My favorite bits from Howard Mark's Dec 18 2014 memo : Lessons of Oil

Despite my protestations that I don’t know any more than others about future macro events – people insist on asking me about the future. Over the last eighteen months , most of the macro questions I’ve gotten have been about whether the Fed would move to increase interest rates, and particularly when.

Since mid-2013, the near-unanimous consensus has been that rates would rise. And, of course, the yield on the 10-year Treasury has fallen from roughly 3% at that time to 2.2% today. I mention it to provide a reminder that what “everyone knows” is usually unhelpful at best and wrong at worst.

• Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing. In short, while everyone was asking whether the rate rise would begin in December 2014 or April 2015 (or might it be June?) – in response to which I consistently asked why the answer matters and how it might alter investment decisions – few people I know were talking about whether the price of oil was in for a significant change.

-I included “$100 oil” (since a barrel was selling in the $70s at the time) and ended with “the things I haven’t thought of.” I suggested that it’s usually that last category – the things that haven’t been considered – we should worry about most. Asset prices are often set to allow for the risks people are aware of. It’s the ones they haven’t thought of that can knock the market for a loop.

• In my book The Most Important Thing, I mentioned something I call “the failure of imagination.” I defined it as “either being unable to conceive of the full range of possible outcomes or not understanding the consequences of the more extreme occurrences.” Both aspects of the definition apply here.

The usual starting point for forecasting something is its current level. Most forecasts extrapolate, perhaps making modest adjustments up or down. In other words, most forecasting is done incrementally, and few predictors contemplate order-of-magnitude changes. Thus I imagine that with Brent crude around $110 six months ago, the bulls were probably predicting $115 or $120 and the bears $105 or $100. Forecasters usually stick too closely to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude. Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months.

Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand.

.

As a side note, it’s interesting to observe that growth in China already was widely understood to be slowing, but perhaps that recognition never made its way into the views on oil of those present at Byron’s lunches. This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis.

• Turning to the second aspect of “the failure of imagination” and going beyond the inability of most people to imagine extreme outcomes, the current situation with oil also illustrates how difficult it is to understand the full range of potential ramifications. Most people easily grasp the immediate impact of developments, but few understand the “second-order” consequences . . . as well as the third and fourth. When these latter factors come to be reflected in asset prices, this is often referred to as “contagion.” Everyone knew in 2007 that the sub-prime crisis would affect mortgage-backed securities and homebuilders, but it took until 2008 for them to worry equally about banks and the rest of the economy.

The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:

• Lower prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficits to rise.
• There’s a drop in the amounts sent abroad to purchase oil by oil-importing nations like the U.S., China, Japan and the United Kingdom.
• Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.
• Investment in oil drilling declines, causing the earnings of oil services companies to shrink, along with employment in the industry.
• Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.
• Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries.
• With the cost of driving lower, people buy bigger cars – perhaps sooner than they otherwise would have – benefitting the auto companies. They also keep buying gasoline-powered cars, slowing the trend toward alternatives, to the benefit of the oil industry.
• Likewise, increased travel stimulates airlines to order more planes – a plus for the aerospace companies – but at the same time the incentives decline to replace older planes.
• By causing the demand for oil services to decline, reduced drilling leads the service companies to bid lower for business. This improves the economics of drilling and thus helps the oil companies.
• Ultimately, if things get bad enough for oil companies and oil service companies, banks and other lenders can be affected by their holdings of bad loans.

• Further, it’s hard for most people to understand the self-correcting aspects of economic events.

• A decline in the price of gasoline induces people to drive more, increasing the demand for oil.
• A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.
• A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices.

In all these ways, lower prices either increase the demand for oil or reduce the supply, causing the price of oil to rise (all else being equal). In other words, lower oil prices – in and of themselves – eventually make for higher oil prices. This illustrates the dynamic nature of economics.

