Mike Kueber's Blog

October 22, 2011

Sunday Book Review #50 – The Most Important Thing by Howard Marks

In my most recent book review – Islam, a short guide to the faith – I noted that the “little, highly readable” book reminded me of Harvey Penick’s Little Red Book on golf.  That description applies even more to Howard Marks’ book on investing – The Most Important Thing.

Marks describe his little book (180 pages) as a collection of insights (20) about investing that he has made over his 40-year career.  Each insight was initially a stand-alone comment that Marks might have fleshed-out in a memo to clients.  But over the years, as Marks’ insights gained critical mass, he began to realize that, although these insights could stand alone, they were more effective when considered as part of a package.  (Of course this alleged synergy justified consolidating the memos into book form.)  Although I have never heard of Marks, he is apparently famous as a value investor and the cofounder of Oaktree Capital Management, with $80 billion under management.

According to Marks in Chapter One, the most important thing is “second-level thinking,” which he describes as something a little deeper or more nuanced than the conventional wisdom. An investor needs
to focus on achieving second-level thinking because only with this ability can an investor consistently out-perform the market.

According to Marks in Chapter Two, the most important thing is understanding market efficiency and its limits.  The efficient-market hypothesis generally posits that the market absorbs all available information and then generates pricing that reflects that information.  Marks’ position is that the market is incredibly efficient, but he defines efficient as “speedy, quick to incorporate information, not necessarily right.”

By now you should be understanding the format of this book.  It reminds me of MMA fighting.  Every few months, my son tells me about an upcoming fight that he invariably calls the fight of the century.  After a few such fights, I pointed out the ludicrousness of the claim, and he responded that I shouldn’t take everything so literally.  The same rule applies to Marks’ insights.  Each one may be the most important thing, but not really.

According to Marks in Chapter Four, the most important thing is value.  In this chapter, Marks briefly describes fundamental analysis, technical analysis, random-walk hypothesis, and momentum investing, and then focuses on the difference between value investors and growth investors.  He describes value investors as those who buy stocks because their current value is high relative to its current price.  By contrast, growth investors buy stock because its current value is likely to grow enough to cause substantial appreciation in the future price.  Marks endorses value investing because it is easier to consistently make profitable purchases.  Growth investing is more speculative.  According to Marks, “In my book, consistency trumps drama.”

Chapter Four describes the relationship between price and value.  According to Marks, no asset is of such good quality that price is not the dominant consideration.  Stating the obvious, Marks points out that
investment profits can be derived from (1) an increase in the intrinsic value of an asset, (2) selling an asset for more than it is worth, or (3) buying something for less than its value.  The last of these is the most reliable, but even that is not foolproof because “the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’”

Chapters Five, Six, and Seven deal with risk – understanding risk, recognizing risk, and controlling risk.  Marks suggests that the conventional thinking equates risk with volatility.  He disagrees.  He equates risk with the possibility of loss, or even more, the risk of permanent loss.  That makes sense.  Personally, I believe the market will inevitably recover before I need to cash-in most of my investment assets, and
therefore I don’t think the current volatility creates an inordinate amount of risk.  If the market is down significantly in 20 years, then I will have make a bad decision, and my estate and me will suffer the consequences.

Chapters Eight and Nine warn investors to be attentive to cycles and pendulums, with cycles referring to economic expansion and contraction and pendulums referring to investor optimism and pessimism.

Chapter Ten advises investors to combat the negative influences of human nature – e.g., greed, fear, a willing suspension of disbelief, a tendency to conform to the view of the herd, envy, ego, and capitulation.

Chapter Eleven endorses contrarianism, which makes sense for anyone trying to beat the conventional wisdom.  The trick is identifying what about the conventional wisdom is likely incorrect.  For example, when the market is crashing, most experts say, “We’re not going to try to catch a falling knife; it’s too dangerous.  We’re going to wait until the dust settles and the uncertainty is resolved.”  Marks
interprets this to mean that they are too frightened and unsure of what to do.  “The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled, and the uncertainty has resolved, there’ll be no great bargains left.”  If you know what you are doing, this is the time to do it.

Chapter Twelve recommends finding bargains.  These are usually unattractive assets that provide value because of their unreasonably low prices.  Because of their “unusual ratios of return to risk, they represent the Holy Grail for investors.”

Chapter Thirteen prescribes patient opportunism.  Marks credits Warren Buffett for articulating this concept in one of his annual shareholder letters.  Buffett taught the concept by first describing a baseball batter who is punished by baseball rules if he takes a juicy pitch right down the middle.  Pass on three such pitches and the batter is declared out.  By contrast, investors can take as many pitches as they want, even if the pitches are right down the middle.  Because of this unlimited opportunity, wise investors can wait until really good investments come along before pulling the trigger.

Chapter Fourteen warns about knowing what you don’t know.  Marks thinks most investing mistakes are made by persons who don’t know what they don’t know.  In this chapter, he contrasts actions taken
by investors in the “I don’t know” school vs. those in the “I know” school.

Chapter Fifteen compares three ways of dealing with inevitable cycles – (1) refuse to accept that cycles are unpredictable and try to predict them better than the average Joe, (2) ignore cycles and employ a
“buy and hold” strategy, or (3) instead of prediction or ignoring cycle, have a more limited objective of trying to figure out where we stand in the current cycle and what that implies for our actions.  We should be able to discern whether other investors are acting with reckless exuberance or undeserved caution, and that would suggest contrarian moves.  I think Warren Buffett said something like, “When others are fearless, I fear.  When others are frightened, I am emboldened.

Chapter Sixteen talks about appreciating the role of luck.  Although Bill Parcells is famous for saying a team is as good as its record, that is not necessarily true.  Some actions may look brilliant in hindsight, but the result was not pre-ordained.

Chapter Seventeen advises investing defensively.  There are old investors, and there are bold investors, but there are no old bold investors.

Chapter Eighteen says that the most important thing is to avoid pitfalls.  An investor needs to do very few things right as long as he avoids big mistakes – Warren Buffett.

Chapter Nineteen says the most important thing is to add value.  That value can be gaining more than the market when it goes up or losing less than the market when it goes down.  Marks, like Buffett, prides
himself in keeping up with the market in good years and then separating from the market (in a good way) in the bad years.

Chapter Twenty says the most important thing is to pull it all together.  This chapter contains 27 aphorisms that re-state the insights contained in the 19 previous chapters.  Among my favorites:

  • The relationship between price and value holds the ultimate key to investment success.  Buying below value is the most dependable route to profit.  Paying above value rarely words out as well.
  • The superior investor never forgets that the goal is to find good buys, not good assets.  (I wonder if Buffett agrees with this.)
  • Economies and markets cycle up and down.  Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever.  This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.
  • Underpriced is far from synonymous with going up soon.  Thus, being too far ahead of your time is indistinguishable from being wrong.  It can require patience and fortitude to hold positions long enough to be proved right.
  • Never forget the six-foot-tall man who drowned crossing the stream that was five-feet deep on average.