[00:02:18] Kyle Grieve: To me, it’s just the best book on the practical aspects of risk that I think I’ve ever read. He has so many great points on the downside specifically and how it really is everything in investing. And so one quote that I really loved from the book was that there are old investors and there are bold investors, but there are no old and bold investors.

[00:02:36] Kyle Grieve: And I think this quote just does such a great job of delineating between those who take a lot of risk. And those who survive in the markets for decades. And the point being that nobody does both simultaneously. And I think you and I are both in agreement that we’re trying to survive for a long period of time.

[00:02:51] Kyle Grieve: So I think that’s why this book really had such a big impact on me. Another thing I love about this book is just, I can pick it up when the market is really getting overly exuberant. Or just overly depressed and I feel it helps ground me and makes me get a better grip of where my own emotions are, where the market’s emotions are and makes it so that I don’t really get caught up in investor sentiment.

[00:03:12] Kyle Grieve: I try to be level as much as possible. A couple parts that really stuck out to me were the parts on market cycles. This is something that I’ve sometimes asked other investors, you know, what they think of the market using some of the lessons from the book specifically about not necessarily guessing where the market is going, but understanding where it stands currently.

[00:03:32] Kyle Grieve: And it’s interesting because I always seem to get investors that assume that I’m asking where they think the market will go, but I’m not really interested in that. I like noting the behavior of other investors, especially in concern to their risk appetite. And I think that really helps me understand where capital is flowing and if the market is most likely to be expensive or cheap.

[00:03:51] Kyle Grieve: Another critical lesson on market cycles from the book was the fascinating table that he shared called the poor man’s guide to market assessment. So I’ll be commenting on this later, so I won’t get too into the weeds now, but it’s essentially just a simple checklist to go over that helps you determine whether you should open or close your wallet, which is a very valuable tool to use.

[00:04:09] Kyle Grieve: And then a few other areas that I enjoyed were his concepts on luck and skill. So this is something that I spent a lot of time thinking about. I’m always trying to determine if my decisions are creating a good outcome and if that outcome is a product of luck and skill. Luck is always going to have a part in outcomes, but I think over the long term, skill is what determines outcomes.

[00:04:31] Kyle Grieve: So Buffett has said that five years are needed in order to determine if a money manager is adding value. And I’m getting close to that number now in terms of investing in stocks. I was also intrigued by other areas of the book, but let’s save those for later in this conversation.

[00:04:45] Clay Finck: Yeah, the concept of luck and skill is certainly something I’m excited to dive into a bit later.

[00:04:50] Clay Finck: And I think there’s just some authors that when you read them, you just feel like you’re getting smarter. It seems like a silly way of putting it. And it’s sort of hard to explain since it’s just this feeling you get when you read it. And Howard Marks is certainly one of those people because he’s just such a good writer and just so effective at sharing these complex investing concepts.

[00:05:12] Clay Finck: So jumping to the first chapter of the book here, it covers second level thinking. And it’s a concept that I know you and I have both benefited a lot from over the years. Second level thinking is just essential to understand when you get down to the core of successful investing. Much of it is really just about out thinking other people.

[00:05:33] Clay Finck: And behaving more rationally than other people. This definitely requires second level thinking. So to give a couple of examples here, first level thinking would suggest that if we see a good company, then the stock is a buy. Second level thinking would lead us to think that we see a good company, and it’s trading at a price that would suggest it’s a great company.

[00:05:54] Clay Finck: Then it’s a sell because it’s actually overpriced. And then a second example here, first level thinking says that inflation is rising, so we should sell stocks. Second level thinking might suggest that because inflation is rising and sentiment is really poor, maybe we should buy stocks. The pattern I see with this first and second level thinking is to consider your view and then compare that to the view of others.

[00:06:18] Clay Finck: In a way, this can be expressed through just market prices. You don’t have to go out and just chat with other people. It’s also easier said than done, but it can be very helpful mental model, I think, when thinking through our decisions. So with that, Kyle, I’ll throw it over to you here to discuss second level thinking.

[00:06:34] Kyle Grieve: Yeah, so you really nailed it here with the importance of second level thinking, Clay. Second level thinking is just vital to being a very good investor. I think you could argue. And I think that Howard Marks would agree with me here that you probably must think in second order, if you want to outperform the market.

[00:06:50] Kyle Grieve: So why doesn’t everyone think in second order? Everyone probably does think in second order to some extent in other areas of their life, but I don’t think so much when it comes to the roller coaster ride of emotions and managing your own money offered in the stock market and other risk assets. So thinking in second order in the stock market is where you can either get crushed by purely thinking in the first order, which is, I think, what most of the market does anyways, or you can take advantage of the market by thinking in second order.

[00:07:20] Kyle Grieve: So one of my biggest mistakes was a mistake of omission. This was on a business called in mode that I no longer own. But while I owned it, it went up about seven times from my cost basis. And this was in, I think it was about a year. Like it was very, very fast. And so my brain was telling me, okay, great, it’s going up, but the business was still improving.

[00:07:38] Kyle Grieve: And since the business was undervalued in the past, now is this time to shine. And so I saw the momentum and I believe the business would continue to go up. And this is just fundamental first level thinking huge error on my part. But since then, my selling criteria has shifted and I’ve tried to fix problems like these to the best of my abilities.

[00:07:56] Kyle Grieve: You know, looking back, I wish I had used second level thinking. Probably if I had, I would have sold the business. I would have thought since everyone is buying this and assuming that the current all time high levels of both price and price earnings expansion will continue rising, I should probably exit the stock before the market changes its mind.

[00:08:14] Kyle Grieve: So don’t worry, I still got out and it was still a multi bagger for me, but it could have been a bigger multi bagger. So, the problem here with second level thinking is that it takes a lot of mental energy. So, Howard mentions questions that you need to ask to think in the second level. So, that’s questions such as what is the range of likely future outcomes?

[00:08:31] Kyle Grieve: Which outcome do I think will occur? What’s the probability that I’m right? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future and with mine? So, these are wonderful questions to, I think, spend time thinking about. And as Bill Miller has said, there are three general areas of investing in which you can have an edge, which are analytical, informational, and psychological.

[00:08:55] Kyle Grieve: So using second order thinking helps you improve your analytical thinking. So suppose you’re doing things like thinking in decision trees, talking to other investors about what they think about a stock or an industry, coming up with contrary opinions, and actively evaluating the psychology of the stock market and yourself.

[00:09:11] Kyle Grieve: In that case, I think you’re ahead of 90%, maybe even 99 percent of the market, because I just don’t think many investors think that way. Unfortunately, most investors see a stock that goes up and they’re attracted to it like a moth to a flame. But you should really tend to avoid this line of thinking at all costs, because there’s a very, very good chance that thinking like this is going to lose you a lot of money.

[00:09:31] Kyle Grieve: So Howard mentions that first level thinkers tend to oversimplify the market when buying a stock. For instance, they’ll say that they had a really good experience with a product or service, then go out and buy the stock. So Peter Lynch said something similar where understanding a product at some level is never the single reason to buy a stock.

[00:09:49] Kyle Grieve: It’s simply a lead. And I think that’s a really good way to think of ideas. So a simple contrarian way to search for investments is to actually look at the bad news that’s out there and then explore that in more detail. Much of the bad news is going to be baked into the stock price. And if you hold a view that the event that caused the stock price to go down and that that event is going to be short lived in nature, then you will have fought in the second order and might even come up with a very, very decent investing opportunity.

[00:10:14] Kyle Grieve: So I mentioned one quote from this chapter that really resonated with me. The upshot is simple. To achieve superior investment results, you have to hold non consensus views regarding value and they have to be accurate. That’s not easy. So second level thinking will help you hold non consensus views. From there, you just have to do the work and to make sure that you’re accurate on those views.

[00:10:33] Clay Finck: I’ve personally found that one of the more difficult parts of investing is that almost everything I look at isn’t black or white. And Munger famously said that great opportunities are rare. So if you aren’t looking at a great opportunity, you might be looking at a decent or a good opportunity. And for those, it can be somewhat hard to assess the moat, the market’s expectations and such.

[00:10:54] Clay Finck: One tool that I think might be useful for our listeners is a reverse DCF model. So simply put a reverse DCF really just allows an investor to determine how fast the market expects a company’s earnings to grow in the future. And then you compare that to what you expect earnings to grow at. So let’s say the market has priced a company to the point where it expects earnings to grow at, say, 5 percent over the next, say, 5 or 10 years.

