The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Book Review: The Most Important Thing by Howard Marks
With only a few weeks left in my MBA career, I am now fully aware that being a student again offers some very valuable perks. Through my fellowship on UCLA Anderson’s Student Investment Fund I have had access to a number of great investors. But, by far my biggest break was having the opportunity to meet with
Howard Marks, the founder of Oaktree Capital Management and author of so many memorable investment memos. Like many of you who unfailingly read Marks’s memos right when they are released on Oaktree’s website, I was thrilled when I heard that Marks was going to publish a new book on investing. However, I never anticipated that I would be lucky enough to receive an advance copy from Howard
himself or have the opportunity to review it for my blog. But, as I said, being a student again is not too bad. So, in an attempt to revive the book-reviewing skills that have been lying dormant since middle school, the following is my commentaryon Howard Marks’s soon-to-be-released book, The Most Important Thing.
Oddly enough, I think it is important to start off with a disclaimer. The Most Important Thing is not a how-to book about investing. Marks doesn’t provide a Joel Greenblatt-esque magic formula or any shortcuts to becoming a great investor. In fact, on the very first page of chapter one Marks reminds us that no investing rule always works. The book also does not separate out specific investment techniques for different asset classes. Instead, in the tradition of Ben Graham’s The Intelligent Investor and Seth Klarman’s Margin of Safety, it is a book on how to think about investing. In reality, Marks builds on the ideas of the most famous value investors by adding his own insights and anecdotes. For people who are devoted value investors, the philosophy he articulates will sound familiar and certainly will not drastically alter the way you invest. However, what is both unique and striking about this book is the way he breaks down the important aspects of his investment approach into very approachable and wisdom-filled sections. When the reader has the book, the lasting impression is that Marks was able to provide a comprehensive and detailed overview of his investment approach in less than 200 pages.
In his thoughtful and didactic way, Marks aims to help the reader develop the mental tools and investment framework that are required for success in this very difficult and treacherous domain. Specifically, using his four decades of experience as a basis, Marks introduces the reader to his investment philosophy with a
combination of new material and a brilliant integration of passages from previous memos. The transitions between the original and previously articulated ideas are so seamless that Marks comes off like a wise grandfather who always has a perfectly poignant story to tell, no matter what the context. For example, even in the
introduction, the reader gets the sense that Marks has been able to leverage his vast experience in way that gives him an investment edge:
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importantly, a philosophy like mine comes from going through life with your eyes wide open. You must be aware of what’s taking place in the world and what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this—more than anything else—is what dooms most investors to being victimized repeatedly by cycles of booms and bust.
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I chose to highlight the above passage because I think it is very emblematic of two of the major themes that run throughout the book. The first is the idea of viewing and thinking about the world in the most open manner possible. Marks introduces the reader to the difference between first-level and second-level thinkers and
suggests that we all work to become the latter if we want to survive in the investment wilderness. First-level thinkers are people who look at the world simplistically and superficially and who don’t take the time to reflect on the meaning of the events they witness. On the other hand, second-level thinkers are contrarians who cogitate about probabilities, risk and whether or not they actually have an investing edge. These are people who are constantly questioning their own assumptions and those of their peers in an attempt to be what Marks calls “different and better” than the rest of the crowd. Not surprisingly, Marks firmly believes that being a second-level thinker is a necessary condition for achieving consistently superior returns.
The next theme embodied in the above passage and discussed throughout the book is that of the cyclical nature of financial markets. Chapters eight and nine are all about paying attention to cycles and being mindful of the swings in the pendulum between greed and fear. In many instances, Marks clearly stresses that those who forget history are doomed to repeat it. In fact, he starts off the chapter on cycles with what looks to be a play on one of Buffett’s most famous quotes:
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Rule number one: most things will prove to be cyclical.
Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
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The point is that through experience, investors can gain an advantage over newcomers to the business or those who forget that financial markets are inherently cyclical and that boom and busts are inevitable. What is required then is an understanding of the historical parallels with current events that only comes from an ability to step back from periods of euphoria and excessive pessimism.
