- First-level thinking is simple and superficial, whereas second-level thinkers possess a deeper and more investigative mindset. First-level thinkers react as such: “The earnings outlook has been downgraded – sell!” Second-level thinkers wonder: “The earnings outlook has weakened, which does pull the valuation south, indeed. However, all are selling in panic, so the price is now below intrinsic value – buy”
- Mix your second-level thinking with the courage and vigour of a contrarian, and you’re mentally prepared to take advantage of bargains whenever they present themselves.
- Howard Marks exclaims the following in regards to the price vs. value debate: “For an investment to be reliable and succesful, an accurate estimation of intrinsic value is the inevitable starting point. Without it, any hope of consistent success is nothing but that: hope.”
- Bargains are found among those, which no others will touch: the complicated, the dubious, the controversial, the frightening and the unloved.
- High return and low risk is achieved simultaneously by acquiring assets for less than their worth.
One of my absolute favorite books is value investor Howard Mark’s The Most Important Thing. Howard observed that he throughout time often exclaimed: “The most important thing is…”, and then named “the most important thing” for that given situation. Howard collected 20 of these important lessons, each of which is discussed in its own chapter. All 20 lessons are essential, so choosing just a handful for a blog post was difficult. Nevertheless, here’s my shot at it!
The most important thing is.. second-level thinking
In the first chapter, Howard teaches you a distinction that’s crucial to the rest of the book: first-level thinking vs. second-level thinking. As most investors, speculators and traders are bright and well-informed, one needs to find an advantage – an edge – the others do not have. You need to think, react and behave differently; you need to be a second-level thinker.
First-level thinking goes: “This is a good company; let’s buy the stock!” Second-level thinkers are more reticent; they wonder: “Indeed, this is a good company. But everybody knows it, and because of it, the price exceeds its value. I’ll pass.” In times of distress, first-level thinkers panic: “Shit! The outlooks are downgraded. The growth rates are no longer that great – sell!” Second-level thinkers take a step back, and wonder: “The outlooks have weakened, and surely its intrinsic value suffered as a consequence. However, everyone’s selling in panic, so the price is well below its true value – buy!”
It’s obvious that first-level thinking is simple and superficial, whereas second-level thinkers possess a deeper, more complex and investigative mindset.
The most important thing is.. being a contrarian
Mix your second-level thinking with the courage and vigour of a contrarian, and you’re mentally ready to take advantage of bargains whenever they present themselves. Being a contrarian, the ability to swim against the current, is an essential quality for all value investors. You must be willing to buy when others are selling in desperation as well as being able to sell when all others are euphoric. “Buy when they hate ’em, and sell when they love ’em”, Howard advises. ‘Wisdom of the crowd’ is a paradox according to Howard. That, which seems obvious in everyone’s eyes, often turns out to be a false truth.
It’s obviously not enough to just swim against the current; you need to know why you’re doing it. Analysis and reason must document why a certain price is either too optimistic or pessimistic.
In this context, remember Howard’s golden quote: “Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.”
The most important thing is.. the relationship between price and value
In practically any book about value investing, there is a chapter on the price-value relationship. The Most Important Thing is no different, but I would like to highlight one quote that underscores the distinction between the two: “For an investment to be reliable and successful, an accurate estimation of intrinsic value is the inevitable starting point. Without it, any hope of consistent success is nothing but that: hope.” Howard reminds us that no asset has a birth right to a high return. An asset is only attractive when it’s priced right (below intrinsic value).
The most important thing is.. finding bargains
In length of the previous lesson, Howard explains that succesful investing is about constructing a portfolio that consists of the best investment ideas, which you make room for by selling the inferior ones and staying clear from the worst of the lot. The raw material for constructing such a portfolio is 1) a list of potential investment ideas; 2) estimates of intrinsic value; 3) a comparison of these values relative to market price (essentially determining which ideas posses the widest margin of safety); 4) an assessment of each asset’s isolated risk as well as its effect on the portfolio’s overall risk profile (how does a given asset correlate with other assets in the portfolio?). Howard explains that “investment is a discipline in relative selection.”
Remember, the objective is not to find good assets; everybody can do that. The objective is to find good bargains. When first-level thinkers go “who on earth would want to own that?”, it’s usually an invitation for the second-level thinking value investor to take a closer look. The necessary condition for a bargain to surface is that the perception is worse than reality. Bargains are found among those, which nobody else will touch: the complicated, the dubious, the controversial, the frightening and the unloved.
The most important thing is.. to understand risk
The classic mantra goes: “More risky investments produce higher returns. If you wish to make more money, the answer is more risk.” But this is contradictory. If more risky investments reliably produce higher returns, they would not be more risky. This ‘theory’ about high returns and high risk going hand-in-hand because the former compensates for the latter, do not hold water. To overpay for an asset means low return and high risk based on the thesis “the higher you fly, the further you fall.” Value investors believe that high returns and low risk is achieved simultaneously by acquiring assets for less than their worth.
Besides the above-mentioned lessons, The Most Important Thing will too outline the fallacy of the efficient market hypothesis; an in-depth discussion of value versus price; teach you to recognize, understand and control risk; explain market cycles; underscore luck’s role in investing as well as a walk-through of the various psychological pitfalls you should be aware of. It is a well of knowledge presented in an easy-to-understand fashion. In my view, this is an absolute must-read!