[00:11:21] Clay Finck: But you feel pretty confident that earnings are going to grow well above 10%, then that might be an opportunity worth diving deeper into. I’m curious, Kyle, what are some of the most common reasons you think a company can be mispriced?

[00:11:35] Kyle Grieve: Yeah, this is a really good subject to think a lot about. And while I personally love value investing, and I also love quality businesses.

[00:11:43] Kyle Grieve: There’s definitely a difference there because prominent quality businesses spend a lot of time trading at a premium, which some people might think are at odds with value investing. But the thing is, is that these premium prices that they trade at don’t actually happen all the time. So the best time to look for mispricings and quality businesses is to optimize your understanding of them.

[00:12:03] Kyle Grieve: So many of our listeners will be familiar with a business called Topicus, a business, which I own. I think it’s probably the highest quality business in my entire portfolio. But let’s examine the share price here. So I went off in chat and looked at the drawdowns. And so from between March of 2022 until April of 2023, this business had drawdowns in excess of 40%.

[00:12:25] Kyle Grieve: So companies that are obviously of high quality do go on sale. And in topic is his situation. I think it was basically being lumped together with a tech sell off that happened in 2022. So this is kind of a prime example of throwing the baby away with the bathwater. It’s during these market busts that very high quality businesses like Topicus can be had for very steep discounts.

[00:12:46] Kyle Grieve: But if we back up even more and look at businesses that aren’t maybe of such a high quality compared to a business like Topicus, we can see that there’s many other reasons that a business can be mispriced. Reasons might be that it might be going through temporary headwinds, which are underappreciating the long term earnings power of the company.

[00:13:03] Kyle Grieve: It could be a business that isn’t maybe well known by the investing community as a whole. For it could be that the business is in an unloved industry, and maybe that industry will become loved once again. But, you know, that type of benefit only goes to the people who are willing to be patient and wait out that change in sentiment.

[00:13:21] Kyle Grieve: So, if you’re a long term investor, you should always observe the events that can really punish the share price of what you own. And if you’re a net buyer of stocks, you should be monitoring for these types of events to add to your best positions, because these are the types of times and they’re very concentrated where you can really lower your cost basis and increase your returns.

[00:13:40] Clay Finck: Yeah, I think this ties in pretty well with chapter two where Marks discusses his thoughts on the efficient market hypothesis. And you know what you said in relation to mispricings is still so difficult. I think about many of the stocks I own, those that execute and those whose earnings increase the stock price increases with it.

[00:13:58] Clay Finck: And those who maybe are going through some headwinds, earnings really aren’t going anywhere. Then the stock price really isn’t going anywhere. It can be hard to find those mispricings, but. It can be obvious at times when you see earnings continuing to march upward, but the share price for whatever reason is just coming down.

[00:14:13] Clay Finck: Those are some of the things I like to try and look for from a very basic level. So chapter two is on the efficient market hypothesis, and to some extent the efficient market hypothesis does make sense because there’s millions of investors. They all have access to instant information online and such, and many of these investors are very smart, very hardworking.

[00:14:34] Clay Finck: Which Howard dives in deep into on his book. On the other hand, you’ve read in the book about how Yahoo in January of 2000 was trading for 237. And then in April of 2001, just over one year later, it was trading for 11. I’ll share a quote here from his book. Anyone who argues that the market was right, both of those times has his or her head in the clouds.

[00:14:58] Clay Finck: It has to have been wrong on at least one of those occasions. So with that said, how about you give us an overview of some of the lessons you learned from marks on efficient markets?

[00:15:08] Kyle Grieve: So I think a lot about efficient markets because on the one end, I do not think that the market is always efficient as you kind of pointed out there, but if you’re a value investor and you are looking for inefficiencies, you have to actually have some belief in the efficient market hypothesis.

[00:15:23] Kyle Grieve: Otherwise, the gap between price and value may never close. So I would say that I guess I’m a partial believer in the efficient market hypothesis. I think it works a lot of the time, because like you said, the market has many participants that if there’s any arbitrage, they close it off real quick. And as people like Michael J. Mauboussin have shown, one of the optimal ways to reduce noise is through the consensus of a large number of people. And I think the market is really just that. It’s a consensus tool that evaluates stocks in real time. But here’s the thing that Marks really focuses on the key to overperformance is holding non consensus views.

[00:15:58] Kyle Grieve: It’s at the times when you disagree with the consensus that the best opportunities really lie. A simple example of this, I think, is Buffett’s great investment went to Apple. Yes, I realize he’s been cutting some of his Apple stake lately, but the important part about his Apple investment is when he bought it.

[00:16:13] Kyle Grieve: He bought it at low double digit multiple, and that was when many investors were exiting the business, and it dropped 50 percent or so in price when he got interested. The multiple is now over three times what he paid for it. And Apple is a massive company that is followed by numerous analysts and is very well known by the general public.

[00:16:29] Kyle Grieve: I’m sure you and I both have Apple phones or Apple devices. So this points out that the market as a whole can be wrong. And if you had the non consensus view that Buffett did on Apple back in 2016, you would have done very well if you’d held onto your stock. So the other important point here is that non consensus views work just as well in markets that have gone up.

[00:16:48] Kyle Grieve: Okay. As in markets that have gone down, I think marks might argue that they’re even more important in up markets. The reason is simple in euphoric markets. The consensus view tends to be positive, rosy and open to taking risks that these are not the market conditions that we want to take part in. All of the largest bubbles in history have happened when the consensus thought that good conditions would last forever.

[00:17:11] Kyle Grieve: For instance, John Kenneth Galbraith mentions that speculative bubbles are often associated with the very dangerous term, this time is different. But if enough of the market believes the term to be true, then the consensus will drive up the prices up to just astronomical levels that you’ll see in bubbles.

[00:17:27] Kyle Grieve: So holding a non consensus view during these times is actually very, very important. If the key to being a successful investor for the long term or survival, you must be able to avoid partaking in bubbles. And if you have non consensus views on bubbles, that hopefully will help you avoid taking part in them.

[00:17:43] Kyle Grieve: So Marks makes a very good point that theory should inform our decisions, but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. We can buy securities for the return, but ignore their risk.

[00:18:01] Kyle Grieve: So while it’s okay to use theory to, I think, aid in decision making, we must also be careful not to use it as a crutch because that crutch can be kicked out from under you and cause some really, really big falls. It’s also important to recognize that if we were to fully embrace theory, there really is no point in picking individual stocks because the theory does state that returns we get should track the market due to the embedded efficiencies.

[00:18:26] Clay Finck: I already mentioned that we’ll be getting to luck and risk later. But since you mentioned Apple, I first got into stock investing when I was in college and literally had next to no idea what, what I was doing. And I had an iPhone at the time and I saw Apple stock going up. So I decided to buy some Apple stock.

[00:18:44] Clay Finck: I would definitely consider that a very, very lucky decision because I ended up holding onto it for a number of years. But the investment that is more difficult to bring up is a offshore oil driller that my friend told me about. And his uncle, that was a stock broker. He had bought the stock and recommended it to him and whatnot.

[00:19:00] Clay Finck: I’m like, oh, it sounds like a good idea. Oil prices are low. Eventually they’ll come back. Well, that investment essentially went to zero. It ties in well to what we were saying with chapter one earlier, this very first level type thinking that can really burn us. But luck also is a big part of investing.

[00:19:15] Clay Finck: And I’m very excited to chat about that later. But sticking with the efficient market hypothesis, one of my issues with it is that I think it assumes that investors are rational and that they’re all largely taking this fundamental viewpoint of each particular stock. I just don’t think this is really the case.

[00:19:34] Clay Finck: There’s plenty of technical traders. There’s plenty of momentum traders. That really don’t care much if at all about the fundamentals and there are funds out there that just purely trade on momentum and these momentum funds may push a hot stock higher and higher like Nvidia, for example, and the crowd starts to believe that the fundamentals are just unbelievable because the stock just keeps going up.

[00:19:56] Clay Finck: So there’s, you know, a lack of sellers, more and more buyers coming in. Which helps create that inefficiency in some companies from time to time. And I’m not one to say whether Nvidia is overvalued or undervalued. I think it’s just an example that’s definitely in the limelight nowadays. The other great point he makes is that when there is efficiencies, this can lead to great opportunities for the intelligent investor, but it can also lead to abysmal returns for a greedy investor. So when tech stocks only went up in 2020 and 2021 investors who really didn’t know what they were doing, they were piling into these stocks in this inefficiency led to them getting well below average returns relative to the overall market. And you know, that makes sense.

