Investment Wisdom

Howard Marks, Chairman of Oaktree Capital Management, publishes memos that we enjoy following. He has been investing since the 1960s and maintains a very successful track record. Excerpts from his most recent memo, “It’s Not Easy,” are worth sharing. In the 15-page piece, Marks reviews more than 15 popular nuggets of investment “wisdom,” pointing out their potential flaws and misconceptions that lead investors astray.


Marks describes them as “a collection of time-honored bromides that range from (a) only effective part of the time to (b) just plain wrong. These investment myths are pervasive but of little help. That fact leaves the investor to struggle in a complex, challenging environment.”


We will review 10 of the investing rules of thumb he critiques that resonated with us and can help us all become better dividend investors.


1. Risky investments produce high returns

Marks’ Thoughts: “This is one of the greatest of the old saws, and one of the wrongest. A collection of low-risk investments can produce a high return if the low-risk character of the components permits them to perform dependably and keeps there from being any big losers to pull down the overall result. An absence of losses can give you a great start toward a good outcome. On the other hand, high-risk investments can’t be counted on for high returns. If they could, they wouldn’t be high-risk. High-risk investments can fail to provide the high returns they seemed to promise if the analysis underlying them proves to have been ill-founded or if they run into negative developments.”


What It Means for Dividend Investors: the first thought that comes to mind is the desire to chase high yield dividend stocks. In almost all cases, dividend yields in excess of 5% signal either extremely weak dividend growth prospects or risk of the current dividend payment being cut in the near future. Both of these scenarios can lead to capital losses and disappointing long-term performance. You can check a dividend payment’s safety by checking its “Safety Score” in our Stock Analyzer tool (scores are out of 100; 25 is risky, 50 is average, 75 is very good).


2. It’s desirable that everything in a well-diversified portfolio performs well

Marks’ Thoughts: “The truth is, if all the holdings were to perform well in one scenario, they could all perform poorly in another. That means the benefit of diversification wouldn’t be enjoyed. It shouldn’t be surprising – or totally disappointing – to have some laggards in a portfolio that’s truly well-diversified.”


What It Means for Dividend Investors: many dividend investors are still licking their wounds after feeling the effects of the commodity collapse ripple through their portfolios, hitting favorites from XOM to CVX to CAT. Many industries have very different drivers from each other, and dispersion is to be expected. Make sure your sources of dividend income are spread across different types of industries and businesses – predicting which sector will rise or fall next is impossible. If nothing has changed to the long-term outlook of your laggards, you might want to think twice before making an emotional sale. The market chorus can change quickly, shifting industry winners and losers within weeks.




3. Understanding the science of economics will enable you to safely harness the macro future

Marks’ Thoughts: “There are no immutable rules in play. ‘In economics and investments, because of the key role played by human nature, you just can’t say for sure that ‘if A, then B’ as you can in real science. The weakness of the connection between cause and effect makes outcomes uncertain. In other words, it introduces risk.’ (“Risk Revisited,” September 2014).”


What It Means for Dividend Investors: we are most reminded about this investing myth with the recent speculation about the impact rising interest rates will have on dividend stocks. Such generalizations are impossible to make, but they draw in plenty of listeners and readers. Our last article takes a long-term view on the interest rate debate. Ultimately, no one knows what will happen or what other factors will be at work impacting investment outcomes, and our brains are not good at processing so many different variables working together at once. The best we can do is consistently, conservatively, and logically analyze dividend stocks to assess their quality and valuation attractiveness over a range of different outcomes.


4. Sometimes the outlook is clear, and sometimes it’s complicated and unpredictable. You have to be careful when it’s the latter

Marks’ Thoughts: “The truth is, the future is never worry-free. Sometimes it seems to be, because no risks are apparent. But the skies are never as clear as they seem at their clearest. Which is more treacherous: when everyone understands that the future presents risks, or when they believe it to be knowable and benign? As I mentioned earlier, I worry about the latter much more than the former.”


What It Means for Dividend Investors: buying a consumer staple dividend stock like PG or CL might give us comfort – we know the dividend is very safe and business results are very predictable. As such, these types of investment scenarios can become the riskiest from a valuation standpoint when everyone flocks to them mindlessly. The future will always contain a degree of uncertainty, and sometimes the safest looking dividend stocks turn out to be the riskiest – who would have ever thought in 2013 that within two years we would be analyzing whether or not CVX could continue paying its full dividend?


5. Correct forecasts lead to investment gains

Marks’ Thoughts: “The easiest way to have a correct forecast is to extrapolate a trend and see it continue as expected. Most forecasters do a lot of extrapolating, meaning their forecasts are usually broadly shared. Thus when the trend does continue, everyone’s right. But since everyone held the same view, the continuing trend was probably discounted in advance in the price of the asset, and the fact that it rolls on as expected doesn’t necessarily produce profit. For a forecast to be highly profitable, it has to be idiosyncratic. But, given how often trends continue, idiosyncratic forecasts aren’t often right.”


What It Means for Dividend Investors: it’s a challenge to break free from the linear thinking we often employ with our investment analysis – e.g. the dividend yields 3% and earnings are growing 4-6%, so the stock’s total return should be 7-9% per year going forward. The world is far too chaotic to expect anything to follow a straight path. As dividend investors, we need to embrace a longer-term investment horizon and stick with it, even when a stock temporarily runs off the extrapolated path. In these situations, if nothing has changed with the dividend’s safety and the company’s long-term outlook, you might have an opportunity to buy a great business at a discount as other market participants extrapolate unfavorable near-term headwinds.


