If Warren Buffett, Christopher Davis, Joel Greenblatt and Seth Klarman recommend a book, it might—just might—be worth reading.   It certainly got my attention.

Warren Buffett calls Howard Marks’ The Most Important Thing “that rarity, a useful book.”  And as a researcher with a library of a couple hundred books myself, I couldn’t agree more.

For those unfamiliar with Howard Marks, he is the Chairman and cofounder of Oaktree Capital Management, an investment firm with $77 billion under management.  The Most Important Thing Illuminated, published in 2013, is an update to Marks’ original, published in 2011, though in Illuminated Marks has help.  Greenblatt, managing partner of Gotham Capital and author of The Little Book That Beats the Market, offers his own commentary throughout the pages, as do Christopher Davis, portfolio manager of the Davis Large Cap Value fund, and Seth Klarman, president of The Baupost Group and a well-respected value investor.  Marks keeps good company.

I had high expectations when I picked up The Most Important Thing Illuminated, and I wasn’t disappointed.  This isn’t yet another “how to invest” book or a tired rehashing of received investment “wisdom” that looks more like something found in a fortune cookie and which rarely seems to hold up in practice.

Instead, Marks gives us the insightful thoughts of a man who struggles with his own investing decisions on a daily basis.  There are no shortcuts, formulas, or easy tricks.  But there is a wealth of experience and thoughtful contemplation from a real “in the trenches” investor who has been doing this a long time.

Marks starts the book with a chapter on “second-level thinking,” and I consider this one of the most valuable lessons in the entire book.  Having a good understanding of this chapter alone will put you head and shoulders above most of your peers.

Mechanical trading rules work really well…right up until the point that they don’t.  And why don’t they work consistently over time?  As Marks explains,

The reasons are simple.  No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.  Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed.  And if others emulate an approach, that will blunt its effectiveness.

Investing, like economics, is more art than science.  And that means it can get a little messy.

“Messy” is not a technical term, but it is accurate and descriptive hear.  Markets are driven by people and by ever-changing real-world events.  Trying to cram this into a mechanical trading model or a black box is a recipe for disaster.  And frankly, it’s mentally lazy and reflects an unwillingness (or inability!) to grasp complexity.

This brings me to Marks’ points about second-level thinking.  What exactly is “second-level thinking.”  Perhaps it is best explained by example:

• “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 it’s not.  So the stock’s 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.’”

Call it contrarian thinking, applied game theory, or just being clever, but this is the mindset that is required to be a successful investor over time.  It’s also a skill that few investors have or have the mental discipline to use.

It’s not easy going against the grain and taking views that are contrary to the consensus.  But then, no one ever said that investing should be easy.

Market Technicals and Psychology

As a value investor, Marks is not a fan of technical analysis (i.e. charting) but he does stress the importance of understanding what he calls “market technicals,” or non-fundamental factors that affect the supply and demand for a security.  Failing to understand these can lure an investor who looks at value alone.

What are some examples?  Marks lists two specifically: the forced selling that takes place when a market crash trips margin calls, which forces leveraged investors to sell at any price, and the cash inflows that go to mutual funds that are usually invested irrespective of price.  To these I would add short squeezes, secondary stock price offerings that dilute shareholders, and buyout offers.

These technical factors are often closely related to market psychology.  And as Marks writes, “The discipline that is most important Is not accounting or economics, but psychology…

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.  At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.

Need an example?  Think of Apple’s performance over the past few years.  Apple was the “must own” stock of the 2010s.  Everyone owned it—individual investors, mutual fund managers, hedge fund managers…you name the investor, and chances are good that Apple made up a good-sized chunk of their portfolio.

There were cases of focused hedge funds having 20-30% of their portfolio in Apple.  Even now, after Apple’s massive slide, the stock accounts for nearly 15% of the Technology Select SPDR (NYSE:$XLK), one of the most popular ETFs for investing in the tech sector.  Apple’s position in the ETF is bigger than Google’s and IBM’s combined.

It’s not a figure of speech to say that there was no one left to buy Apple.  No matter how great a company is, there is a limit to how high a percentage of investors’ portfolios it could comprise.

And we all know what followed.  Apple’s share price fell by over 40%, and may or may not be finished falling.