[00:20:42] Clay Finck: If everything’s efficiently priced, then most investors would be getting an average return. So some investors that take advantage of the miss pricings, to one direction, they tend to outperform the market. And then investors who think they’re taking advantage of a mispricing can be burned because they’re buying overpriced stocks.

[00:20:58] Clay Finck: So to some extent, mispricings are creating winners and losers. So the seller of an overvalued stock is considered a winner in a mispricing. And the buyer of an undervalued stock is also considered a winner. Of course, and Marks has the poker analogy that I loved and wanted to share here. In every game, there’s a fish.

[00:21:18] Clay Finck: If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you. The same is certainly true of efficient market investing in quote. And admittedly, I’ve been the fish in the market for a number of years starting out and who knows, I might still be a fish today. So let’s move on here to the subject of risk and risk is definitely a big part of the book and something that marks is pretty well known for in addition to market cycles.

[00:21:42] Clay Finck: Marks dedicates three chapters to risk. So there’s understanding risk, recognizing risk, and controlling risk. He outlines three areas of risk that all investors should understand. So first is risk is bad. So trying to avoid it is smart. Second risk and return are intimately connected. And third, any good investment requires the assessment of the risk involved with making it.

[00:22:05] Clay Finck: So Kyle, what were some of the key takeaways you had with regards to understanding risk that chapter in his book?

[00:22:13] Kyle Grieve: Yeah, so one of my favorite Marks sayings on risk was concerning that second point that you made there on the relationship between risk and return. So Marks shares a risk reward graph where the slope goes up linearly to the right, showing that an increase in risk results in increase in rewards.

[00:22:30] Kyle Grieve: But Marks wrote riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple. If riskier investments reliably produce higher returns, they wouldn’t be riskier. So how does Marks kind of consolidate all this to give a better representation of risk? He says risk investment has more to do with the probability of the distribution of returns.

[00:22:51] Kyle Grieve: He outlines three possibilities, one higher expected returns to the possibility of lower returns and three, the possibility of losses. So this makes sense to me. My preference personally in investing is to attempt to increase the probability of making a higher expected return while simultaneously decreasing the possibilities of losing money.

[00:23:09] Kyle Grieve: And it’s not easy and I’ve definitely been wrong in the past and I know I’ll probably be wrong again in the future. But I think it’s a good way of looking at risk and return. One other addition I’ll make here is concerning volatility. So finance theory loves discussing volatility as the primary component of risk.

[00:23:26] Kyle Grieve: But Marks points out that he doesn’t necessarily think that volatility is a risk that most investors actually care about. So he discusses how he’s never heard any of his colleagues say that they wouldn’t buy something because it has a wide fluctuation in price or if it’s going to have a single down quarter.

[00:23:42] Kyle Grieve: But he does mention that his colleagues will avoid buying something because the returns maybe just aren’t good enough or they’ll lose too much capital making that bet. So for marks risk is the likelihood of losing capital. And this is exactly how all great investors kind of think about investing. It makes me think directly of Monish Pabrai and his asymmetric bets.

[00:24:03] Kyle Grieve: If the bad scenario happens and you don’t lose much and the good scenario happens and you make a lot, then that is what good investors would consider a good investment. They would not be worried about the volatility of that investment if they thought the chances of permanent capital destruction are very, very low.

[00:24:19] Kyle Grieve: They’ll wait out market volatility or take advantage of it to decrease their cost basis.

[00:24:25] Clay Finck: Turning here to how to recognize risk, Howard likes to look at risk sort of from a market cycle point of view and risk to him means more things can happen than will happen. So it’s important to understand when the market is expressing that risky behavior.

[00:24:43] Clay Finck: When we can recognize risk, we can make sure that we’re making investments at that proper time. So some people view this as market timing, but I really don’t think it is. And the reason for that is market timers attempt to buy and sell based on where they think the market will go. As you mentioned earlier, Marks is saying recognizing risk just helps you determine when there will be more or less risk embedded in the market.

[00:25:09] Kyle Grieve: And I think that recognizing risk is very, very important and also just kind of underutilized. So let’s look at an example of an interaction that I had recently. So I have a friend, he’s not an investor, but he knows that I work for TIP and he also wants to generate wealth for himself. So we were talking a little bit about stocks one time, and the conversation shifts to a subject that everyone’s aware of, which is what’s happening with a high lately.

[00:25:34] Kyle Grieve: And because of that, he mentions a stock that probably everyone knows that you already mentioned here, which is Nvidia as a potential investment. So my friend is a smart guy, you know, he has a master’s degree. But he doesn’t spend even a fraction of the time thinking about investing compared to someone like you or me.

[00:25:49] Kyle Grieve: So the concept of risk doesn’t necessarily compute as it’s just, you know, not something that goes through his head. So I think what most investors see when they look at a stock is how far that stock has gone up. And then they daydream about how much farther it can go up after they buy it. And here’s where Marks’s concept of recognizing risk just comes into play.

[00:26:08] Kyle Grieve: So if we look at Dataroma for 13F use on Nvidia, there’s been about 27 submissions in the last year. Nine of those are buys and 18 of them are sells. So what I would hypothesize here is that many of these great investors who own or did own Nvidia probably recognize that the price is becoming overextended.

[00:26:26] Kyle Grieve: And as a result, they’re probably starting to realize that Nvidia is starting to actually increase in risk as the price goes higher and higher, but the market has had this recent history of here bidding the price up more and more as more investors get interested into that business. So the key here is that not all of the investors on data Roma are selling.

[00:26:45] Kyle Grieve: Some of them are buying. So risk tolerance on even very, very good investors that are featured on data Roma. Maybe that’s coming down. It’s kind of hard to say.

[00:26:55] Clay Finck: Yeah. To put it really simply, what marks is really getting at in this chapter is that prices When they get too steep, when prices get too high, he’s just looking at the perspective returns.

[00:27:06] Clay Finck: And that’s just something that really doesn’t interest them when prices get elevated or said another way, when prices do get really elevated, the perception of the risk present is quite low, which coincidentally makes it one of the riskiest times to invest. So in 2005 and 2006, financial experts believed that a nationwide decline in housing prices just wasn’t possible.

[00:27:31] Clay Finck: And this is what led to housing prices getting overextended, getting overvalued, and this sowed the seeds for a nationwide decline in housing prices. So we should be careful listening to anyone try to explain how times aren’t as risky as they once were in the past. And to your example on Nvidia, I’d be curious to know how many investors talking about Nvidia are discussing things like the underlying value and the potential downside instead of all the upside that lies ahead and how much Jensen Huang is just a total genius, which I’m not doubting that he is.

[00:28:03] Clay Finck: What’s also interesting is that Marks believes that risk is actually unmeasurable. So it’s not like there’s a formula for it, but that doesn’t mean that risk isn’t important. His antidote to dealing with this is try to determine the mood of the market. So when he feels that investors are too optimistic and they’re making these riskier investments, then he wants to act with more caution.

[00:28:26] Clay Finck: And if investors are becoming overly pessimistic and they’re fleeing from your typical stocks for things like blue chip value stocks, gold or treasuries, for example, then that is the time that he believes that the pendulum swung the other way. And it’s time to get more aggressive, given that more attractive prices are available.

[00:28:43] Clay Finck: And I almost think of any stock, it lies on like a risk and a return spectrum. So many people will say, for example, Apple’s worth 300 a share or Apple’s going to 300 a share. And my question is, well, what rate of return are you embedding in that stock price? Each person has different expectations for what they’re looking to get out of a stock.

[00:29:05] Clay Finck: So a stock can really trade at any price. There’s an expected return that’s embedded in each one of those stock prices. So in theory, the lower a stock price goes, the higher your expected return. And a stock price is strongly influenced by both the fundamentals as well as the sentiment. Let’s move on here to the third chapter on risk, which is controlling it.

[00:29:27] Clay Finck: At the end of the day, as investors, this is really what we’re trying to do. Marks talks a lot about his investment style and where he feels he adds the most value to his investors. He says in up markets, he’s generally going to track the market, which really doesn’t require much skill in a lot of cases, but he believes that his edge as an investor or where his skill comes in is during the bear markets.

