Monday, April 22, 2019

Book Review #40: The Most Important Thing Author:Howard Marks

Book Name: The Most Important Thing:  Uncommon Sense for the Thoughtful Investor

Author: Howard Marks

Published by: Harper Business

ISBN: 978-9-35-302279-2 (Print)

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This book gets rating of 3/5

This is the review of the book 'The most important thing - Uncommon sense for the thoughtful investor', written by Howard Marks. Mr.Marks is a famous investor who is the co-founder of Oaktree Capital Management that he and his friends started in 1995. This book is an elaboration of various memos that Mr.Marks wrote to his investors over the years. Each memo deals with one thing that he considers to be the most important thing in investment. There are 19 'Most Important Things' covered in this book.

In comparison to other books that I have read in the genre of finance and investments, this is a much lighter read, devoid of any math. Personally I did not find a lot of value in this book since almost all of what I read in this book is covered in other books. However considering that this book has sold over 4.5 Million copies, it has to find a place in the list of finance books that I review as a part of my project.
The most important things are (I have grouped them for better clarity)

General Market Understanding
  • Second level thinking
  • Understanding market efficiency and its limitations.
  • Value
  • Relationship between price and value
 Investment Ideas and Concepts
  • Understanding risk
  • Recognizing risk
  • Controlling risk
  • Being attentive to cycles
  • Awareness of pendulum
Personal Behaviour and Psychology
  • Combating negative influences
  • Contrarianism
  • Finding bargain
  • Patient opportunism
  • Self knowledge - knowing what you don't know
  • Having a sense of where we stand
  • Appreciating role of luck
  • Defensive investing
  • Avoiding pitfalls
  • Adding value
Each chapter of the book is dedicated to each of the above items. Chapter 20 summarizes the ideas covered in this book

The key message in this book is that investing is a balance between risk and return. One who understands this and fits this into his investment strategy will win in the end. Marks is not advocating Zero risk strategy, the key aspect is to keep risk at the front and centre of the investment strategy. Risk is the most interesting, challenging and essential aspect of investing. The focus of this book is risk adjusted returns

Mr.Marks uses these memos to explain his investment philosophy, the workings of finance and to provide his take on the recent events. In his memo of July 2003, he compiled a set of 18 elements which he called 'the most important thing'. All of them are important. Successful investment requires  considering many factors simultaneously.

This is not a 'how to book'. It doesn't tell you what to do, instead it provides a way to think so that investors make good investment decisions while avoiding the pitfalls.

The book begins with a discussion of the market environment in which the investing takes place. This is followed by discussion of the elements that lead to investment success, with final chapter as the summary.

There are some key themes that run through this book. One is 'second level thinking' where you have to think deeper and more incisive than an average investor. What is the benefit of second level thinking if markets are efficient as per efficient market theory.? As per the author, while some markets may be efficient, like currency market and some part of the stock market, there are pockets of inefficiency even in stock market which a discerning investor can capitalize on. 

There are two types of knowledge. One is a generic awareness of the economy that almost everyone has and the second is a detailed knowledge of a specific company or an industry that one can pick up by putting in time and effort. With this extra knowledge, one can make money by using second level thinking. Mr.Marks calls it 'Knowing the knowable'.

The author stresses on is the idea of risk adjusted returns. As per the market theory, the higher the risk, the higher is the return. As per the author, if you are sure of the higher return, then you are not taking any risk. The point is you can get good returns without taking proportional risk.

How do you define risk? As per the author, the definition of risk could depend on the individual and the situation that the individual is in. Risk could be related to being not able to meet the investment objective, it could be risk of a career failure, or risk of illiquidity - not having cash when required etc. Author defines risk as a potential for permanent loss of  capital. While much of risk is hidden and subjective, skilled investors can judge risk by comparing price and value. By looking at the market behaviour one can understand if risk exists or not. The key is to be 'Greedy when others are fearful and fearful when others are greedy'. Author makes an interesting point that 'risk tolerance is generally inimical to successful investing. The reason is that if you are tolerant to risk you will end up taking more of it. This goes against the conventional wisdom. Risk aversion is very important for the market to discover the right price for an asset.

(Example of Warren Buffet is relevant here. When markets were high in 1973, Mr.Buffet exited the market and sat with cash. So he was in a great position to find great bargains in the crash of 1974)

Risk is a potential for loss. It exists even if the loss did not happen. It is when markets are going really well that risk control becomes most important.

Author talks of an interesting paradox. When investors perceive risk, they drive down the prices so low that an asset is no longer risky. On the other side, when investors perceive an asset to be less risky they recklessly buy and drive the price up resulting in increased risk. This means that the current price of an asset is the ideal risk indicator. The paradox is that instead of looking at the price as an indicator of risk, investors tend to look at price as an indicator of return.

