The Most Important Thing

chapter 6, I expressed my view that (a) the capital market line

112 PATIENT OPPORTUNISM then was “low and fl at,” meaning prospective returns in almost all mar￾kets were among the lowest we’d ever seen and risk premiums were the narrowest, and (b) if prospective returns should rise, it’d likely happen through price declines. But the hard question is, what can we do about it? A few weeks later, I suggested a few possibilities: How might one cope in a market that seems to be off ering low returns? • Invest as if it’s not true. Th e trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in re￾sponse to my memo, in which he said something wonderful: “Th e market’s not a very accommodating machine; it won’t pro￾vide high returns just because you need them.” • Invest anyway— trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute. • Invest anyway— ignoring short- run risk and focusing on the long run. Th is isn’t irrational, especially if you accept the no￾tion that market timing and tactical asset allocation are diffi - cult. But before taking this path, I’d suggest that you get a com￾mitment from your investment committee or other constituents that they’ll ignore short- term losses. • Hold cash— but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t. • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy. Th e truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one

PATIENT OPPORTUNISM 113 course of action— one classic mistake— that I most strongly feel is wrong: reaching for return. Given today’s paucity of prospective return at the low- risk end of the spectrum and the solutions being ballyhooed at the high- risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier in￾vestments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return in￾crements for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of ) in the past, when the prospective returns were much higher. Th is may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fl eeing from it, not when they’re competing with you to do so. “There They Go Again,” May 6, 2005 It’s clear that this was written too early. May 2005 wasn’t the perfect time to get off the merry- go- round; May 2007 was. Being early provided a good reminder about the pain involved in being too far ahead of your time. Having said that, it was much better to get off too soon in May 2005 than to stay on past May 2007. I’ve tried to make clear that the investment environment greatly infl uences outcomes. To wring high returns from a low- return environment requires the ability to swim against the tide and fi nd the relatively few winners. Th is must be based on some combination of exceptional skill, high risk bearing and good luck. High- return environments, on the other hand, off er opportunities for generous returns through purchases at low prices, and typically these can be earned with low risk. In the crises of 1990, 2002 and 2008, for example, not only did our funds earn unusually high returns, but we feel they did it through investments where loss was unlikely. Th e absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers. From time to time, holders become forced sellers for reasons like these:

114 PATIENT OPPORTUNISM • Th e funds they manage experience withdrawals. • Th eir portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums. • Th ey receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders. As I’ve said many times, the real goal of active investment manage￾ment is to buy things for less than they’re worth. Th is is what the effi cient market hypothesis says we can’t do. Th e theory’s objection seems reason￾able: why should someone part with something at a bargain price, espe￾cially if the potential seller is informed and rational? Usually, would- be sellers balance the desire to get a good price with the desire to get the trade done soon. Th e beauty of forced sellers is that they have no choice. Th ey have a gun at their heads and have to sell re￾gardless of price. Th ose last three words—regardless of price— are the most beautiful in the world if you’re on the other side of the transaction. If a single holder is forced to sell, dozens of buyers will be there to ac￾commodate, so the trade may take place at a price that is only slightly re￾duced. But if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity. Th e diffi culties that mandate selling— plummeting prices, with￾drawal of credit, fear among counterparties or clients— have the same im￾pact on most investors. In that case, prices can fall far below intrinsic value. Th e fourth quarter of 2008 provided an excellent example of the need for liquidity in times of chaos. Let’s focus on leveraged investment entities’ holdings of se nior bank loans. Because these loans were highly rated and credit was freely available during the years leading up to the crisis, it was easy to borrow large sums with which to lever debt portfolios, magnifying the potential returns. A typical investor on “margin” might have agreed to post additional capital if the price of the collateral fell below 85 cents on the dollar, secure in the knowledge that in the past, loans like these had never traded much below “par,” or 100 cents on the dollar. When the credit crisis hit, everything went wrong for leveraged inves￾tors in bank loans. (And because the yields on these supposedly safe loans had been so low, almost all of the buyers had used leverage to enhance their expected returns.) Loan prices fell. Liquidity dried up. Since much of the buying had been done with borrowed funds, the credit market contraction aff ected large numbers of holders. As the number of would- be sellers ex-

