1. The Most Important Thing Is… Second Level Thinking
Howard Marks talks about second level thinking as being unconventional, intuitive and adaptive in a deep, complex, and convoluted manner. A second level thinker takes many different outcomes into account asking questions like, how do my expectations differ from the consensus or which outcomes are likely to occur versus the probability of others. In a sense it is thinking about what others are thinking, their beliefs, and possible actions that may ensue from them. It is having a perspective about other participants perspectives asking why, how and what constantly. It is simple, all investors can’t beat the market since, collectively, they are the market. Howard uses a simple example of different and better thinking summing up second level thinking. An investor may go out a step further thinking abstractly about the biases and influences that are present, influencing his attitude. Humans have a cause-and-effect relationship with one another and no simple rule works always, outcomes may or may not be rational, like economics, investing is an art and the key is to think at a second level.
"To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?"
2. The Most Important Thing Is… Understanding Market Efficiency (and Its Limitations)
Under the efficient market theory there are certain assumptions made like, many investors are hard at work, they are all intelligent, objective, motivated and well equipped. They have equal access to available information and they are all open to buying, selling, or shorting any or every asset. This simply is not the case for all investors. The institutional portfolio managers are assigned and confined to various asset classes, investment styles, or niches. As Howard puts it, “Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.” Although there are many smart people involved in creating the market and it is viewed as efficient most of the time, there are times where it is not, whether in certain asset classes, a single bargain, or in it’s entirety.
Howard has the view it should be looked at in a second level:
A) Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
B) If the return appears so generous in proportion to risk, might you be overlooking some hidden risk?
C) Why would the seller of the asset be willing to part with it at a price from which you will receive an excessive return?
D) Do you really know more about the asset than the seller does?
To sum up the efficient market theory there is a story involving a finance professor and his student having a walk.
“Isn’t that a $10 bill laying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The teacher walks away and the student picked it up and walked off to the pub for a cold beer.
3. The Most Important Thing Is… Value
“We all know that even if a coin has come up heads ten times in a row, the probability of heads on the next throw is still fifty-fifty. Like wise the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do tomorrow.”
Now what is it that makes a company or underlying security valuable? It is the patents, brand names, equipment, buildings, land, human capital, financial resources, growth potential or ability to produce earnings and cash flow? Most would say it is of all the inputs above working in combination to produce earnings, although a liquidation value would also be present. Sometimes this is known as negative enterprise value or a “net-net” (popularized by Ben Graham) and is when a company’s short-term assets are of more value after paying all liabilities than the market quoted capitalization. The 1950’s were known for these types of investment when businesses share prices would advance on news of closing and liquidation, also known as “Worth more dead than alive.” Although, one must be able to distinguish between value of today and value of tomorrow. One must also hold a firm view on intrinsic value to cope with the disconnect that is present or may become present in the market.
Howard also says that being to early is indistinguishable from being wrong and that averaging down is how value investors make their biggest returns when a firm sense of intrinsic value and confidence in ones thesis is present. The final matter that is quite obvious, is that you also have to be right.
“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”
4. The Most Important Thing Is… The Relationship Between Price and Value
“Investment success doesn’t come from buying good things but rather from buying things well.” No asset is entitled to a high return and it is only attractive if it is priced right.
Due to the nature of the investment business there will be opportunities where people are both forced sellers and forced buyers. Examples of forced buying may be closet indexers or managers attempting to emulate an index fund or other fund managers that receive inflows of capital and must put it to work regardless of price. An example of a forced seller is when investors or managers are levered up on margin and when losses start to accumulate margin calls are made, if liquidity is not sufficient, forced selling occurs. Simply speaking these opportunities do not present themselves on a regular basis and are unpredictable in their very nature, thus a career cannot be made from them. Having psychology on your side and understanding or at the very least, attempting to understand other investor’s minds and motives, may provide valuable insight that can be found no where else.
The exact opposite of value investing would be aimlessly chasing bubbles with no thought of risk, only potential profit on the mind. A few examples of bubbles include: South Sea, Tulips, The Internet and Real Estate. As Howard Marks had put it “Buying something for less than its value. In my opinion is what it is all about—The most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market is functioning properly, value exerts a magnetic pull on price.”
