These are the notes taken by GuruFocus editor Holly LaFon
from Value Investor Conference in Omaha that is still ongoing
today. - Editor's note.
People are risk averse. It's one of the great fallacies that
riskier assets get better returns. Truth is sometimes risk
premium is appropriate. Sometimes it is inadequate and sometimes
excessive. As you move up the risk, you move up the return. But
in practice, Q2 of 2007, before crisis hit, it looked like this.
Risk was low and return was little. In Q4 08, investors became
highly risk averse. They demanded extremely high amounts of
return. It was a great time to invest. Theory: since markets
price assets fairly, if you buy at market prices you can expect a
"fair" risk-adjusted return. Practice: Buying without
People want more of something at lower prices and less of it at
higher prices. Practice: People tend to warm to investments as
they rise and shun them when they fall. This is one of the
biggest mistakes people make. We can take advantage of it.
At Chicago they talk about efficient markets - markets that don't
make mistakes. We want to find things that are priced wrong. Most
of mistakes come from human failures. Best way to understand, is
by thinking of the pendulum. I write about the pendulum a lot. In
1991 my second memo was that, and I still think it's the most
important thing, along with 20 others. Pendulum always swings
between optimism and pessimism. Risk aversion and tolerance.
Buying too much and selling too much. And it will never stop.
These things will never stop as long as people are involved in
So this fluctuation takes place. Where is the pendulum now? Macro
is in favor now. Everyone wants to predict what political, euro,
all these questions are about, which we can't know anything. But
we can know something about the operation of the pendulum. My
mother used to talk about happy medium. I should balance fear and
greed, optimism and pessimism. The happy medium is rarely seen.
Usually the market is going to or just back from an extreme. It
is a much better way to think of the market. It is caused by the
errors of the herd. Again, profit opportunity.
Think about a bull market cycle. I use adages and quotes because
people were wiser before I got here. In 1973 three stages of bull
market: people believe things will get better, most believe it
has gotten better, and third when everyone thinks things will
stay good forever.
You want to buy at first and sell at third.
It is very important that realize that there aren't safe or risky
things to buy. There aren't safe or risky investment strategies.
They are safe in phase one, and risky in phase three. The
greatest of all is what the wise man does in the beginning the
fool does in the end. Every trend eventually becomes overdone.
Why? In beginning only wise man finds it, and it works. They see
it and are attracted to it and until the last fool buys it at a
high price and loses a lot of money. You have to be conscious of
where we are in the cycle.
Other than buying securities one at a time, most important
question is whether to be on offense or defense, or how much of
each. That decision should be informed based on where we are
based on three stages of bull market. Or bear market.
stage one: few people realize things are overpriced and going to
fall; stage two: most people believe they are falling; stage
three: everyone thinks they are gong to fall forever and you'll
never make a dime. People then want out. Because they extrapolate
and think things will only get worse. If you could only ask one
question of every stock, it should be: how much optimism is there
in the price? Do people love it or hate it? Want to buy things
they hate and sell things they love and can only get better. The
truth is somewhere in between.
Human Failings: Few people are able to act in a contrarian
fashion relative to these market cycles. But it is essential...
Charlie Munger: "This stuff is not easy, and people who think it
is are stupid."
We must be contrarian, but I don't want to suggest that it is
Dave Swensen wrote a book about 14 years ago called "Pioneering
Portfolio Management." Great quote: "Establishing and maintaining
an unconventional investment profile requires acceptance of
uncomfortably idiosyncratic portfolios, which frequently appear
downright imprudent in the eyes of conventional wisdom." The
things they're doing appear to work for a while. You are going to
look wrong and feel wrong.
being too far ahead of your time is indistinguishable from being
wrong. And we all know what they feel like. And being wrong is
not pleasant. And being able to hang on is very challenging.
In order for the extremes of bubbles and challenges to take
place, investor memory has to fail. Galbraith: Contributing to...
euphoria are two further factors little noted in our time or in
past times. The first is the extreme brevity of the financial
Memory, and the result prudence, always come out the lower when
pitted against greed. When you see the devil on a guys shoulder,
says you should buy it because you'll get rich. The angel says
don't buy it, there are very good reasons not to. And the devil
wins. Madoff investors engaged in willing suspension of belief.
People fell for it.
Cyclical vs. anti-cyclical behavior. In typical upcycle, economic
indicators doing well, increasing earnings, investor's returns
are good, assets appreciate, riskier approaches outperform,
leverage adds to gains and the capital markets eagerly provide
financing. What are the human effects of all these things? People
become more enthusiastic. As things get higher, they want to buy
more. This is not right. We must do the opposite. But again, it's
Knowledge of the future: overestimating what you know about the
future introduces great risk. I am not talking about making
predictions of company earnings. Must figure out what companies
will earn in the future, whether will be successful or
unsuccessful. On micro level, that's what I call trying to know
the knowable. When you get into the macro, the economy, markets -
it's very difficult and overestimating can risk. I have more
quotes on this than any other.
