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Book Review: The Most Important Thing by Howard Marks

With only a few weeks left in my MBA career, I am now fully aware that being a
student again offers some very valuable perks. Through my fellowship on UCLA
Anderson’s Student Investment Fund I have had access to a number of great
investors. But, by far my biggest break was having the opportunity to meet with
Howard Marks, the founder of Oaktree Capital Management and author of so many
memorable investment memos. Like many of you who unfailingly read Marks’s
memos right when they are released on Oaktree’s website, I was thrilled when I
heard that Marks was going to publish a new book on investing. However, I never
anticipated that I would be lucky enough to receive an advance copy from Howard
himself or have the opportunity to review it for my blog. But, as I said, being a
student again is not too bad. So, in an attempt to revive the book-reviewing skills
that have been lying dormant since middle school, the following is my commentary
on Howard Marks’s soon-to-be-released book, The Most Important Thing.

Oddly enough, I think it is important to start off with a disclaimer. The Most
Important Thing is not a how-to book about investing. Marks doesn’t provide a Joel
Greenblatt-esque magic formula or any shortcuts to becoming a great investor. In
fact, on the very first page of chapter one Marks reminds us that no investing rule
always works. The book also does not separate out specific investment techniques
for different asset classes. Instead, in the tradition of Ben Graham’s The Intelligent
Investor and Seth Klarman’s Margin of Safety, it is a book on how to think about
investing. In reality, Marks builds on the ideas of the most famous value investors
by adding his own insights and anecdotes. For people who are devoted value
investors, the philosophy he articulates will sound familiar and certainly will not
drastically alter the way you invest. However, what is both unique and striking
about this book is the way he breaks down the important aspects of his investment
approach into very approachable and wisdom-filled sections. When the reader has
finished the book, the lasting impression is that Marks was able to provide a
comprehensive and detailed overview of his investment approach in less than 200
pages.

In his thoughtful and didactic way, Marks aims to help the reader develop the
mental tools and investment framework that are required for success in this very
difficult and treacherous domain. Specifically, using his four decades of experience
as a basis, Marks introduces the reader to his investment philosophy with a
combination of new material and a brilliant integration of passages from previous
memos. The transitions between the original and previously articulated ideas are so
seamless that Marks comes off like a wise grandfather who always has a perfectly
poignant story to tell, no matter what the context. For example, even in the
introduction, the reader gets the sense that Marks has been able to leverage his
vast experience in way that gives him an investment edge:
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Importantly, a philosophy like mine comes from going through life with your
eyes wide open. You must be aware of what’s taking place in the world and
what results those events lead to. Only in this way can you put the lessons to
work when similar circumstances materialize again. Failing to do this—more
than anything else—is what dooms most investors to being victimized
repeatedly by cycles of booms and bust.

I chose to highlight the above passage because I think it is very emblematic of two
of the major themes that run throughout the book. The first is the idea of viewing
and thinking about the world in the most open manner possible. Marks introduces
the reader to the difference between first-level and second-level thinkers and
suggests that we all work to become the latter if we want to survive in the
investment wilderness. First-level thinkers are people who look at the world
simplistically and superficially and who don’t take the time to reflect on the
meaning of the events they witness. On the other hand, second-level thinkers are
contrarians who cogitate about probabilities, risk and whether or not they actually
have an investing edge. These are people who are constantly questioning their own
assumptions and those of their peers in an attempt to be what Marks calls
“different and better” than the rest of the crowd. Not surprisingly, Marks firmly
believes that being a second-level thinker is a necessary condition for achieving
consistently superior returns.

The next theme embodied in the above passage and discussed throughout the book
is that of the cyclical nature of financial markets. Chapters eight and nine are all
about paying attention to cycles and being mindful of the swings in the pendulum
between greed and fear. In many instances, Marks clearly stresses that those who
forget history are doomed to repeat it. In fact, he starts off the chapter on cycles
with what looks to be a play on one of Buffett’s most famous quotes:

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 point is that through experience, investors can gain an advantage over
newcomers to the business or those who forget that financial markets are
inherently cyclical and that boom and busts are inevitable. What is required then is
an understanding of the historical parallels with current events that only comes
from an ability to step back from periods of euphoria and excessive pessimism.
While Marks may not say it directly in this section, the implication is that the
development of a particular type of even temperament is paramount if a person
wants to avoid being caught in the herd during a painful turn in the cycle. (He does
say later in the book that the “biggest investing errors come not from factors that
are informational or analytical, but from those that are psychological.”)
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It is in that context that Marks expands on Ben Graham’s assertion that market
psychology moves wildly between greed and fear by likening those fluctuations to
the swing of a pendulum. While the underlying concept will be very familiar to value
investors, I think the simple way he articulates his understanding of market
psychology is very compelling and memorable:

Like a pendulum, the swing of investor psychology toward an extreme causes

energy to build up that eventually will contribute to the swing back in the
other direction. Sometimes, the pent-up energy is itself the cause of the
swing back—that is, the pendulum’s swing toward and extreme corrects of its
very weight.

