Book Review: The Most Important Thing By Howard Marks

Gregg and I attended the Value Investor Congress in Vegas last week. I downloaded a couple of books to read on the flights.  Let me just say that we highly recommend the book and is one of the best investment books I have read in years. The book is not a “how to analyze a company” book, nor does it have any “magic formulas”.  The main goal of the book is to show “how to think and how to deal with the psychological influences that interfere with investment thinking.” There are lots of investment books that talk about traits of successful investors and characteristics of stocks that perform well over time, but there are few books that deal will the other side of the investment equation, dealing with emotion in real time. This website is an attempt to do that by showing investors what we are thinking at the time we are building the portfolio. The book uses quotes from previous shareholder letters he wrote and expands on them. Other well-known investors such as Joel Greenblatt, Paul Johnson and Seth Klarman also make comments throughout the book.

There are some very good behavioral finance books written by James Montier and Michael J. Mauboussin that address many of the issues that keep investors from maximizing their potential. Each chapter in the book is “The Most Important Thing” in investing. As it turns out, Marks comes up with 21 “most important things.” I am not going to list all of them or discuss all of them here. But I think a few of the “more important” of the “most important” things  are:

The idea of “Second-Level Thinking” 

Marks distinguishes between first and second-level thinking. First-level thinking is simplistic and superficial and needs an opinion about the future. An example of first-level thinking was “the outlook for the company is favorable, meaning the stock will go up.” We see this type of thinking far too often on most popular investment websites. Second-level thinking is” deep, complex and convoluted.” First-level thinkers look for magic formulas and easy answers and think very linearly. Second-level thinkers are thinking about multiple concepts and scenarios.  Since first-level thinkers think the same way, they will generally reach the same conclusions, which by definition means average results. He explains that superior results are extremely difficult to achieve, but many first-level thinkers believe they will achieve those results will simple strategies and analysis. As he points out at the end of the first chapter, “but the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers.”

The future is unknowable and unpredictable and improbable outcomes happen all the time.

Marks talks about how successful investors acknowledge that the future is unknowable and unpredictable and do not over emphasize using models or assuming specific growth rates or anticipating certain macro events. All of this type of thinking creates what we like to call, the “illusion of control.” It gives investors a way to deal with the inherent uncertainty of investing.  This is one of the hardest things for investors to accept. The idea that no matter how good your analytical skills are (which need to be good as a basic requirement to be successful), the outcome of that analysis is totally out of your control once you make an investment. There are too many unknowns and unknowable unknowns will impact your investment to really be able to have a high degree of confidence that your desired outcome will happen in the time frame in which you want it to. And that is one of the ironies of successful investing. You have to have a high degree of confidence to act in a way that is against conventional wisdom, while at the same time accepting the fact that you really don’t know anything about the future you are so confident will occur.

The importance of “Value” in value investing.

Marks gives several examples of how value investing differs from growth investing. Aside from the obvious attention to absolute “cheapness” vs. relative “cheapness” and growth of earnings or sales, he believes the main difference  between the two styles is that “growth investing is about the future, whereas value investing emphasizes current-say conditions but can’t escape dealing with the future.” Other examples are that he believes that “growth investing is betting on a company’s performance that may or many not occur, while value investing is based primarily on analysis of the company’s current worth.” Simply put, value investing is buying stocks believing that the “current value is high relative to the current price”, while growth investors believe the “current value will grow fast enough in the future to produce substantial appreciation.” This is something Graham and other value investors understand. That it is much easier to analyze the past and present than predict the future, so they emphasize balance sheet and cash flow analysis over making lots of assumptions about the future.

 Dealing with “risk”

We agree completely with his idea that risk is not volatility, which is what academics have believed for years. As he points out, since most risk is unknown or unknowable, therefore unmeasurable, academics took the convenient way out and chose to measure something that was measurable, volatility, and used it to fit the definition of risk. Marks, as do we, believe that volatility is maybe the least relevant risk of all types of risks. He uses the example that he has never heard anyone say. “I won’t buy it, because its price might show big fluctuations.” The real risk he says is the permanent loss of capital, a risk most value investor think about the most. But if much risk is ”subjective, hidden and unquantifiable”, what is an investor to do? It breaks down to making a judgement call based on two things a) the stability and dependability of the value and b) the relationship between price and value.  Marks also points out that since risk is non quantifiable and subjective, it can’t be measured in retrospect any more than it can a priori. The discussions about risk are humbling. Investing is all about the future and attempting to minimize risk of loss, yet risk exists only in the future and its impossible to know the future. It is also impossible to know after the fact what the real risks were. Risk can’t be modeled, most “worst-case scenarios” aren’t negative enough and most people overestimate their ability to gauge risk. I will save his suggestions on dealing with all this for those who read the book. I will say that a large degree of fear of risk and low valuations by definition need to be present to allow for the possibility to achieve superior investment results.

The rest of the book talks about the concepts of contrarianism, the role luck plays in determining investment outcomes, being patient and having reasonable expectations.

The book is loaded with insightful quotes and ideas. Here are just a few to give you a sense for what to expect.

  • “Experience is what you get when you didn’t get what you wanted.”
  • “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That’s not easy.”
  • “Good times teach only bad lessons.”
  • The first test in looking at an idea is “and who doesn’t know that?”
  • “Leverage doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.”
  • “Risk means more things can happen than will happen.”
  • “The relation between different kinds of investments and the risk of loss is entirely too indefinite and too variable with changing conditions to permit sound mathematical formulation.”
  • “Investing consists of exactly one thing: dealing with the future. Yet it is clearly impossible to “know” anything about the future.”
  • “Think in terms of a range of outcomes, not single scenarios.”
  • “Loss is what happens when risk meets adversity.”
  • “The necessary condition for the existence of bargains is that perception has to be considerably worse than reality.”

 Every investor at almost any level will get something out of this book and is a great refresher for older types like us.

Here is another review on Guru Focus link.

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  1. [...] discussed in Howard Marks’ book, The Most Important Thing. (See our review of the book here and a comment on second level thinking.) When the idea comes from our own thought process, it is [...]

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