The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks

1 – The Most Important Thing Is . . . Second-Level Thinking

Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half. To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?

extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

2 – The Most Important Thing Is . . . Understanding Market Efficiency (and Its Limitations)

Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception. My son Andrew is a budding investor, and he comes up with lots of appealing investment ideas based on today’s facts and the outlook for tomorrow. But he’s been well trained. His first test is always the same: “And who doesn’t know that?”

Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.

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. Therefore, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.

Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty. For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of.

Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.

The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.

“Isn’t that a $ 10 bill lying on the ground?” asks the student. “No, it can’t be a $ 10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The professor walks away, and the student picks it up and has a beer.

3 – The Most Important Thing Is . . . Value

Several times a day, they would try to guess whether a stock they’d been watching would rise or fall in the next few hours. I’ve never understood how people reach conclusions like these. I liken it to trying to guess whether the next person to come around the corner will be male or female. The way I see it, day traders considered themselves successful if they bought a stock at $ 10 and sold at $ 11, bought it back the next week at $ 24 and sold at $ 25, and bought it a week later at $ 39 and sold at $ 40. If you can’t see the flaw in this—that the trader made $ 3 in a stock that appreciated by $ 30—you probably shouldn’t read the rest of this book.

“Being too far ahead of your time is indistinguishable from being wrong.”

An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

4 – The Most Important Thing Is . . . The Relationship Between Price and Value

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. The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

Buying something for less than its value. In my opinion, this is what it’s all about—the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.

Trying to buy below value isn’t infallible, but it’s the best chance we have.

8 – The Most Important Thing Is . . . Being Attentive to Cycles

One of my favorite books is a little volume titled Oh Yeah?, a 1932 compilation of pre-Depression wisdom from businessmen and political leaders. It seems that even then, pundits were predicting a cycle-free economy:

• There will be no interruption of our present prosperity. (Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 1, 1928)

• I cannot help but raise a dissenting voice to the statements that . . . prosperity in this country must necessarily diminish and recede in the future. (E.H.H. Simmons, President, New York Stock Exchange, January 12, 1928)

• We are only at the beginning of a period that will go down in history as the golden age. (Irving T. Bush, President, Bush Terminal Co., November 15, 1928)

• The fundamental business of the country . . . is on a sound and prosperous basis. (President Herbert Hoover, October 25, 1929)

  Every once in a while, an up-or down-leg goes on for a long time and/ or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical. “YOU CAN’T PREDICT. YOU CAN PREPARE,” NOVEMBER 20, 2001

9 – The Most Important Thing Is . . . Awareness of the Pendulum

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you.

• The first, when a few forward-looking people begin to believe things will get better

• The second, when most investors realize improvement is actually taking place

• The third, when everyone concludes things will get better forever

There are a few things of which we can be sure, and this is one: Extreme market behavior will reverse. Those who believe that the pendulum will move in one direction forever—or reside at an extreme forever—eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.

10 – The Most Important Thing Is . . . Combating Negative Influences

“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. It happens so regularly that there must be something dependable at work, not a random influence.

11 – The Most Important Thing Is . . . Contrarianism

The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.

a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

12 – The Most Important Thing Is . . . Finding Bargains

“investment is the discipline of relative selection.” That expression has stayed with me for thirty-five years. Sid’s simple phrase embodies two important messages. First, the process of investing has to be rigorous and disciplined. Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there. Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.

Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it. A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.

the best opportunities are usually found among things most others won’t

It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.

13 – The Most Important Thing Is . . . Patient Opportunism

Patient opportunism—waiting for bargains—is often your best strategy.

You’ll do better if you wait for investments to come to you rather than go chasing after them. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.

At Oaktree, one of our mottos is “we don’t look for our investments; they find us.” We try to sit on our hands. We don’t go out with a “buy list”; rather, we wait for the phone to ring. If we call the owner and say, “You own X and we want to buy it,” the price will go up. But if the owner calls us and says, “We’re stuck with X and we’re looking for an exit,” the price will go down. Thus, rather than initiating transactions, we prefer to react opportunistically.

It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly. The other possibilities are (a) acting without recognizing the market’s status, (b) acting with indifference to its status and (c) believing we can somehow change its status. These are most unwise. It makes perfect sense that we must invest appropriately for the circumstances with which we’re presented. In fact, nothing else makes sense at all. I come to this from a philosophic foundation:

Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

Thus, our clients are prepared for results that put risk control ahead of full participation in gains.

14 – The Most Important Thing Is . . . Knowing What You Don’t Know

It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on. AMOS TVERSKY

There are two kinds of people who lose money: those who know nothing and those who know everything. HENRY KAUFMAN

15 – The Most Important Thing Is . . . Having a Sense for Where We Stand

The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals—

If you make cars and want to sell more of them over the long term—that is, take permanent market share from your competitors—you’ll try to make your product better…. That’s why—one way or the other—most sales pitches say, “Ours is better.” However, there are products that can’t be differentiated, and economists call them “commodities.” They’re goods where no seller’s offering is much different from any other. They tend to trade on price alone, and each buyer is likely to take the offering at the lowest delivered price. Thus, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price….

Contrarian investors who had cut their risk and otherwise prepared during the lead-up to the crisis lost less in the 2008 meltdown and were best positioned to take advantage of the vast bargains it created.

