The Most Important Thing: Uncommon Sense for the Thoughtful Investor

by Howard Marks

Howard Marks is the co-founder and co-chairman of Oaktree Capital Management and he ranks #374 on the 2017 Forbes 400 list of wealthiest Americans. In this book he covers 20 topics: second-level thinking; market efficiency and its limitations; intrinsic value; the relationship between price and value; understanding risk; recognizing risk; controlling risk; market cycles; the pendulum; combating negative influences; contrarianism; finding bargains; patient opportunism; knowing what you don’t know; having a sense for where we stand; appreciating the role of luck; investing defensively; avoiding pitfalls; adding value; and pulling it all together.

Can you guess which one is the most important thing? 

Actually, the title of every chapter is The Most Important Thing. “Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is likely to be less than satisfactory.”

“What is it that makes a security—or the underlying company—valuable? There are lots of candidates: financial resources, management, factories, retail outlets, patents, human resources, brand names, growth potential and, most of all, the ability to generate earnings and cash flow. In fact, most analytical approaches would say that all of those other characteristics… are valuable precisely because they can translate eventually into earnings and cash flow.”

“The emphasis in value investing is on tangible factors like hard assets and cash flows. Intangibles like talent, popular fashions and long-term growth potential are given less weight.”

“An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing…  Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day… Buying below value is the most dependable route to profit.”

“Let’s say you figure out that something’s worth 80 and have a chance to buy it for 60. Chances to buy well below actual value don’t come along every day, and you should welcome them… But don’t expect immediate success… you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses… This makes it very difficult to hold, and to buy more at lower prices (which investors call ‘averaging down’), especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50… and much more at 40 and 30.”

“Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. The key lies in understanding what impact things like these are having.”

“I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa: When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all… When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.”

“Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash… The inevitable hallmark of bubbles is a dearth of risk aversion. In crashes, on the other hand, investors fear too much. Excessive risk aversion keeps them from buying even when no optimism—only pessimism—is embodied in prices and valuations are absurdly low.”

“A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it… If prices can be very wrong, that means it’s possible to find bargains or overpay.”

Marks explains second-level thinking.

  • “First-level thinking says, ‘It’s a good company; let’s buy the stock.’
    Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and its’ not. So the stock is overrated and overpriced; let’s sell.’
  • First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’
    Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’
  • First-level thinking says, ‘I think the company’s earnings will fall; sell.’
    Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’”

“The second-level thinker takes a great many things into account: What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future, and with mine? Is the consensus psychology that’s incorporated in the price too bullish or bearish? What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?”

“There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite… Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against… 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 a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait… Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive… Patient optimism—waiting for bargains—is often your best strategy… An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.”

“The absolute best buying opportunities come when asset holders are forced to sell… Most purchases of depressed, distressed debt made in the fourth quarter of 2008 yielded returns of 50 to 100 percent or more over the next eighteen months… At that moment, being optimistic and buying was the ultimate act of contrarianism… When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain. Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.”

“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 things: 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.”

“I think it’s essential to remember that just about everything is cyclical… Economies will wax and wane… Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down. Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good. Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.” Paying attention to where we are in the cycle will inform your investment decisions.

“A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio… Many investors… assume the world runs on orderly processes that can be mastered and predicted. They ignore the randomness of things and the probability distribution that underlies future developments. Thus, they opt to base their actions on the one scenario they predict will unfold. This works sometimes… but not consistently enough to produce long-term success. In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right… but it’s rarely the same person twice.”

“The suboptimizers of the ‘I don’t know’ school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest… The avoidance of losses in terrible years is more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term track record. Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors I know.”

“Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.”

“Risk control and margin for error should be present in your portfolio at all times. But you must remember that they’re ‘hidden assets.’ Most years in the market are good years, but it’s only in the bad years—when the tide goes out—that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place… even though it turned out not to be needed.”

Are you diversified? “Few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third… and thus the limitations of diversification… The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.”

“The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.”

Marks, Howard. The Most Important Thing: Uncommon Sense for the Thoughtful Investor. New York: Columbia Business School Publishing, 2011. Buy from Amazon.com

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