[00:29:51] Clay Finck: Because marks, he just thinks so much about risk throughout any point in the market cycle. And this really goes to show during the bear markets, his portfolios are generally going to go down less than the overall market. So for instance, if the market were to go down 10%, he gives the example of his portfolio only going down 5%.

[00:30:11] Clay Finck: So in Marks’s view, this is what highly skilled investors are really capable of doing. I’ll throw it back over to you, Kyle, to chat about controlling risk.

[00:30:20] Kyle Grieve: Yeah, I think he’s obviously completely correct about the role of skill in market. So in a recent video that he made titled how to think about risk, he showed five potential investor profiles.

[00:30:30] Kyle Grieve: So the first one here is where the investor basically tracks the market perfectly in both up and down cycles. So in this case, the portfolio manager is adding zero value. The second one outperforms in bull markets, but underperformed in bear markets to the same degree. So again, in this case, the manager is adding zero value.

[00:30:50] Kyle Grieve: Sure, they’re taking risk, and they’re outperforming in bull markets, which is great, but when the tide turns, their high levels of risk end up punishing them and bringing them back down to earth, and can often result in overall underperformance. So the third example here underperforms in bull markets and outperforms in bear markets to the same degree.

[00:31:06] Kyle Grieve: So, just like the previous example, this manager is once again adding zero value. So now is when things get interesting, which is when you show what skill can do to help generate value. So the fourth outperforms the market in bull markets and tracks the market in down markets. So you can see there that over a long period of time, they’re going to outperform.

[00:31:26] Kyle Grieve: And then the fifth and final option, which is what Marks kind of compares himself to, as you already alluded to. Is where they track the market in bull markets, but they actually outperform in bear markets. So to your example there, you know, say the market goes up 10%, Mark’s probably going to go up 10%.

[00:31:41] Kyle Grieve: Market goes down 10%, Mark’s is going to only going to go down 5%. So that’s where he gets his outperformance and that’s where he shows his skill. The most skillful investors are going to obviously be in that fourth and fifth bucket. So while Mark’s admires bucket five the most, you can obviously still succeed in bucket four.

[00:31:57] Kyle Grieve: But I think that many value investors specifically will probably be in bucket 5 and it just makes a lot of sense because they’re buying cheaper stocks, which hopefully have less risk. And because they’re cheaper, they’re less likely to be punished, I think, in bear markets. So Mark’s also made a really good point that awards for risk control are never given out in good times.

[00:32:17] Kyle Grieve: So he says the reason is that risk is covert invisible risk. The possibility of loss is not observable. What is observable is loss and loss generally happens only when risk collides with negative events. And I think this is why just so few investors think about risk. It’s really easy to think about how much money you’re going to make in good times, but imagining how much money we can lose during bad times is just not a very enjoyable simulation to think about.

[00:32:45] Kyle Grieve: But as Marks would probably say, it’s very important to try and understand how much risk you are bearing. And if you bear a lot of risk unknowingly, which investors unfortunately do all the time, they are punished for taking that risk when they least expect it. Now, the final point here on risk control I’d like to make is in regards to performance during bear markets.

[00:33:05] Kyle Grieve: I think a lot of investors want to think that their investments will go up each and every year that they’re in the market, but it doesn’t take very long to go back and look at other investors track records to understand that this is not how it works in real life. So there’s going to be bear markets and during these bear markets, you will 100 percent of the time encounter periods when your entire portfolio goes down in price, but not necessarily down in value.

[00:33:30] Kyle Grieve: It’s just a part of investing that you have to live with, but Marks has some very good advice on this. So long term investment success runs through risk control more than aggressiveness. So I think this just goes to show you that you need to make sure that you’re always focusing on what could possibly happen on the downside.

[00:33:49] Kyle Grieve: And if you do that long enough, you know, you’re going to survive and you’ll end up with a very nice track record. Hopefully. The second point here is that, um, investors results will be a function of how many losers they have and how bad those losers are over the greatness of their winners. So, This is super important because in investing, we’re going to be wrong a lot of the time, but if you can make it so that the times that you’re wrong, you don’t end up losing too much money.

[00:34:15] Kyle Grieve: Well then the rest of the times when you’re right, those ones are going to make up for all those losses that you potentially have. So this just kind of goes hand in hand with, you know, position sizing, making sure that you’re somewhat diversified. I mean, we’re not going to go into that too much here just because that’s a whole nother rabbit hole.

[00:34:31] Kyle Grieve: But the key point there is just make sure that if you are losing, you’re hopefully not losing your entire portfolio because that’s something that’s really hard to come back from. And then the final 1 here is that skillful risk control is the indicator of a superior investor. And so if you deem yourself to be a superior investor, or you’re looking at somebody else as a superior investor, you should look at how they’re controlling risk.

[00:34:54] Kyle Grieve: And I think one of the most important points here. Is if you’re looking at your own track record, or if you’re looking at someone else’s track record, use a long time horizon, right? Because if you find someone taking a lot of risk during a bull market, they’re going to outperform the market. And that’s just the way it is, but you have to then look at how they perform during bear markets as well.

[00:35:13] Kyle Grieve: So, according to Marks, if the market, say, goes down 20 percent and your portfolio only goes down 10%, that’s a win, and I think Buffett would also agree with that. Buffett would tell you to think of the market as kind of a yardstick. If you can go a full market cycle of both an up cycle and a down cycle, and you’re ahead of the market in totality, then you are expressing some level of skill.

[00:35:34] Kyle Grieve: And comparing this yardstick analogy to Marks’s examples, you can see how the fourth and fifth option would yield a performance while the first three would yield similar or inferior results to the market.

[00:35:44] Clay Finck: Yeah, I think you’re probably right. That most value investors are in bucket five and it’s sort of an interesting thought experiment because I think.

[00:35:52] Clay Finck: I think value investing itself has evolved in more recent years because you just think of, you know, how for many years in the 2010s we were in a lower interest rate environment and it was sort of a confusing time period for a lot of investors with generally elevated asset prices and a lot of multiple expansion across many stocks.

[00:36:09] Clay Finck: I think back to how companies like MasterCard and Microsoft, they were treating at low double digit P multiples in their early 2010s. You know, some experts were calling for a double dip recession, and we’ll be chatting a lot about quality stocks during our next conversation on the droids of compounding, but.

[00:36:25] Clay Finck: Getting quality at a good price in today’s market can be pretty difficult, especially if you’re looking at U. S. markets, I think, and Marks reminds us that even the highest quality companies can be terrible investments if you’re paying too high of a price, and the lower quality companies can actually turn out to be great investments if you get it at a depressed valuation, and that’s why understanding price is essential.

[00:36:46] Clay Finck: So shifting gears here to market cycles actually covered Marks’s other book, mastering the market cycle back on episode five 59 for those that are interested in checking out his other book and thinking about market cycles with how it relates to companies. At least I personally like to try and avoid cyclical businesses if I can, but I think that essentially all businesses are subject to some level of cyclicality in relation to the broader market, at least.

[00:37:13] Clay Finck: So look at March, 2020. The U. S. dollar was bidding during a liquidity crisis, so you’ll see pretty much every single stock in the market is going to fall during a period like that, even if the fundamentals are improving rapidly and marks rights here that in investing as in life, there are very few sure things.

[00:37:33] Clay Finck: Values can evaporate. Estimates can be wrong. Circumstances can change and quote unquote, sure things can fail. However, there are two concepts we can hold to with confidence. So rule number one, most things will prove to be cyclical. Rule number two, some of the greatest opportunities for gain and loss.

[00:37:53] Clay Finck: Come when other people forget rule number one, end quote. So I read this and I think about how a couple of members in our mastermind community, one member did a presentation on his portfolio, and he’s capitalized on this trend and met coal and uranium, both of which are highly cyclical, but have shown the potential for a lot of upside if you’re able to time that cycle, right?

[00:38:14] Clay Finck: So I’ll give you a chance here to chat about market cycles.

[00:38:19] Kyle Grieve: I find market cycles fascinating for a few reasons. The first is that I find it so interesting how many market participants are interested just in predicting which way the market is likely to go. And the second is that I enjoy gaining insights from where we are today in the cycle, which I feel is a much more useful and practical signal.

