Book Summary — The Most Important Thing

Uncommon Sense for the Thoughtful Investor

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MBReads

11 min readMar 31, 2019

You can find all my book summaries — here.

A high-level summary of the most important things when you invest and don’t want to follow the herd. Enjoyed the read and it helped me formulate my idea of the world.

1 paragraph summary:

‘Mark Howards’ investment philosophy of the ‘human side of investing’. Cycles are unavoidable. Price is everything and if things are “too good to be true” hold on to your wallet.

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times. I like to say, “Experience is what you got when you didn’t get what you wanted.”

Second Level Thinking

Investing calls for more perceptive thinking… at what I call the second level.

You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently.

First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everybody thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced, let’s sell.”

First-level thinking is simplistic and superficial, and just about everyone can do it. All you need is an opinion on the future. Second-level thinking is deep, complex and convoluted.

You can’t do the same things others do and expect to outperform.

Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.

Understanding Market Efficiency

If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.

His first test is always the same “Who doesn’t know that?”

Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.

One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you”. The same is certainly true of inefficient market investing.

Value

For investment to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.

An investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.

Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.

Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.

If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That's because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.

When the price falls people begin to doubt their decision to buy. This makes it very difficult to hold, and to buy more at lower prices, especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50… and much more at 40 and 30.

No one’s comfortable with losses, and eventually any human will wonder, “maybe I was wrong and the market is right”. The danger is maximised when they start to think “It’s down so much, I’d better get out before it goes to zero.” That’s the kind of thinking that makes bottoms… and causes people to sell there.

An accurate estimate of intrinsic value is essential for steady, unemotional and potentially profitable investing.

Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

Relationship between Price and Value

Investment success doesn’t come from “buying good things”, but rather from “buying things well.”

Bottom line: there’s no such thing as a good or bad idea regardless of price!

What to look for to asses price? Underlying fundamental value and short-term fluctuations determined primarily — by two other factors: psychology and technicals.

Technicals — these are nonfundamental factors — that is, things unrelated to value — that affect the supply and demand. ie margin calls, inflows to portfolio managers requiring them to buy

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into the price, and no new buyers are left to emerge.

The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

People should like something less when its price rises, but in investing they often like it more.

Being too early can still be a killer: “The market can remain irrational longer than you can remain solvent.”

Understanding Risk

Volatility is the academics definition of risks — at Oaktree the possibility of permanent loss is the risk we worry about.

Falling short of one’s goal — everyone has a different one, for investors this can be an existential threat
Underperformance — the risk of bailing, giving up and imitating the index → in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up
Career risk — people who manage money can lose their work
Unconventionality — fear of being different and getting yourself fired
Illiquidity — whenever you need to turn investments into cash

Recognising Risk

The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in question is sure to produce profits intoxicates the herd and causes its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity.

“It’s only when the tide goes out that you find out who’s been swimming naked.” Pollyannas take note: the tide cannot come in forever.

I’m firmly convinced that investment risk resides most where it is least perceived and vice versa:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.
When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

The paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.

Controlling Risk

Risk control is invisible in good times buy still essential, since good times can so easily turn into bad times.

Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbering false sense of security. Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality.

Being Attentive to Cycles

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail However, there are two concepts we can hold to with confidence:

Rule number one: most things will prove to be cyclical.
Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

The basic reason for cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

The process is simple:

The economy moves into a period of prosperity
Providers of capital thrive, increasing their capital base
Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk
Risk averseness disappears
Financial institutions move to expand their businesses — that is, to provide more capital
They compete for market share by lowering demanded returns, lowering credit standards, providing more capital for a given transaction and easing covenants

Awareness of the Pendulum

When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And that will ever be so.