Nothing scary about saying I don't know. Scary is saying I know
and I'm wrong. After this meeting I have to drive to Lincoln. If
I say I don't know how to go, get a map, I use GPS, ask
directions and go slowly. But if I think I know the way, I don't
ask directions and drive fast and if turns out I don't know the
way, I may end up in Trenton before I get to Lincoln. Not knowing
something is not fatal to an investor. Very dangerous.
That led me to talk about people in the I know school vs. people
in the I don't know school. I wrote a memo on this. I know
school: confident in its foreknowledge. I don't know school is
skeptical. Invests for one outcome, concentrate, lever heavily,
target maximum gains: I know school. Target maximum gains. I
don't know, like myself, school: hedge against uncertainty,
diversify, avoid or limit leverage, avoids losses. Avoiding
losses is at least as important as achieving gains. If we avoid
the lowers, the winners take care of themselves: Oaktree motto.
For a stock portfolio the promised return on stocks is not high,
to have a good outcome you have to have some good ones, not
adequate to just avoid losers, but having high emphasis on
avoiding losers is very important.
Most people think in terms of the average or the norm and ignore
the outliers. Don't give enough allowance. Single scenario
investing - the difficulty of seeing future events as the range
of possibilities. When people think of the future as one thing I
get turned off. There is never one future. There are always many
futures. L Roy Demptom: Risk means more things can happen than
will happen. The variability of outcomes.
Must view the future at best as a range of possibilities.
Smartest investors are who understand the probability.
Even when you know exactly the probability distribution, it's
different from saying you know what's going to happen: if you
take one thing away. Investing consists of one thing: dealing
with the future. We decide how to invest our money based on what
we think we will return, yet I feel the future is not knowable.
We have to wrestle with this conundrum. That's what the book is
Things that are supposed to happen fail all the time. Things that
are improbable happen all the time. This tells us what dealing
with the future is like.
I told you about my favorite adage. Wise man and third adage.
Second adage: never forget the six foot tall man who drowned
crossing the stream that was five feet deep on average. When
people fixate on one outcome, they can be fatally wrong. Every
time we go through a crash, we see the failure of investors and
entities that were set up for good outcome. And it's obvious in
investing it's not sufficient to survive on average, have to
survive everything. Which means that we have to survive the worst
case. Highly levered investors hit a bad patch, out, once they're
out they never get to recover. You never enjoy the recovery. Must
survive on the bad days.
In particular (this slide focuses on black swans, the title of a
book by Talib. First book called fooled by randomness. Oh lots of
hands. I know I'm among friends. Your experience when you read
it, most important badly written book you'll ever read or... very
challenging book. Deal with the world is uncertainty, future is a
distribution of possibilities and randomness plays a great roll
in which outcome happens.) Most investors ignore the possibility
of extreme outcomes, so called black swans."
What he called black swans I call the improbable disaster. The
events of 08. Do you have lived through 08? Have your portfolio
been set up so that if you lived through 08 you would do okay? By
definition, if you say I must be prepared for a repeat of 08, you
can never participate in the market. People talk about the worst
case - well it can always get worse. Many who thought they
prepared for the worst got played out. How much planning should
you do for the worst case?
One of messages of Taleb is short term success and short term are
imposters. Tell you very little about dependability of an
investor. Rudyard Kipling knows twin imposters, success and
failure. It is important not to fixate on short-term results.
Given randomness in markets, tell you nothing about what's really
about the underlying process. I've seen people get famous for
being right once in a row. If you think about randomness, in a
system governed by randomness, anything can happen and anyone can
be right in regard to anything. Can't prove that person is a
leader or genius or has a reliable process, the key word being
The twin imposters: non-appreciation of "alternative histories"
the difficulty of seeing past events as the range of possible
things that could have happened and thus the reduced significance
of what actually did happen. I said in a memo, Amarant's problems
didn't start in 06 when it melted down. Its problems started in
05 when it was up 100 percent. Most people don't see their
statement up 100% and say oh no, I'm screwed here, what is this
person doing? They send in more. Market timing is much worse than
buy and hold. You have to appreciate the alternative. What
happened wasn't important thing, but what could have happened.
The difficulty of getting timing right - "should" isn't the same
as "will." It's hard to do the right thing in the investing
world, and impossible to do the right thing at the right time. No
one should work under the assumption that they're going to get
the time right. If you have bet too much on what should happen
happening right away, you could be in big trouble.
The pitfalls of investment bureaucracy:
"active management strategies demand uninstitutional behavior
from institutions, creating a paradox that few can unravel." -
. Marriage is a wonderful institution, for people who like living
Most institutions in my opinion expend effort for the purpose of
avoiding embarrassment, and thus over diversify. We would never
do enough of something so that if I made a mistake I would look
wrong. But corollary is true too. That's why investing in an
institutional setting interferes with great investing. I once
wrote a memo "dare to be great," do you dare to be great? And if
you do, you run the risk of being wrong and being embarrassed.
