Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
In these, the final chapters of the book, Marks discusses the issue of adding value. Since anyone can generate average market returns by simply buying a passive index, the goal of investing is to generate alpha, or a spread between your returns and the market's return. Marks discusses how a portfolio of volatile stocks can appear to be generating alpha when the market is doing well, but this is simply beta, and investors shouldn't confuse the two. The problem with beta is that if the market goes down, so will the highly volatile stocks; therefore, beta cannot generate outperformance.
Marks reminds the investor that a year or two's worth of returns is not enough to determine if a manager has skill in outperforming the market. If the market had a good year, for example, it's possible that the manager was aggressively weighted towards riskier stocks. As such, his performance will tell you little about what may happen if the market were to collapse, as it does every so often.
For his firm, Oaktree, Marks prefers a defensive strategy whereby the portfolio barely keeps up when times are good, but outperforms when the market does poorly. Marks recommends investors select stocks with the same strategy in mind.
In the book's last chapter, Marks summarizes the lessons he has described in the book. He emphasizes employing a margin of safety, avoiding investing with the crowds, and knowing the value of what you have bought.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Marks finds it illustrative to use sports analogies to describe certain facets of investing. In professional tennis, for example, players are aggressive in that they win by going for winners i.e. they win with offense. Amateur tennis players, however, win by just keeping the ball in play and letting the opponent make a mistake i.e. they win by playing defensively.
Investing is much more like amateur tennis, Marks argues. While professional tennis players can take certain actions that will result in a highly accurate and precise shot, investors are subject to a whole lot more randomness. A company can be affected by unforeseen forces from economic factors to new government rules to management actions to competitor activities, all of which make a "precise shot" extremely difficult.
But most investors seem to be playing offense, picking their investments such that they will only work out if everything goes as planned. In other words, they go for homeruns. In Marks' experience, however, the careers of professional investors are remarkably short, considering investing is not physically demanding. He believes this is not due to a lack of homeruns, but an abundance of strikeouts.
At Marks' firm, they win by avoiding losers, which is not the same as picking winners. Marks wants companies with margins of safety, so that even if things don't work out as planned, the investment won't be a loser. To continue the baseball analogy, he goes for batting average instead of homeruns.
Marks also makes the point that making an investment because everyone believes something to be true is a very bad idea. Often, the fact that everyone believes something to be true can contribute to making it not true. For example, in 2007 (and the years leading up to it) everyone thought house prices could not go down. This in turn affected how conservative lenders and borrowers were with respect to leveraging residential real estate, which led to the downturn. As a result, it became more likely that house prices would go down because of the belief that house prices could not fall!
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Since we can't know the future, we should have a good understanding of the present. Marks is a proponent of "taking the market's temperature". If the market is too hot, investors (as contrarians) should be wary of entering and should seek to exit. If the market is cold, investors should look to jump in. Marks lists a number of signs investors should look for to gauge market sentiment.
He uses some of these signs to show the market's "temperature" in 2007 before the crash. For example, there was a belief that real-estate prices could never fall, creditors were issuing record amounts of debt and demanding little in the way of spreads or security, and buyouts were being completed at higher and higher multiples of cash flow (higher than they were in 2001, for example).
Marks also warns about the role of luck in investing, particularly in the short-term. You can't tell the difference between a good money manager and a poor one over short periods of time, because there is so much randomness in market prices over periods as long as years. Marks references Buffett's tale of the 2 million people who flipped coins, where after 15 flips, there were a number of people that had flipped 15 heads in a row. These people would write books about flipping techniques that others would lust after, even though it was all due to luck. Marks also frequently references the ideas espoused by the book Fooled by Randomness, which is summarized here.
Investors who recognize that the future is difficult to predict will construct portfolios based on the present and knowable, whereas most investors have an idea of what the future will look like and construct their portfolios accordingly. Marks argues that the latter group is doomed to failure over the long-term, since the future is not knowable but a probability distribution. Those who construct their portfolios defensively with the understanding that if things don't go as planned they will still be okay, stand to outperform.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Patience is a virtue that will make you money in the market, according to Marks. He suggests avoiding having buy lists and chasing stocks or securities you would like to own. Just because you have a lot of cash does not mean you can create opportunities where there are none; doing this results in a race to chase yield, where investors bid up prices to such an extent that risk is too high.