PATIENT OPPORTUNISM 115 ploded, buyers for cash disappeared. And with additional credit unavail￾able, no new levered buyers could step forward to absorb the selling. Prices fell to 95, and then 90, and then 85. And as each portfolio reached its “trigger,” the bank issued a margin call, or a demand for a capital infusion. Few investors had the resources and nerve required to add capi￾tal in that environment, so the banks took over the portfolios and liquidated them. BWIC, pronounced “bee- wick,” came into common use, an acronym for “bid wanted in competition.” Investors were informed of a BWIC in the aft ernoon and told bids were wanted for an auction to be held the next morning. Th e few possible buyers bid low, hoping to get real bar￾gains (no one needed to worry about bidding too low, since there was sure to be another BWIC behind this one). And the banks weren’t concerned with getting fair prices; all they needed was enough proceeds to cover their loans (perhaps 75 or 80 cents on the dollar). Any excess would go to the in￾vestor, but the banks didn’t care about generating anything for them. Th us BWICs took place at incredibly low prices. Loan prices eventually fell into the 60s, and every holder on short￾term credit who couldn’t access additional capital was likely wiped out. Selling prices were ridiculous. Th e declines on se nior loan indices in 2008 exceeded those on subordinated high yield bond indices, certainly signal￾ing an ineffi ciency. You could buy fi rst lien debt at prices from which you would break even if the issuing company turned out to be worth 20 to 40 percent of what a buyout fund had paid for it just a year or two earlier. Th e promised yields were very large, and in fact much of this paper appreciated dramatically in 2009. Th is was a time for the patient opportunist to step forward. It was pri￾marily those who had been cognizant of the risks in 2006 and 2007 and kept their powder dry— waiting for opportunity— who were able to do so. Th e key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead. To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long- term capital and a strong stomach. Patient opportun￾ism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profi ts during meltdowns.

14 Th e Most Important Th ing Is . . . Knowing What You Don’t Know We have two classes of forecasters: Those who don’t know— and those who don’t know they don’t know. JOHN KENNETH GALBRAITH It’s frightening to think that you might not know some￾thing, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on. AMOS TVERSKY There are two kinds of people who lose money: those who know nothing and those who know everything. HENRY KAUFMAN I’ve chosen three quotes with which to lead off this chapter, and I have a million more where those came from. Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing. I’m fi rmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. Th ere are two cave￾ats, however: • Th e more we concentrate on smaller- picture things, the more it’s possi￾ble to gain a knowledge advantage. With hard work and skill, we can

KNOWING WHAT YOU DON’T KNOW 117 consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Th us, I suggest people try to “know the knowable.” • An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an eff ort to fi gure out where they stand at a moment in time in terms of cycles and pendulums. Th at won’t render the future twists and turns knowable, but it can help one prepare for likely developments. I am not going to try to prove my contention that the future is un￾knowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro- wise. Of all the economists and strategists you follow, are any correct most of the time? My “research” on this subject (and I use quotation marks because my ef￾forts in the area are too limited and anecdotal to be considered serious research) has consisted primarily of reading forecasts and observing their lack of utility. I wrote two memos as a result, “Th e Value of Predictions, or Where’d All Th is Rain Come From?” (February 15, 1993) and “Th e Value of Predictions II, or Give Th at Man a Cigar” (August 22, 1996). In the sec￾ond memo, I used data from three semiannual Wall Street Journal eco￾nomic polls to examine the usefulness of forecasts. First, were the forecasts generally accurate? Th e answer was clearly no. On average, the predictions for the ninety- dayT-bill rate, thirty- year bond rate and yen/dollar exchange rate six and twelve months out were off by 15 percent. Th e average forecaster missed the interest rate on the long bond six months later by 96 basis points (a divergence big enough to change the value of a $1,000 bond by $120). Second, were the forecasts valuable? Predictions are most useful when they correctly anticipate change. If you predict that something won’t change and it doesn’t change, that prediction is unlikely to earn you much money. But accurately predicting change can be very profi table. In the Journal polls, I observed, the forecasters completely missed several major changes (when accurate forecasts would’ve helped people make money or avoid a loss): the interest rate increases of 1994 and 1996, the rate decline of