• Finally, in addition to the logical but often hard-to-anticipate second-order consequences or knock-on effects, negative developments often morph in illogical ways. Thus, in response to cascading oil prices, “I’m going to sell out of emerging markets that rely on oil exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper oil.

In part the emotional reaction to negative developments is the product of surprise and disillusionment. Part of this may stem from investors’ inability to understand the “fault lines” that run through their portfolios. Investors knew changes in oil prices would affect oil companies, oil services companies, airlines and autos. But they may not have anticipated the effects on currencies, emerging markets and below-investment grade credit broadly. Among other things, they rarely understand that capital withdrawals and the resulting need for liquidity can lead to urgent selling of assets that are completely unrelated to oil. People often fail to perceive that these fault lines exist, and that contagion can reach as far as it does. And then, when that happens, investors turn out to be unprepared, both intellectually and emotionally.

A grain of truth underlies most big up and down moves in asset prices. Not just “oil’s in oversupply” today, but also “the Internet will change the world” and “mortgage debt has historically been safe.” Psychology and herd behavior make prices move too far in response to those underlying grains of truth, causing bubbles and crashes, but also leading to opportunities to make great sales of overpriced assets on the rise and bargain purchases in the subsequent fall. If you think markets are logical and investors are objective and unemotional, you’re in for a lot of surprises. In tough times, investors often fail to apply discipline and discernment; psychology takes over from fundamentals; and “all correlations go to one,” as things that should be distinguished from each other aren’t.

• Energy is a very significant part of the high yield bond market. In fact, it is the largest sector today (having taken over from media/telecom, which has traditionally been the largest). This is the case because the exploration industry is highly capital-intensive, and the high yield bond market has been the‎ easiest place to raise capital. The knock-on effects of a precipitous fall in bond prices in the biggest sector in the high yield bond market are potentially substantial: outflows of capital, and mutual fund and ETF selling. It would be great for opportunistic buyers if the selling gets to sectors that are fundamentally in fine shape . . . because a number of them are. And, in fact, low oil prices can even make them better.
• An imperfect analogy might be instructive: capital market conditions for energy-related assets today are not unlike what we saw in the telecom sector in 2002. As in telecom, you’ve had the confluence of really cheap financing, innovative technology, and prices for the product that were quite stable for a good while. [To this list of contributing factors, I would add the not-uncommon myth of perpetually escalating demand for a product.] These conditions resulted in the creation of an oversupply of capacity in oil, leading to a downdraft. It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general “contagion.”
• Selling has been reasonably indiscriminate and panicky (much like telecom in 2002) as managers have realized (too late) how overexposed they are to the energy sector. Trading desks do not have sufficient capital to make markets, and thus price swings have been predictably volatile. The oil selloff has also caused deterioration in emerging market fundamentals and may force spreads to gap out there. This ultimately may create a feedback loop that results in contagion to high yield bonds generally.

• Over the last year or so, while continuing to feel that U.S. economic growth will be slow and unsteady in the next year or two, I came to the conclusion that any surprises were most likely to be to the upside. And my best candidate for a favorable development has been the possibility that the U.S. would sharply increase its production of oil and gas. This would make the U.S. oil-independent, making it a net exporter of oil and giving it a cost advantage in energy – based on cheap production from fracking and shale – and thus a cost advantage in manufacturing. Now, the availability of cheap oil all around the world threatens those advantages. So much for macro forecasting!

• There’s a great deal to be said about the price change itself. A well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.” I don’t know if many people were thinking about whether the price of oil would change, but the decline of 40%-plus must have happened much faster than anyone thought possible.

• “Everyone knows” (now!) that the demand for oil turned soft (due to sluggish economic growth, increased fuel efficiency and the emergence of alternatives) at the same time that the supply was increasing (as new sources came on stream). Equally, everyone knows that lower demand and higher supply imply lower prices. Yet it seems few people recognized the ability of these changes to alter the price of oil. 