While you cannot predict most of the events in the market, there are two things that you can predict with 100% accuracy. One is that the market always moves in cycles. There will be a period of bust, followed by a long period of stability followed by a boom and then a crash. It is important for the investor to be aware as to which phase of the cycle the market is currently in before making any investment. The other certainty in market is that it swings like a pendulum around an average. The swing can take the prices to excessive highs and to excessive lows. If you buy into the market when the prices are excessively low, you will make very good risk adjusted returns.

However patience is the key. The pendulum will not reverse the next day after you invest. It will take its own time and that may test the patience of the investor leading him to exit the investment at the wrong time. The stomach for staying on when others are quitting is what separates a good investor from an average one. Other than patience, an investor should be aware of negative influences like greed, fear, envy as potential pitfalls that will prevent him from achieving his potential. Contrarianism aided by second level thinking is another personal trait that helps an investor to find bargains in the market.

It is also important for an investor to know what they don't know. While it sounds like a paradox, it is really simple. If you don't know how currency or commodity market works, do not invest in those market. Do not invest in exotic pharma stock if you don't know the business. While there are lots of things that an investor may not know, there are a few things like knowledge about industry or specific companies that an investor can pick up. Once an investor picks a detailed knowledge about a niche, it is better to stay invest within that niche. This niche forms your universe of investible assets. 

Investing is always a choice between increasing returns (Return) and lowering losses (Risk). They go together. As per the author, an investor should focus on the latter. It could mean that you miss out on some returns, but in the long run you will be more successful than many career investors out there. Focus on excessive returns is the reason why you do not see many career investment managers out there.

There are two aspects to any transaction decision in the market, price and value. Focusing on one without the other is fruitless. They are the yin and yang of investing. An investor should have a keen eye for value aided by superior knowledge and second level thinking. She should also know that value is not static. An investor should by when the price is sufficiently lower than the current value. This is the margin of safety that the investment provides. Investor should sell when price has exceeded the current value.

Buy at a price lower than value and sell at a price higher than value. That is how great investments are made.

It is that simple.

Chapter Notes

Ignoring cycles and extrapolating trends is the most dangerous things an investor can do.

The first thing is second level thinking. In investing, valid approaches work sometime but not always. The first reason is that no rule always works. Environment changes, people change or cause and effect are not hardwired. One's investment approach should be intuitive and adaptive rather than rigid and mechanistic. Successful investing is doing better than market and other investors. To do this you need either luck or superior insight. Luck is not in your control, but superior insight is.

What is meant by superior insight? It comes from second level thinking, a deeper and perceptive way of thinking. Only a few people will achieve the superior insight, intuition, sense of value and the awareness of psychology required for consistent outperformance. To do this you need second level thinking. It is more powerful and at a higher level than the average thinking. To do better than other people you have to think something that they have not thought of, see something they miss or bring insights they don't possess. You have to react and behave differently. You must be more right than others which means your thinking should be superior. First level thinking is simplistic and superficial. First level thinkers only need an opinion to make decisions. Second level thinking is deep, complex and convoluted. Second level thinker takes a lot of things into account an hence the work load of a second level thinker is much more massive. To outperform the average investor, you have to out think the consensus. Extraordinary performance comes from correct non-consensus forecast, but they are hard to make, hard to make correctly and hard to act on. To find bargains in market, you have to bring  exceptional analytical ability, insight and foresight, which is nothing but second level thinking. The good news is that prevalence of many first level thinkers increases the chances of success of a second level thinker.

The only way to make money in market is to buy low and sell high. The question is 'low' or 'high' compared to what. There are two parameters that can be used to compare. One is to compare the current price with the expected price. This approach is called technical analysis. Second is to compare the price with the intrinsic value, an approach called fundamental analysis. Marks recommends value approach. You can identify value based on analysis of cash flow and earnings. There are two approaches in fundamental analysis. One is the value approach and the other is the growth approach. The former compares the current price with the the current value and the latter compares current price with future value based on expected growth. The challenge with value investing is that market may not immediately agree with the investor of the intrinsic value. Market may time to recognize value and investor has to have tons of patience while following the value approach.

