[Oak Tree Capital Howard 2022 Memorandum]

[Oak Tree Capital Howard 2022 Memo] Casual Talk on Investment CLEC Investment and Financial Education Academy Blog Date: January 21, 2022

A worthy investment memo to read!

The following attachment is my translation from 'Howard 2022 Memorandum' into Chinese:

[Sold Out] -

Since I am now in the fourth decade of writing memoranda, sometimes I am tempted to conclude that I should stop, because I have already covered all relevant topics. Then a new memorandum idea suddenly appears, bringing a surprise. In my January 2021 memorandum 'Valuable Things,' I recorded the time I spent living with and discussing investments with my son Andrew in 2020, recounting a semi-true conversation in which we briefly discussed whether and when to sell appreciated assets. I suddenly realized that, although sales are an inevitable part of the investment process, I have never written a complete memorandum on this topic.

Basic concept

Everyone is familiar with a saying that is supposed to capture the basic premise of investing: 'buy low, sell high.' This is a cliché for how most people view investing. But few important things can be distilled into four words; therefore, 'buy low, sell high' is just the starting point for discussing a very complex process.

Will Rogers was an American movie star and humorist in the 1920s and 1930s, and he offered what he possibly considered a more comprehensive roadmap to pursuing wealth and success:

Do not gamble; take all your savings, buy some good stocks, hold them until they rise, and then sell. If they do not rise, then do not buy.

The illogical nature of his advice clearly shows how simple this proverb—like many other proverbs—is in practice. However, regardless of the details, people may undoubtedly accept that they should sell investments that have appreciated. But how much help does this basic concept really provide?

Origin

Most of what I am going to write here originated from a memorandum called Liquidity in 2015. At that time, a hot topic in the investment community was concerns about the decline in market-provided liquidity (when I say 'market,' I am referring to the U.S. stock market, but the statement has broad applicability). This is usually attributed to (a) the measures taken by investment banks during the 2008-09 global financial crisis and (b) the Volcker Rule, which prohibits systemically important financial institutions from engaging in risky activities such as proprietary trading. The latter limits banks' ability to 'position' or buy securities when clients want to sell (James notes: this limits investment banks' ability to provide market liquidity).

Perhaps liquidity in 2015 was less than before, or perhaps not. However, looking at the events of that day, when I concluded that memo, I stated that I firmly believed (a) most investors trade too much to their own detriment, and (b) the best solution to insufficient liquidity is to build a long-term portfolio that does not rely on liquidity to succeed. Long-term investors have an advantage over short-term investors (I believe the latter describes most market participants today). Patient investors can ignore short-term performance, hold for the long term, and avoid excessive trading costs, while others worry about what will happen next month or next quarter and thus trade excessively. In addition, if illiquid assets can be purchased at a low price, long-term investors can take advantage of this.

However, like many things in investing, simply holding is easier said than done. Too many people equate trading activity with increasing value. Inspired by what Andrew said, I summarized this idea in Liquidity:

One of the hardest things when you discover an investment with long-term compounding potential is to be patient and maintain your position, as long as doing so is justified by the expected returns and risks. Investors can easily be driven by the news, emotions, the fact that they have made a lot of money so far, or the excitement over a seemingly more promising new idea. When you look at charts showing something that has been rising for 20 years, think about all the times holders had to convince themselves not to sell.

Everyone wishes they had bought Amazon at $5 on the first day of 1998, because it has now risen 660 times, reaching $3,304.

However, when the stock reached $85 in 1999 (rising 17-fold in less than two years), who could continue holding it? (James added: So this is what we always say, if you never sell, you will become wealthy. But if you can't hold on after it has risen 17 times, and if you can't be sure that the company's future is very bright, then you simply don't have the ability to hold individual stocks. In that case, you should just invest in index funds.)

In 2001, when the price fell 93% to $6, who among those who held on could avoid panic? By the end of 2015, when it reached $600, who would not sell, 100 times higher than the low point of 2001? However, anyone who sold at $600 only gained the first 18% of the overall increase from that low point.