A price that’s kept aloft by the operation of a cartel is, by definition, higher than it would be based on supply and demand alone. Maybe the thing that matters is how far the cartelized price is from the free-market price; the bigger the gap, the shorter the period for which the cartel will be able to maintain control. Initially a cartel or a few of its members may be willing to bear pain to support the price by limiting production even while others produce full-out. But there may come a time when the pain becomes unacceptable and the price supporters quit. The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever. Maybe we’ve just proved that this extends to the effectiveness of cartels.

• Anyway, on the base of 93 million barrels a day of world oil use, some softness in consumption combined with an increase in production to cut the price by more than 40% in just a few months. What this proves – about most things – is that to Dornbusch’s quote above we should append the words “. . . and they go much further than you thought they could.”

The extent of the price decline seems much greater than the changes in supply and demand would call for. Perhaps to understand it you have to factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the oil market by cutting production, after having done so for many years, and (b) a large contribution to the decline on the part of psychology

The price of oil thus may have gone from too high (supported by OPEC and by Saudi Arabia in particular) to too low (depressed by negative psychology). It seems to me with regard to the latter that the price fell too far for some market participants to maintain their equanimity. I often imagine participants’ internal dialogues. At $110, I picture them saying, “I’ll buy like mad if it ever gets to $100.” Because of the way investor psychology works, at $90 they may say, “If it falls to $70, I’ll give serious thought to buying.” But at $60 the tendency is to say, “It’s a falling knife and there’s no way to know where it’ll stop; I wouldn’t touch it at any price.”

But it’s usually smarter to buy after they’ve fallen for a while.

• I said it about gold in All That Glitters (November 2010), and it’s equally relevant to oil: it’s hard to analytically put a price on an asset that doesn’t produce income. In principle, a non- perishable commodity won’t be priced below the variable production cost of the highest-cost producer whose output is needed to satisfy total demand. It’s clear that today’s oil price is well below that standard.

It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was it too high at $100-plus, an unsustainable blip? History says no: it was there for 43 consecutive months through this past August. And if it wasn’t too high then, isn’t it laughably low today? The answer is that you just can’t say. . And if you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil.

 Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure. Especially given the pervasive role of energy in economic life, uncertainty about oil introduces uncertainty into many aspects of investing.

“Value investing” is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future. But you can’t assess present value without taking some position on what the future holds, even if it’s only assuming a continuation of present conditions or perhaps – for the sake of conservatism – a considerably lower level. Recent events cast doubt on the ability to safely take any position.

One of the things that’s central to risk-conscious value investing is ascertaining the presence of a generous cushion in terms of “margin of safety.” This margin comes from conviction that conditions will be stable, financial performance is predictable, and/or an entry price is low relative to the asset’s intrinsic value. But when something as central as oil is totally up for grabs, as investors seem to think is the case today, it’s hard to know whether you have an adequate margin.

On the other hand –  high levels of confidence, complacency and composure on the part of investors have in good measure given way to disarray and doubt, making many markets much more to our liking. For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion. This paragraph describes a process through which investors are made to feel pain, but also one that makes markets much safer and potentially more bargain-laden.

In particular with regard to the distress cycle, confident and optimistic credit markets permit the unwise extension of credit to borrowers who are undeserving but allowed to become overlevered nevertheless. Negative subsequent developments can render providers of capital less confident, making the capital market less accommodative. This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt

But we knew great buying opportunities wouldn’t arrive until a negative “igniter” caused the tide to go out, exposing the debt’s weaknesses. The current oil crisis is an example of something with the potential to grow into that role. We’ll see how far it goes.

For the last 3½ years, Oaktree’s mantra has been “move forward, but with caution.” For the first time in that span, with the arrival of some disarray and heightened risk aversion, events tell us it’s appropriate to drop some of our caution and substitute a degree of aggressiveness.

