Groundwork for the Thoughtful Investor
Insight from Howard Marks’ The Most Important Thing
On active management
- Investing is a zero-sum game, before fees.
- To outperform, then, one must out-think the consensus consistently. Effective investors have unconventional and superior insight. Different and better.
- The sense for market prices comes from their comparison with an estimate of fair (or intrinsic) value: the price a reasonable and informed party would be willing to bet for the assets in a private transaction.
- Then the idea is simple (yet not easy): buy low, sell high. Rational interactions with the market are to take advantage of discrepancies between market prices and one’s skillful appraisal of fair value.
- Estimates of fair value are best derived from thorough bottom-up fundamental analysis with special emphasis placed on tangible factors such as hard assets and cash flows.
- Buying at a wide enough discount to fair value buffers for analytical error and unexpected or improbable occurrences.
- No asset is so good it can’t become a bad investment if purchased for too high a price. No asset is so bad it can’t become a good investment if purchased for low enough a price. The goal is to find good buys, not good assets.
- Being right on value isn’t all, and certainly isn’t synonymous with being proven right. Correction is rarely immediate, nor is it a sure thing. A firmly held view and a long investment horizon on value can help cope with the disconnect and navigate cycles.
On efficient market hypothesis
- Efficient market hypothesis holds in general, but some markets some times are more easily exploitable.
- Mispricing provides the raw material for the superior investor to outperform.
- In some markets, prices are often wrong and the asset class’ risk-adjusted return can be far out of line. ‘Inefficient’ markets often share such characteristics: obscure, slightly followed, unpopular, out of favour, overlooked, with limited information spread unevenly, etc.
- Psychological and technical factors play an important role in determining securities’ prices, and can sway prices astray from rational, fair value. Even in so-called ‘efficient’ markets.
- Reason must overcome emotion. Resisting human nature impulses such as greed, fear, envy, ego and the likes is crucial for rational decision making.
- Most things prove to be cyclical.
- The credit cycle tells most of the story. In the up-leg: the economy moves into a period of prosperity > providers of capital thrive, increasing their capital base > bad news is scarce; risk seems to have shrunk > risk awareness disappears > financial institutions provide more capital > lenders compete for market share by lowering demanded returns (interest rate), lowering credit standards, and easing covenants. In the down-leg: losses cause lender to shy away > risk awareness rises, and along with it, interest rate, credit restrictions, and covenant requirements > less capital is made available — to the most qualified borrowers, if anyone > companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
- Trends don’t go on forever. Most become overdone. Threes don’t grow to the sky. Cycles reversals provide some of the best opportunities for gain and loss.
- It isn’t possible to predict a trends’ extent or the timing of its reversal. But tempered investors can position their portfolios to minimize losses in the reversal and then benefit from the subsequent pick-up.
On investing as a contrarian
- Market psychology swings from optimistic to pessimistic, credulous to skeptic, eager to buy to desperate to sell.
- Herding behaviour makes market participants buy at highs and sell at lows.
- Outstanding opportunities arise when perception under- or overstate reality. Act with caution when others are unworried and with conviction when others panicked.
- In fair markets odds aren’t much in you favour. Proceed with caution.
- Risk aversion is the basis of a rational market. Investors require added return for bearing more risk.
On risk definition
- Investing deals with future outcomes. As such, risk is inevitable.
- Risk should be though of as the risk of permanent capital loss and the risk of inadequate returns for the risk born.
- Risk is subjective, hidden and unquantifiable. It can only be roughly gauged by talented experts.
- Many futures can happen, but only one materializes. Probable things fail to happen and improbable things happen all of the time.
- Return alone says little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken.
- Risk is present even if loss doesn’t occur.
- The manager’s job is to bear risk intelligently for profit.
On risk management
- Risk doesn’t stem from weak fundamentals. Risk largely depends on price. High risk comes from high prices. High prices come from excessive optimism and inadequate skepticism.
- Unworried investors don’t demand sufficient risk premiums. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.
- Undisciplined investor behaviour brings elevated price/earning ratio, narrow credit spreads, heavy use of leverage and strong demand for investment vehicle of all type.
- One should recognize the extent of his/her knowledge and stick to the knowable: industry, business, securities.
- Accept the future is unknowable and position your portfolios accordingly. You can’t predict, you can prepare.