This reminded me of the time I went to Malibu with a friend, and we mentioned that the Rindge family supposedly bought the entire area in 1892 for $300,000 or $22.50 per acre—all 13,330 acres. (Today, obviously worth billions.) My friend said, 'I want to buy all of Malibu for $300,000.' My response was simple: 'When it reaches $600,000, you'll sell it.'

Since writing 'Liquidity,' the more I think about it, the more I believe there are two main reasons why people sell their investments: because they go up and because they go down. You might say this sounds crazy, but what is truly crazy is the behavior of many investors.

Sell, because it is rising

In our business, 'profit-taking' is a term that sounds clever, used to sell things that have already appreciated. To understand why people participate in it, you need to have a deep understanding of human behavior, because many investors sell for psychological reasons.

In short, the reason a large-scale sell-off occurs is that people like the fact that their assets show profits, and they worry that those profits will disappear. Most people spend a lot of time and effort trying to avoid unpleasant feelings such as regret and embarrassment. What could make investors feel more guilty than watching huge gains vanish before their eyes? Professional investors report big winners to clients in one quarter and then have to explain why the holding prices in the next quarter are equal to or below cost. Only humans want to realize profits to avoid these outcomes. (James explains: This illustrates that professional investors also sell their profitable stocks because they do not want this season...)

Reporting to everyone that we made a profit on a certain stock, and then reporting next quarter that we suffered a loss on this stock. Therefore, there is no need to explain such a predicament to investors when changing positions.

If you sell an appreciating asset, the gains are "locked in" and can never be reversed. Therefore, some people believe that selling winners is highly desirable—they like realized gains. In fact, at a meeting of a nonprofit organization's investment committee, a member suggested that they should be cautious about increasing donation spending in response to gains, because those gains were unrealized. I quickly pointed out that it is usually wrong to consider realized gains as more tangible than unrealized gains (assuming there is no reason to doubt the authenticity of unrealized book value). Yes, the former has been actualized. However, realized capital gains are often reinvested, which means the profits—as well as the principal—are put at risk (James explained: the risk of reinvesting the proceeds from a sale into new stocks). Some might argue that compared to new investments in currently attractive assets, appreciated securities are more vulnerable to declines, but this is far from certain.

I am not saying that investors should not sell appreciating assets and realize profits. However, selling them just because their prices have gone up is definitely meaningless.

Sell, because it is wrong to sell appreciating assets just to gain profits, and it is even worse to sell them simply because they are falling. Nevertheless, I believe many people will do so.

Although the rule is 'buy low, sell high,' it is obvious that the more prices fall, the more motivated many people are to sell assets. In fact, just as continuously buying appreciating assets can eventually turn a bull market into a bubble, widely selling declining assets can also potentially turn a market downturn into a crash. Bubbles and crashes do occur, proving that investors contribute to excessive behavior in both directions.

In the movie playing in my mind, a typical investor buys something at $100. If it reaches $120, he says, 'I think I'm doing well—I should add more.' If it reaches $150, he says, 'Now I am very confident—I will double down.' On the other hand, if it drops to $90, he says, 'I will consider increasing my position to lower the average cost,' but at $75, he concludes that before further lowering the average cost, he should reconfirm his argument. He says, at $50, 'I'd better wait until the dust settles before buying more.' At $20, he says: 'It feels like it will go to zero; let me get out!'

Just like those who are afraid of giving up profits, many investors worry about letting losses compound. They may worry that their clients will say (or they may say to themselves): 'Who in their right mind would continue to hold a security after it dropped from $100 to $50? Everyone knows that such a decline could indicate further drops. Look—it happened.'