Instead, investors should let their buys come to them in the form of opportunities where sellers are dumping securities. Sellers can be dumping for all sorts of reasons. They can be down on a stock, they could be experiencing redemptions/withdrawals from clients, or they could be facing margin calls for securities they own that have fallen in price. Investors can find very attractive prices in such situations.
Marks also advises that investors know what they don't know. It's not what you don't know that will get you in trouble, but what you think you know but don't. A big part of this has to do with the macroeconomic environment. Marks argues that no one can predict it consistently, and so investors should focus their time on things they can know better, like individual companies.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Investing with the crowd is a sure way to lose money. If everyone thinks an investment is a bargain, then recent buying has been built into the price, in effect borrowing returns from the future. Investing with the crowd can thus generate returns for a while, but at the extremes (market highs and market lows) it will cost the investor. To be successful, investors must be contrarians.
Simply investing against the crowd does not guarantee success, however. For one thing, just because something is overpriced does not mean it is going down tomorrow. Investors must be prepared to be wrong for years. To do that, they need a strong sense of the intrinsic value of the security in question. Anything less will result in a sale when the price moves further against them. Casual commitments to securities invites casual reversal when the psychological pressure is on.
To find bargains, therefore, investors must be willing to go where others don't want to. Examples Marks gives include securities that are:
- not fully understood
- fundamentally questionable on the surface
- controversial, unseemly or scary
- deemed inappropriate for respectable portfolios
- unpopular and unloved
- have a record of poor returns
- recently the subject of disinvestment
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Though market prices may be right "on average", this doesn't adequately describe investor sentiment at any one time. Marks describes investor sentiment as that mimicking a pendulum. While the pendulum may be in the middle "on average", it spends a lot of time moving away from the average toward the extremes.
The pendulum swings describe the risk appetite of the market. When investors are greedy, they don't ask for much in return for the risk they take on. When investors are fearful, they avoid risk even when they are being paid handsomely to take it on. And yet mainstream finance argues that investor risk aversion is some constant presence.
Marks then goes into a discussion about bubbles and crashes. He draws on a few other authors who have studied these phenomena, including John Kenneth Galbraith, who describes "the extreme brevity of the financial memory". When bubbles are forming, a number of human emotional traits take over to remove rationality. Investors drop their independence in the face of herd-like crowds (as demonstrated in the Asch experiments) and become part of the crowd. These end in crashes where many lose everything.
To avoid falling prey to the same psychology as the market, Marks has a few recommendations for investors. First, they need a strongly held sense of the intrinsic value of every security in their portfolio. Then, they must insist on acting as they should; that is, they should buy as the price deviates significantly from intrinsic value. Investors should also have an understanding of past cycles and past pendulum swings, to have a long-term view of what may be occurring in the present. Finally, investors need to have a willingness to look wrong while the market goes from misvalued to even more misvalued.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
What makes the best managers great is their ability to reduce and manage risk. Over the course of most managers' careers, their results will not be determined by the winners, but rather by the number of losers and the magnitude of their losses.
But investment managers are recognized for their returns. This is because risk is invisible to most; during good periods, it's difficult to tell whether someone is taking too much risk. Similarly, one cannot tell the difference between a responsible builder and one who cuts corners, until an earthquake hits that is.
Marks urges investors to recognize that most things go in cycles. Trees do not grow into the sky, and neither do most things go to zero. But when a cycle is rising or falling, there will always be those who extrapolate a short-term trend into the future, and argue that "it's different this time". When this opinion becomes the consensus, this is usually a sign for investors that opportunity knocks, because assets are likely mispriced.
For Marks, the credit cycle is one of the most important cycles. When times are good, capital providers compete for business and therefore don't demand great returns on their money. Eventually, terrible loans/investments are made and come crashing down. At the other end of the cycle, competition is low and therefore providers of capital are able to demand great returns.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
Because investment returns are based on events that will take place in the future, risk in investing is inescapable, according to Marks. Furthermore, an understanding of risk is essential. Simply looking at a manager's returns does not tell you how much risk was employed in generating those returns, but an understanding of the risk employed is essential in ascertaining whether the manager is indeed skilled.
