Book Number 4 – The Most Important Thing by Howard Marks (Revised May 18)

Lachlan Hughes

Swell Asset Management

Howard Marks is the Chairman and Founder of Oaktree Capital Management, an investment firm managing over $120B. This is not a how to invest book and you will not find any step by step instruction. When it comes to investing, Marks believes there is no sure-fire recipe for success. This book, “The Most Important Thing”, reflects Marks’s investment philosophy. With recommendations from some of the world’s best investors, this book is essential reading for any investor. As with my prior reviews, I have limited this summary to the concepts that resonated with me.

Second level thinking

Second level thinking is the process of trying to think one step ahead of the market. Marks believes the stock market is very good at first level thinking. First level thinking is simplistic and superficial. For example, the outlook for the company is favourable, therefore the stock will go up. Second level thinking is deeper and more complex. Second level thinking asks questions such as:

  • What is the probability and range of future outcomes?
  • Which outcome do I think will occur?
  • What is the consensus view and how does this differ to my own view?
  • What is the consensus psychology that is imputed in the current price?

He recommends investors garner a deep understanding of the consensus opinion. Why? Because the only way to generate outperformance is to do something different to the majority of market participants. Extraordinary performance comes from correct non-consensus forecasts.

 “Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others.” – Howard Marks

This means that your best investment ideas will feel uncomfortable, as you will be investing against the consensus opinion. He makes the point that investing is a discipline, where there is no safety in numbers. He summarises his view in the following table. You can see that the best results will be generated with favourable outcomes and unconventional behaviour.

 The Relationship between Price and Value

Marks is a true value investor and spends considerable time addressing the concept of price and value, a recurring theme in these reviews. For investing to be reliable, an accurate estimate of the intrinsic value is an “indispensable starting point”. Not that this comment should come as any great surprise. If you don’t know how much something is worth, then how can you pay less than it is worth? Marks summarises the three essential ingredients required to consistently make money.

  1. You must have a view on intrinsic value;
  2. You must hold that view strongly enough to keep the faith as the stock price declines; and
  3. You must be right.

Therefore, it makes sense to only invest in those businesses that can be reliably valued. Buffett refers to this as his ‘circle of competence’. Everyone’s circle of competence is different. The size of the circle is not as important as knowing where the boundaries rest.

While Marks believes that valuation is vitally important, he also stresses the importance of holding your nerve as the stock price fluctuates in the short term. To do this, investors must have a model for combating the negative influences of the market.

Combating Negative Influences

We are all influenced by psychological factors which inhibit our ability to make rational and reasoned decisions. Unfortunately, being aware of these biases does not guard against them. We can only limit their impact over time. Marks believes that the biggest investment errors do not stem from informational or analytical errors, rather from psychological bias. He identifies six psychological influences to guard against.

  1. The desire for money, greed.
  2. The counterpart of greed, fear.
  3. The tendency to dismiss logic.
  4. The tendency to conform.
  5. Envy.
  6. Ego.

Fortunately, Marks provides some weapons investors may deploy to combat these negative influences. He recommends the following.

  1. A strongly held sense of intrinsic value.
  2. An understanding of past cycles.
  3. An understanding of the effect of psychology on the investment process.
  4. A promise to remember, when things look too good to be true, they probably are.
  5. The willingness to look wrong in the short term.

Marks notes that while these weapons help, they do not remove our innate biases. While knowing what you do know is important. It is also important that you know what you don’t know.

Knowing What You Don’t Know

John Galbraith once quipped;

“We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”

Marks hypothesises that those who understand their limitation around forecasts will be prone to acting quite differently. Those who understand their limitation will diversify, hedge, borrow less and generally act more prudently that those who believe the future is knowable. Acknowledging our limitations is an excellent place to start when it comes to forecasting.

After all, how many forecasters predicted the sub-prime problem, GFC and financial meltdown? A mere handful. Of those few, how many went on to predict the economic recovery? I believe the answer is none. Marks's message is clear, know your limitations!

I hope you have enjoyed this book review. I look forward to bringing you Book Review number 3 tomorrow. For further insights from the Swell team, please visit our blog

Book Review

Book Number 5 - Only the Paranoid Survive by Andrew Grove.

Book Number 6 – The Little Book of Value Investing by Christopher H. Browne.

Book Number 7 – The Great Crash 1929 by John K. Galbraith.

Book Number 8 – Common Stocks & Uncommon Profits by Philip A. Fisher.

Book Number 9 – The Art of Short Selling by Kathryn Staley.

Book Number 10 – You Can Be a Stock Market Genius by Joel Greenblatt of Gotham Capital. 

Lachlan Hughes
Swell Asset Management

Lachlan is the founder and CIO of Swell Asset Management, a boutique investment manager specialising in global equities.

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