My favorite quotes from Howard Marks book (some paraphrasing):

* Pg 16
In the end, I've come to an interesting resolution: Efficiency is not so universal that we should give up on superior performance. Efficiency should be presume to be true until someone proves otherwise.
Respect for efficiency says we should ask some questions before we embark on a course of action:
   -Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that's too cheap?
-If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
-Why would the seller be willing to part with it at a price from which it will give you an excessive return?
-Do you really know more about the asset than the seller does?
-Why aren't others snapping it up?

*Pg 26
Like participants in any field requiring the application of skill under challenging circumstances, superior investor's batting averages will be well below 1.000 and marked by errors and slumps. Judgements that prove correct don't necessarily do so promptly, so even the best investors look wrong a lot of the time. "Being too far ahead of your time is indistinguishable from being wrong"

*Pg 27
Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time.

*Pg 30
Hopefully, if I offered to sell you my car, you'd ask the price before saying yes or no. Deciding on an investment without carefully considering the fairness of its price is just as silly.

*Pg 31
At Oaktree we say, "Well bought is half sold". If your estimate of intrinsic value is correct, over time as asset's price should converge with its value.
What are the companies worth? Eventually this is what it comes down to. Its not enough to buy a share in a good idea. You must buy it at a reasonable (or, hopefully a bargain) price.

*pg 32
Most nonprofessionals know little about technicals. These are nonfundamental factors that affect supply and demand for securities. e.g. Levered investors receive margin calls and the inflows of cash into mutual funds that require portfolio managers to buy. (Mine: adding and dropping to indexes/ETFs, year end tax selling). People are forced to enter into securities transactions without much regard for price.

*Pg 32
Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship lies largely in insight into other investors' minds. Investor psychology can cause a security to be priced just about anywhere in the short run regardless of its fundamentals.

*Pg 33
The discipline that is most important is not accounting or economics, but psychology.
The key is who likes this investment now and who doesn't. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future.
Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.

The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price can only go one way: up.

*Pg 38
Buying cheap is clearly the most reliable. Even that however, isn't sure to work. You can be wrong about the current value. Or events can come along that reduce value.
Trying to buy below value isn't infallible, but its the best chance we have.

*Pg 39
Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

*Pg 47
First, risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset - a less than stellar company's stock, a speculative-grade bond or a building in the wrong part of town can make for a very successful investment if bought at a low-enough price.

*pg. 52

Understanding uncertainty: We mustn't think of the future in terms of a single result but rather as as a range of possibilities. We must think of the full range, not just the ones that are most likely to materialise.

*pg. 53

Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often leads excessive authority to statements that should be taken with a grain of salt. 

*pg. 54

A portfolio can be set up to withstand 99 percent of all scenarios but succumb because its the remaining 1 percent that materialises. Based on the outcome, it may seem to have been risky, whereas the investor might have been quite cautious.

*pg. 55

Investment risk is largely invisible before the fact.

We hear a lot about the worst case projections, but they often turn out not to have been negative enough. I tell my father's story of the gambler who lost regularly. One day he heard about a race with just one horse in it, so he bet his rent money. Halfway around the track, the horse jumped over the fence and ran away.

Invariably things can get worse than people expect.

*pg. 58

High risk primarily comes from high prices.

*pg. 59

When investors are unworried and risk-tolerant, they buy stocks at high price/earnings ratios and private companies at high multiples of EBITDA(cash flow), and they pile into bonds despite narrow yield spreads and into real estate at minimal "cap rates" (the ratio of net operating income to price)

There are few things as risky as the widespread belief that there's no risk.

The riskiest things: A few times in my career, I've seen the rise of a belief that risk has been banished, cycles won't occur any longer, or the laws of economics have been suspended. The experienced, risk-conscious investor takes this as a sign of great danger.