[00:38:37] Kyle Grieve: But I think it’s useful here to delineate what Marks is saying. So market cycles are an observation tool, not a predictive tool that any investor can use to better understand things like risk appetite. An example that I recently thought of was just a telescope. So let’s imagine that you are a general in a war 200 years ago, you’re sitting on your horse on a hill, a safe distance away from any harm.

[00:39:01] Kyle Grieve: But in front of you are thousands of your men going to battle against your enemy. They march towards each other and they engage in battle, but the battlefield is large. You pull out your telescope to observe how the battle is going. You can tell that your side of the battle is winning. And you can tell this by just simply observing, you know, maybe your side having more soldiers on the other side, or maybe your side has more advanced technology than your opponent.

[00:39:25] Kyle Grieve: Maybe you’re using guns and they’re using swords. Perhaps you observe that your enemy is fleeing the battlefield. So this is all obviously a really good indication that you have won this particular battle, but it doesn’t give you enough information to tell you if you will win or lose the entire war.

[00:39:40] Kyle Grieve: And that final distinction is what’s so important. You can observe things that will give you a picture of where things stand right now, but your predictive powers on where they are likely to go or how fast things will likely move is going to be very, very weak at best. So let’s look at how Marks assesses credit cycles starting from a period of prosperity.

[00:39:59] Kyle Grieve: So providers of capital thrive and they increase their capital base because bad news is scarce. The risks entailed in lending and investing seem to have shrunk risk averse since this appears financial institutions move to expand their business that is to provide more capital. They then compete for market share by lowering the demand of returns, lowering credit standards, writing more capital for a given transaction and easing covenants.

[00:40:26] Kyle Grieve: So these are the things to look out for during bull markets and these are areas where you might be at the top of the credit cycle and in Marks’s opinion would not be the time that you want to deploy money. So now let’s look at the other side. Let’s say we’re at the peak of a bull market. So once you’re at the peak, the only direction you can go from there is down.

[00:40:44] Kyle Grieve: So as things start to unfold cracks begin forming. So here’s how that part of the cycle forms. So losses cause lenders to become discouraged and shy away. Risk averseness rises and along with it, interest rates, less capital is made available. And at the trough of the cycle, only the most qualified of the borrowers, if anyone has access to credit.

[00:41:04] Kyle Grieve: Companies then become star for capital borrowers are unable to roll over their debts, which can end up leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction. So kind of as clay alluded to during the great financial crisis, this 2nd scenario is kind of what unfolded.

[00:41:22] Kyle Grieve: And this is where marks noted that this was the best possible time to deploy money. But you have to be aware that all of these bad things are happening. And kind of going back to holding non contestant’s views, you have to be willing to go in and deploy money where everyone else is selling and that takes a lot of courage.

[00:41:41] Clay Finck: So what are some of the practical ways in which market cycles can apply to us as investors?

[00:41:48] Kyle Grieve: So the mixture, I think, of observing market cycles and then using that with risk is just a really powerful combination. And I think it’s where the tool of market cycles is most useful. So as I previously mentioned, Marks thinks that successful investors will have fewer losses that have a lower impact on the totality of their portfolios.

[00:42:09] Kyle Grieve: So if we analyze success by inverting and instead consider success through a lack of large failures, we should strive to make investments that accomplish a few key things. One, they have a low probability of bankruptcy. So these are going to be businesses that are probably flushing cash, is generating large amounts of cash, and is unlikely to require capital injections from bank or equity markets in the future for sustaining or for growing the business.

[00:42:35] Kyle Grieve: The second one here is that they should have a robust or anti fragile business models that can hopefully survive and flourish during economic downturns. And the third one here, just to your point about pricing, is that they should not be ridiculously overpriced. So if we search for investments that meet these three criteria, we should be able to hold them through bear markets and come out perhaps even better on the other side.

[00:42:56] Kyle Grieve: Once that bear market shifts to a bull market. But here’s where cycles I think come into play. If we observe where we are in the credit cycle, we can observe a few keys about business. We can see which businesses are on the edge of bankruptcy because they have no access to capital. You could do this just by simply looking at a company’s balance sheet.

[00:43:13] Kyle Grieve: Do they have large amounts of debt and no cash? Okay. And are they not generating cash flow? Well, then how are they going to service that debt in the future? Whereas a good investment, you might look at the balance sheet, might have no debt, might have a ton of cash, and it might be continuing to cash flow into the future.

[00:43:28] Kyle Grieve: That’s obviously a business where the likelihood of going into bankruptcy is going to be very, very low. So you can see here that the fundamentals of the business are all going to be visible to you. You can just use the financial statements to help you make that decision. And then you can just observe what’s happening in those businesses.

[00:43:45] Kyle Grieve: So, if we analyze the credit cycle and we see that credit markets are very risk averse, there is a good chance that prices will also be very, very depressed. And this is why someone like Buffett deploys a lot of capital during economic downturns. If you go back to the great financial crisis, Buffett invested billions into businesses like Goldman Sachs and Marks.

[00:44:04] Kyle Grieve: And he did this because he was very aware of where the market was in its cycle. He could better identify these just significant opportunities. So instead of cowering in fear like a lot of market participants, he ended up buying businesses that were likely to continue performing really, really well. And they were very, very cheap, which obviously reduced risk and increased perspective returns.

[00:44:25] Kyle Grieve: And then he then profited, of course, from the way he structured the deals. And because he was able to extend credit in just really favorable terms for Berkshire Hathaway. So in 2008, Marks wrote, The last several years have provided an unusually clear opportunity to witness the swing of the pendulum. And how consistently most people do the wrong thing at the wrong time.

[00:44:45] Kyle Grieve: When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so. So my big takeaway is that you can use market cycles to help you determine if it’s a good time to deploy capital or maybe just hoard cash.

[00:45:08] Kyle Grieve: If you’re managing smaller sums of money, you may be able to always stay invested. That’s how I invest. But again, you know, the credit cycle still has its usefulness. You can use it to look at where the market is and to try to kind of figure out where your businesses are priced. And that can help you determine if maybe now’s a really good chance to add to a position, or maybe now’s just a good chance to hold onto a position and wait for better opportunities in the future.

[00:45:33] Clay Finck: I do agree with you that understanding market cycles can really help us know when we should be more aggressive or more defensive, but I think for me personally, since I’m earlier on in my investing journey, I tend to have a pretty strong bias towards being fully invested. And I think you’re fairly similar.

[00:45:51] Clay Finck: I mentioned the 2010s, and this is a period of very low interest rates, elevated valuations, and I’m sure many people thought. You know, stocks were expensive for much of that period and they might have sat on the sidelines and I would say for most people, I think this was a mistake, but this is of course hindsight bias at play as well.

[00:46:08] Clay Finck: And similar to the efficient market hypothesis discussion earlier, I think that most of the time stocks are not priced at the extremes. So price way too high or way too low. Usually they’re somewhere in normal territory, whatever normal means. And in my opinion, we shouldn’t wait for a correction that might not happen for, say, multiple years.

[00:46:32] Clay Finck: And some investors to try and solve this issue, they like to use assets that are almost like a cash or a bond proxy. If they aren’t able to find good opportunities within individual stocks or whatever market they’re in. Some people like to use Berkshire Hathaway, for example, since it’s highly defensive and has one fourth of its market cap in cash.

[00:46:51] Clay Finck: Other people like things like a value ETF or an index fund, or even the S&P 500, just to ensure that they are fully invested for the most part. So his memo that was titled the limits of negatism, he shared a bit about his experience during the great financial crisis. And it’s something you sort of see over and over again, when you go through his work.

[00:47:13] Clay Finck: So prior to the GFC, Marks, he started to use some leverage in his fund and it was a pretty conservative amount is much less than many of the other players in the industry. And once asset prices started to collapse and Lehman brothers went bankrupt, all the assets that Marks owned, like anyone else, they were dropping to just unprecedented levels.

[00:47:35] Clay Finck: So Marks needed to raise money to ensure that he wasn’t going to get margin call. And I’m sure he had developed some strong relationships and he knew he’d be able to get more capital from investors. And the markets really just turned into this massive liquidity event. You know, there’s all these margin calls and massive sellers and no buyers in sight.

[00:47:54] Clay Finck: And prior to the GFC, the types of bonds that Howard Marks owned, they rarely sold below 96 cents on the dollar. And after Lehman collapsed, they fell to 70 cents on the dollar and margin calls, you know, we’re just flowing in and prices continued to collapse and no buyers were in sight. And since the prices kept falling, he went out and tried to raise more and more money to try and capitalize on these just amazing opportunities, some of the best opportunities he’s ever seen as an investor.