118 KNOWING WHAT YOU DON’T KNOW 1995 and the massive gyrations of the dollar/yen relationship. In summary, there simply wasn’t much correlation between predicted changes and actual changes. Th ird, what was the source of the forecasts? Th e answer here is simple: most of the forecasts consisted of extrapolations. On average, the predic￾tions were within 5 percent of the levels that prevailed at the time they were made. Like many forecasters, these economists were driving with their eyes fi rmly fi xed on the rearview mirror, enabling them to tell us where things were but not where they were going. Th is bears out the old adage that “it’s diffi cult to make accurate predictions, especially with re￾gard to the future.” Th e corollary is also true: predicting the past is a snap. Fourth, were the forecasters ever right? Th e answer is a fi rm yes. For example, in each semiannual forecast, someone nailed the yield on the thirty- year bond within 10 or 20 basis points, even as interest rates changed radically. Th e winning forecast was much more accurate than the consen￾sus forecast, which was off by 70 to 130 basis points. Fift h, if the forecasters were sometimes right— and right so dramatically— then why doI remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. Th e important thing is getting it right consistently. I went on in the 1996 memo to show “two things that might make you think twice about heeding the winners’ forecasts.” First, they generally failed to make accurate predictions in surveys other than the one they won. And second, half the time in the surveys they didn’t win, their forecasts were much more wrong than even the inaccurate consensus. Th e most important thing, of course, isn’t the data, but the conclusions (assuming they’re correct and capable of being generalized) and their ramifi cations. One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fi xed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value. . . . It’s possible to be right about the macro- future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty- four forecasts that includes a few that are accu￾rate; you have to know which ones they are. And if the accurate

KNOWING WHAT YOU DON’T KNOW 119 forecasts each six months are made by diff erent economists, it’s hard to believe there’s much value in the collective forecasts. “The Value of Predictions II, or Give That Man a Cigar,” August 22, 1996 Th is discussion of forecasts suggests that we have a dilemma: investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are “nor￾mal,” we can’t know much about what will happen at those moments when knowing would make the biggest diff erence. • Most of the time, people predict a future that is a lot like the recent past. • Th ey’re not necessarily wrong: most of the time the future largely is a rerun of the recent past. • On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: Th ey’ll usually extrapolate recent experience and be right. • However, the many forecasts that correctly extrapolate past experience are of little value. Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of re￾cent history. Th us if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would. • Once in a while, however, the future turns out to be very diff erent from the past. • It’s at these times that accurate forecasts would be of great value. • It’s also at these times that forecasts are least likely to be correct. • Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s un￾likely to be the same people consistently. • Th e sum of this discussion suggests that, on balance, forecasts are of very little value. If you need proof, ask yourself how many forecasters correctly predicted the subprime problem, global credit crisis and massive meltdown of 2007– 2008. You might be able to think of a few, and you might conclude that their