* pg. 64

Market line:

 In increasing order of risk:

Money market 4%

5 yr. treasuries 5%

10 yr. treasuries 6%

High grade bonds 8%

S&P stocks 10%

High yield bonds 12%

Small stocks 13%

Real estate 15%

buyouts 25%

Venture capital 30%

A big problem for investment returns today stems from the starting point Fr. this process: The risk-less rate isn't 4%, its closer to 1%

*pg. 66

Where do we stand in mid-2007 ? I see low levels of skepticism, fear and risk-aversion. The promised returns from traditional safe investments seem so meagre. I see few assets that people are eager to get rid of, and few forced sellers; instead most assets are strongly bid for. Trust has replaced skepticism, and eagerness has replaced reticence.

*pg. 72

Risk is covert, invisible. Loss generally happens only when risk collides with negative events.

Homes in California may or may not have construction flaws that would make them collapse during earthquakes. We find out only when earthquakes occur.

Risk is the potential for loss when things go wrong.

*pg. 75

Since usually there are more good years than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control - in the form of return foregone- can seem excessive. Controlling risk in your portfolio is a very important and worthwhile pursuit.

Bearing risk unknowingly can be a huge mistake, but its what those who buy the securities that are all the rage and most highly esteemed at a particular point in time-to which "nothing bad can possibly happen"-repeatedly do. On the other hand, the intelligent acceptance of recognised risk for profit underlies some of the wisest, most profitable investments-even though most investors dismiss them as dangerous speculations.

*pg. 76

What does it mean to bear risk intelligently for profit? LEts take an example of life insurance. How do they insure people when they know they're *All* going to die?

-Its risk they're aware of. They know everyone is going to die, they factor this reality into their approach.

-Its risk they can analyse - they have doctors assess applicant health.

-Its risk they can diversify. By ensuring a mix of policyholders by age, gender, occupation and location, they make sure they're not exposed to freak occurrences and widespread losses.

-And its risk they're well-paid to bear. They set premiums so they'll make a profit if the policyholders die according to the actuarial tables on average. If they can sell a policy to someone likely to die at age eighty at a premium that assumes he would die at seventy, they'' be better protected against risk and positioned for exceptional profits if things go as expected

We do exactly the same thing at Oaktree. We try to be aware of the risks, which is essential given how much of our work involves assets that some simplistically call "risky". We employ highly skilled professionals capable of analysing investments and assessing risk. We diversify our portfolios appropriately. 

*pg. 77

As Nassim Taleb wrote in "Fooled by Randomness"

"Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet…

*pg. 78

You can't run a business on the basis of worst-case assumptions. You wouldn't be able to do anything.

*pg. 79

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

*pg. 80

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

*pg. 81

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and "sure things" can fail. However there are two things we can hold to with confidence:

- Rule number 1 - Most things will prove cyclical

-Rule number 2 - Some of the greatest opportunities for gain or loss come when other people forget rule number 1

*pg. 83

The longer I'm involved in investing, the more impressed I am by the power of the credit cycle.

The process is simple:

-The economy moves into a period of prosperity.

-Providers of capital thrive, increasing their capital base

-Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.

-Risk averseness disappears.

-Financial institutions move to expand their businesses- i.e. to provide more capital.

-They compete for market share by lowering demanded returns (e.g. cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.

As the Economist said" The worst loans are made in the  best of times"

This leads to capital destruction - that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

*pg. 84

When the above point is reached, the cycle is reversed -

-Losses cause lenders to become discouraged and shy away.

-risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.

-Less capital is made available.

-companies become starved of capital. Borrowers are unable to roll over their debts, leading to defaults and 

Look around the next time there's a crisis: you'll probably find a lender. Over-permissive providers of capital frequently aid and abet financial bubbles. There have been numerous examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989-92, emerging markets in 1994-98, LTCM in 1998, venture capital funds and telecom companies in 1999-2001.

In each case, lenders and investors provided too much cheap money and the result was over expansion and dramatic losses.

*Pg 87

In the end, few things go to zero and trees don't grow to the sky. Rather, most phenomena turn out to be cyclical. 