6. The earning of a profit prove the investor made a good decision

Marks’ Thoughts: “One of the first things I learned at Wharton was that you can’t necessarily tell the quality of a decision from the outcome. Given the unpredictability of future events and, especially, the presence of randomness in the world, a lot of well-reasoned decisions produce losses, and plenty of poor decisions are profitable. Thus one good year or a few big winners may tell us nothing about an investor’s skill. We have to see a lot of outcomes and a long history – and especially a history that includes some tough years – before we can say whether an investor has skill or not.”


What It Means for Dividend Investors: if a stock you bought rises 10% over the next three months, was it a successful investment? Did that price movement validate your thesis? No. Anything can happen in a matter of months, and oftentimes it has little, if anything, to do with a stock’s long-term dividend growth potential. Continue to seek out companies that have the best potential to keep raising their dividends year after year but are not trading at nose-bleed prices.


See a List of Companies with 20+ Straight Years of Dividend Growth



7. A low price makes for an attractive investment

Marks’ Thoughts: “I talked at the bottom of page seven about the importance of price in determining whether an investment is risky. But if you reread the part in bold, you’ll see it doesn’t say a low price is the essential element. An asset may have a low absolute dollar price, a low price compared to the past, or a low P/E ratio, but usually the price has to be low relative to the asset’s intrinsic value for the investment to be attractive and for the risk to be low. It’s easy for investors to get into trouble if they fail to understand the difference between cheapness and value.”


What It Means for Dividend Investors: a high dividend yield is not enough information to go off of to make an investment decision. Are the company’s earnings declining? Is the dividend safe? If business fundamentals are falling, can they recover? A high yield can almost always go higher…or suddenly drop after the dividend is cut. You can check out the key fundamental and valuation information for most dividend stocks here.


8. Assets that are appreciating deserve your attention

Marks’ Thoughts: “Most people impute intelligence to the market and thus they think rising prices signal fundamental merit. They may be attracted to ‘momentum investing,’ which is based on the belief that something that has been appreciating is likely to continue doing so. But the truth is, the higher the price (everything else being equal), the less attractive an asset is. Momentum investing works until it stops, at which time the things that have been doing worst – and may be the most undervalued – take over market leadership.”


What It Means for Dividend Investors: emotions can be our worst enemies when it comes to managing our portfolios. High-flying dividend aristocrats are quick to capture our attention, but patience is a profitable virtue. Ted Williams, one of the best baseball players of all-time, would break up the strike zone into about 40 baseball-sized sections. He knew which zones gave him the best chance to get a hit and would wait patiently for his pitch. Investing is no different – establishing a strategy before investing helps take emotions out of the equation during periods marked by extreme price movements, up or down. After all, buying something that has risen because it makes you feel more “comfortable” has nothing to do with the stock’s value relative to its price. The same is true of selling after a stock has declined because it feels uncomfortable to own it.


9. It’s important to do what feels right

Marks’ Thoughts: “The best investors know intellectually what the right thing to do is. But while this knowledge gives them comfort, they have to tamp down their feelings in order to follow it. The best ideas are ones others haven’t tumbled to, and as I wrote in ‘Dare to Be Great,’ ‘Non-consensus ideas have to be lonely. By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron…Most great investments begin in discomfort.’ Good investors are subjected to the same misleading influences and emotions as everyone else. They’re just more capable of keeping them under control.”


What It Means for Dividend Investors: just like emotions drive us to want to buy the best performing dividend stocks, they also drive us away from unpopular ideas. When no one agrees with your investment position, it’s not a great feeling. Our recent analysis of Caterpillar (CAT), found here, caused a bit of a stir when we posted it on Seeking Alpha. Given the stock’s decline and unfavorable end markets at the moment, sentiment is pretty sour. During these times, it is more important than ever to stick to your conservative analytical framework to identify dividend stocks with the best long-term outlook to provide dividend growth and capital appreciation. Stay rooted in facts, not emotions.


10. The level of risk in a portfolio can be kept low by applying a simple formulaic process

Marks’ Thoughts: “Rather, risk comes in many forms and they can be overlapping, contrasting and hard to manage. For example, as I said in ‘Risk Revisited,’ efforts to reduce the risk of losing money invariably increase the risk of missing out on gains, and efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics.”


What It Means for Dividend Investors: many mechanical or formulaic processes used to select investments and reduce risk can seem brilliant and foolproof while they work – “I will only buy dividend stocks trading at less than 16x earnings and yielding at least 4% to make sure the stock is cheap. Each holding will account for 5% of my portfolio’s initial value to make sure I am diversified.” What if most of these stocks have high debt loads and rates start to rise? Are many of them attached to demand trends in China or indirect demand related to oil prices? What is risk, really? If risk is defined as the permanent loss of capital, then such a simple formulaic does nothing more than provide false sense of confidence. Do your homework. There are no shortcuts.


If you are interested, Howard Marks’ entire memo can be found here. The memo starts with a Charlie Munger quote about investing – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” Whenever you feel like an investment decision is obvious, remember Marks’ memo and make sure your own fundamental analysis and valuation work has led you to your conclusions, not some talking head, polished financial writer, recent stock price movement, or opinion of the investing herd.

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