 Howard Marks (Trades, Portfolio)' regular memos should be required reading for every investor. Over the years, he has delivered some incredibly insightful comments into all areas of investing, but mainly value investing as this is where Oaktree specializes.
As of yet, I have not personally been able to read all of the memos, but I have been able to review a fair few, and every single one has helped me build my investment process.
One of my favorite memos was published by Marks in September 2015 titled "It's Not Easy."
As you can probably guess, the memo focuses on the complexities of investing and how it is not easy to invest successfully and beat the market.
As Marks explains, one of the reasons why it is difficult to beat the market is because, if you think it is easy to achieve unusual profits, you are overlooking the way markets operate.
Charlie Munger (Trades, Portfolio) once said, "Anyone who finds it [investing] easy is stupid." As Marks explains, if you believe investing is easy, you do not understand one of the key functions of markets; to eliminate opportunities for excess returns.
Marks writes, "In most markets transparency needs to reveal and thus preclude obvious mispricing’s (thanks to the incredible gains and access to data by way of the Internet, this is certainly more true today than ever before.)"
The memo goes on to introduce something called second-level thinking; a term Marks has coined to describe the intelligent investor's ability to think differently than the rest of the market.
Second-level thinking is the requirement to think better than others, at a higher level, finding an edge not available to the remainder of the market.
Marks writes, "You have to think of something they haven't thought of, see things they miss, or bring insight they don't possess. You have two react differently and behave differently."
Only by thinking differently than everyone else, and viewing the general prevailing opinion with a degree of skepticism, will you be able to outperform the rest of the market's participants.
Marks goes on to give some examples. For instance, if a first-level thinker is saying "it's a good company, let's buy the stock," second-level thinking will interpret this as "it's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell." Or another example, if first-level thinkers believe the company's earnings will fall, second-level thinking says, "I think the earnings will fall far less than people expect." Put simply, second-level thinking is not only contrarian in nature, but it should seek to ask why I should have a different view compared to the rest of the market and what is likely to be the alternative outcome(s).
Marks’ summary is this:
“The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buying or sell on the basis of their reactions. They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all of this for the route to success.”
Personally, I have no opinion on where high-growth tech stocks like Amazon (AMZN, Financial), Alphabet Inc. (GOOG, Financial) (GOOGL, Financial), Facebook (FB, Financial) and Netflix (NFLX, Financial) will end up over the next 10 years or so. But the very fact so many people believe these companies will continue to dominate the world reminds me of Marks’ description of first-level thinking. So does the demand for passive index trackers at a time when markets trade at near record valuations. Would a second-level thinker look at these valuations and take them at face value?
Disclosure: The author owns no stock mentioned.
