.
The first-level thinker says: “It’s a good company let’s buy the stock.”
The second-level thinker says: "It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
The first-level thinker says: “The outlook calls for low growth and rising inflation. Let’s dump our stocks.”
The second-level thinker says: “The outlook stinks, but everyone else is selling in panic. Buy!”
The first-level thinker says: “I think the company’s earnings will fall; sell.”
The second-level thinker says: “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”
What Marks is trying to get across is that one has to understand how securities are valued and how money is made. If you take a simplistic approach you can’t succeed. Second-level thinking says that you have to think different from and better than the crowd. If you think the same as the crowd you’ll have average results. If you are going to make money to an above average extent, you have to see when the crowd’s thinking is off. By definition, if you think like the crowd you can’t know when the crowd is off.
Neither is it enough to bet against the crowd for the sake of it. That’s stupidity. The potentially profitable recognition of divergences from consensus thinking must be based on reason and analysis. You must do things not just because they're the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.
Marks has built his career on choosing bargains correctly. When talking about timing, he once stated that he doesn’t expect to be able to pick up a stock when it has hit the bottom. What he does care about is buying cheap. If it gets cheaper, he buys more. Eventually, it’ll work out – if his hypothesis is right.
He uses the same contrarian philosophy in his distressed debt fund. After the collapse of Lehman Brothers in September 2008, he went on a shopping spree because he saw an outstanding opportunity to buy bank debt and other securities at distressed prices. (The distressed debt fund he launched at that time did exceedingly well).
- Distressed debt investors almost never invest in companies where everything's going well and investors are enthralled.
- Distressed debt investors rarely invest before the emergence of significant problems.
- Distressed debt investors are in business to buy debt at significant discounts, often from forced or highly motivated sellers. They are bargain hunters whose ardor rises as prices fall...not the reverse like so many other investors.
In an interview with Pensions & Investments, he summed up his company’s mantra as “good company, bad balance sheet,” which is different from a bad company; those can be challenging to turn around. But if you have a good company with the wrong balance sheet, that's easier to fix.
Next: Howards Marks on how to be a smart contrarian