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The next prevalent theme in the book is that of risk. It will not be surprising to
frequent readers of Marks’s memos that he devotes three full chapters to risk
assessment and management. The first time I was exposed to Marks was at a
Wharton Hedge Fund Network event in New York. I have been fortunate enough to
meet and learn from a number of wonderful investors in my life, but something
Marks said at that event still sticks with me to this day. What he said was that the
main job of a steward of other people’s assets is to manage risk and protect capital.
It was such a simple statement but the implications are so powerful, especially
considering that most of the people in the investment business seem to believe that
their primary responsibility is to make themselves rich.

In any case, Marks begins by discussing how to measure risk. You will not be
shocked to learn that there is no discussion of beta, value at risk or price volatility
as measures of risk. Instead, he humbly suggests that there is no viable standard
that can be used to quantify risk and that risk and return estimates cannot be
reliably turned over to a computer. Therefore, risk lies in the very subjective eye of
the beholder:

Where does that leave us? If the risk of loss can’t be measured, quantified or
even observed—and if it’s consigned to subjectivity—how can it be dealt
with? Skillful investors can get a sense for the risk present in a given
situation. They make that judgment primarily based on (a) the stability and
dependability of value and (b) the relationship between price and value.

In other words, risk has to do what price you pay and the relationship of that price
to the intrinsic value of the asset. For anyone who does not recognize this idea, it is
very much the same as the margin of safety concept espoused by Graham and
Klarman. Believers in the merits of value investing when it comes to equity security
selection should take comfort in the fact that one of the best debt investors in the
world uses the same risk framework to find avoid overpriced fixed income assets:
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Whereas the theorist thinks return and risk are two separate things, albeit
correlated, the value investor thinks of high risk and low prospective return
as nothing but two sides of the same coin, both stemming from high prices.

The final chapter on risk includes commentary on how to control risk. Marks
explains that during good times — when markets are rising — risk control can look
as though it is a waste of time. By managing portfolio risk, investors navigating
within favorable market conditions inevitably leave money on the table in the form
of forgone returns. After a number of years of perceived underperformance due to
what in hindsight looks to be unjustified attempts to protect against losses, even a
risk-averse investor might contemplate abandoning his or her risk management
techniques. However, according to Marks’s investment philosophy, such a decision
would be a terrible mistake. It is precisely when the manager is unable to detect
the risk of loss that he or she should be looking for ways to protect capital. The
logical extension of this idea is that we should be content owning insurance against
portfolio losses just like we sleep better at night because we know we have
homeowner’s insurance... even if there’s no fire.

My favorite allegory on this exact subject is the one told by Nassim Taleb of Fooled
by Randomness and The Black Swan fame. (Incidentally, Taleb’s work is referenced
a number of times in this book.) Taleb tells the story of a turkey that lives on a farm
and every day is fed and cared for by what he sees as a benevolent and loving
farmer. In fact, each day the farmer is there to take care of the turkey only further
reinforces the turkey’s belief that the farmer is its friend and would never do
anything to harm it. Unfortunately, the same dynamic plays out each day until a few
weeks before one unfortunate Thanksgiving. The realization that the farmer’s
intentions all along were to harm the turkey would clearly be a black swan event in
the eyes of the animal. But, in reality, the risk was always there. It was just invisible
because nothing ever went wrong until that last fateful day. In the same vein, Marks
warns us that only thoughtful and skillful investors can avoid becoming a
Thanksgiving Day turkey:

The important thing here is the realization that risk may have been present
even though loss didn’t occur. Therefore, the absence of loss does not
necessarily mean that the portfolio was safely constructed. So, risk control
can be present in good times, but it isn’t observable because it’s not tested.
Ergo, there are no awards. Only a skilled and sophisticated observer can look
at a portfolio in good times and divine whether it is a low-risk portfolio or a
high-risk portfolio.

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I think my favorite chapter in the book is the one on contrarianism. Marks highlights
what value investors already know, which is that most investors are trend followers.
These people are first-level thinkers who feel comfortable and safe following the
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crowd. But, what people forget is that every investment decision is by definition a
contrarian bet that the market is wrong. Either you buy a stock because you think
the current price is undervalued or you sell it because you think it is fully- or over-
valued. Accordingly, to be right in a long run you have to have a different view than
that of the market. Mistakes come when investors focus on the trend of a stock
price—generally up or generally down—and base their buy and sell decisions on
that. Instead, contrarian investors are better served by assessing whether or not the
trend will hold and making the opposite bet when he or she has conviction that the
herd has fallen prey to irrational exuberance or panicked selling.