The fourth most important thing is the relationship between price and value. This is the core of successful investing. Any asset class can be a good investment if the price is lower than the value. How do you determine if the price is right. The price of a security will be affected by two factors, psychology and technical. The latter could be forced selling due to market crash, margin calls etc. During technicals the best thing for you is to become a buyer, the worst thing is to become a seller. It is very important to arrange your affairs so that you will be able to hold out and not sell during the worst of the times. This requires both long term capital and psychological resources. The second aspect is psychology. The key is how the other investors think. There are two challenges to psychology. First is that psychology is elusive, it is difficult to understand how others think. The second is that the factors that invest others will also influence you. This causes an average investor to take actions opposite of what a superior investor will do. In bubbles 'attractive' morphs into 'attractive at any price'. There are various ways to make investment profit. One is to benefit from a rise in the asset's intrinsic value. The problem is that the rise in intrinsic value is difficult to predict accurately. Another way is to apply leverage. Leverage doesn't make anything a better investment, it just maximizes your profit from a transaction. The third way is selling more than an asset's worth. The fourth approach is to buy something far lower than its intrinsic value. This is the most dependable way to make money. Value approach is not infallible. Sometimes market may sell an asset at a price significantly lower than value, or the value could deteriorate or the market could take a long time to realize the value.

There are three aspects to risk. One is to understand what is meant by risk, second is to recognize it when it makes its appearance and third is to control risk. Chapter 5 deals with the first aspect, understanding risk. There are three reasons why dealing with risk is essential. One, people are naturally risk averse and want to avoid or minimize it. Two, any investment is defined by both the return and the risk needed to get that return. Three, returns are normally calculated based on risk adjusted basis. Author defines risk as the possibility for permanent loss of capital. Investment risks come in many forms like falling short of one's investment goal, under-performance - any high level of alpha is fraught with periods of under-performance, career risk (of money managers), unconventionality, risk of illiquidity etc. Much of the risk is subjective, hidden and unidentifiable. Skilled investors make judgment about risk by looking at the dependability of value and its relationship with price. The challenges is that absolute value of return is not a good indicator without normalizing it with the risk undertaken, but risk is difficult to measure. Risk exist only in future and people overestimate their ability to gauge risk 

In the chapter on recognizing risk Mr.Marks talks about an interesting paradox. When people perceive some asset as risky, they will drive down the price to a level where it is no longer risky. The reverse also happens. People focus on the asset they buy rather than the price they pay. The fascinating point is that instead of using price as a gauge of the risk, many people use price as a gauge of the expected return.

The chapter 6 is on 'recognizing risk'. Risk means the uncertainty about which outcome will occur and about the possibility of loss when the unfavourable outcomes occur. Recognizing risk often starts with understanding when investors are paying too little heed, being too optimistic and paying too high a price for an asset. Risk arises when market go so high that prices imply losses rather than potential rewards. Truth is 'risk tolerance' is antithetical to successful investing. When people are not afraid of risk, people will take more of it. There are few things as risky as the widespread belief that there is no risk because it is only when the investors are suitably risk averse that the prospective return will mirror the risk premium. Prime element in risk creation is the belief that there is no risk. For example, in 2007 many people were thinking that risk has been globalized, the risk is well diversified, the leverage is cheaper etc. He talks about the moral hazard where better analytical methods can entice the investors to take more risk. Worry, skepticism and risk aversion are essential ingredients in a safe financial system. Only when investors are sufficiently risk averse that market will offer adequate risk premium. Risk is ephemeral and unmeasurable. You have to recognize it by its symptoms of high price. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it. Thus they accept risk unknowingly and contribute to its creation.

To control the risk, it is important to remember that risk is a potential for loss. Risk exists even if the loss did not occur. In Chapter 7 on controlling risk, author says that for a portfolio to make it through tough times, risk has to be controlled. In good times it is difficult to know if risk control was present, but it is required most importantly in good times. The road to long term investment success runs through risk control. Skillful risk control is the mark of a superior investor.

In Chapter 9 author mentions that investor sentiments behave like a pendulum moving around an average value.Investment markets always follow a pendulum between optimism and pessimism. Like cycle, this is a very dependable phenomenon. This phenomenon is caused when people's attitude to risk changes and they toggle between greed and fear. There are two opposing risks that people toggle between, which are risk of losing money and risk of missing opportunity. The pendulum swings between these two positions. At the negative end of the pendulum, the investors should become more risk tolerant and start investing. At the bubble end of of the pendulum investors should become more risk averse, sell their holdings and exit the market or not buy at all. The challenge is that we do not know how far the pendulum will swing on either side and how long a swing in any direction will last.

Chapter 10 discusses the negative influence factors that an investor must conquer. The first one is greed. This emotion can overcome common sense, risk aversion and prudence. The second factor is fear, the opposite of greed. The third factor is the tendency to dismiss logic, history and time-honoured norms. Process of investing requires strong dose of disbelief, says the author. The fourth factor is the tendency to follow the herd. The fifth negative influence is envy, the tendency to compare with others. The sixth factor is the ego, the tendency to feel proud of one's returns. The thoughtful investors are aware of gaps in their knowledge and their psychological limitations. The final factor is capitulation due to extreme panic. Investors can counter these forces through a disciplined approach of taking the right decision based on the divergence between price and value.

