the most important thing by howard marks

8/7/2019 The Most Important Thing by Howard Marks

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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

Andersons 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 withHoward Marks, the founder of Oaktree Capital Management and author of so many

memorable investment memos. Like many of you who unfailingly read Markss

memos right when they are released on Oaktrees 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 commentary

on Howard Markss soon-to-be-released book, The Most Important Thing.

Oddly enough, I think it is important to start off with a disclaimer. The MostImportant Thing is not a how-to book about investing. Marks doesnt 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 Grahams The Intelligent

Investor and Seth Klarmans Margin of Safety, it is a book on how to thinkabout

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

finished 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 previousmemos. 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 whats 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 thismore

than anything elseis what dooms most investors to being victimized

repeatedly by cycles of booms and bust.

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 dont 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 betterthan 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 Buffetts most famous quotes:

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.

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.)


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It is in that context that Marks expands on Ben Grahams 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:

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 backthat is, the pendulums swing toward and extreme corrects of its

very weight.

************************************************************************************

The next prevalent theme in the book is that of risk. It will not be surprising to

frequent readers of Markss 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 peoples 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 standardthat 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:

Where does that leave us? If the risk of loss cant be measured, quantified or

even observedand if its consigned to subjectivityhow 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.

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.

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 lookas 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 Markss 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

homeowners insurance... even if theres no fire.

My favorite allegory on this exact subject is the one told by Nassim Taleb ofFooled

by Randomness and The BlackSwan fame. (Incidentally, Talebs 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 turkeys 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 farmers

intentions all along were to harm the turkey would clearly be a black swan event inthe 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:

The important thing here is the realization that risk may have been present

even though loss didnt 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 isnt observable because its not tested.

Ergo, there are no awards. Only a skilled and sophisticated observer can lookat a portfolio in good times and divine whether it is a low-risk portfolio or a

high-risk portfolio.

*********************************************************************************

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


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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 over-

valued. 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

pricegenerally up or generally downand base their buy and sell decisions onthat. 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 Markss 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:

Contrarianism doesnt make money all the time because there are not alwaysmarket 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

And the clinchers:

You must do things not just because theyre 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. Thats 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 sellingand our

view turns out to be rightthats the route to the greatest rewards earned

with the least risk.

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


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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 oftheir 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, thats because Marks takes a very Graham-like

approach. As I said before, the reason the book adds to everyones 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 wisdomlike this one:

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 lookbeneath the surface to understand it thoroughly, or fail to overcome some

non-value-based tradition, bias or stricture.

The most interesting thing about Oaktrees search for value is that, at least

according to the firms motto, the process doesnt 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 Buffetts idea of waiting for a fat pitch before

investing. Marks can invest this way because he is not solely trying to achieve highreturns. 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 theyre not there.

The dumbest thing you can do is to insist on perpetuating high returnsand

give back your profits in the process. If its not there, hoping wont make it

so.

If an investor can remain patient and maybe even endure bouts ofunderperformance, 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:

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.

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 dont want to steal his

thunder or spoil it for readers, but I thought this passage sums up very well hisfeelings on what happened to many investors during the crisis:

But if the ability to live with volatility and maintain ones composure has

been overestimatedand usually it hasthat 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 investingthe most

unfortunate aspect of pro-cyclical behaviorbecause of its permanence and

because it tends to affect large portions of portfolios.*********************************************************************************

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


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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:

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.

**********************************************************************************

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 Safetyand The Intelligent Investorbecause 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

Markss 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 toeducate is quite commendable and I appreciated that in no way did the book come

off as marketing material for Oaktree.

Finally, I dont 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 asthough 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


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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 Markss experiences and investment approach. Truthfully, this reviewhasnt 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.

the most important thing by howard marks

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