What is unique about Marks’s description of the contrarian approach is that he

warns the reader of certain pitfalls of being a contrarian. It is easy to tell people to
do the opposite of what the crowd is doing. It is much tougher to make money as an
investor using a contrarian perspective. Here are a few caveats from Marks:

• Contrarianism doesn’t make money all the time because there are not always
market excesses to bet against
• Even when assets are overpriced, there is no guarantee that they will go
down in price tomorrow (i.e., the market can stay irrational longer that you
can stay solvent)
• There are times when a lot of people take on the same contrarian viewpoint
and thus it will be hard to separate out the contrarian stance from that of the
herd

And the clinchers:

You must do things not just because they’re the opposite of what the crowd
is doing, but because you know why the crowd is wrong. Only then will you
be able to hold firmly to your views and perhaps buy more as your positions
take on the appearances of mistakes and as losses accrue rather than gains.

It is our job as contrarians to catch falling knives, hopefully with care and
skill. That’s why the concept of intrinsic value is so important. If we hold a
view of value that enables us to buy when everyone else is selling—and our
view turns out to be right—that’s the route to the greatest rewards earned
with the least risk.

One of things that Howard is best known for is his ability to catch falling knives in
the distressed debt space. He has a history of buying securities that the casual
observer would wonder out loud what he was thinking upon learning that they had
been added to an Oaktree portfolio. What separates Marks is that just about
invariably the world comes to learn that he was buying dollars for 60 cents while
everyone else was trying to get out as fast as they could. As such, the question
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arises of how does he identify these bargains? Despite the fact that there is a full
chapter on finding bargains, we mainly get the framework that Marks uses to find
undervalued assets. While this is clearly more valuable than juicy anecdotes, the
entire time I was reading the book, I was yearning for more practical applications of
his philosophy. Personally, I find it motivating to hear successful investment stories
in which managers took an incredibly contrarian position and made a multiple of
their original investments. When such feats are accomplished without much risk and
due to a focus on margin of safety, it gives me hope that I will be able to do the
same in my career.

But, in all honesty I believe the book is actually better without a lot of war stories
that prove to the reader that Marks is a world-class investor. I understand why
Marks would be leery of touting his accomplishments, as he is not the type to brag
about his success. Therefore, I am content with the simple roadmap he presents for
finding value. Specifically, he tells us to search for little known, questionable,
controversial, seemingly inappropriate, and unappreciated assets that have poor
recent returns and have been sold en masse. If that sounds a bit like what Ben
Graham would have advised, that’s because Marks takes a very Graham-like
approach. As I said before, the reason the book adds to everyone’s understanding
of investing is not because Marks introduces a brand new philosophy. Instead, he
uses previously articulated frameworks and builds on them by inserting his own,
periodic nuggets of wisdom—like this one:

Since the efficient-market process of setting fair prices requires the

involvement of people who are analytical and objective, bargains are usually
based on irrationality or incomplete understanding. Thus, bargains are often
created when investors either fail to consider an asset fairly, or fail to look
beneath the surface to understand it thoroughly, or fail to overcome some
non-value-based tradition, bias or stricture.

The most interesting thing about Oaktree’s search for value is that, at least
according to the firm’s motto, the process doesn’t really involve a search. While the
firm ideally invests in the unloved types of assets described above, Marks believes
that Oaktree should not go out and find investments. On the contrary, he thinks that
he and his colleagues at Oaktree are better served by letting those investments
come to them. This is similar to Buffett’s idea of waiting for a fat pitch before
investing. Marks can invest this way because he is not solely trying to achieve high
returns. The risk of permanent capital impairment is always on his mind, and he has
a track record that allows him to be patient without investors’ getting antsy.
Obviously, this is a luxury that many investors do not have, but that does not mean
people should change their approach in order to achieve high returns in a low return
environment:
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You simply cannot create investment opportunities when they’re not there.
The dumbest thing you can do is to insist on perpetuating high returns—and
give back your profits in the process. If it’s not there, hoping won’t make it
so.