Chapter 11 talks of Contrarianism, the habit of buying when others are selling and vice versa. Most investors are trend followers. A contrarian investor should be able to clearly identify when prices have diverged from intrinsic value, should have the courage to go against the flow, Practicing contrarianism is difficult. We don't know how far the pendulum will swing, Also, it could take more time for the cycles to reverse. You must be contrarian not because it the the opposite of what the crowd is doing, but because you know why the crowd is wrong. Most of the great investments often starts with discomfort.

Chapter 12 talks about finding bargains in the market. First step is to identify a criteria to pick investments from. The investments that meet the criteria is the universe that you must play within. Once you have the feasible set of investments you can use another criteria to pick the best ones to invest in. The goal is not to buy good assets, but to by good investments. Most of the investors mistake good assets for good investments. How to identify bargains? Potential bargains display some kind of objective deficit. Bargains are based on incomplete understanding. That is where second level thinking comes into play. Good places to start looking for bargains will be little known assets, scary assets or assets that are no respectable for some portfolios. For bargains to exist, perception should be worse than reality.

Chapter 13 discusses Patient Opportunism. Author says that you will do better if you patiently wait for opportunities, when sellers want to sell. Patient investors can pass up a lot of opportunities until they see one that is terrific. A patient investor will first decide if we are in a low return or a high return environment. In a low return environment, the only way to make good returns is by taking big risks. Low return environment will happen when the prices are high. In a low return environment, a patient investor should hold cash and wait for the inevitable correction. The best buying opportunities come when buyers are forced to sell. Patient opportunism coupled with a contrarian attitude and a strong balance sheet can yield excellent profits during meltdowns.

While it is impossible to know more than the market, one could learn more about specific industries and companies and create an advantage. This is the focus of Chapter 14: Knowing what you don't know. The people who don't know about the future will take less risks, will hedge, take less leverage and focus on value today rather than growth tomorrow.

Chapter 15: Having a sense of where we stand talks about knowing which phase of the cycles were are currently in. In the world of investing, nothing is as dependable as cycles. One should look at IPO market, credit cycles, tightening yield spreads etc. The author has given a checklist of items that one can use to evaluate if the cycle is upbeat or down. This include Economy (Vibrant / Sluggish), Capital Market (Loose / Tight), Spreads (Narrow / Wide) and others. You can find the complete list here.

Chapter 16 discusses appreciating the role of luck in investing. This chapter borrows heavily from the writings on Randomness by Nassim Nicholas Taleb. The summary is that investors could be right or wrong for all the wrong reasons and the correctness of the decision cannot be judged from the outcome. Considering that luck plays a big role in investment success, a smart investor must spend time on finding value among the knowable rather than on hazy macroeconomic forecasts. Also since we do not know how the future will pan out, we should have strong margin of safety to support our purchases.

One of the ways of handling uncertain outcomes is to invest defensively. This is the focus of Chapter 17. There are two principles in defensive investing. First is the exclusion of losers from portfolio. This can be achieved by due diligence, low price compared to value and a generous margin or error. The second element is the avoidance of poor years and exposure to meltdown in crashes. This can be established by proper portfolio diversification. A conscious balance must be had between striving for return and avoidance of risk. Stay scared ! is the mantra of this chapter.

Chapter 18 talks about avoiding investment pitfalls. The sources of pitfall can be analytical / intellectual or psychological / emotional. The former could be lack of due diligence. Other than the pitfalls discussed in Chapter 10, another is the failure to recognize market cycles and manias and move in the opposite direction. One of the analytical / intellectual pitfall is 'Failure of Imagination' - the inability to understand full breadth of a range of outcomes. Normally investors focus on potential returns and extrapolate the recent past into the future. However, they should not ignore the fact that highly improbably things could happen in the market from time to time. Another failure is the understanding of asset correlation, which is an important limitation of portfolio diversification. One another interesting pitfall is that the returns of an investor are dependent on the mistakes of others. For example, if you have invested in NPS in India, the investor do not have control on how the pension fund invests their savings. Investor requires awareness, flexibility, adaptability and a mind-set focused on taking cues from environment.

Chapter 19 talks about Adding Value. An investor should strive to capture most of the upsides while capping the downsides. For that you need knowledge and superior insights derived from second level thinking.

Chapter 20 sums it all together.

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