[00:48:25] Clay Finck: So he approached a pension fund that was one of his investors. But they were worried about the possibility of loan defaults. And then Howard, of course, he’s thought of this. He went on to explain that even if they saw the worst default rate in the history of high yield bonds, their fund would still make money.

[00:48:44] Clay Finck: Just because the prices were so, so attractive. So essentially this particular pension fund was just really scared. They were extremely pessimistic on the economy and Howard’s insight was that when you’re in this really negative environment, people are just going to assume that extremely negative things are going to continue to happen because they’re just extrapolating the recent past.

[00:49:05] Clay Finck: I think recency bias is something you see over and over again when you study these past cycles. And during panics, people spend 100 percent of their time making sure they’re not going to lose money. And this is the exact time that you should instead be worrying about missing out on great opportunities. So that pension funds, they ended up not investing with Howard at that point.

[00:49:26] Clay Finck: And ironically, this is when Howard was making some of the best investments in his career because the prices were just so, so absurdly cheap.

[00:49:35] Kyle Grieve: Before we move away from market cycles, I’d like to share just a really interesting table that Mark shares in the book from the chapter titled having a sense for where we stand.

[00:49:44] Kyle Grieve: So the table has several prompts that you can go through and check off where you think we are in the cycle, which I think can help you hold on to your wallet or open it up. So here are a few of the line items and characteristics to observe. This is just a fraction of them. There’s a lot, but the first one here is the economy.

[00:49:59] Kyle Grieve: Is it vibrant or is it sluggish? And what’s the outlook? Is a positive or is a negative? How is capital flows happening? Is it plentiful or is it scarce? What are interest rates like? Are they high or are they low? What’s investor sentiment? Is it optimistic? Are they eager to buy? Or are they pessimistic and uninterested in buying?

[00:50:19] Kyle Grieve: And what’s the recent performance of the asset? Is it strong or is it weak? So if you check these off and your checks are leading to the left, Mark says it’s a good time to hold onto your wallet and wait until it moves to the right.

[00:50:31] Clay Finck: Wonderful. So turning here to probably one of my favorite chapters, it’s on appreciating the role of luck and investing is one of those fields where you really don’t know if your good results are primarily a result of luck or primarily a result of skill.

[00:50:48] Clay Finck: So someone who’s extremely knowledgeable can achieve poor results and look like a fool. And someone who knows next to nothing about stocks can have the best results out of everybody because they got purely lucky. So I try to remove the role of luck when I’m looking at someone’s track record. For example, ideally they have a track record of at least 10 plus years, and then see how their performance has varied over different time periods.

[00:51:12] Clay Finck: If they have a long track record, for example, what works in the 2010s might not work as well in the years that followed. And it reminds me, I’ve recently interviewed Richard Lawrence from overlook investments, and he has a track record of 14. 3 percent over 30 years. He had wrote in his book titled the model that I recently read that they outperformed when the fund was small, they outperformed when the fund was mid sized and they outperformed when they had a large fund.

[00:51:37] Clay Finck: So I would say that when it came to stock selection, he had a pretty dang good process that nailed down that skill set of picking great companies at great prices and minimize the role of luck in this process. And they also really enjoyed learning more about the role of luck from Nassim Taleb’s book, fooled by randomness.

[00:51:55] Clay Finck: Taleb believes that a substantial amount of success in the field of investing is driven by luck. And it’s just really difficult, if not impossible, to distinguish luck from skill when looking at anyone’s track record. And another key lesson that Taleb helped me better understand was survivorship bias.

[00:52:12] Clay Finck: So if you have 5 million people enter the world of investing, it really shouldn’t come as a surprise that one of them would turn out like Warren Buffett. And if millions of people are starting businesses, working like crazy, really smart people, you’re bound to have an Elon Musk and a Jeff Bezos come out of that.

[00:52:30] Clay Finck: And the danger is that these outliers can almost deceive us into thinking that what they did was easy and can be easily replicated and ignore the countless people that failed that we never even heard of. So, nobody would go out and say that Buffett’s success was But it certainly played some sort of part in it.

[00:52:51] Clay Finck: So I’ll throw this over to you to share your takeaways on luck.

[00:52:55] Kyle Grieve: My first introduction into the role of luck and skill was in reading this exact book. And one of my favorite quotes was, I always say that the keys to profit or aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.

[00:53:10] Kyle Grieve: So I think we’ve already talked a lot about the role of skill here and how over the long time periods it’s required in order to consistently outperform the market. But I remember back in 2020 when I was following a number of tech stocks, such as meta on seeking alpha. And I would get just bombarded with updates from different hedge fund letters that a tag met as one of the stocks that they owned.

[00:53:32] Kyle Grieve: So I’d open up the letter and I’d eagerly check their performance for the year. And I was often just blown away because the fun as a whole would be up in excessive, say 40%, sometimes even 50%. And I will admit that I definitely had some envy, but luckily I didn’t pull the trigger on many of these types of investments other than Alibaba, but that’s another story.

[00:53:49] Kyle Grieve: But I was lucky that the most important thing was one of the first investing books that I ever got my hands on because I understood well that investors returns will go through periods of over and under performance and the quote above really stuck in my head because I believed in the next bear market.

[00:54:05] Kyle Grieve: There was a pretty good chance that some of the funds that owned a lot of these high flying tech stocks would massively underperform in the next bear market. Whenever that would happen, I obviously had no idea. And then, you know, fast forward to 2022 and that’s basically exactly how it played out.

[00:54:21] Kyle Grieve: Unfortunately, with a lot of these funds, the S&P 500 decreased by 19%. And many of these same funds that I was admiring were now down say 30, 40, or even 50 percent or more. So this example does just an excellent job. I think of showing Howard’s points on risk taking, you know, you can take lots of risks and be lucky where the outcome will be outstanding.

[00:54:42] Kyle Grieve: But then when the market turns, the risk you took comes to light and the outcome to the downside just wipes away the excessive performance that you previously had on the upside. So here’s what Marks says happens during boom times. The easy way to see this is that in boom times, the highest returns often go to those who take the most risk.

[00:55:00] Kyle Grieve: That doesn’t say anything about them being the best investors. The critical takeaway is that we can’t attribute high skill levels to outperformance in a bull market. Now this applies to everyone from institutions to retail investors. Well, it’s great to look at your performance during bull market and feel elated because of how well you’re doing.

[00:55:18] Kyle Grieve: Emotions have to be controlled because it’s during these boom times that the potential downside risk needs to be at the forefront of people’s minds. I tend to be a buy and hold investor, so I have no problem holding during bull and bear markets. But I think that it’s really essential to regularly monitor your portfolio to see if any of your holdings are exhibiting bubble like behavior or even less severe.

[00:55:39] Kyle Grieve: You should know just if your business are getting too expensive, that your body is exhibiting any signals causing pain or discomfort. If you can’t sleep because you were thinking about how expensive one of your holding is, then that’s a really good signal that I think you should address. And then I just want to finish this part off.

[00:55:55] Kyle Grieve: The thing about luck is that theoretically speaking, a monkey could throw a dart at a dart board. And let’s say that aligns with a certain stock. Let’s say it was Nvidia in 2020. That was the only stock they bought. They probably would have done really, really well. But in reality, they just got lucky. I know Nassim Taleb has this concept called a lucky fool, and I would consider that exact scenario to be a lucky fool where, you know, you’re just kind of throwing a dart in the dark, and you’re landing on something good, and over that short time period, luck can obviously give you great rewards, or you can be really unlucky and you can go to zero.

[00:56:27] Kyle Grieve: But over a very, very long time period, I think that skill will ultimately drive what your performance is.

[00:56:33] Clay Finck: Yeah. And the more you’re in the investing game, the more you realize just how short like a one or two year time period can be, you know, something can work extraordinarily well over one or two years, but can it endure over the really longterm is sort of what matters if you’re going to hang onto it for that long.

[00:56:51] Clay Finck: And in understanding luck, it’s also important to understand alternative histories. So people tend to. Also, just fixate on outcomes and not the randomness that was associated with that outcome and also the alternative histories. And when I was thinking about alternative histories for the episode I did on Fooled by Randomness, I was reminded how, when I was a kid, I watched the New York Giants beat the New England Patriots in Super Bowl XLII in 2008.