Conventional market theory asserts that high risk results in high returns. While Marks agrees that investors need to be compensated for taking on more risk, there are several problems with how conventional theory views this point.
First, the definition of risk is considered to be price volatility by conventional theorists. Marks rejects this definition. He argues that it is convenient to use volatility as the measure of risk, but that risk of loss of capital is what risk really is.
By this definition, however, risk is not measurable. Instead, risk is subjective, hidden and unquantifiable. As such, it can't be computerized, as the output would only be as good as the inputs and assumptions relied on. Marks argues, therefore, that only sophisticated, experienced, second-level thinkers can properly evaluate risk.
Risk can't even be analyzed in retrospect. Just because an investment worked out (or didn't), doesn't mean the risk warranted (or didn't warrant) the investment in the first place. There is only one history, but there were many possibilities that could have occurred but didn't due to chance.
Marks argues that risk is highest when it's perceived to be low. The low perception of risk leads to high prices, and it is high prices that lead to risk. Many investors associate risk with the quality of the asset, when it actually has to do with the price paid for the asset. At some point, even a low quality asset can have low risk when the price paid is very low.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
In these two chapters, Marks discusses what he believes to be the only market philosophy that works that doesn't require luck: purchasing below intrinsic value and selling higher than the purchase price.
Technical analysis involves studying past price movements in order to determine future price movements. Marks doesn't believe technical analysis works, and refers to some texts that have proven this. Momentum investing can work for a while, but it only works until it doesn't. This leaves the investor susceptible to holding the bag when the party ends, which can result in big losses.
When it comes to fundamental investing, Marks distinguishes growth from value investing. Too much of growth investing is based on a very uncertain future, and so he prefers the consistency delivered by value. He does concede, however, that correct prediction of growth (e.g. identifying the company that invents the next blockbuster drug) should lead to returns superior to those delivered from value investing; unfortunately, correctly predicting growth is difficult.
In Marks' opinion, therefore, investors should always compare value to price. Any asset, no matter how terrific, can trade at a price that is too high. For example, the Nifty Fifty were all great companies, but some investors in them lost 90% of their investment because they paid way too high a price. At the same time, even a poor asset can be worth buying at some low price.
The trick in all this is an understanding of market psychology. Marks argues that psychology is more important than economics or accounting for investors. Investors must be able to resist the urge to buy a stock that has risen and avoid a stock that has fallen. After purchasing a stock, it can still fall further. In this case, "being too far ahead of your time is indistinguishable from being wrong". In such cases, investors must be able to hold onto their convictions if they are right (and the market is wrong) without holding on too strong to a belief that may be erroneous, which isn't easy.
Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.
According to Marks, investing is more art than it is science. As such, successful investors aren't the ones with the fastest computers or the quickest trigger fingers, but rather those with superior insight. Marks calls this "second-level thinking".
For example, first-level thinking may say: "The sector is strengthening, therefore this stock will go up." Second-level thinking goes beyond what is already out there. Second-level thinkers may say: "The sector is expected to go up and therefore the stock price is high; time to sell."
Many aspects of second-level thinking can't be taught, Marks argues. As in basketball, you can't coach height. Therefore, even most of those exposed to world-class educations in economics and accounting will be limited by a lack of insight that relegates them from being superior investors. To beat the market, one has to not only have non-consensus views, but be correct about them more often than not. This is very difficult.
On efficient markets, Marks does concede that many asset classes are efficiently priced most of the time. He discusses some criteria that lead to the relative pricing efficiency or inefficiency of assets/sectors.
But in many cases, prices are not efficient. They may react quickly to news, but that doesn't mean the consensus price reaction was correct in direction and magnitude. For example, Yahoo traded at $237 in January of 2000 and $11 in April of 2001; the market could not have been right about the price in both cases.
The fact that there is some inefficiency offers investors the chance to both win or lose in the market. The fact that investors can lose from an inefficient market is often neglected. Those with superior insight can beat the market, but there will be losers in this zero-sum game.
