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Further Review of “The Most Important Thing”-On Finding Bargains

Finding Bargains and Patient Opportunism

Previously, we discussed the book contents in relationship to  psychological pitfalls in investing, cycles and the market pendulum, risk and attitudes towards risk, price and the relationship between price and value. The following two chapters deal are sort of “how-to” chapters, in the sense they inform us as to find bargains in the markets, and where to look for bargains, and they also tell us about the value of patient opportunism in markets.

The Most Important Things is…….Finding Bargains

The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst.

The first step is usually to make sure that the things being considered satisfy some absolute standards. It’s not unreasonable to want to emphasize assets that fall within a certain portion of the risk spectrum. In other words, there can reasonably be some places investors won’t go, regardless of price.

The starting point for portfolio construction is unlikely to be an unbounded universe. Some things are realistic candidates for inclusion, and others aren’t. The next step is to select investments from it. That’s done by identifying those that offer the best ratio of potential return to risk, or the most value for the money.

The process of investing has to be rigorous and disciplined. Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there.

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.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.

What is it that makes price low relative to value, and return high relative to risk? Unlike assets that become the subject of manias, potential bargains usually display some objective defect. 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. Generally, the greater the stigma or revulsion, the better the bargain.

First-level thinkers tend to view past price weakness as worrisome, not as a sign that the asset has gotten cheaper.

A bargain asset tends to be one that’s highly unpopular. Fairly priced assets are never our objective, since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved.

A good place to start is among things that are:   •   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; and •   recently the subject of disinvestment, not accumulation.

The necessary condition for the existence of bargains is that perception has to be considerably worse than reality. Investment bargains needn’t have anything to do with high quality.

We’re active investors because we believe we can beat the market by identifying superior opportunities. It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.

The Most Important Thing is …… Patient Opportunism

There aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive.

Patient opportunism—waiting for bargains—is often your best strategy.

You’ll do better if you wait for investments to come to you rather than go chasing after them.You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.

This is one of the hardest things to master for professional investors: coming in each day for work and doing nothing.

It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly. The other possibilities are (a) acting without recognizing the market’s status, (b) acting with indifference to its status and (c) believing we can somehow change its status. These are most unwise.

investors needn’t feel pressured to act. They can pass up lots of opportunities until they see one that’s terrific. One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable. Missing a profitable opportunity is of less significance than investing in a loser.

The motto of those who reach for return seems to be: “If you can’t get the return you need from safe investments, pursue it via risky investments.” 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.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action—one classic mistake—that I most strongly feel is wrong: reaching for return.

Trying to earn aggressive returns not only doesn’t ensure that you will achieve them but also increases the likelihood that by making increasingly risky investments you will incur losses and fall far short, exacerbating your problem.

High valuations can often go higher and last for longer than expected, continually frustrating disciplined and patient value investors. To wring high returns from a low-return environment requires the ability to swim against the tide and find the relatively few winners. High-return environments, on the other hand, offer opportunities for generous returns through purchases at low prices, and typically these can be earned with low risk.

The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers. Usually, would-be sellers balance the desire to get a good price with the desire to get the trade done soon. The beauty of forced sellers is that they have no choice. They have a gun at their heads and have to sell regardless of price. The difficulties that mandate selling—plummeting prices, withdrawal of credit, fear among counterparties or clients—have the same impact on most investors. In that case, prices can fall far below intrinsic value.

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 things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach.

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More Excerpts from “The Most Important Thing Illuminated”-On Negative Influences

On combating negative influences and Contrarianism

 

In the review of the previous chapters of the book, we dealt with importance of price and the relationship between price and value, then in another post, we dealt with the recognition of risk and the control of risk. In the last post, we considered the cyclical nature of investment markets, and the pendulum like swings between greed and fear, and euphoria and despair.

The next two chapters deal with the negative influences on investor psychology and the need to embrace contrarianism to be successful in markets. Here are the excerpts:

Chapter 10: The Most Important Thing is ……Combating Negative Tendencies

The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—-these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.

Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

These psychological factors create opportunities for superior investors to augment their results by refusing to hold at the highs and by insisting on buying at the lows. Resisting the inimical forces is an absolute requirement.

The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed. from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price. The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk;  It makes them pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left.

The counterpart of greed is fear—the second psychological factor we must consider. Fear is overdone concern that prevents investors from taking constructive action when they should.