Three stages of a bull market:

when a few forward-looking people begin to believe things will get better
when most investors realise improvement is actually taking place
when everyone concludes things will get better forever

Combating Negative Influences

Greed — drives investors to throw in their lot with the crowd in pursuit of profit, and eventually, they pay the price
Fear — prevents investors from taking constructive action
There can be a few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
Tendency to conform to the view of the herd — even when the herd is clearly cockeyed.
Envy — when people compare themselves with others
Ego — comparing in the short run, incorrect, imprudent, best returns bring best ego rewards
Capitulation — investors hold believes for a long time, but then end up jumping on the bandwagon

What can you do to prevent yourself from succumbing:

strongly held belief about the intrinsic value
insistence on acting when price diverges from value
experience with past cycles
understanding of psychology
promise to remember that if “things are too good to be true” they usually are
willingness to look wrong while market goes from misvalued to more misvalued
like-minded friends and colleagues from whom to gain support

Contrarianism

Most investors are trend followers. Superior investors are exactly the opposite.

Remember:

Overpriced is incredibly different from “going down tomorrow”
Markets can be over- and underpriced and stay that way — or become more so — for years
It can be extremely painful when the trend is going against you

There are two primary elements in superior investing:

seeing some quality that others don’t see or appreciate
having it turn out to be true

Fear of looking wrong: Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. Usually — and certainly at the extremes of the pendulum’s swing — being part of the herd should be a reason for worry.

Finding Bargains

The best opportunities are usually found among things most others won’t do.

The raw materials for the process consist of

a list of potential investments
estimates of their intrinsic value
a sense for how their prices compare with the intrinsic value
an understanding of the risks involved in each

Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it.

A bargain asset tends to be one that’s highly unpopular. Capital stays away from it for flees, and no one can think of a reason to own it.

Where should you look for them? Good places to start:

little known and not fully understood
fundamentally questionable on the surface
controversial, unseemly or scary
deemed inappropriate for “respectable” portfolios
unappreciated, unpopular and unloved
trailing a record of poor returns
recently the subject of disinvestment, not accumulation

Patient Opportunism

The market’s not a very accommodating machine; it won’t provide high returns just because you need them.

The challenge is that many investors confuse action for adding value when, in fact, all of the studies suggest that most investors overtrade their portfolio.

Knowing what you don’t know

Acknowledging the boundaries of what you can know — and working within those limits rather than venturing beyond — can give you a great advantage.

Having a Sense for Where We Stand

Figure out which part of the cycle we’re in.

Look around and ask yourself:

Are investors optimistic or pessimistic?
Does media say markets should be piled into or avoided?
Are novel investment schemes accepted or avoided?
Is capital readily available?
Are price/earnings ratios high or low in the context of history?

The seven scariest words in the world for the thoughtful investor — too much money chasing too few deals.

Market assessment

Check off the one term below which you think applies more — if you have most checkmarks in the left-hand column, hold on to your wallet:

Economy: Vibrant vs Sluggish
Outlook: Positive vs Negative
Lenders: Eager vs Reticent
Capital markets: Loose vs Tight
Capital: Plentiful vs Scarce
Terms: Easy vs Restrictive
Interest Rates: Low vs High
Spreads: Narrow vs Wide
Investors: Optimistic vs Pessimistic
Asset owners: Happy to hold vs Rushing for the exits
Sellers: Few vs Many
Markets: Crowded vs Starved for attention
Funds: New ones daily vs Only the best ones can raise money
Recent Performance: Strong vs Weak
Asset prices: High vs Low
Prospective returns: Low vs High
Risk: High vs Low

Appreciating the Role of Luck

We all know that when things go right, luck, looks like skill. Coincidence looks like causality. A “lucky idiot” looks like a skilled investor.

Short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof).

Investing Defensively

Tennis — winner’s game (pros) vs loser’s game (amateurs)

I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often — not because they don’t have enough winners, but because they have too many losers.

Avoiding Pitfalls

Technical errors — collect wrong or not sufficient info

Failure of imagination — being unable to conceive the full range of possible outcomes

Willingness to accept novel rationals about bubbles — “It’s different this time”

Adding Value

Beta — measure of portfolio’s relative sensitivity to market movements

Alpha — personal investment skill — ability to generate performance that is unrelated to the movement of the market

Reasonable Expectations

Every investment effort should begin with a statement of what you’re trying to accomplish. The key questions are what your return goal is, how much risk you can tolerate, and how much liquidity you’re likely to require in the interim.