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Howard Marks Memos Review

January 19, 2020

Over the course of Marks’ career, he has publicly published over 100 memos written to his institutional investment clients. Howard loves to take the temperature of the market and give his take on current events. While I greatly enjoy his commentary, I was really looking for Howard to impart his investing philosophy and secrets so one day I could be super-rich and own a 30-room apartment on the Upper East Side like Howard (just kidding – I’d be fine with a two bedroom in Chelsea). Nonetheless, in between Howard’s insightful commentary on current events, he managed to slip in profound investing advice that I will attempt to distill here. But first, I would like to put forth a list of Howard’s most educational memos (in chronological order):

  1. Microeconomics – 10/8/92
  2. Risk in Today’s Markets Revisited – 11/4/94
  3. How the Game Should Be Played – 5/26/95
  4. Safety First… But Where? – 4/10/01
  5. The Most Important Thing – 7/1/03
  6. Risk and Return Today – 10/27/04
  7. There They Go Again – 5/6/05
  8. Risk – 1/19/06
  9. You Can’t Eat IRR – 7/12/06
  10. It’s All Good – 7/16/07
  11. Whodunit – 2/20/08
  12. How Quickly They Forget – 5/25/11
  13. What Can We Do for You? – 1/10/12
  14. Déjà Vu All Over Again – 3/19/12
  15. It’s All a Big Mistake – 6/20/12
  16. Dare to Be Great II – 4/8/14
  17. Risk Revisited – 9/3/14
  18. Risk Revisited Again – 6/8/15

I believe it is important to read Marks’ memos in chronological order regardless of whether or not you are preparing to embark on a journey to read every single one or just the highlights I recommended above. Chronological order is pedagogical because it allows you to feelMarks’ thoughts throughout the various economic cycles which he has successfully navigated. Understanding investor psychology and how it affects the markets at every phase of an economic cycle is one of Marks’ most persistent lessons.

You may have noticed I didn’t save any memos from 2009 or 2010. These years are characterized by risk aversion and low asset prices. Marks’ may have been too busy buying everything at a discount to write memorable memos, or he prefers writing heedful memos rebuking market exuberance.

In these memos, Marks’ asks you to think deeper about second order effects of actions relating to the market and other topics such as internal rate of return and taxes. However, Marks’ focus is on proving the fact that most markets are relatively efficient, making it extremely difficult to generate alpha, or outsized, risk-adjusted returns (keep this in mind the next time someone tells you they made 25% return on their stock portfolio last year when the market only went up by 8%). I wrote a fair amount about the efficient market hypothesis in my very first memo: Quality Asset ¹Quality Investment.

Howard Marks’ and I share a favorite topic, which is risk. As you can see from his writings, Marks’ places much emphasis on risk and more importantly, has somewhat of a unique perspective on it. Rewinding a bit, when I first began exploring investing, I was fascinated by risk. Risk is omnipresent in everything you do and although the word carries negative connotations, risk is not necessarily a bad thing. Additionally, risk comes in many forms, some more pernicious than others. For example, an interesting risk to examine is opportunity cost. Choosing one thing over another bears the risk of missing out on the choice not taken. While reading about finance and investment, I began seeing measures of risk and explanations that volatility is the measure of risk. Once complex formulas are overlaid this idea, the simple, yet striking inconsistency becomes shrouded. I didn’t feel quite comfortable accepting the notion that risk equals volatility. If you study modern finance theory, you are taught that you can measure a stock’s risk by calculating its standard deviation or similar measures (Sharpe ratio, Sortino ratio, etc.). However, the problem with any of these measures is (1) these calculations are performed on historical figures, (2) the result of an event does not prove out the risk, (3) standard deviation is a symmetrical measurement, and (4) they do not consider your exit strategy. As you can see I have a difficult time accepting these notions. One reason volatility is not very helpful is it does not provide any meaningful insight into the real risk of an investment which is first, foremost and ALWAYS: a permanent loss of capital. As real estate investors, we enjoy the benefit of not being marked to market every second which means paper losses are not staring you in the face constantly. Additionally, real estate is an income producing investment which means the value of the asset could potentially be volatile while the cash flows of the underlying asset are stable. A great example of volatility being almost worthless is that Blackstone, the world’s largest owner of real estate, bought Hilton Hotels at the exact worst time, Q4 of 2007. Shortly after their acquisition, Blackstone had to mark down the investment’s value by 70% – that’s some crazy volatility! However, Blackstone had bought a fundamentally strong asset, a strong plan to improve the operations and increase intrinsic value, and importantly, did not have a need for liquidity. An important point to note: A strong way to combat volatility and illiquidity risk is by simply not needing liquidity. To prove this, 11 years later, Blackstone exited Hilton as the most profitable real estate investment of all time.

Now back to risk. I eschewed standard deviation and historical measures of risk and began searching for the truth. In my mind I thought there had to be a way to quantify the real risk of permanent loss and build that into my financial models. One day, I stumbled upon Howard Marks and began studying his philosophy. While I didn’t find my ideal, statistical measure of risk, I did find a billionaire investment professional who also felt that volatility was a terrible proxy for risk. Marks’ put into words my incipient thoughts about risk. Marks claimed that his investors aren’t ever concerned about how volatile something is, but instead whether they will lose money!

Furthermore, Howard, a big fan of Nassim Nicholas Taleb and his book Fooled by Randomness, which explains that the outcome of an event does not necessarily prove the probability of something being accurate. A simple example, is a weatherman right or wrong if he or she predicted a 45% chance of rain and it rains? You could say no because he or she predicted less than 50% chance of rain but is that really helpful? To complicate things, who is more accurate a weatherman that predicted 45% of rain or 35% chance of rain on a rainy day? You see, Marks and Taleb both believe that the result of a decision is not necessarily a strong indicator whether the decision was good at the time it was made. The role of luck or randomness has a significant impact on everything we do and must be accounted for in investing via a margin of safety, coined by Ben Graham and made popular by Warren Buffet.

Another interesting topic Howard Mark’s brings up in his memos is his stance on income producing assets versus non-income producing assets. Marks’ claims that non-income producing assets (barrels of oil, art, or international skimmed milk powder) are extremely difficult to value on an intrinsic basis and thus he will never invest in them. Discounted cash flow models or even forward relative valuation are impossible to perform on non-income producing assets because there are no future cash flows to discount back to the present value. These ideas helped focus me and turn me into an income producing asset investor (this, of course, is not the only reason – I’d like to one day live off of the cash flows generated passively from my investments).