120 KNOWING WHAT YOU DON’T KNOW forecasts were valuable. But then ask yourself how many of those few went on to correctly foresee the economic recovery that started slowly in 2009 and the massive market rebound that year. I think the answer’s “very few.” And that’s not an accident. Th ose who got 2007– 2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009. Th e overall usefulness of those forecasts wasn’t great . . . even though they were partially right about some of the most momentous fi nancial events in the last eighty years. So the key question isn’t “are forecasters sometimes right?” but rather “are forecasts as a whole— or any one person’s forecasts— consistently ac￾tionable and valuable?” No one should bet much on the answer being affi rmative. A prediction of global crisis in 2007– 2008 would have had great po￾tential value. But if you saw that it came from someone who wasn’t right consistently— and someone with a visible negative bias— would you have acted? Th at’s the trouble with inconsistent forecasters: not that they’re never right, but that the record isn’t positive enough to inspire action on their occasional brainstorms. It’s no secret that I have a limited opinion of forecasters and those who reso￾lutely believe in them. In fact, I’ve come up with a label for these people. Most of the investors I’ve met over the years have belonged to the “I know” school. It’s easy to identify them. • Th ey think knowledge of the future direction of economies, in￾terest rates, markets and widely followed mainstream stocks is essential for investment success. • Th ey’re confi dent it can be achieved. • Th ey know they can do it. • Th ey’re aware that lots of other people are trying to do it too, but they fi gure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them. • Th ey’re comfortable investing based on their opinions regard￾ing the future.

KNOWING WHAT YOU DON’T KNOW 121 • Th ey’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis. • Th ey rarely look back to rigorously assess their record as forecasters. Confi dent is the key word for describing members of this school. For the “I don’t know” school, on the other hand, the word— especially when dealing with the macro- future—is guarded. Its adherents generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge. As a member of the “I know” school, you get to opine on the future (and maybe have people take notes). You may be sought out for your opinions and considered a desirable dinner guest . . . es￾pecially when the stock market’s going up. Join the “I don’t know” school and the results are more mixed. You’ll soon tire of saying “I don’t know” to friends and strangers alike. Aft er a while, even relatives will stop asking where you think the market’s going. You’ll never get to enjoy that one- in￾a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowl￾edge of the future. “Us and Them,” May 7, 2004 No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and fi nd other ways to cope than through forecasts. What ever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead. Oh yes; one other thing: the biggest problems tend to arise when in￾vestors forget about the diff erence between probability and outcome— that is, when they forget about the limits on foreknowledge:

122 KNOWING WHAT YOU DON’T KNOW • when they believe the shape of the probability distribution is knowable with certainty (and that they know it), • when they assume the most likely outcome is the one that will happen, • when they assume the expected result accurately represents the actual result, or • perhaps most important, when they ignore the possibility of improbable outcomes. Imprudent investors who overlook these limitations tend to make mistakes in their portfolios and experience occasional large losses. Th at was the story of 2004– 2007: because many people overestimated the extent to which outcomes were knowable and controllable, they underestimated the risk present in the things they were doing. Th e question of whether trying to predict the future will or will not work isn’t a matter of idle curiosity or academic musing. It has— or should have— signifi cant ramifi cations for investor behavior. If you’re engaged in an activity that involves decisions with consequences in the future, it seems patently obvious that you’ll act one way if you think the future can be fore￾seen and a very diff erent way if you think it can’t. One key question investors have to answer is whether they view the future as knowable or unknowable. Investors who feel they know what the future holds will act assertively: making direc￾tional bets, concentrating positions, levering holdings and count￾ing on future growth— in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite diff erently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possi￾ble outcomes. Th e fi rst group of investors did much better in the years lead￾ing up to the crash. But the second group was better prepared when the crash unfolded, and they had more capital available

KNOWING WHAT YOU DON’T KNOW 123 (and more- intact psyches) with which to profit from purchases made at its nadir. “Touchstones,” November 10, 2009 If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversifi cation is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportu￾nity costs (forgone profi ts). On the other hand, if you don’t know what the future holds, it’s fool￾hardy to act as if you do. Harkening back to Amos Tversky and the power￾ful quote that opened this chapter, the bottom line is clear. Investing in an unknowable future as an agnostic is a daunting prospect, but if fore￾knowledge is elusive, investing as if you know what’s coming is close to nuts. Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Overestimating what you’re capable of knowing or doing can be ex￾tremely dangerous— in brain surgery, transocean racing or investing. Ac￾knowledging the boundaries of what you can know— and working within those limits rather than venturing beyond— can give you a great advantage.