If an investor can remain patient and maybe even endure bouts of

underperformance, the cyclical nature of markets often leads to an opportunity to
generate substantial returns. Somehow, so-called once in a lifetime crises seem to
occur far more frequently than they should. As such, investors who combine the
proper temperament with strong analytical skills can take advantage of crashes and
irrational selling, as long as they are prepared. But, investors also need to make
sure that their portfolios are what Nassim Taleb would call robust. Fortunately,
Marks has some advice on how to set up a firm and portfolio that will allow them to
be greedy when others are fearful:

The key during a crisis is to be (a) insulated from the forces that require
selling and (b) positioned to be a buyer instead. To satisfy those criteria, an
investor needs the following: staunch reliance on value, little or no use of
leverage, long-term capital, and a strong stomach. Patient opportunism;
buttressed by a contrarian attitude and a strong balance sheet, can yield
amazing profits during meltdowns.

Of course, since this book was written after the acute portion of the financial crisis
was over, Marks was able to reflect on what lessons should have been learned by
investors as a result of what happened in 2008 and 2009. Specifically, Marks
presents a list of things that we should learn from the crisis. I don’t want to steal his
thunder or spoil it for readers, but I thought this passage sums up very well his
feelings on what happened to many investors during the crisis:

But if the ability to live with volatility and maintain one’s composure has
been overestimated—and usually it has—that error tends to come to light
when the market is at its nadir. Loss of confidence and resolve can cause
investors to sell at the bottom, converting downward fluctuations into
permanent losses and preventing them from participating fully in the
subsequent recovery. This is the greatest error in investing—the most
unfortunate aspect of pro-cyclical behavior—because of its permanence and
because it tends to affect large portions of portfolios.
*********************************************************************************

Just when you think it is virtually impossible for Marks to provide any more wisdom,
he finishes the book with a bullet-point-like summary of the major takeaways from
the entire book. In all seriousness, I highlighted too many passages from this final
chapter to discuss them all here. Suffice to say that Marks does a tremendous job of
explaining the primary themes from the book in a concise manner and of reinforcing
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what the reader has been exposed to throughout the preceding chapters without
sounding preachy. Accordingly, I thought it would be fitting to close with some
advice from Marks on how to distinguish value from quality:

What causes on asset to sell below its value? Outstanding buying

opportunities exist primarily because perception understates reality.
Whereas high quality can be readily apparent, it takes keen insight to
determine cheapness. For this reason, investors often mistake objective
merit for investment opportunity. The superior investor never forgets that the
goal is to find good buys, not good assets.

**********************************************************************************

What is my ultimate conclusion? Well, the book is too fresh in my mind to know
where it belongs in the pantheon of investing books. My first impression is that it is
up there with Margin of Safety and The Intelligent Investor because it presents a
complete investment philosophy in a way that just about anyone can understand
and appreciate. I do know for sure that it represents a much desired extension of
Marks’s memos. For example, similar to when I am reading the latest memo, I
always had the feeling that I did not want the book to end. It is also true that the
way he articulates his investment approach does offer unique insights despite the
fact that his philosophy has clearly been influenced by the great investors who have
come before him. I believe there is a ton of value in being able to re-frame and add
nuance to the tenets of value investing, and Marks unquestionably achieves these
goals in a very comprehensive manner. Additionally, throughout the entire book I
felt as though Marks had the sole intent of teaching the reader and sharing his
wisdom with complete sincerity and transparency. The willingness and desire to
educate is quite commendable and I appreciated that in no way did the book come
off as marketing material for Oaktree.

Finally, I don’t know whether I have become more cynical in general, but it is
definitely true that I am not impressed by much these days. Many of the books I
read seem not to break new ground or introduce new interpretation of ideas that I
hold dear. Further, I have to admit that some of the behavioral finance material gets
a bit redundant when you read books about the subject and take multiple classes on
it as well. But, in my initial meeting with Howard Marks, my subsequent
conversations with him and in reading The Most Important Thing, I always felt as
though I was being exposed to a man with an expertise in investing like that of
Buffett, Graham and Klarman. I meet a lot of investors and read dozens of letters to
investors and I rarely hang on the next word, anticipating that something earth
shattering will be forthcoming. But, with Marks, there was constantly the feeling
that the next sentence or paragraph could cause a light bulb to go on over my
head. Somehow, in the most unassuming and modest way, Marks is able to
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consistently articulate his insights in way that anyone can comprehend and learn
from.

Needless to say, I highly recommend The Most Important Thing to anyone who is
interested in investing. I think both novices and experts can gain from being
exposed to Marks’s experiences and investment approach. Truthfully, this review
hasn’t even scratched the surface in terms of the amount of valuable material
included in the text. The passages that were included were used to supplement
what I saw as the main themes but certainly do not capture the nuances of the book
in a meaningful way. Therefore, if you are like me and have been wishing to better
understand what makes Marks and Oaktree different, I humbly suggest that you
check out this new book.