While Marks may not say it directly in this section, the implication is that the development of a particular type of even temperament is paramount if a person wants to avoid being caught in the herd during a painful turn in the cycle. (He does say later in the book that the “biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”)
It is in that context that Marks expands on Ben Graham’s assertion that market psychology moves wildly between greed and fear by likening those fluctuations to the swing of a pendulum. While the underlying concept will be very familiar to value investors, I think the simple way he articulates his understanding of market psychology is very compelling and memorable:
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Like a pendulum, the swing of investor psychology toward an extreme causes energy to build up that eventually will contribute to the swing back in the other direction. Sometimes, the pent-up energy is itself the cause of the swing back—that is, the pendulum’s swing toward and extreme corrects of its very weight.
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The next prevalent theme in the book is that of risk. It will not be surprising to frequent readers of Marks’s memos that he devotes three full chapters to risk assessment and management. The first time I was exposed to Marks was at a Wharton Hedge Fund Network event in New York. I have been fortunate enough to meet and learn from a number of wonderful investors in my life, but something
Marks said at that event still sticks with me to this day. What he said was that the main job of a steward of other people’s assets is to manage risk and protect capital.
It was such a simple statement but the implications are so powerful, especially considering that most of the people in the investment business seem to believe that their primary responsibility is to make themselves rich.
In any case, Marks begins by discussing how to measure risk. You will not be shocked to learn that there is no discussion of beta, value at risk or price volatility as measures of risk. Instead, he humbly suggests that there is no viable standard that can be used to quantify risk and that risk and return estimates cannot be reliably turned over to a computer. Therefore, risk lies in the very subjective eye of the beholder:
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Where does that leave us? If the risk of loss can’t be measured, quantified or even observed—and if it’s consigned to subjectivity—how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value.
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In other words, risk has to do what price you pay and the relationship of that price to the intrinsic value of the asset. For anyone who does not recognize this idea, it is very much the same as the margin of safety concept espoused by Graham and Klarman. Believers in the merits of value investing when it comes to equity security selection should take comfort in the fact that one of the best debt investors in the world uses the same risk framework to find avoid overpriced fixed income assets:
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Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming from high prices.
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The final chapter on risk includes commentary on how to control risk. Marks explains that during good times — when markets are rising — risk control can look as though it is a waste of time. By managing portfolio risk, investors navigating within favorable market conditions inevitably leave money on the table in the form
of forgone returns. After a number of years of perceived underperformance due to what in hindsight looks to be unjustified attempts to protect against losses, even a risk-averse investor might contemplate abandoning his or her risk management techniques. However, according to Marks’s investment philosophy, such a decision would be a terrible mistake. It is precisely when the manager is unable to detect the risk of loss that he or she should be looking for ways to protect capital. The logical extension of this idea is that we should be content owning insurance against portfolio losses just like we sleep better at night because we know we have homeowner’s insurance... even if there’s no fire.
My favorite allegory on this exact subject is the one told by Nassim Taleb of Fooled by Randomness and The Black Swan fame. (Incidentally, Taleb’s work is referenced a number of times in this book.) Taleb tells the story of a turkey that lives on a farm
and every day is fed and cared for by what he sees as a benevolent and loving farmer. In fact, each day the farmer is there to take care of the turkey only further reinforces the turkey’s belief that the farmer is its friend and would never do anything to harm it. Unfortunately, the same dynamic plays out each day until a few
weeks before one unfortunate Thanksgiving. The realization that the farmer’s intentions all along were to harm the turkey would clearly be a black swan event in the eyes of the animal. But, in reality, the risk was always there. It was just invisible because nothing ever went wrong until that last fateful day. In the same vein, Marks warns us that only thoughtful and skillful investors can avoid becoming a
Thanksgiving Day turkey:
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The important thing here is the realization that risk may have been present even though loss didn’t occur. Therefore, the absence of loss does not necessarily mean that the portfolio was safely constructed. So, risk control can be present in good times, but it isn’t observable because it’s not tested. Ergo, there are no awards. Only a skilled and sophisticated observer can look at a portfolio in good times and divine whether it is a low-risk portfolio or a high-risk portfolio.