The third psychological factor which clouds investors minds is the tendency to engage in willing suspension of disbelief- people’s tendency to dismiss logic, history and time-honored norms. This tendency makes people accept unlikely propositions that have the potential to make them rich. However, the process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses.

The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even when the herd’s view is clearly cockeyed. Many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.

The fifth psychological influence is envy. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. People who might be perfectly happy with their lot in isolation become miserable when they see others do better.

The sixth key influence is ego. Investing—especially poor investing—is a world full of ego. Since risk bearing is rewarded in rising markets, ego can make investors behave aggressively in order to stand out through the achievement of lofty results. the road to investment success is usually marked by humility, not ego.

The final influence Marks’ talks about is a phenomenon he calls capitulation, a regular feature of investor behavior late in cycles. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.

The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—these factors are near universal. Thus they have a profound collective impact on most investors and most markets. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored. Doing these things isn’t easy, and thus few people are able to abstain. In just the same way, it’s essential that investors avoid selling—and preferably should buy—when fear becomes excessive in a crash.

Mastery over the human side of investing isn’t sufficient for success, but combining it with analytical proficiency can lead to great results.

Investors who believe they’re immune to the forces described in this chapter do so at their own peril. What weapons might you marshal on your side to increase your odds?

  • a strongly held sense of intrinsic value
  • insistence on acting as you should when price diverges from value, •   enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded
  •  a thorough understanding of the insidious effect of psychology on the investing process at market extremes
  • a promise to remember that when things seem “too good to be true,” they usually are
  •  willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and
  • like-minded friends and colleagues from whom to gain support (and for you to support).

 

Chapter 11: The Most Important Thing is ………Contrarianism

There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite.

Doing the same thing others do exposes you to fluctuations that in part are exaggerated by their actions and your own. It’s certainly undesirable to be part of the herd when it stampedes off the cliff, but it takes rare skill, insight and discipline to avoid it.

the key to investment success has to lie in doing the opposite: in diverging from the crowd. Those who recognize the errors that others make can profit enormously through contrarianism.

Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite.

market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach.

Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

Accepting the broad concept of contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction. On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond).

On the third hand, however, because of the variability of the many factors that influence markets, no tool—not even contrarianism—can be relied on completely.

Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against.

Even when an excess does develop, it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.” •   Markets can be over- or underpriced and stay that way—or become more so—for years. •   It can be extremely painful when the trend is going against you.

If you look to the markets for a report card, owning a stock that declines every day will make you feel like a failure. But if you remember that you own a fractional interest in a business and that every day you are able to buy in at a greater discount to underlying value, you might just be able to maintain a cheerful disposition.

it’s not enough to bet against the crowd. Given the difficulties associated with contrarianism just mentioned, the potentially profitable recognition of divergences from consensus thinking must be based on reason and analysis. 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 with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and, uncomfortable. What’s clear to the broad consensus of investors is almost always wrong. … The very coalescing of popular opinion behind an investment tends to eliminate its profit potential.

Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit. Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.

there are two primary elements in superior investing: seeing some quality that others don’t see or appreciate and having it turn out to be true (at least have the market accept it as true).

Every time a bubble bursts, a bull market collapses or a silver bullet fails to work, we hear people bemoan their error. The skeptic, highly aware of that, tries to identify delusions ahead of time and avoid falling into line with the crowd in accepting them. So, usually, investment skepticism is associated with rejecting investment fads, bull market manias and Ponzi schemes.

In dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.

In general, following the beliefs of the herd—and swinging with the pendulum—will give you average performance in the long run and can get you killed at the extremes.

Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t

skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

The herd applies optimism at the top and pessimism at the bottom. To benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.

Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.

Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

It’s 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 if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.

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More Excerpts from “The Most Important Thing” by Howard Marks-On Cycles

Howard Marks on Cycles
Howard Marks on Investing Cycles

Previously, we reviewed chapters on risk, and on an investors attitude to risk. The next two chapters (8 and 9) focus on the cyclical nature of markets, and how we can take advantage of the pendulum of markets.