Do investors really make the behavioral mistakes I described? There is a lot of anecdotal evidence. For example, research shows that the performance of the average mutual fund investor is worse than that of the average mutual fund. How is that possible? If she simply held her positions, or if her mistakes were unsystematic, then by definition, the performance of the average fund investor would be the same as that of the average fund. For the research results to occur, investors must, on the whole, reduce the amount of capital in funds that perform better subsequently, and increase allocations to funds that continue to perform worse. Let me put it another way: on average, mutual fund investors tend to sell funds that have performed the worst recently (missing potential recovery opportunities) and chase the best-performing funds (participating in their returns).

We know, as mentioned above, that 'retail investors' tend to be trend followers, so their long-term performance is often affected. What about experts? The evidence here is even clearer: over the past few decades, a strong shift toward indexation and other forms of passive investment has occurred, and the reason is simple—active investment decisions are often wrong. Of course, many forms of errors contribute to this reality. However, whatever the reason, we must conclude that, on average, active professional investors hold more underperforming stocks and fewer well-performing stocks, and/or they buy too much at high prices and sell too much at low prices. Passive investing has not grown to cover most of the capital in U.S. stock mutual funds because passive investment results are exceptionally good; I believe it is because active management is so bad.

As early as 50 years ago, when I was working at the First National City Bank, potential clients would often ask, 'What kind of return do you think you can get from a stock portfolio?' The standard answer was 12%. Why? 'Well,' we would say (so simply), 'the stock market returns about 10% per year. With a little extra effort, we can increase it by at least 20%.' Of course, as time has shown, this is not true. 'A little effort' does not increase anything. In fact, in most cases, active investing reduces returns: most stock funds fail to keep up with the index, especially after fees.

The final proof? Oak Tree Capital's fundamental element in distressed debt investing—buying at low prices—stems from the huge opportunities provided to us by sellers. During economic and market crises, negative sentiment reaches its peak, causing many investors to become discouraged or fearful and to sell in a panic. Only when holders sell to us at unreasonably low prices can results like those we achieve with distressed debt be realized.

Excellent investing mainly involves taking advantage of the mistakes made by others. Clearly, selling goods because of low prices is a mistake that can present huge opportunities for buyers.

When should investors sell?

If you shouldn't sell things because they go up, and you shouldn't sell them because they go down, then is selling correct? As I mentioned earlier, I described the discussion that took place in 2020 when Andrew and his family lived with Nancy and me. That experience indeed had tremendous value—it brought an unexpected glimmer of hope during this pandemic. So far, this memorandum has elicited the strongest reactions from all my memorandum readers. This response may be attributed to (a) the content, mainly related to value investing; (b) the personal insights offered, especially my acknowledgment that I need to keep up with the times; or (c) the recreated dialogues I included as an appendix. The last one is like this, in part:

Howard: Hey, I saw that XYZ has risen by xx% this year and is selling at a P/E of xx. Do you want to take some profit?

Andrew: Dad, I told you I’m not selling. Why would I sell?

H: Well, you might sell some here because (a) you've gained a lot; (b) you want to "book" some profits to make sure you don't give it all back; (c) at this valuation, it might be overvalued and unstable. And, of course, (d) no one goes broke from taking profits.

Answer: Yes, but on the other hand, (a) I am a long-term investor, and I do not consider stocks as tradable pieces of paper, but as part of ownership in a business; (b) the company still has enormous potential; (c) I can tolerate short-term downside fluctuations, which are part of the threat that creates stock opportunities. Ultimately, only the long term matters. (Our family has a lot of 'a-b-c'. I want to know where Andrew got his.)

H: But if it might be overvalued in the short term, shouldn't you reduce your holdings and pocket some gains? Then, if it drops, (a) you have already limited your regret, and (b) you can buy in at a lower price.

A: If I held shares in a private company with huge potential, strong growth momentum, and top-notch management, I would never sell any part of my holdings just because someone offered me a high price. Great compound return investments are hard to find, so selling future growth stocks is often a mistake. In addition, I believe it is much easier to predict a company's long-term results than to predict short-term price movements, and weighing a decision in an area you are confident about is meaningless if it is limited to low conviction...