Most people strive to adjust their portfolios based on what they think lies ahead. At the same time, however, most people would admit forward visibility just isn’t that great. That’s why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.

16 – The Most Important Thing Is . . . Appreciating the Role of Luck

Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill. At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because of the nature of randomness.

I find that I agree with essentially all of Taleb’s important points.

• Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).

• The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.

• Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).

• For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.

• Thus, it’s essential to have a large number of observations—lots of years of data—before judging a given manager’s ability. “RETURNS AND HOW THEY GET THAT WAY,” NOVEMBER 11, 2002

the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating. This idea was powerfully reinforced when I read Taleb’s book. He highlights the ability of chance occurrences to reward unwise decisions and penalize good ones.

The “I know” school quickly and confidently divides its members into winners and losers based on the first roll or two of the dice. Investors of the “I don’t know” school understand that their skill should be judged over a large number of rolls, not just one (and that rolls can be few and far between). Thus they accept that their cautious, suboptimzing approach may produce undistinguished results for a while, but they’re confident that if they’re superior investors, that will be apparent in the long run.

Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls. To me that’s what thoughtful investing is all about.

17 – The Most Important Thing Is . . . Investing Defensively

There are old investors, and there are bold investors, but there are no old bold investors.

There are a lot of things I like about investing, and most of them are true of sports as well.

• It’s competitive—some succeed and some fail, and the distinction is clear.

• It’s quantitative—you can see the results in black and white.

• It’s a meritocracy—in the long term, the better returns go to the superior investors.

• It’s team oriented—an effective group can accomplish more than one person.

• It’s satisfying and enjoyable—but much more so when you win. These positives can make investing a very rewarding activity in which to engage. But as in sports, there are also negatives.

• There can be a premium on aggressiveness, which doesn’t serve well in the long run.

• Unlucky bounces can be frustrating.

• Short-term success can lead to widespread recognition without enough attention being paid to the likely durability and consistency of the record.

Oaktree’s preference for defense is clear. In good times, we feel it’s okay if we just keep up with the indices (and in the best of times we may even lag a bit). But even average investors make a lot of money in good times, and I doubt many managers get fired for being average in up markets. Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below-average volatility, and our clients will enjoy outperformance when others are suffering.

At Oaktree, on the other hand, we believe firmly that “if we avoid the losers, the winners will take care of themselves.” That’s been our motto since the beginning, and it always will be. We go for batting average, not home runs. We know others will get the headlines for their big victories and spectacular seasons. But we expect to be around at the finish because of consistent good performance that produces satisfied clients.

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.

18 – The Most Important Thing Is . . . Avoiding Pitfalls

An investor needs do very few things right as long as he avoids big mistakes.

Many of the psychological or emotional sources of error were discussed in previous chapters: greed and fear; willingness to suspend disbelief and skepticism; ego and envy; the drive to pursue high returns through risk bearing; and the tendency to overrate one’s foreknowledge. These things contribute to booms and busts, in which most investors join together to do exactly the wrong thing.

Too much capital availability makes money flow to the wrong places.

When capital goes where it shouldn’t, bad things happen.

When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.

Widespread disregard for risk creates great risk.

Inadequate due diligence leads to investment losses.

In heady times, capital is devoted to innovative investments, many of which fail the test of time.

Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.

Psychological and technical factors can swamp fundamentals.

Markets change, invalidating models.

Leverage magnifies outcomes but doesn’t add value.

Excesses correct.

19 – The Most Important Thing Is . . . Adding Value

The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer…. Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.

A single year says almost nothing about skill, especially when the results are in line with what would be expected on the basis of the investor’s style. It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investor is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill suited.

20 – The Most Important Thing Is . . . Pulling It All Together

The best foundation for a successful investment—or a successful investment career—is value. You must have a good idea of what the thing you’re considering buying is worth. There are many components to this and many ways to look at it. To oversimplify, there’s cash on the books and the value of the tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.

To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally, all three.

The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.

The superior investor never forgets that the goal is to find good buys, not good assets.

Economies and markets cycle up and down. Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever. This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.

The power of psychological influences must never be underestimated. Greed, fear, suspension of disbelief, conformism, envy, ego and capitulation are all part of human nature, and their ability to compel action is profound, especially when they’re at extremes and shared by the herd. They’ll influence others, and the thoughtful investor will feel them as well. None of us should expect to be immune and insulated from them. Although we will feel them, we must not succumb; rather, we must recognize them for what they are and stand against them. Reason must overcome emotion.

Most trends—both bullish and bearish—eventually become overdone, profiting those who recognize them early but penalizing the last to join. That’s the reasoning behind my number one investment adage: “What the wise man does in the beginning, the fool does in the end.” The ability to resist excesses is rare, but it’s an important attribute of the most successful investors.

When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.

“Being too far ahead of your time is indistinguishable from being wrong.”

Oaktree’s motto, “If we avoid the losers, the winners will take care of themselves,” has served well over the years. A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.

One of the essential requirements for investment success—and thus part of most great investors’ psychological equipment—is the realization that we don’t know what lies ahead in terms of the macro future.

The more micro your focus, the greater the likelihood you can learn things others don’t.

Many more investors assume they have knowledge of the future direction of economies and markets—and act that way—than actually do.

Investing on the basis of strongly held but incorrect forecasts is a source of significant potential loss.

The most successful investors get things “about right” most of the time, and that’s much better than the rest.