15 Th e Most Important Th ing Is . . . Having a Sense for Where We Stand We may never know where we’re going, but we’d better have a good idea where we are. Market cycles present the investor with a daunting challenge, given that: • Th eir ups and downs are inevitable. • Th ey will profoundly infl uence our per for mance as investors. • Th ey are unpredictable as to extent and, especially, timing. So we have to cope with a force that will have great impact but is largely unknowable. What, then, are we to do about cycles? Th e question is of vital importance, but the obvious answers— as so oft en— are not the right ones. Th e fi rst possibility is that rather than accept that cycles are unpre￾dictable, we should redouble our eff orts to predict the future, throwing added resources into the battle and betting increasingly on our conclu￾sions. But a great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability. Further, superior results in investing come from knowing more than others, and it hasn’t been demonstrated to my satisfaction that a lot of people know more than the consensus about the timing and extent of future cycles. Th e second possibility is to accept that the future isn’t knowable, throw up our hands, and simply ignore cycles. Instead of trying to predict them, we could try to make good investments and hold them throughout.

HAVING A SENSE FOR WHERE WE STAND 125 Since we can’t know when to hold more or less of them, or when our in￾vestment posture should become more aggressive or more defensive, we could simply invest with total disregard for cycles and their profound eff ect. Th is is the so- called buy- and- hold approach. Th ere’s a third possibility, however, and in my opinion it’s the right one by a wide margin. Why not simply try to fi gure out where we stand in terms of each cycle and what that implies for our actions? In the world of investing, . . . nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. Th ey are the givens. We cannot know how far a trend will go, when it will turn, what will make it turn or how far things will then go in the oppo￾site direction. But I’m confi dent that every trend will stop sooner or later. Nothing goes on forever. So what can we do about cycles? If we can’t know in advance how and when the turns will occur, how can we cope? On this, I am dogmatic: We may never know where we’re going, but we’d better have a good idea where we are. Th at is, even if we can’t predict the timing and extent of cyclical fl uctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly. “It Is What It Is,” March 27, 2006 It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms. “First Quarter Per for mance,” April 11, 1991 I don’t mean to suggest that if we can fi gure out where we stand in a cycle we’ll know precisely what’s coming next. But I do think that understanding

126 HAVING A SENSE FOR WHERE WE STAND will give us valuable insight into future events and what we might do about them, and that’s all we can hope for. When I say that our present position (unlike the future) is knowable, I don’t mean to imply that understanding comes automatically. Like most things about investing, it takes work. But it can be done. Here are a few concepts I consider essential in that eff ort. First, we must be alert to what’s going on. Th e phi los o pher Santayana said, “Th ose who cannot remember the past are condemned to repeat it.” In very much the same way, I believe those who are unaware of what’s going on around them are destined to be buff eted by it. As diffi cult as it is know the future, it’s really not that hard to under￾stand the present. What we need to do is “take the market’s temperature.” If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do. Th e essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media. But how many people make an eff ort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confi dent and buying ag￾gressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive. So look around, and ask yourself: Are investors optimistic or pessi￾mistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities off erings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle ren￾dered capital readily available or impossible to obtain? Are price/earn￾ings ratios high or low in the context of history, and are yield spreads tight or generous? All of these things are important, and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future. Th e key is to take note of things like these and let them tell you what to do. While the markets don’t cry out for action along these lines every