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I think my favorite chapter in the book is the one on contrarianism. Marks highlights what value investors already know, which is that most investors are trend followers. These people are first-level thinkers who feel comfortable and safe following the crowd. But, what people forget is that every investment decision is by definition a contrarian bet that the market is wrong. Either you buy a stock because you think the current price is undervalued or you sell it because you think it is fully- or overvalued.
Accordingly, to be right in a long run you have to have a different view than that of the market. Mistakes come when investors focus on the trend of a stock price—generally up or generally down—and base their buy and sell decisions on that. Instead, contrarian investors are better served by assessing whether or not the
trend will hold and making the opposite bet when he or she has conviction that the herd has fallen prey to irrational exuberance or panicked selling. What is unique about Marks’s description of the contrarian approach is that he warns the reader of certain pitfalls of being a contrarian. It is easy to tell people to do the opposite of what the crowd is doing. It is much tougher to make money as an
investor using a contrarian perspective. Here are a few caveats from Marks:
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· Contrarianism doesn’t make money all the time because there are not always market excesses to bet against
· Even when assets are overpriced, there is no guarantee that they will go down in price tomorrow (i.e., the market can stay irrational longer that you can stay solvent)
· There are times when a lot of people take on the same contrarian viewpoint and thus it will be hard to separate out the contrarian stance from that of the herd
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And the clinchers:
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You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearances of mistakes and as losses accrue rather than gains.
It is our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling—and our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.
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One of things that Howard is best known for is his ability to catch falling knives in the distressed debt space. He has a history of buying securities that the casual observer would wonder out loud what he was thinking upon learning that they had been added to an Oaktree portfolio. What separates Marks is that just about invariably the world comes to learn that he was buying dollars for 60 cents while everyone else was trying to get out as fast as they could. As such, the question arises of how does he identify these bargains? Despite the fact that there is a full chapter on finding bargains, we mainly get the framework that Marks uses to find undervalued assets. While this is clearly more valuable than juicy anecdotes, the entire time I was reading the book, I was yearning for more practical applications of his philosophy. Personally, I find it motivating to hear successful investment stories in which managers took an incredibly contrarian position and made a multiple of their original investments. When such feats are accomplished without much risk and due to a focus on margin of safety, it gives me hope that I will be able to do the same in my career.
But, in all honesty I believe the book is actually better without a lot of war stories that prove to the reader that Marks is a world-class investor. I understand why Marks would be leery of touting his accomplishments, as he is not the type to brag about his success. Therefore, I am content with the simple roadmap he presents for
finding value. Specifically, he tells us to search for little known, questionable, controversial, seemingly inappropriate, and unappreciated assets that have poor recent returns and have been sold en masse. If that sounds a bit like what Ben Graham would have advised, that’s because Marks takes a very Graham-like
approach. As I said before, the reason the book adds to everyone’s understanding of investing is not because Marks introduces a brand new philosophy. Instead, he uses previously articulated frameworks and builds on them by inserting his own, periodic nuggets of wisdom—like this one:
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Since the efficient-market process of setting fair prices requires the
involvement of people who are analytical and objective, bargains are usually based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
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The most interesting thing about Oaktree’s search for value is that, at least according to the firm’s motto, the process doesn’t really involve a search. While the firm ideally invests in the unloved types of assets described above, Marks believes that Oaktree should not go out and find investments. On the contrary, he thinks that
he and his colleagues at Oaktree are better served by letting those investments come to them. This is similar to Buffett’s idea of waiting for a fat pitch before investing. Marks can invest this way because he is not solely trying to achieve high returns. The risk of permanent capital impairment is always on his mind, and he has
a track record that allows him to be patient without investors’ getting antsy.
Obviously, this is a luxury that many investors do not have, but that does not mean people should change their approach in order to achieve high returns in a low return environment:
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You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns—and give back your profits in the process. If it’s not there, hoping won’t make it so.
