Howard Marks (Trades, Portfolio)’ latest memo dated Sept. 9 has been released here. The memo title is “It’s Not Easy” quoting Charlie Munger (Trades, Portfolio)’s assessment of investing: “It’s not supposed to be easy. Anyone who finds it easy is stupid.”
The memo covers many topics, but here are some of my favorite discussions with my own interpretation.
Second Level Thinking
- Anyone who thinks investing is easy must use superficial and simplistic thinking. “The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth, or the lowest p/e ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it.” If I introspect, I can take comfort that my research into the oil industry allowed me to avoid value traps. On the other hand, my lack of research and my first level thinking on the DRAM industry led me to underestimate the amount of risk in Micron (MU).
- Second level thinking needs to begin with questioning conventional wisdom and your own assumptions. What misconceptions are everyone else acting upon? Marks’ uses the example of the housing boom leading up to 2008. Many people bought homes with the belief that housing prices never fall.
- First level thinkers like shiny objects, and as a result the underlying asset has risen and likely becomes overvalued. In my observation, many retail investors don’t even understand such concepts as market capitalization or shares outstanding. I’ve seen such crazy logic such as "Tesla is ~$250 per share and Netflix is ~$99 per share, I like Netflix better because it’s a better value." These speculators are “valuing” companies by comparing relative prices.
- Marks uses the examples of Kodak, Polaroid, and Xerox, which either went bankrupt or needed to rise from the ashes.
- I think a prime example of finding first level thinking is to watch CNBC.
Risk and Counterintuitiveness
- Some of Marks’ most successful investments have come when he’s heard the phrase “I wouldn’t buy that at any price, everyone knows it’s too risky.”
- “The truth is, the herd is wrong about risk at least as often as it is about return.”
- Many people believe stocks are safe when they’re going up in price when the opposite is true.
- “The problem that befalls most people - the first level thinkers - is that they fail to distinguish between fundamental risk and investment risk.”
- Marks points out that even good companies can become overpriced, which makes them risky from an investment standpoint. Bad companies can also become underpriced to the point where the investment risk is low.
- Glamour stocks like Netflix (NFLX), Tesla (TSLA), and Facebook (FB) are examples of good companies that become overpriced.
Nuances
- Marks then lists 16 statements of conventional wisdom and points out that investors must apply second level thinking to avoid pitfalls and capitalize on opportunities.
- “Risky investments produce high returns.” This misconception makes me think of Warren Buffett (Trades, Portfolio)’s quote:
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we are trying to do. It is imperfect but that is what it is all about. -- Warren Buffett, 1989 Berkshire annual meeting.
- If the risk involved makes the probability of loss greater than the probability of gain, then a risk investment does NOT produce high returns.
- “Adding risky assets to a portfolio makes it riskier.” Marks points out that this may not be the case if an individual has a portfolio of “safe” assets that doesn’t correlate to the “risky” asset. Adding the risky asset would diversify and make the portfolio less risky.
- “A forecast has to be correct in order to be profitable.” Marks points out that people can profit by being less wrong.
- “It’s important to do what feels right... Most great investments begin in discomfort. Good investors are subjected to the same misleading influences and emotions as everyone else. They’re just more capable of keeping them under control.”
Final Thoughts
Investing is a process of continual improvement and learning. When great investors like Howard Marks (Trades, Portfolio) share their viewpoints and experiences, I consider myself lucky to be able to learn from their insights. From this particular newsletter, it’s comforting to know that even great investors acknowledge that investing isn’t easy. I also highly recommend Marks' book, "The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor".