Here goes:

  • It is essential to remember that just about everything is cyclical.
  • there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.
  • we never know what lies ahead, but we can prepare for the possibilities and reduce their sting.
  • there are two rules 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 underlying principle is that things will wax and wane, grow and decline. The same is true for economies, markets and companies: they rise and fall.
  • basic reason for the cyclicality in our world is the involvement of humans. people are emotional and inconsistent, not steady and clinical.
  • objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.
  • The extremes of cycles result largely from people’s emotions and foibles, nonobjectivity and inconsistency.
  • Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Success carries within itself the seeds of failure, and failure the seeds of success.
  • Look around the next time there’s a crisis; you’ll probably find a lender. Overpermissive providers of capital frequently aid and abet financial bubbles. In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.
  • Understanding that cycles are eventually self-correcting is one way to maintain some optimism when bargain hunting after large market drops.
  • Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case. And yet, every decade or so, people decide cyclicality is over. They think either the good times will roll on without end or the negative trends can’t be arrested. At such times they talk about “virtuous cycles” or “vicious cycles”—self-feeding developments that will go on forever in one direction or the other.
  • This belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions.technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend.
  • It’s essential that you be able to recognize this form of error when it arises. It turns out that the old rules do still apply, and the cycle resumes.
  • There is a right time to argue that things will be better, and that’s when the market is on its backside and everyone else is selling things at giveaway prices. It’s dangerous when the market’s at record levels to reach for a positive rationalization that has never held true in the past. But it’s been done before, and it’ll be done again. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. 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 it will ever be so.
  • The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.
  • Investment markets follow a pendulum-like swing:   •    between euphoria and depression, •    between celebrating positive developments and obsessing over negatives, and thus •    between overpriced and underpriced.
  • This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”
  • The pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.
  • The swing in the last of these—attitudes toward risk—is a common thread that runs through many of the market’s fluctuations. The greed/fear cycle is caused by changing attitudes toward risk.
  • Risk aversion is the essential ingredient in a rational market, as I said before, and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.
  • Reaping dependably high returns from risky investments is an oxymoron. The main risks in investing are two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates. 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 it will ever be so.
  • The ultimate danger zone is reached when investors are in agreement that things can only get better forever. That makes no sense, but most people fall for it. It’s what creates bubbles—just as the opposite produces crashes.
  • Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.
  • The significance of all this is the opportunity it offers to those who recognize what is happening and see the implications. At one extreme of the pendulum—the darkest of times—it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk. But at the other extreme, when everyone assumes and prices in the impossible—improvement forever—the stage is set for painful losses.
  • In theory with regard to polarities such as fear and greed, the pendulum should reside mostly at a midpoint between the extremes. But it doesn’t for long. Primarily because of the workings of investor psychology, it’s usually swinging toward or back from one extreme or the other
  • The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever. 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 an extreme corrects of its very weight.
  • The swing back from the extreme is usually more rapid—and thus takes much less time—than the swing to the extreme.
  • The occurrence of this pendulum-like pattern in most market phenomena is extremely dependable. But just like the oscillation of cycles, we never know:   •   how far the pendulum will swing in its arc, •   what might cause the swing to stop and turn back, •   when this reversal will occur, or •   how far it will then swing in the opposite direction.

 

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Some Excerpts from Howard Marks’ book “The Most Important Thing-Illuminated”

I think Marks’ book is one of the nicest books on investment on the stock markets. More than a book, it is a compilation of a series of letters written by Howard Marks to the investors who invested with his firm, Oaktree Capital. In the particular Kindle Edition I read, there are also a comments on few of his important thoughts by other influential investors. I really got started on thinking off about investment in 2013 after I read this book, and it is only appropriate that this book should be one of the books I start of by reviewing. It is not so a much a review, as a collection of the highlights I did when I read the book. Read the highlights, but better still, read the book. It will open your minds in new ways.

Chapter 1: The Most Important thing is ….. Second Level Thinking
  • Few people have what it takes to be great investors. Some can be taught, but not everyone … and those who can be taught can’t be taught everything.
  • Even the best investors don’t get it right every time.
  • It is essential that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.
  • definition of successful investing: doing better than the market and other investors. To accomplish that, you need either good luck or superior insight.Counting on luck isn’t much of a plan, so you’d better concentrate on insight.
  • As with any other art form, some people just understand investing better than others. Only a few investors will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results.
  • being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different.
  • A second level thinker takes a great many things into account:  What is the range of likely future outcomes? •   Which outcome do I think will occur? •   What’s the probability I’m right? •   What does the consensus think? •   How does my expectation differ from the consensus? •   How does the current price for the asset comport with the consensus view of the future, and with mine? •   Is the consensus psychology that’s incorporated in the price too bullish or bearish? •   What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
  • First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.
  • The problem with investing is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.
  • to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.
Chapter 2: The Most Important Thing is…. Understanding Market Efficiency (and its Limitations)

The efficient market hypothesis states that •

There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed. •

Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.