*pg. 88

The first time rookie investors see this (cyclical) phenomenon occur, its understandable that they might accept that's never happened before-the cessation of cycles-could happen. But the second time or the third time, those investors, now experienced, should realise its never going to happen, and turn that realisation to their advantage.

*pg. 96

(on the oscillation of the investor pendulum)

The swing back from the extreme is usually more rapid- and thus takes much less time-than the swing to the extreme. (Or as my partner Sheldon Stone likes to say, "The air goes out of the balloon much faster than it went in".

*pg. 102-103

The best returns bring the greatest ego rewards. When things go right, its fun to feel smart and have others agree.

The tendency to compare returns is the most invidious.  Investing-especially poor investing-is a world full of ego. Ego can make investors behave aggressively just to stand out through the achievement of lofty results. 

In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behaviour because they're aware of how much they don't know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation-but it doesn't provide much ego gratification in the short run. Its just not that glamorous to follow a path that emphasises humility, prudence and risk control. 

*pg. 107

All bubbles start with a modicum of truth. 

Of course the entire furore over technology, e-commerce and telecom stocks stems from the companies' potential to change the world. I have absolutely no doubt that these movements are revolutionising life as we know it, or that it they will leave the world almost unrecognisable from what it was only a few years ago. The challenge lies in figuring out who the winners will be, and what a piece of them is really worth today… jan 3, 2000

*pg. 120

Certain common threads run through the best investments I've witnessed. They're usually contrarian, challenging and uncomfortable. 

Its our job as contrarians to catch falling knives, hopefully with care and skill. That's why the concept of intrinsic value is so important. 

*pg. 122-23

Finding bargains -

The first step is usually to make sure that the things being considered satisfy some absolute standards.

Examples include the risk of obsolescence is a fast moving segment of the technology world, the risk a hot consumer product will lose its popularity, or the industries are too unpredictable or their financial statements are not sufficiently transparent.

*pg. 125

What makes something sell cheaper than it should ?

-An asset class may have weaknesses, a company may be a laggard in the industry, a balance sheet may be over-levered

-The orphan asset is ignored or scorned. To the extent its mentioned in the media and at cocktail parties, its in unflattering terms.

-A bargain asset tends to be one that's highly unpopular, capital stays away from it or flees and no one can think of a reason to own it.

*pg. 186

I think of the sources of error as being primarily analytical/intellectual or psychological/emotional. The former are straightforward: we collect too little information or incorrect information. Or perhaps we apply the wrong analytical processes, make errors in our computations or omit ones we should have performed. 

*pg. 192

What we learn from a crisis - or ought to:

When there's too much capital chasing too few ideas, investments will be made that do not deserve to be made. 

When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. 

Bidding more for something is the same as saying you'll take less for your money. The higher bids for investments can be viewed as a statement of how little return investors demand.

*pg. 194

!!!!!!!!!!!!

Leverage magnifies outcomes but doesn't add value. 

It can make great sense to use leverage to increase investment in assets at bargain prices offering a high promised return or generous risk premiums. But it can be dangerous to use leverage to buy more assets that offer low returns or narrow risk spreads - in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to turn inadequate gains into adequate returns.

-Be alert to what's going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them. Oversupply of capital can be dangerous for your investing health and must be recognised and dealt with. . Too much money chasing too few ideas and the accompanying dearth of prudence is worth noting.

Leading up to the 2008 crisis, what could investors have done?

-take note of the carefree, incautious behaviour of others

-preparing psychologically for a downturn

-selling assets, or at least the more risk-prone ones

-reducing leverage

-raising cash

-tilting the portfolio toward increased defensiveness.

pg. 197:

Since countercyclical behaviour was the essential element in avoiding the full effect of the recent crisis, behaving pro-cyclically presented the greatest potential pitfall. Investors who maintained their bullish positions as the market rose (or added to them), were least prepared for the bust and the subsequent recovery.