A pure value investor wouldn’t have seen the risk in Apple.  Based on popular metrics such as price/earnings or price/sales, Apple wasn’t particularly expensive.  It actually looked pretty cheap compared to the broader market.

But if you had taken market technical and investor psychology into account, you would have known to be wary.  You almost certainly wouldn’t have timed the top perfectly, but you would have known that caution was warranted.

Unfortunately, as Marks acknowledges, “psychology is elusive…and the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.”

There are no shortcuts here.  You have to remain as dispassionate as possible and, where possible, try to apply second-level thinking.

Thoughts on Risk

Risk is one of the most difficult concepts in investing because it is impossible to quantity.  Yes, we have measures such as standard deviation, variance, or beta, but these measure volatility.  Volatility and risk are not at all the same thing.

A better definition of risk is the possibility of loss.  But even this is hard to define or quantify in any meaningful way.  And at the time when a stock appears the most risky—such as after a recent volatile drop—it may actually be relatively less risky, as the selloff shook out the less committed investors.  And on the flip side, it is when a stock looks least risky—think Apple this time last year—when it is in fact most at risk.

And it gets more complicated than that.  You can’t gauge the riskiness—or the quality—of a trade based on what happened.  You have to base it on what could have happened.

In other words, you can take a phenomenally bad gamble with negative expected returns and still come out ahead.  But that doesn’t mean it was a good decision.  Let me state it bluntly: A good outcome does not mean that the decision that led to it was a good one.

If you don’t understand what I’m talking about, you should probably stop reading.  And you should definitely stop investing.

Winning the lottery is a fantastic outcome.  But the expected value on any given lottery ticket is negative because the possibility of a payoff is infinitesimally small. Most people would agree that winning the lottery is good luck.  But, being overconfident in their own abilities, they fail to see the role of luck in good investment returns based on bad trading.

Marks, in thinking very similar to that of Black Swan guru Nassim Taleb, does a good job of explaining this:

A few years ago, while considering the difficulty of measuring risk prospectively, I realized that because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

Let’s say you make an investment that works out as expected. Does that mean it wasn’t risky?… Perhaps it exposed you to great potential uncertainties that didn’t materialize….

Need a model?  Think of the weatherman.  He says there is a 70 percent chance of rain tomorrow.  It rains; was he right or wrong?

It’s easy to get overly academic here and veer off into directions that are not particularly practical.  Perhaps it can be summed up with the old Wall Street adage to “Never confuse brains with a bull market.”

More broadly, we should always remember that risk is a complicated concept and that we can’t get complacent in our investment process.  When you have capital at risk, you need to be vigilant.

Does this mean we should avoid risk?  Not at all.  As Marks puts it, “risk avoidance is likely to lead to return avoidance.”  Assuming risk is part of the investment game.  It is just a matter of keeping risk under control and making sure that the returns we realistically expect are worth the risk we are taking.

On Cycles

While Marks eschews charting and most forms of technical analysis, he does have respect for market cycles.  In fact, he offers two rules for investing with a mind to cycles:

• 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.

Marks’ interest in cycles ties back to his belief in the importance of market psychology:

Objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to such things that causes investors to overreact or underreact and thus determines the amplitude of the cyclical fluctuations…

Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events.  They reverse (rather than going on forever) because trends create the reasons for their own reversal.  Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

Well said.  Marks’ views are consistent with those of Hyman Minsky, who believed that stability inevitably leads to instability (and vice versa) because stability encourages risky behavior and instability prompts more sober behavior.

Within the markets, a long period of stability and growth leads investors to assign higher and higher earnings multiples to stocks—think of the 1980s and 1990s.  But during long periods of economic malaise and market turmoil, investors assign lower and lower earnings multiples.  This cycle is probably the one permanent fixture throughout the history of the capital markets.

Marks offers so specific trading strategy to trade cycle fluctuations; his intent is simply to offer a word of advice to not ignore them.

In this book review, I have barely scratched the surface of The Most Important Thing.  This book is chocked full of very accessible, very down-to-earth investment advice, and the praise heaped on it by Buffett, Klarman and the rest is well deserved.  This is a book that I recommend you keep on your desk and thumb through on those days where the market isn’t making sense and you need a little grounding.

Compliments on a book well written.

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