•   Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong. •

Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk. That’s a more or less official summary of the highlights.

  • Now Marks’ take. When he speaks of this theory, he also uses the word efficient, but he means it in the sense of “speedy, quick to incorporate information,” not “right.”
  • Because investors work hard to evaluate every new piece of information, asset prices immediately. reflect the consensus view of the information’s significance. Marks’ does not, however, believe the consensus view is necessarily correct.
  • 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.
  • describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.
  • A market characterized by mistakes and mispricings can be beaten by people with rare insight.
  • Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.
  • If prices can be very wrong, that means it’s possible to find bargains or overpay.
  • Marks’ wholeheartedly appreciates the opportunities that inefficiency can provide, but  he also respects the concept of market efficiency, and he believes strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.
  • Efficiency is not so universal that we should give up on superior performance. However, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.
  • For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of. Some assets have to priced too low, or some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter.
  • Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.
  • The key turning point in Marks’ investment management career came when he concluded that because the notion of market efficiency has relevance, he should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.
  • We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. But equally, swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.
Chapter 3: The Most Important thing is…. Value
  • The oldest rule in investing is also the simplest: “Buy low; sell high.”
  • There has to be some objective standard for “high” and “low,” and most usefully that standard is the asset’s intrinsic value.
  • For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point.
  • There are two general broad ways of investing (excluding technical analysis, which Marks dismisses with disdain).
  • The difference between the two principal schools of investing can be boiled down to this:

•    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.

  • To Marks, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.
  • Compared to value investing, growth investing centers around trying for big winners. If big winners weren’t in the offing, why put up with the uncertainty entailed in guessing at the future? the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Marks describes himself as someone from the Value Investing School.
  • Is Value Investing Easy? No. For one thing, it depends on an accurate estimate of value.  Also, 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. The most value investors can hope for is to be right about an asset’s value and buy when it’s available for less. But doing so today certainly doesn’t mean you’re going to start making money tomorrow.A firmly held view on value can help you cope with this disconnect.
  • Many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy. An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.
  • Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. 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.
Chapter 4: The Most Important Thing Is….The Relationship Between Price and Value
  • Investment success doesn’t come from “buying good things,” but rather from “buying things well.”
  • If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.
  • Remembering that the market eventually gets it right, is one of the most important things to remember when the market acts emotionally over the short term.
  • It’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.
  • What should a prospective buyer be looking at to be sure the price is right? Underlying fundamental value, of course, but most of the time a security’s price will be affected at least as much—and its short-term fluctuations determined primarily—by two other factors: psychology and technicals.
  • Technicals are nonfundamental factors—that is, things unrelated to value—that affect the supply and demand for securities.
  • The second factor that exerts such a powerful influence on price: psychology.
  • Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship—and the outlook for it—lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.
  • The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.
  • 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.
  • Psychology is an area that is (a) of critical importance and (b) extremely hard to master.  First, psychology is elusive. And second, the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.
  • It’s essential to understand that fundamental value will be only one of the factors determining a security’s price on the day you buy it. Try to have psychology and technicals on your side as well.
  • The polar opposite of conscientious value investing is mindlessly chasing bubbles.
  • All bubbles start with some nugget of truth. A few clever investors figure out (or perhaps even foresee) these truths, invest in the asset, and begin to show profits. Then others catch on to the idea—or just notice that people are making money—and they buy as well, lifting the asset’s price. But as the price rises further and investors become more inflamed by the possibility of easy money, they think less and less about whether the price is fair. People should like something less when its price rises, but in investing they often like it more.
  • Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.   •   The positives behind stocks can be genuine and still produce losses if you overpay for them. •   Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy. •   A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.
  • “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so. •   Eventually, though, valuation has to matter.
  • In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway.
  • Buying at the right price is the hard part of the exercise. Once done correctly, time and other market participants take care of the rest.
  • One of the most important roles of your strong view of intrinsic value is as a foundation for conviction: to help you hang in until the market comes to agree with you and prices the asset where it should.
  • There are four possible routes to investment profit
  1. Benefiting from a rise in the asset’s intrinsic value.
  2. Applying leverage.
  3. Selling for more than your asset’s worth.
  4. Buying something for less than its value.
  • The most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.
  • Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have;
  • Trying to buy below value isn’t infallible, but it’s the best chance we have.