H: Don't you have a specific time when you start selling?

Answer: In theory, yes, but this largely depends on (a) whether the fundamentals are as I wish, and (b) how this opportunity compares with other available opportunities, considering my high level of comfort with this opportunity.

A proverb like 'No one goes bankrupt for the sake of profit' may relate to those who do part-time investing for themselves, but they should not have a place in professional investing. There are certainly plenty of reasons to sell, but they have nothing to do with fear of making mistakes, feeling regret, or looking bad. On the contrary, these reasons should be based on investment prospects—not the investor's psychology—and must be determined through calm financial analysis, rigor, and discipline.

Stanford University professor Sidney Cottle is the editor of the later edition of Benjamin Graham and David L. Dodd's 'Security Analysis,' 'the Bible of Value Investing,' including the version I read at the Wharton School of Business 56 years ago. For this reason, I refer to this book as 'Graham, Dodd, and Cottle.' Sid was a consultant for the investment department of First National City Bank in the 1970s, and I have never forgotten his description of investing: 'the discipline of relative selection.' In other words, most portfolio decisions made by investors are relative selections.

Clearly, relative considerations should play an important role in any decision to sell existing assets.

If your investment thesis seems less effective than before and/or the likelihood of it proving accurate has decreased, then selling part or all of your shares may be appropriate.

Similarly, if another investment appears to be more promising—offering a higher risk-adjusted expected return—it is reasonable to reduce or eliminate existing holdings to make room for it.

Selling assets is a decision that must never be considered in isolation. Cottle's concept of 'relative choice' emphasizes the fact that every sale generates revenue. How would you handle them? What ideas do you have that you think might generate higher returns? What might you miss out on by switching to new investments? If you continue to hold the assets in your portfolio instead of making a change, what would you be giving up? Or you might not intend to reinvest the proceeds. In that case, would holding cash proceeds rather than the sold assets be more likely to make you better off? Such questions are related to the concept of 'opportunity cost,' which is one of the most important concepts in financial decision-making.

Looking at it from another perspective, since you believe there will be a temporary decline in the future, which will affect one of your holdings or the entire market, what about the idea of selling? This approach has real problems:

Why sell something you believe has a positive long-term future to prepare for the temporary decline you anticipate?

Doing this would introduce another kind of error (among many), because the decline may not occur.

Berkshire Hathaway Vice Chairman Charlie Munger pointed out that selling based on market timing actually gives investors two wrong approaches: a decline may happen, or it may not; if it happens, you have to figure out when it's time to buy back.

Or it might be three ways, because once you sell, you still have to decide how to handle the proceeds while waiting for a decline to occur and re-enter.

People who try to avoid declines by selling too frequently may become intoxicated with their own talent and be unable to recover from the resulting lows. Therefore, even the correct sellers may be unable to accomplish anything of lasting value.

Finally, what if you are wrong and it doesn't go down? In this case, you will miss out on the resulting gains, either never coming back or doing so at a higher price.

Therefore, selling for the purpose of market timing is usually not a good idea. There are few opportunities where this would be profitable, and even fewer people have the skills needed to take advantage of these opportunities.

Before I conclude this topic, it is important to note that the decision to sell is not always within the control of the investment manager. Clients can withdraw funds from accounts and funds, thereby necessitating a sale, and the limited life cycle of closed-end funds may require managers to liquidate held assets even if they are not yet ready to be sold. Under these conditions, the choice of what to sell can still be based on the manager's expectations for future returns, but the decision not to sell is not within the manager's options. (James: So the trades of active fund managers are sometimes obligatory; in addition to their own operations, there are also forced sales and actions required.)

How much is too much?

Of course, sometimes it is correct to sell one asset to support another based on the idea of relative choice. But we cannot do this mechanically. If we did, in a logically extreme case, we would put all our capital into the one investment we think is the best.