HAVING A SENSE FOR WHERE WE STAND 127 day, they do at the extremes, when their pronouncements are highly important. Th e years 2007– 2008 can be viewed as a painful time for markets and their participants, or as the greatest learning experience in our life￾times. Th ey were both, of course, but dwelling on the former isn’t of much help. Understanding the latter can make anyone a better investor. I can think of no better example than the devastating credit crisis to il￾lustrate the importance of making accurate observations regarding the present and the folly of trying to forecast the future. It warrants a de￾tailed discussion. It’s obvious in retrospect that the period leading up to the onset of the fi nancial crisis in mid- 2007 was one of unbridled— and unconscious— risk taking. With attitudes cool toward stocks and bonds, money fl owed to “alternative investments” such as private equity— buyouts—in amounts suffi cient to doom them to failure. Th ere was unquestioning ac cep tance of the proposition that homes and other real estate would provide sure profi ts and cushion against infl ation. And too- free access to capital with low in￾terest rates and loose terms encouraged the use of leverage in amounts that proved excessive. Aft er- the- fact risk awareness doesn’t do much good. Th e question is whether alertness and inference would have helped one avoid the full brunt of the 2007– 2008 market declines. Here are some of the indicators of heatedness we saw: • Th e issuance of high yield bonds and below investment grade leveraged loans was at levels that constituted rec ords by wide margins. • An unusually high percentage of the high yield bond issuance was rated triple- C, a quality level at which new bonds usually can’t be sold in large amounts. • Issuance of debt to raise money for dividends to own ers was routine. In normal times, such transactions, which increase the issuers’ riskiness and do nothing for creditors, are harder to accomplish. • Debt was increasingly issued with coupons that could be paid with more debt, and with few or no covenants to protect creditors. • Formerly rare triple- A debt ratings were assigned by the thousands to tranches of untested structured vehicles.

128 HAVING A SENSE FOR WHERE WE STAND • Buyouts were done at increasing multiples of cash fl ow and at increasing leverage ratios. On average, buyout fi rms paid 50 percent more for a dol￾lar of cash fl ow in 2007 than they had in 2001. • Th ere were buyouts of fi rms in highly cyclical industries such as semi￾conductor manufacturing. In more skeptical times, investors take a dim view of combining leverage and cyclicality. Taking all these things into consideration, a clear inference was pos￾sible: that providers of capital were competing to do so, easing terms and interest rates rather than demanding adequate protection and poten￾tial rewards. Th e seven scariest words in the world for the thoughtful investor—too much money chasing too few deals— provided an unusually apt description of market conditions. You can tell when too much money is competing to be deployed. Th e number of deals being done increases, as does the ease of doing deals; the cost of capital declines; and the price for the asset being bought rises with each successive transaction. A torrent of capital is what makes it all happen. If you make cars and want to sell more of them over the long term— that is, take permanent market share from your competitors— you’ll try to make your product better. . . . Th at’s why— one way or the other— most sales pitches say, “Ours is better.” However, there are products that can’t be diff erentiated, and economists call them “commodities.” Th ey’re goods where no seller’s off ering is much diff erent from any other. Th ey tend to trade on price alone, and each buyer is likely to take the off ering at the lowest delivered price. Th us, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price. . . . It helps to think of money as a commodity just like those others. Everyone’s money is pretty much the same. Yet institu￾tions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money— that is, get people to go to you instead of your competitors for their fi nancing— you have to make your money cheaper. One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by

HAVING A SENSE FOR WHERE WE STAND 129 paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return. “The Race to the Bottom,” February 17, 2007 One trend investors might have observed during this dangerous pe￾riod, had they been alert, was the movement along the spectrum that runs from skepticism to credulousness in regard to what I described earlier as the silver bullet or can’t-lose investment. Th oughtful investors might have noticed that the appetite for silver bullets was running high, mean￾ing greed had won out over fear and signifying a nonskeptical— and thus risky— market. Hedge funds came to be viewed as just such a sure thing during the last de cade, and especially those called “absolute return” funds. Th ese were long/short or arbitrage funds that wouldn’t pursue high returns by mak￾ing “directional” bets on the market’s trend. Rather, the managers’ skill or technology would enable them to produce consistent returns in the range of 8 to 11 percent regardless of which way the market went. Too few people recognized that achieving rock- steady returns in that range would be a phenomenal accomplishment— perhaps too good to be true. (N.B.: that’s exactly what Bernard Madoff purported to be earning.) Too few wondered (a) how many managers there are with enough talent to produce that miracle, especially aft er the deduction of substantial man￾agement and incentive fees, (b) how much money they could do it with and (c) how their highly levered bets on small statistical discrepancies would fare in a hostile environment. (In the diffi cult year of 2008, the term absolute return was shown to have been overused and misused, as the average fund lost about 18 percent.) As described at length in