[00:57:19] Clay Finck: I don’t know if you watched that game, but there was a play where David Tyree wide receiver for the Giants. He had this, what I would call like almost a miracle catch. And shortly after they went on to win the game and he made that catch with like a minute left. So had that catch not been made, it’s very possible that the Giants wouldn’t have won, but people are going to be fixating on the outcome.

[00:57:39] Clay Finck: So maybe many people would say, hey, I should have bet money on the giants or whatnot. And when we look back at the history books, it’s just going to show the giants want it’ll show the score. It won’t say how much luck was involved and there won’t be an asterisk that says that there’s this miracle catch made with one minute left.

[00:57:56] Clay Finck: So lab has this really funny quote that I think ties in well here. So he says such tendency to make an unmake profits based on the fate of the roulette wheel. Is symptomatic of our ingrained inability to cope with the complex structure of randomness prevailing in the modern world. And I think it’s a good reminder that we really need to train our minds to try and think in these probabilistic terms and think about the alternative histories that may have played out or may play out in the future instead of just fixating on those outcomes that bring so much hindsight bias with it.

[00:58:31] Kyle Grieve: Yeah, those are some great points there, Clay. And that Taleb quote does a really good job expressing of how much randomness there is in the world and just how bad we are at dealing with it. So Marks added some great commentary on alternative histories that I’d like to expand on here. So alternative histories are the other things that reasonably could have happened.

[00:58:50] Kyle Grieve: Now, this is just a very powerful concept because when we look at the future, we are definitely aware that there is uncertainty, but that uncertainty just gets thrown out the window when we look at history as we have a clear picture of what happened. The point about alternative histories is that the narrative that played out was just one of many potential narratives, just like your Super Bowl example there.

[00:59:11] Kyle Grieve: So even if your strategy worked well on what ended up happening in the past, how do you necessarily know how it would have played out in an alternative narrative? So, this is just a very interesting thought experiment to use to help make just better decisions in the future. It plays very well as well with probabilistic thinking that you just brought up, which is a significant tenant, I think, for great investors such as Howard Marks and Warren Buffett.

[00:59:35] Kyle Grieve: So, let’s use this theory to maybe explore some practical use cases. Obviously, we cannot change the past, but I think we can spend some time thinking about it and using alternative histories to create alternative narratives. We might then just observe what happened in previous markets during similar narratives, and I’m talking about things that actually happened in history, not alternative histories.

[00:59:56] Kyle Grieve: Even though we’ll never be able to align an alternative history with what happened in reality, I still think it’s just a good tool because at least we’ll have some degree of knowledge of how much risk maybe we were taking. Now I want to talk about an excellent thought experiment that Marks writes about regarding decision making here.

[01:00:14] Kyle Grieve: So what is a good decision? Let’s say someone decides to build a ski resort in Miami, and three months later, a freak blizzard hits South Florida, dumping 12 feet of snow. In its first season, the ski turns a hefty profit. Does that mean building it was a good decision? No. A good decision is one that a logical, intelligent, and informed person would have made under the circumstances as they appeared at the time before the outcome was known.

[01:00:39] Kyle Grieve: So even though alternative histories can be taken to all sorts of places, like Mark says, a good decision must be based on the circumstances as they appeared before the outcome was known.

[01:00:50] Clay Finck: That Miami example you mentioned is so similar to just some of the things you see in investing. So even if GameStop, for example, or any stock goes up 100 percent in a month, that doesn’t mean it was a wise decision to buy it.

[01:01:03] Clay Finck: Now when it comes to investing, one of the most difficult parts is finding bargains instead of let’s say value traps, let’s call them. And oftentimes cheap stocks are often cheap for a reason. So you really have to sift through and understand the situation quite well. Mark says a chapter on bargains.

[01:01:21] Clay Finck: What does he suggest to how we can find bargains and take advantage of them?

[01:01:27] Kyle Grieve: Bargain hunting I think is probably one of the most enjoyable and rewarding parts of value investing. Marks, of course, also has some very fantastic advice on where to find underpriced assets. So it’s important to remember here that Marks plays in the bond world, but his points on where to find underpriced assets works perfectly well in the stock market as well.

[01:01:45] Kyle Grieve: So he has a seven point checklist of where to look for underpriced assets. So, one, unknown and misunderstood, maybe going over these in a little more detail. Two, be a little ugly on the surface. Three, controversial, unseemly or scary. Four, deemed inappropriate for respectable portfolios. Five, unloved. Six, owns a record of poor returns.

[01:02:05] Kyle Grieve: And seven, higher selling pressure than buying pressure. He breaks it down further and makes it as simple as possible. To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that the perception has to be considerably worse than reality. This is a fundamental notion for finding bargains.

[01:02:23] Kyle Grieve: You must search for businesses where a gap exists between perception and reality. Now, there’s just a ton of example of this, so let’s dig a little bit deeper. A simple example I’ve spoken about is Warren’s initial purchase of American Express. It had just gone through being associated with this massive, enormous scandal, which was already baked into the stock price.

[01:02:42] Kyle Grieve: The market perceived that American Express would lose earnings power, but Buffett did work to discover that this commonly held perception didn’t actually align with reality. By going into businesses that accepted their payment cards, he found that users were still using their cards to pay for goods.

[01:02:58] Kyle Grieve: The fact that the scandal happened didn’t actually make people less likely to use their cards. And so we bought it and ended up doing very well on that investment. Now, this example ticks almost all of Marks’ boxes, except maybe 0. 6, which is the owns a record of poor returns. And I’m talking about that in the light of fundamentals, not stock price.

[01:03:16] Kyle Grieve: This point is one where I don’t necessarily disagree with Marks, but it’s an area where I don’t necessarily go fishing for ideas. I don’t mind a very short period, for instance, of poor returns. Again, fundamentally speaking, not stock price. You know, let’s say a business, maybe it has a slowdown in growth, or maybe it has a weak quarter.

[01:03:36] Kyle Grieve: If I have a long term holding that’s maybe going through these types of headwinds, I don’t have a problem with that. You know, it’s part of the cyclicality of businesses. And a lot of times I’ll use this as an opportunity to add to my position. So Clay and I did an episode on Dino Polska, which was episode 587, which is a business that we both own.

[01:03:53] Kyle Grieve: And the business right now, as of September 17th, is going through some pretty big headwinds. So the current headwinds are in relation to the price war that’s going on between two of their biggest competitors, and this is causing margin compression. However, I personally believe that these headwinds will be short lived, and I have taken this opportunity with the decrease in share price to actually add to my position rather than sell out of fear or anything.

[01:04:15] Kyle Grieve: So time will tell if my perception of Dino Polska is correct or not. Now, as I’ve matured as an investor, I realized that I am comfortable with a more concentrated portfolio. I’m increasingly interested in some of the characteristics that Marks listed above. I think it’s useful to examine all of the businesses that you have in your portfolio and observe possible weaknesses closely.

[01:04:36] Kyle Grieve: If you deem these weaknesses as being short lived in nature, you can monitor what happens in reality. And if a short term event happens that you’ve literally already thought about and maybe had some idea that could happen, you can then use the weakness to add to your position at depressed prices. So here are some things to look for in each of Marks points that I went over.

[01:04:53] Kyle Grieve: So to the point about being unknown and misunderstood, I think you should look for businesses that have minimal or zero institutional ownership. These are the types of businesses that are often left for dead, even though they might actually be quality businesses or growing earnings at astonishingly high rates.

[01:05:10] Kyle Grieve: So these are frequently misunderstood for the very reason that very few institutions follow them, which makes them less discussed in investment circles. The second one here to do with being a little bit ugly on the surface. It’s Some businesses may look ugly on the surface, but when you just really dig down into the depth of the businesses, you realize how strong the business really is.

[01:05:31] Kyle Grieve: There’s just so many examples of companies maybe that have certain segments that are holding the business down and making it look less attractive than it actually is in reality. And what often happens is they spin these poor segments off and the original business is better off for it. If you find these types of investment opportunities, you can make some really good ones.

[01:05:49] Kyle Grieve: The next point here is on being a business that’s controversial, unseemly, or scary. This is a good quality because it means that other investors will not want to get involved. In TIP 651, I spoke with Scott Barbie about a business that he owned called Orezone. This business owned a mine in Burkina Faso, and that area has had a very, very rocky history in terms of internal country risk.