5. The Most Important Thing Is… Understanding Risk
Some may view risk as the divergence of expected or probable outcomes from potential outcomes. Although finance theory defines risk as volatility or deviation this does not make sense to me. I view risk as inescapable and relating to capital allocation, the potential or probability of a permanent capital loss. When prices are high in relation to intrinsic value, yet an investor still participates, this is a main source of risk.
“Risk means more things can happen than will happen.” - Elroy Dimson
The following chart is from “The Most Important Thing” by Howard Marks depicting the “capital market line” with a twist. It includes bands of probability of essentially bell curves plotted on the traditional capital market line. This removes the auspicious and deceptive assumption that taking more risk leads to more returns. This cannot be further from the truth, if riskier investments reliably produced higher returns, they would not be riskier.
But what is risk?How can it be defined objectively? Intellects most likely chose volatility as an objective measure that may be extrapolated into the future for modeling purposes. However what if potential uncertainties did not materialize and the person was right for the wrong reasons? Tail events that occur once in a generation may cripple an investor that was protected to a degree of 99% or to the other extreme, a speculator may hit a once in a generation long shot making millions or billions by betting on tail events that are unlikely to materialize. The on lookers view the prior as risky and possibly aggressive and the latter as exceptional foresight. Many assumptions are also based on “as worse as the past” but what if the future disasters exceed the past, which more often then not, they do.
Many futures are possible but only one future occurs. The future is unpredictable and worst case scenarios often surpassed with very few showing ability to consistently predict or forecast catalytic events. The key to risk is that it is merely an opinion or a subjective measure based on how far price exceeds intrinsic value of a business and because risk only exists in the future and the future cannot be known, risk cannot be known.
Ben Graham and David Dodd said in “Security Analysis” that “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions to permit of sound mathematical formula.”
Further Reading:
The 20 Most Important Things Proposed By Howard Marks (Part II Of IIII)
“Irrational Exuberance”, “Bubble.com”, “No different this time” and “Risk” all by Howard Marks.
Howard Marks talks about second level thinking as being unconventional, intuitive and adaptive in a deep, complex, and convoluted manner. A second level thinker takes many different outcomes into account asking questions like, how do my expectations differ from the consensus or which outcomes are likely to occur versus the probability of others. In a sense it is thinking about what others are thinking, their beliefs, and possible actions that may ensue from them. It is having a perspective about other participants perspectives asking why, how and what constantly. It is simple, all investors can’t beat the market since, collectively, they are the market. Howard uses a simple example of different and better thinking summing up second level thinking. An investor may go out a step further thinking abstractly about the biases and influences that are present, influencing his attitude. Humans have a cause-and-effect relationship with one another and no simple rule works always, outcomes may or may not be rational, like economics, investing is an art and the key is to think at a second level.
| Howard Marks 2-by-2 Matrix | Conventional Behavior | Unconventional Behavior |
| Favorable Outcomes | Average Good Results | Above-average Results |
| Unfavorable Outcomes | Average Bad Results | Below-average Results |
"To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?"
2. The Most Important Thing Is… Understanding Market Efficiency (and Its Limitations)
Under the efficient market theory there are certain assumptions made like, many investors are hard at work, they are all intelligent, objective, motivated and well equipped. They have equal access to available information and they are all open to buying, selling, or shorting any or every asset. This simply is not the case for all investors. The institutional portfolio managers are assigned and confined to various asset classes, investment styles, or niches. As Howard puts it, “Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.” Although there are many smart people involved in creating the market and it is viewed as efficient most of the time, there are times where it is not, whether in certain asset classes, a single bargain, or in it’s entirety.
Howard has the view it should be looked at in a second level:
A) Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
B) If the return appears so generous in proportion to risk, might you be overlooking some hidden risk?
C) Why would the seller of the asset be willing to part with it at a price from which you will receive an excessive return?
D) Do you really know more about the asset than the seller does?
To sum up the efficient market theory there is a story involving a finance professor and his student having a walk.
“Isn’t that a $10 bill laying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The teacher walks away and the student picked it up and walked off to the pub for a cold beer.
3. The Most Important Thing Is… Value
“We all know that even if a coin has come up heads ten times in a row, the probability of heads on the next throw is still fifty-fifty. Like wise the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do tomorrow.”
