Type ‘Howard Marks’ into your search engine of choice and you could end up with two very different types of holiday reading – the memoirs of a prolific marijuana smuggler, who for a period in the 1980s was Britain’s most wanted man; and the investments insights of one of our favourite investors, here on The Value Perspective. For the avoidance of doubt, this article will be focusing on the latter.
In contrast to our previous holiday reading tip, Margin of Safety, The Most Important Thing (2011) will not set you back the price of a holiday in itself – not, at least, if you avoid clicking on the second-hand paperback on offer on Amazon for £870.
Shelling out £20 or so, for the hardback or Kindle version will net you a short but still deeply insightful text that offers a good bridge from value investing primer to more ambitious reads.
Indeed, the only fault we can find with the book, here on The Value Perspective, is the slightly misleading nature of its title as, in fact, it highlights not one but a number of important things for the value investor to consider.
As with Margin of Safety, rather than offering a traditional review, we will instead touch on the lessons – or important things – we personally took from the books themselves.
So what were they?
The importance of ‘second-level thinking’
Any investor who wants better than average returns needs to find a better than average way of thinking.
As Marks explains, first-level thinkers look for simple formulas and easy answers – and, because first-level thinking is easy, you can be sure everybody is doing it. In contrast, adds Marks, second-level thinkers know “success in investing is the antithesis of simple”.
He continues: “Since other investors may be smart, well-informed and highly computerised, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others …which by definition means your thinking has to be different.”
The importance of thinking about both risk and return
As we discussed in Value investing skills #3, our own investment methodology, here on The Value Perspective, considers not only the potential rewards of buying into a business but also the associated risks of doing so. Risk and reward are two sides of the same coin and clear-eyed investors must think hard about both before they part with their money.
The importance of understanding market efficiency – and its limitations
There is a widespread view in investing that, because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. This is known as the ‘efficient market hypothesis’ – and Marks does not disagree with it in principle.
Where he does diverge from the majority is in not believing the consensus view is necessarily correct.
By way of explanation, he points to the share price of Yahoo before and after the tech bubble burst, noting: “In January 2000, Yahoo sold at $237. In April 2001 it was $11. Anyone who argues that the market was right both times has his or her head in the clouds – it has to have been wrong on at least one of those occasions.”
Another observation worth noting on this subject from The Most Important Thing is: “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.”
The importance of understanding market cycles
Human beings tend to think in a linear way and yet, notes Marks: “Most things prove to be cyclical.”
Elsewhere in the book, he writes: “Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case.”
As we recently noted in World Cup emotions, the world may be continuously changing but human beings remain constant and our emotions constantly affect markets: they are cheap when we are fearful and expensive when we are greedy. When it comes to investing, therefore, it turns out we are systematically exploitable – and value investing is the system.
The importance of differentiating between price and value
Warren Buffett famously observed “Price is what you pay, value is what you get” but Marks goes further in underlining that by far the most important of the two concepts is value.
He writes: “For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.”
So, as we noted in When to buy a company, you have to have a view on a business but we would go much further still – you also have to have the numbers to back up your thesis and valuation is a key component of that.