Almost all investors—even the best investors—diversify their portfolios. We might know which holding is absolutely the best, but I have never heard of an investor having a single-asset portfolio. They might overweight their favorites to take advantage of what they think they know, but they still diversify to guard against what they don’t know. This means they perform suboptimal optimization, potentially sacrificing some opportunities for maximum returns.

This is a relevant question in the conversation I reconstructed with Andrew:

H: You manage a concentrated investment portfolio. When you invest, XYZ is a large position, and given its appreciation, it is even bigger today. Smart investors concentrate their portfolios and stick to what they know, but they diversify holdings and sell as things develop to limit potential harm from what they don't know. Doesn't the growth of this position make our portfolio out of control in this regard?

A: Maybe that's true, it depends on your goals. But cutting means selling things that I feel very comfortable with based on my bottom-up assessment, and moving toward things that I feel less good about or less familiar with (or cash). For me, having a small number of things I feel strongly about is much better. In my lifetime, I will only have a few good insights, so I have to make the most of the few I have.

All professional investors hope to bring good investment performance to their clients, but they also want to achieve financial success for themselves. Amateur enthusiasts must invest within their risk tolerance. For these reasons, most investors — and, of course, the clients of most investment managers — cannot avoid concerns about portfolio concentration, making them susceptible to adverse developments. These considerations provide valid reasons to limit the size of individual asset purchases and to reduce positions as they appreciate.

Investors sometimes delegate the decision of how to weight assets in a portfolio to a process called portfolio optimization. Inputs regarding the potential returns, risks, and correlations of asset classes are entered into a computer model, which produces a portfolio with the optimal expected risk-adjusted return. If an asset appreciates relative to others, the model can be rerun, and it will tell you what to buy or sell. The main problem with these models is that all the data we have on these three parameters are based on the past, but to achieve an ideal portfolio, the model needs to accurately describe future data. In addition, the model requires numerical inputs for risk, and I firmly maintain that no number can fully describe an asset's risk. Therefore, optimization models cannot successfully determine a portfolio's actions.

Bottom line:

We should make investment decisions based on our estimates of the potential of each asset.

We should not sell just because prices are rising and positions are expanding.

There may be legitimate reasons to limit the size of the positions we hold,

But there is no way to scientifically calculate what these limits should be.

In other words, the decision to reduce positions or sell off completely depends on judgment... just like other important things in investing.

The last words sold

Most investors try to increase value by increasing or decreasing specific assets and/or by buying and selling at the right time. Although few people have proven capable of consistently doing these things correctly (see my comments on active management on page 4), everyone is free to try. However, there is a big 'but'.

What is very clear to me is that simple investing is by far the 'most important thing'. (Someone should write a book with this title!) Most actively managed portfolios do not outperform the market by adjusting portfolio weights or timing the market. You can try to increase returns by participating in such schemes, but these actions are unlikely to work at best and may hinder you at worst.

Most economies and companies benefit from positive potential long-term trends, so most securities markets rise in most years, and of course over a very long period of time. As one of the longest-running stock indices in the United States, the S&P 500 Index has an estimated compound average return of 10.5% per year over the past 90 years. This is an amazing performance. This means that $1 invested in the S&P 500 Index 90 years ago would have grown to about $8,000 today.

Many people have spoken about the wonders of compound interest. For example, it is reported that Albert Einstein referred to compound interest as the 'eighth wonder of the world.' If one could invest $1 today at a historical compound return rate of 10.5% per year, it would grow to $147 in 50 years. Some may argue that economic growth in the coming years will be slower than in the past, or that it was easier to find cheap stocks in earlier periods than it is now. Nevertheless, even if its compound growth rate is only 7%, $1 invested today would grow to over $29 in 50 years. Therefore, if they simply start investing quickly and avoid tampering with the process through trading, people entering adulthood today can actually ensure a good outcome for their retirement.