[01:06:12] Kyle Grieve: But squat invested there anyways, because it was cheap and he thought the business was still undervalued. The best part about businesses that are scary is that it usually scares away money from entering the idea. So if you hold a correct variant perception, you can be very well rewarded. The next one here about being deemed inappropriate.

[01:06:28] Kyle Grieve: For respectable portfolios, many portfolio managers have to defend what they own to their partners. If something is inappropriate, they may get enough pressure from their partners that they actually have to sell it and never buy something in that similar industry again. And this has the effect of keeping businesses unloved, which has many additional benefits that I’ll cover on next year.

[01:06:49] Kyle Grieve: So unloved, unloved businesses obviously tend to be very out of favor. They’re rarely discussed, and if they are, it’s usually in a very negative light. This is why looking at newspapers can be beneficial if you are looking for potential bad news, not good news. Since the media likes to focus on specific stories in a very negative light, they often scare investors away rather than attract them to a specific idea.

[01:07:11] Kyle Grieve: So the next one here is that it owns a record of poor returns. I spoke about this one above. The right business going through some temporary hiccup might have a decrease in their fundamentals that results in a reduction in the share price. Dino Polska was the example I gave. Now the market loves momentum.

[01:07:26] Kyle Grieve: And if a business loses momentum, sometimes market participants will sell out of that lower momentum and buy into higher momentum stocks or other ideas. So this can result in a company where things aren’t necessarily going perfectly fundamentally wise, but a quick regression to the mean towards normalization can often be an excellent catalyst for future returns.

[01:07:46] Kyle Grieve: And the last one here, which is higher selling pressure than buying pressure. It’s quite simple. You know, if there are more sellers of a stock than there are buyers, the share price goes down. That’s just how market works. This point is generally a result of all the aspects above. If everyone is selling and you’re the only buyer, you’re likely to get a very, very cheap price.

[01:08:03] Kyle Grieve: But you also have to have a contrarian view that defers from all the sellers and all the other people that are running for the doors. One good question to ask when the price of a stock is cheap is why are people selling it to you? If you can answer those questions and deem that their reasoning is incorrect, you probably have a very fine investing opportunity.

[01:08:20] Clay Finck: All very, very good points. And this ties in well to one podcast, which is that the point of investing isn’t to buy good things, but from buying things well. It’s not what you buy, it’s what you pay. And it’s just such a profound idea. I think it’s also worth mentioning that the market almost always tends to offer opportunities at almost any point in time because there are just so many stocks and so many opportunities in the market.

[01:08:48] Clay Finck: So. While some markets are hot, other markets might be getting hammered. If all eyes are on U. S. large caps, investors are probably overlooking other pockets of the market, whether that be in small caps in the U. S. or good companies in other areas of the world. So China today is an area that’s quite unloved, and I think most investors don’t want to touch China because it’s just a tough market to get a handle on.

[01:09:10] Clay Finck: And I’m almost certain that there’s people out there that are finding bargains, such as Richard Lawrence’s firm, like he’s done for many years. Howard also made a great point in relation to high yield bonds in his book and how people would make these just blanket statements such as high yield bonds or junk bonds, which obviously have high risk of default.

[01:09:30] Clay Finck: So why would this possibly be appropriate for a pension fund or an endowment? This blanket statement made no mention of the price that’s offered by the market. So Marks came to the key realization early in his career that if practically nobody owned Then demand for it over time is likely to only go up and thus prices will increase.

[01:09:52] Clay Finck: Additionally, if something goes from taboo to even just tolerated by investors, then it can still perform pretty dang well. So in relation to bargains, the last topic we’re going to be chatting about today is patience. Buffett has often said that one advantage of being a stock market investor is that we shouldn’t feel the pressure to act.

[01:10:14] Clay Finck: And it isn’t like in baseball, of course, where you get three strikes to put the ball in play. So you could look at a thousand pitches and investing before swinging if you really wanted to. And that’s really not out of the ordinary for someone like Buffett, who in the early days would be sifting through every page of the manual.

[01:10:31] Clay Finck: I think acting too quickly is what a lot of investors do when they first get started. At least that’s what I did. They hear a great story, they start to act on it, and they don’t really strongly consider any other opportunities. And I know I certainly did this because I didn’t necessarily know exactly what I was looking for.

[01:10:50] Clay Finck: I was just looking for a decent story that I could cling to in the market.

[01:10:55] Kyle Grieve: So I liked how marks built on the mental models in this chapter on patient opportunism, because as investors, we get to choose when we get to swing at the ball, just like you mentioned with Buffett. And since we get to take advantage of this, our default stance should be that we are in the batter’s box, with the bat on our shoulders, not even taking part.

[01:11:14] Kyle Grieve: So as Marks points out, this is Buffett’s version of patient opportunism. We can circle this back around to understanding market cycles as well. When we build awareness of where we are in the market cycle, we can further determine the best time to step up to the plate and swing for fat pitches. Or, if we recognize that we are in a high risk environment, we can just remain in the batter’s box, waiting for the tide to turn.

[01:11:35] Kyle Grieve: This concept of patient opportunism might be best expressed, I think, by Pulak Prasad, who wrote one of my favorite investing books, What I Learned About Investing, from Darwin. I spoke about this book on TIP, episode 597. So Pulak points out that 169 months passed between June 1st, 2007 and June 30th of 2021.

[01:11:55] Kyle Grieve: His fund, Nalanda Capital, invested a total of 1. 86 billion during this period of time. Now to the naked eye, this seems completely normal, but it is the times of concentrated capital deployment that are most important here. So Prasad points out in his book that 46 percent of the total capital deployed was invested in a 26 month period, or using the Marks metaphor Pulak Prasad only took the bat off his shoulders and went to the plate to swing 15 percent of the time.

[01:12:20] Kyle Grieve: And the dates that they did this swing were during severe market downturns. If we look at COVID 19, he was even more active in an even shorter period. They invested nearly 22 percent of their capital in three months. You need to deploy 22 percent of capital in only 2 percent of their existence at that time.

[01:12:38] Kyle Grieve: So Pulak Prasad invests in very high quality businesses, kind of similar to what Clay and I do here. So it really makes sense for him to use these market downturns to deploy the maximum amount of capital while remaining inactive for the majority of the time. I will say that pool like a structure is fun to take full advantage of these types of events, which doesn’t require him to hold large amounts of cash in it.

[01:12:58] Kyle Grieve: This is a incredibly intelligent move as it keeps his returns high and allows him to call on capital when it’s needed at very short notice. Now, this isn’t a feature, unfortunately, that every investor can access, but I think it’s a very exciting feature that I don’t see utilized by very many other institutional investors.

[01:13:14] Kyle Grieve: Now all investors, I think, should practice this patient opportunism. But from my observations, it’s one of those qualities that I think is very hard for every single investor to have or to even develop. I think there’s some degree of inherent patience that some people either have or don’t have. But you know, even if you are an impatient person, which I consider myself to be, you can still express patience in crucial areas of your life.

[01:13:39] Kyle Grieve: And for me, luckily, I’m able to express patience in investing.

[01:13:43] Clay Finck: Yeah. What I Learned About Investing from Darwin, such a phenomenal book. It’s another one we should cover one day on the show here again. And we alluded to this earlier, but Marks outlines in the chapter on patient opportunism, that there really isn’t an easy answer to dealing with overvalued markets.

[01:14:00] Clay Finck: So we can invest in acceptable opportunities, focusing on the longer term, taking that good return instead of taking, say, a very attractive return, like what Pulak’s looking for. We can hold cash. We can look into different markets, but Howard suggests that the very last thing we should do is reach for return.

[01:14:20] Clay Finck: So essentially that means start overpaying for things. So I think that’s all we had for today’s episode covering the most important thing by Howard Marks. We’ll be sure to get the book linked in the show notes in case you’re interested in checking it out. And I also cover this book on the show a couple of years back.

[01:14:36] Clay Finck: I can get that linked as well. Also, be sure to check out the episode coming out this Saturday, Kyle and I are going to be discussing The Joys of Compounding, diving deep into the philosophy of quality investing. And then lastly, if you’re interested in collaborating with many TIP audience members, portfolio managers, sharing stock ideas, and joining a community of like minded investors, you may consider checking out our TIP mastermind community.

[01:15:01] Clay Finck: And I’ll also get that linked in the show notes as well. So thanks so much for tuning in and I hope to see you back here on Saturday, Kyle. Thanks for joining me for today’s episode.

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