Lesson #23: Value Investing – The Most Important Things
Investment philosophy is largely a product of what you practice and who you follow as your role model. Being a value investor, the obvious set of people that you should follow includes Benjamin Graham, Phillip Fisher, Warren Buffett and Charlie Munger.
But there is one more person who deserves to be your role model. Howard Marks is one of the few investors Warren Buffett respects a lot. Marks is the CEO of Oaktree Capital and is one of the most famous investors who manages to keep a low profile, despite managing almost US$ 90 billion.
Marks is also the author of an amazing book – The Most Important Thing: Uncommon Sense for the Thoughtful Investor. In its ultimate praise, Warren Buffett writes, “This is that rarity, a useful book”.
Apart from the investing gems he has shared through this book, Marks also writes regular memos for investors where he outlines his investment philosophy, in line with what Buffett does via his annual letters to shareholders.
Here is what Buffett has to say about Marks’s memos – “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something…”
From whatever I have read in his memos, Marks focuses a lot on risk control and seeks to exploit market cycles. He prefers judgment to mechanical quantification, and believes in the power of checklists. All his memos are masterpieces in themselves and deserve a place next to Buffett’s letters.
SO here are the five most important things, as prescribed by Marks, that you as an investor must follow when it comes to practicing value investing.
- Second-level thinking
- Understanding risk
- Relationship between Price and Value
- Knowing what you don’t know
- Appreciating the role of luck
1. Second-Level Thinking
One of the best tools to think and behave better in investing is what Howard Marks calls the “second level thinking”.
But what exactly is second-level thinking? Here is what Marks writes in his book…
- First-level thinking says, “It’s a good company; let’s buy the stock.” Second- level thinking says, “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.”
- First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
- First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.
Second level thinking is all the more important in complex adaptive systems, stock market being one such system. In complex adaptive systems the second and even third order effects are more important than the immediate ones.
In essence, if you wish to perform better than the rest – or in other words, perform better than average – your thoughts actions, expectations, and portfolio have to diverge from the norm.
2. Understanding Risk
Dealing with risk in investing is one of the most important elements you will be practicing as an investor.
Howard Marks writes…
It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk.
The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.
Which is the biggest risk you must be worried about? It’s the permanent loss of capital, dear friend.
A stock’s price jumping up and down – known as volatility – isn’t the real risk. But a stock price falling down to never jump back…that’s the real big risk in investing, and something you must try to avoid.
3. Relationship between Price and Value
Price is what you pay and value is what you get.
Graham taught that the price you pay for an investment matters a great deal.
In fact, price is the primary determinant of the return you earn on your capital. If you pay Rs 10 to buy ownership of Rs 2 in profit, your return is 20%. If you pay Rs 50 to buy Rs 2 in profit, your return is just 4%.
So never forget this: Price versus value matters a lot.
No matter how great the business is, if you overpay for your ownership, you are going to earn a sub-par rate on your money even if you hold the stock for the long term (like 10 years).
It’s basic math.
4. Knowing What You Don’t Know
The noted American economist and author, John Kenneth Galbraith wrote – “We have two classes of forecasters: Those who don’t know— and those who don’t know they don’t know.”
Then, psychologist Amos Tversky wrote…
It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.
Howard Marks wrote in his book…
Most of the investors I’ve met over the years have belonged to the “I know” school. It’s easy to identify them.
- They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
- They’re confident it can be achieved.
- They know they can do it.
- They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
- They’re comfortable investing based on their opinions regarding the future.
- They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
- They rarely look back to rigorously assess their record as forecasters.
Sounds like most investors are too full of themselves and their theories and predictions about the stock market.
But why look far? Stand in front of the mirror and ask yourself how many times you have also claimed to have belonged to this “I know” school.
You see, overestimating what you’re capable of knowing or doing can be extremely dangerous in investing. On the other hand, acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.
As Mark Twain put it best…
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
5. Appreciating the Role of Luck
Nassim Nicholas Taleb’s Fooled by Randomness is one of the most important books you will ever read as an investor.
In this book, Taleb writes…
$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though, they would be identical. Yet, deep down, I cannot help but consider them as qualitatively different.
In the same way, all stock market returns are not created equal.
Howard Marks writes…
The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.
This is especially true in the short run, when a great deal of investment success can result from just being in the right place at the right time.
That’s why it’s so important to appreciate the role of luck instead of ignoring it, and avoiding considering all your successful stock picks as coming through your skills and then getting blinded into believing that you can continue to beat the markets.
As you move forward, you will gradually create an investment philosophy that will continue to evolve even after the course ends, and that will guide you in your investment decision making in the future.
Creating a sound investment philosophy is one of the most critical steps to take as an investor, because when you start with a map in hand, the journey becomes less troublesome.
Your investment philosophy will serve the role of a map, which will guide you whenever you are about to lose your way.