I like the way one of the greatest investors of our time, Bill Miller, expressed in his 2021 third-quarter market letter:

In the post-war period, the U.S. stock market has risen about 70% of the time. The odds are far from making casino owners extremely rich, but most investors try to guess the 30% of the time stocks fall, or worse, spend time trying to time the market, which is futile given the quarterly ups and downs of the market. As we recently saw during the 2020 pandemic recession, the bulk of stock returns were concentrated in sharp bursts starting from periods of extreme pessimism or fear. We believe that time, rather than timing, is the key to accumulating wealth in the stock market.

(October 18, 2021. Key supplement)

What did Miller mean by a 'sudden burst'? On April 11, 2019, The Motley Fool cited data from Morgan Asset Management's 2019 Retirement Guide, showing that over the 20-year period from 1999 to 2018, the annual return of the S&P 500 index was 5.6%. But if you missed the best 10 days (or about 0.4% of trading days), your return would only be 2.0%. If you missed the best 20 days, you would not make any money at all. In the past, returns were often concentrated in just a few days. However, overly active investors continue to jump in and out of the market, generating trading costs and capital gains taxes, and risking missing these 'sudden bursts.'

As mentioned earlier, investors often sell off because they believe a decline is imminent and that they have the ability to avoid it. However, the fact is that buying or holding—even at high prices—and experiencing a decline itself is far from fatal. Typically, after each market peak, there will be a higher high, after all, it is only the long-term returns that matter. Reducing market risk by considering rash sell-offs—thus failing to fully participate in the market's long-term upward trend—is a major sin in investing. This is even more true for selling items that have already declined for no reason, turning temporary volatility into permanent loss and missing out on the miracle of long-term compounding.

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When I first met people and they found out that I was in the investment business, they often asked (especially in Europe) 'What do you trade?' This question gave me goosebumps. To me, 'trading' means going in and out of individual assets and entire markets based on guessing the price movements for the next hour, day, month, or quarter. At Oaktree, we do not engage in such activities, and few people have shown the ability to do it well.

We consider ourselves not traders, but investors. In my view, investing means allocating capital to assets based on a reasonable assessment of their potential and benefiting from long-term outcomes. Oaktree does employ people called traders, but their work includes implementing long-term investment decisions made by portfolio managers based on the fundamentals of the assets. No one at Oaktree believes they can make money or advance their careers by selling now and buying back after an intervening decline, rather than holding for years and allowing value to drive prices when the fundamental expectations are realized.

When Oak Tree was founded in 1995, the five founders—who at that time had worked together for an average of 9 years—developed an investment philosophy based on our success at the time. One of the six principles expressed our view on attempting to time the market when buying and selling:

Because we do not believe in having the predictive ability needed to correctly time the market, we maintain a fully invested portfolio as long as there are assets available at attractive prices. Concerns about the market environment may lead us to favor more defensive investments, increase selectivity, or take more cautious actions, but we never take action to raise funds. Clients hire us to invest in specific market niches, and we must not neglect our duties. Holding investments that have declined in price is unpleasant, but missing returns because we did not purchase what we were hired to buy is unforgivable.

We have never changed any of the six principles of our investment philosophy—including this principle—and we have no plans to.

Do it this way.

January 13, 2022

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This memorandum expresses the author's views as of the date shown, and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Furthermore, Oaktree makes no representations, and one should not assume that past investment performance is indicative of future results. In addition, as there is potential for profit, there is also the possibility of loss.

This memorandum is for educational purposes only and must not be used for any other purpose. The information contained herein does not constitute, nor should it be interpreted as, an offer to provide advisory services or to sell or solicit the purchase of any securities or related financial instruments in any jurisdiction. Some of the information regarding economic trends and performance contained herein is based on or derived from information provided by independent third-party sources. Oaktree Capital Management, L.P. (“Oaktree”) believes that the sources of such information are reliable; however, it cannot guarantee the accuracy of such information, nor has it independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

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