Book Summary: The Most Important Thing

Book: The Most Important Thing

Author: Howard Marks

This past Thursday, I, and 25 or so other summer interns at UBS, had the fortune to meet Howard Marks. I read his book in preparation for this meeting. This post is a summary of that meeting and my takeaway of the book.

First, an introduction to Howard Marks. He is one of six founders of Oaktree Capital, a distressed assets hedge fund that is planning to go public as of this draft for $8bn. He is considered by many as one of greatest investors of the past decade, and is spoken about in investment circles in the same breath as Peter Lynch, Warren Buffet, Julian Robertson and like. Since he invests in distressed assets and hasn’t managed a mutual fund, he doesn’t quite have the public profile one would assume with his immense success.

This book is a borne out of a letters that Howard Marks sent to his investors over several years. This is not a valuation book, this is not a how-to book, this is a investment thought process book. One could heedlessly argue that the book has a lot of obvious advice, and contains hardly anything new. Indeed, the book talks about simple things like “invest when everyone is afraid”, “don’t be overconfident” and so on, because these are, of course, the basic tenets. But, the beauty of the book is not what to think about investing, but how to think. I believe the editing could have been better, but I guess it’s daunting for an editor to twist an investing legend’s arm too much.

Key takeaways:

  • To begin with, one should assume that the market is efficient: 
    • This would be odd coming from an active investor, but for this — this makes one realize that there are several intelligent and motivated people trying to value the same thing, and so one must give a great deal of thought before taking a stand on a security. Here’s a great excerpt – “Efficiency is not so universal that we should give up on superior performance. At the same time, efficiency is what lawyers call a “rebuttable presumption”—something that should be presumed to be true until someone proves otherwise.”
    • Every investment thesis should be questioned– “who doesn’t know that?”
  • Price paid is extremely important
    • No investment decision can be complete without a discussion of price. It’s not only what you buy, but also what you pay for it.
    • “When prices are high, it’s inescapable that prospective returns are low (and risks are high). “
    • In bubbles, ‘attractive’ morphs into ‘attractive at any price’. Usually, bubbles begin when the investment thesis has a kernel of truth in it. Over time, people stop questioning whether it remains a good idea at an elevated price.
  • Being contrarian makes money, and that’s why its hard to do: 
    • It’s obvious that to beat the market, you have to be unconventional. But, that shouldn’t be the goal. Sounds like a little bit of contradition, right? But this passage in the book explains it pretty well – “Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.” What I take it to mean is that the process should be unconventional, not necessarily the conclusion/decision. I have been guilty of this; just to prove to myself that I am a contrarian investor, I have often fooled myself into taking ill-advised positions that are different from the market.
    • In addition, there’s this – “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.”
    • To be a contrarian, and then to hold on to that view for a long time, so one gives it time to succeed is hard.  Successful investors are said to spend a lot of their time being lonely. A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron. “Like the participants in Solomon Asch’s visual experiments in the 1950s,” Cassidy writes, “many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.”
  • Risk has be at the forefront of every investment thesis:
    • People generally don’t think enough about risk, only when it manifests into a loss.
    • First of all, volatility of returns doesn’t imply anything about risk. Howard Marks says – “The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.” Risk pertains to the final outcome. More clearly put – “Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider.”
    • One should always be on lookout for a hidden risk, especially when the return seems far too generous when compared to apparent risk.
    • Another great point Mr. Marks makes is that risk cannot be thought of as a deterministic value, only a probabilistic value–even when in past. “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?  you buy something for $100 and sell it a year later for $200. Was it risky? Who knows? Perhaps it exposed you to great potential uncertainties that didn’t materialize.” An example that Mr. Marks gave was when a weatherman says that there’s 70% probability of rain, and the next day it rains. Was he right? What if it doesn’t? Is now he right? Mr. Marks says that we can’t say. In both cases he could be 100% right– there was a 70% probability.
    • One should take risk when others are fleeing from it, not when they are competing with you to do so.
  • Business cycles
    • Everything goes through cycles. As an investor, it is imperative that we understand where we stand in the business cycle.
    • In particular, credit cycle has enormous power.  “It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.”
    • “…even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”
  • Buildup and signs of a crisis:
    • Risk keeps increasing during upswing, as financial imbalances build up, and materializes in recessions.
    • Low level of capital market line implies that people are willing to take more risk to earn returns. Hence, a low interest rate is a signal of likely less-than-ideal investment.
    • Some good signs of crisis are margin calls, ratings downgrades, fire sales, unrefinanced bridge loans, pulled maturities etc. These instances further fuel capital market meltdowns.
    • “The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers. From time to time, holders become forced sellers for reasons like these: • The funds they manage experience withdrawals. • Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums. • They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.
  • How should one try to run the investment business
    • One should not bank on future to bring more clarity.
    • Defensive investing is the way to invest. This is a great passage from the book – “While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or nonaspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance. There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that maybe uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.”
    • “In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough. There is a time, however, when we consider it essential to beat the market, and that’s in the bad years. Our clients don’t expect to bear the full brunt of market losses when they occur, and neither do we.”
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