Now what is it that makes a company or underlying security valuable? It is the patents, brand names, equipment, buildings, land, human capital, financial resources, growth potential or ability to produce earnings and cash flow? Most would say it is of all the inputs above working in combination to produce earnings, although a liquidation value would also be present. Sometimes this is known as negative enterprise value or a “net-net” (popularized by Ben Graham) and is when a company’s short-term assets are of more value after paying all liabilities than the market quoted capitalization. The 1950’s were known for these types of investment when businesses share prices would advance on news of closing and liquidation, also known as “Worth more dead than alive.” Although, one must be able to distinguish between value of today and value of tomorrow. One must also hold a firm view on intrinsic value to cope with the disconnect that is present or may become present in the market.
Howard also says that being to early is indistinguishable from being wrong and that averaging down is how value investors make their biggest returns when a firm sense of intrinsic value and confidence in ones thesis is present. The final matter that is quite obvious, is that you also have to be right.
“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”
4. The Most Important Thing Is… The Relationship Between Price and Value
“Investment success doesn’t come from buying good things but rather from buying things well.” No asset is entitled to a high return and it is only attractive if it is priced right.
Due to the nature of the investment business there will be opportunities where people are both forced sellers and forced buyers. Examples of forced buying may be closet indexers or managers attempting to emulate an index fund or other fund managers that receive inflows of capital and must put it to work regardless of price. An example of a forced seller is when investors or managers are levered up on margin and when losses start to accumulate margin calls are made, if liquidity is not sufficient, forced selling occurs. Simply speaking these opportunities do not present themselves on a regular basis and are unpredictable in their very nature, thus a career cannot be made from them. Having psychology on your side and understanding or at the very least, attempting to understand other investor’s minds and motives, may provide valuable insight that can be found no where else.
The exact opposite of value investing would be aimlessly chasing bubbles with no thought of risk, only potential profit on the mind. A few examples of bubbles include: South Sea, Tulips, The Internet and Real Estate. As Howard Marks had put it “Buying something for less than its value. In my opinion is what it is all about—The most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market is functioning properly, value exerts a magnetic pull on price.”
5. The Most Important Thing Is… Understanding Risk
Some may view risk as the divergence of expected or probable outcomes from potential outcomes. Although finance theory defines risk as volatility or deviation this does not make sense to me. I view risk as inescapable and relating to capital allocation, the potential or probability of a permanent capital loss. When prices are high in relation to intrinsic value, yet an investor still participates, this is a main source of risk.
“Risk means more things can happen than will happen.” - Elroy Dimson
The following chart is from “The Most Important Thing” by Howard Marks depicting the “capital market line” with a twist. It includes bands of probability of essentially bell curves plotted on the traditional capital market line. This removes the auspicious and deceptive assumption that taking more risk leads to more returns. This cannot be further from the truth, if riskier investments reliably produced higher returns, they would not be riskier.
But what is risk?How can it be defined objectively? Intellects most likely chose volatility as an objective measure that may be extrapolated into the future for modeling purposes. However what if potential uncertainties did not materialize and the person was right for the wrong reasons? Tail events that occur once in a generation may cripple an investor that was protected to a degree of 99% or to the other extreme, a speculator may hit a once in a generation long shot making millions or billions by betting on tail events that are unlikely to materialize. The on lookers view the prior as risky and possibly aggressive and the latter as exceptional foresight. Many assumptions are also based on “as worse as the past” but what if the future disasters exceed the past, which more often then not, they do.
Many futures are possible but only one future occurs. The future is unpredictable and worst case scenarios often surpassed with very few showing ability to consistently predict or forecast catalytic events. The key to risk is that it is merely an opinion or a subjective measure based on how far price exceeds intrinsic value of a business and because risk only exists in the future and the future cannot be known, risk cannot be known.
Ben Graham and David Dodd said in “Security Analysis” that “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions to permit of sound mathematical formula.”
Further Reading:
The 20 Most Important Things Proposed By Howard Marks (Part II Of IIII)
“Irrational Exuberance”, “Bubble.com”, “No different this time” and “Risk” all by Howard Marks.