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If an investor can remain patient and maybe even endure bouts of
underperformance, the cyclical nature of markets often leads to an opportunity to generate substantial returns. Somehow, so-called once in a lifetime crises seem to occur far more frequently than they should. As such, investors who combine the proper temperament with strong analytical skills can take advantage of crashes and
irrational selling, as long as they are prepared. But, investors also need to make sure that their portfolios are what Nassim Taleb would call robust.
Fortunately, Marks has some advice on how to set up a firm and portfolio that will allow them to be greedy when others are fearful:
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The 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: staunch reliance on value, little or no use of leverage, long-term capital, and a strong stomach. Patient opportunism;buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.
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Of course, since this book was written after the acute portion of the financial crisis was over, Marks was able to reflect on what lessons should have been learned by investors as a result of what happened in 2008 and 2009. Specifically, Marks presents a list of things that we should learn from the crisis. I don’t want to steal his thunder or spoil it for readers, but I thought this passage sums up very well his feelings on what happened to many investors during the crisis:
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But if the ability to live with volatility and maintain one’s composure has been overestimated—and usually it has—that error tends to come to light when the market is at its nadir. Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the greatest error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.
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Just when you think it is virtually impossible for Marks to provide any more wisdom, he finishes the book with a bullet-point-like summary of the major takeaways from the entire book. In all seriousness, I highlighted too many passages from this final chapter to discuss them all here. Suffice to say that Marks does a tremendous job of
explaining the primary themes from the book in a concise manner and of reinforcing what the reader has been exposed to throughout the preceding chapters without sounding preachy. Accordingly, I thought it would be fitting to close with some advice from Marks on how to distinguish value from quality:
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What causes on asset to sell below its value? Outstanding buying
opportunities exist primarily because perception understates reality.
Whereas high quality can be readily apparent, it takes keen insight to determine cheapness. For this reason, investors often mistake objective merit for investment opportunity. The superior investor never forgets that the goal is to find good buys, not good assets.
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What is my ultimate conclusion? Well, the book is too fresh in my mind to know where it belongs in the pantheon of investing books. My first impression is that it is up there with Margin of Safety and The Intelligent Investor because it presents a complete investment philosophy in a way that just about anyone can understand
and appreciate. I do know for sure that it represents a much desired extension of Marks’s memos. For example, similar to when I am reading the latest memo, I always had the feeling that I did not want the book to end. It is also true that the way he articulates his investment approach does offer unique insights despite the
fact that his philosophy has clearly been influenced by the great investors who have come before him. I believe there is a ton of value in being able to re-frame and add nuance to the tenets of value investing, and Marks unquestionably achieves these
goals in a very comprehensive manner. Additionally, throughout the entire book I felt as though Marks had the sole intent of teaching the reader and sharing his wisdom with complete sincerity and transparency. The willingness and desire to educate is quite commendable and I appreciated that in no way did the book come
off as marketing material for Oaktree.
Finally, I don’t know whether I have become more cynical in general, but it is definitely true that I am not impressed by much these days. Many of the books I read seem not to break new ground or introduce new interpretation of ideas that I hold dear. Further, I have to admit that some of the behavioral finance material gets
a bit redundant when you read books about the subject and take multiple classes on it as well. But, in my initial meeting with Howard Marks, my subsequent conversations with him and in reading The Most Important Thing, I always felt as though I was being exposed to a man with an expertise in investing like that of Buffett, Graham and Klarman. I meet a lot of investors and read dozens of letters to
investors and I rarely hang on the next word, anticipating that something earth shattering will be forthcoming. But, with Marks, there was constantly the feeling that the next sentence or paragraph could cause a light bulb to go on over my head. Somehow, in the most unassuming and modest way, Marks is able to consistently articulate his insights in way that anyone can comprehend and learn
from.
Needless to say, I highly recommend The Most Important Thing to anyone who is interested in investing. I think both novices and experts can gain from being exposed to Marks’s experiences and investment approach. Truthfully, this review hasn’t even scratched the surface in terms of the amount of valuable material included in the text. The passages that were included were used to supplement
what I saw as the main themes but certainly do not capture the nuances of the book in a meaningful way. Therefore, if you are like me and have been wishing to better understand what makes Marks and Oaktree different, I humbly suggest that you check out this new book.