You can't have it both ways.
In many ways, the forces that influence investors push them
toward mistakes: investing in things with obvious appeal, that
are easily understood, that are popular, that have been doing
well. All apply to the herd and imply elevated prices, limited
return potential and substantial risk. Try to find the bargain
among those, very very hard. Real bargain usually found in the
things people will not do.
Imprudent, unwise, undesirable - that's where you find the
What could be more unseemly than investing in bankrupt companies?
Well guess what, you can find a lot of bargains there. We've
never had a fund that didn't make 10%.
Smart investing doesn't consist of buying good things, but rather
of buying things well. Price is what matters most for investment
To sum up: the efficient market hypothesis tells us that the
market operates smoothly to incorporate information into prices,
so that no individual can consistently do much better. In fact
"inefficiencies" the investing crowd's mistakes - arise all the
time and are the superior investors raise d'etre.
At the extremes, when the actions of the crowd create bubbles and
crises, the mistakes of others create...
Our approach has always been based on understanding and
controlling risk, insistence on consistency, involvement in
less-efficient markets only, high degree of investment
specialization, no reliance on marco-economic projection, no
raising of cash for purposes of market timing
The common thread running through the tenets of the philosophy is
the recognition of and respect for the limitations imposed by
Question: over the years, how do you continue to become a
better investor, do you learn more from mistakes or
What I have learned through time is to observe what's going on
around in terms of investor behavior and market and act
accordingly. And to see the upward swing of the pendulum which
carries so much enthusiasm as worrisome and the downward swing
encouraging. Buffett favorite quote is the less prudence with
which people conduct their affairs the greater prudence with
which we should conduct ours. I've learned to do that.
Q: Specifically, what investments do you like most, as of
Specifically I'm not going to tell you [laughter]. But most
things are in favor today. But in favor rarely gives you the best
bargains, and things out of favor have bargains include shipping,
Europe, real estate. US commercial real estate. Trouble is always
the first person to think about it and neither have I, people are
lined up. REITs are lined up for income. People exited bonds and
looked elsewhere for yield and did REITs. Not a formula for
success but a place to look.
Q: Not to put on spot, but on cycles couldn't wait to
read your next book, but what state of the cycle are we
People ask me a lot because after Lehman brothers people asked
what are we in. Today we are probably in sixth or seventh inning.
Think of the three stages of cycle, I think we're not in the
bottom third, not at cyclical peak in most asset classes,
certainly not the stock market. Around the middle but if I had to
say, above the midline. I put out a memo called "pros and cons of
equities" and they are distributed on both sides of the equation.
Profits are high, but margins are unsustainably high. Pe ratio is
average but maybe should be below average because growth outlook
is not as good for next 10 years as last 50 years. So both sides.
Move forward but with caution.
Q: In fixed income world, view on analogy to 1994 and
today and how Oaktree is positioned.
We're investing in high yield bonds and least seedy thing we do
[laughter]. Average high yield bond, if went up 200 basis points,
even if interest rates rise, were at 2% a year. But we're at the
lowest interest rate in history. Can't get much lower; they can
get a lot higher.
When you rent a video some videos allow you to pick an ending. If
you buy 10 year at 1.7%, which is the good ending? Answer is good
investment ONLY if we have depression, inflation or calamity. All
three are by definition hard to predict. Not impossible. But
One of the things I always try to do is to try to figure out what
is the available mistake today and don't make it. Hard to figure
out a stroke of genius, but help if you say what is the big
mistake today, is probably long treasuries, or any treasuries at
all. Jeff Gundblack had interesting insight to bond world: bond
investor looks back at opps a year ago and wishes they had made
those investments. And in a year. But, if not buying today is a
mistake, hard to believe it's a huge mistake. Might be a little
mistake. Could you get out five years and say oh I really should
have bought that 10-year at 1.7. I really don't think anyone's
gonna slit their wrist over that.
Q: Good to buy when everyone is down and sell when
Japen in 1990 and us in early 30 and everything selling and if
you buy you would lose a lot of money. In 88 Japan hit a high and
everyone sell and would have lost money for next 22 years. How do
you avoid that and the answer is - you can't. there is no correct
rule. There can't be a rule that always works. Is true that if I
say buy when people are selling there will be times that cause
you to lose money. Nothing reliable to be said about making
money, because if there were, study would be intense and
everybody with a positive IQ would be rich.
Q: How square momentum strategies that outperform, there
is work that supports that view.
A: I haven't seen that work and I'm very strong in my believes so
I probably wouldn't read it. Probably a matter of time frame.
Hard to believe that buying things that have gone up a lot is the
best way to make money over 10 years. None of us can be
successful in any activity if we don't believe in it.
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