While its true that you can't spend relative outperformance, human nature causes defensive investors and their less traumatised clients to derive comfort in down markets when they lose less than others.

This has two very important effects. First, it enables them to maintain their equanimity and resist the psychological pressures that make people sell at lows. Second, being in a better frame of mind and better financial condition, they are more able to profit from the carnage by buying at lows. Thus, they generally do better in recoveries.

*pg. 198

One way to improve investment results at Oaktree is to thing about what "today's mistake" might be and try to avoid it.

*pg. 200

When there's nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

*pg. 202

Equity investors can just emulate an index. Their performance will be the same as that of the index.

Active investors may take different approaches to deviate from the index. They may overweight stocks that fluctuate more than the market or utilise leverage. They may exploit their stock-picking ability, buying more of some of the stocks in the index and underweighting or excluding others, or adding stocks that are not part of the index. They alter their exposure from the market's to specific events that occur at specific companies. As the composition diverges from the index, their return will deviate as well. 

In the long run, unless the investor has superior insight, these deviations will cancel out, and their risk adjusted performance will converge with that of the index.

Active investors who don't possess the superior insight are no better than passive investors. They can try hard, put their emphasis on offence or defence, or trade up a storm, but their return may not be better than an index.. (And it could be worse due to risks borne and transaction costs that are unavailing)

*pg. 206

Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction. These investors contribute nothing beyond their choice of style.

*pg. 207

Here's how I describe Oaktree's performance aspirations.:

In good years in the market, its good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why its important to beat the market when the market does well. No, in the good years average is good enough.

There is a time however when we consider it essential to beat the market, and that's in the bad years.

Thus, its our goal to do as well as the market in the good years and better than the market when it does poorly. At first blush that may sound like a modest goal, but its really quite ambitious.

If we're consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill.

*pg. 210

Higher returns are "unnatural".

Their achievement requires some combination of the following:

-an extremely depressed environment in which to buy   (doesn't come along everyday)

-extraordinary investment skill  (rare)

-extensive risk-bearing (can work against if things go amiss)

-heavy leverage (can magnify losses)

-good luck (uncertain)

Thus, investors should pursue such returns only if they believe some of these elements are present.

Skill is the least ephemeral but its rare (and even skill can't be counted upon to produce high returns in a low-return environment)

*pg. 212

"The perfect is the enemy of the good" - Voltaire. This is especially applicable to investing, where insisting on participating only when conditions are perfect, can make you miss out on a lot. Perfection in investing is generally unattainable, the best we can hope for is to make a lot of good investments and exclude most of the bad ones.

We give up on trying to attain perfection or ascertain when the bottom has been reached. Rather, if we think something is cheap, we buy. 

One of our six tenets of our investment philosophy calls for "disavowal of market timing". Ye we expend a lot of energy to diagnose the market environment. But if we find something cheap, we won't say that it will be cheaper in six months, so we'll wait. Its just not realistic to expect to be able to buy at the bottom.

*pg.215

The best foundation for a successful investment career - is value. You must have a good idea of what the thing you're considering buying is worth. There are many components to this. To oversimplify, there's cash on the books and the value of tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.

*pg. 217

Reason must overcome emotion.

If we avoid the losers, the winners will take care of themselves.

The defensive investor places a heavy emphasis on not doing the wrong thing.

*pg. 220

We don't know what lies ahead in terms of the macros future. Few people know more than the consensus about what's going to happen to the economy, interest rates and market aggregates. Thus, the investor's time is better spent trying to gain a knowledge advantage regarding the "knowable" : industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things that others' don't.

*pg. 221

Many investors assume the world runs on orderly processes that can be mastered and predicted. They ignore the randomness of things and the probability distribution that underlies future developments.

Arthur Levitt:
Compare cash on hand to debt and liabilities. If too far apart, prob best to stay away,