This article on Howard Marks investment was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative
“When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.” — Warren Buffett
In a world characterized by herd mentality, free-thinkers are a rarity. The realms of finance and investing are no exception.
Human psychology demands that we think and act together, along the same lines, in order to survive. Given these biological restraints, it is therefore uncommon for humans to break this mould and truly exhibit the ability to think for themselves.
Fortunately for us, a handful of such mould-breakers do exist on planet earth, and are willing to impart their wisdom upon us. One such individual, often overlooked by deep value investing enthusiasts, is Howard Marks.
Howard Marks Investment Approach: The Early Years
Born in New York in 1946, Marks attended the Wharton School at the University of Pennsylvania, where he majored in Finance.
Between 1969 and 1985, Marks rose from his role at Citi in equity research, to Director of Research, to Vice-President. Following this, and until 1995, Marks worked at TCW Group. He ultimately became Chief Investment Officer for domestic fixed income and the President of TCW Asset Management Company. These roles were key in Marks’ development of the Howard Marks investment approach.
In 1995, Marks co-founded the investment firm Oaktree Capital Management, where he is still co-chairman today.
Howard Marks Investment Approach
The investment firm, as highlighted in Howard Marks’ various investment newsletters to his shareholders, focuses on deep value investing, and using knowledge of human psychological biases to outperform the market.
As a massive stroke of fortune for all of us budding deep value investors, Howard Marks summarised his entire investment philosophy into a single book, called “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor”
For the remainder of this article, we will explore the key elements and points of the book, making us even more competent deep value investors in the process.
So, without further ado, let’s get to it.
Howard Marks Investment and Second-Level Thinking
It would be wrong for anyone, let alone a deep value investing enthusiast like myself, to discuss the Howard Marks Investment approach and not begin with the concept of second level thinking. Dubbed second level thinking by Marks, but synonymous with the idea of “higher-level thinking”, or even just “giving more careful consideration to your decisions”, the concept of second level thinking is crucial to Howard Marks’ investment success.
At the risk of failing to do the concept justice, allow Marks to explain it himself:
“For your performance to diverge from the norm, your expectations — and thus your portfolio — have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second level thinking. Those who consider the investment process simple generally aren’t aware of the need for — or even the existence of — second level thinking.
Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first level thinkers increases the returns available to second level thinkers. To consistently achieve superior investment returns, you must be one of them.”
So, the idea of second level thinking begins with the acceptance of its existence and importance. Assuming that we can allow ourselves to get this far — which is not even close to guaranteed, we then must adopt a critical frame of mind to our own thinking. This means that we must challenge every thought and become our own devil’s advocate.
From here, we can begin to take steps towards the deeper, more inspired, critical types of thinking that is required to achieve the investing heights of the second level thinking investor.
Howard Marks Investment and Market (In)Efficiency
It is difficult to carry out a full discussion on investing without addressing the biggest point of contention between deep value investors, and economics and finance academics. The Efficient Markets Hypothesis, which you can learn more about in any good university course on finance, teaches us that all of the securities in the financial markets are at all times efficiently and correctly priced. It is therefore nonsensical and irrational to believe it possible to outsmart and outperform the market.
Again, Howard Marks’ investment prowess provides us with some clarity on the matter:
“In short, I think theory should inform our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. We can buy securities for their returns but ignore their risk. We can buy fifty correlated securities and mistakenly think we’ve diversified. . . .
But 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. The image here is of the efficient-market-believing finance professor who takes a walk with a student.
‘Isn’t that a $10 bill lying on the ground?’ asks the student.
‘No, it can’t be a $10 bill’, answers the professor. ‘If it were, someone would have picked it up by now.’
The professor walks away, and the student picks it up and has a beer.”
While it is true that in the long-term, the evidence suggests that most investors — professional or otherwise — fail to outperform the market, and their returns tend to converge to the mean, this is more simply an acceptance of the existence of mean reversion — and not a proof of the existence of widespread and deeply efficient financial markets.
As Marks states, while there is room for financial theory in our investment decision-making, the blind acceptance of theories like this will only do harm to our hopes of investing success. This fact is helpfully portrayed by Marks with the use of the above example.
Howard Marks Investment and the Price-Value Relationship
The most important aspect of deep value investing is the relationship between price and value. Whether something is cheap or expensive depends on whether or not it could be sold for a greater price at some stage in the future. Of course, the relative “cheapness” or “expensiveness” of an asset is very much a subjective assessment. However, buying something for less than its intrinsic value is the only way to obtain long term investment success.
In line with the Howard Marks investment way, the man himself reflects on the price-value issue:
“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; as John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’
Trying to buy below value isn’t infallible, but it’s the best chance we have.”
The upshot from what Marks is telling us here is that whatever your desired metric, long term investment success is more attainable if you buy securities at prices below their intrinsic value. So whether you choose liquidation value, net asset value, NCAV, NNWC, Acquirer’s Multiple, or any other logical or measurable metric, you will find greater success if you apply strict rules in relation to the price-value tradeoff.
Howard Marks Investment and Understanding Risk
The standard finance textbook definition of the difference between risk and uncertainty is that risk is measurable, while uncertainty is not. In this generic textbook, this is usually followed by a primer on statistics and the normal distribution. The problem with this measurement of risk is that it is based upon historical facts, not future ones — and it is the risk in the future that we care about.
Marks gives his own opinion on the Howard Marks investment approach to risk:
“Risk exists only in the future, and it’s impossible to know for sure what the future holds…. No ambiguity is evident when we view the past. Only the things that happened, happened. But that definiteness doesn’t mean the process that creates outcome is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed.
The sense that risk and uncertainty is reduced, or that it is even measurable with a high degree of confidence, leads to extreme hubris amongst investors, financial pundits, and even investment experts. Underestimating the degree to which uncertain outcomes occur can help a deep value investor to properly manage their risk exposure.
Howard Marks Investment and Recognising Risk
An enhanced understanding of risk is crucial before one can begin to recognise it. If one is not primed with an understanding of the difference between uncertainty and risk, and why it is that humans are extremely poor at separating the two (whether the issue stems from psychological or biological reasons), then one is not likely to be able to identify risks — even when they are staring them in the face.
The author gives his own opinion on the Howard Marks Investment approach to the recognition of risk:
“‘I wouldn’t buy that at any price—everyone knows it’s too risky.’
That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in….
The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true.
I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa.”
Here the message from the Howard Marks investment approach is a similar one to that provided by the master of risk — Nicholas Taleb — in his book The Black Swan. Their point is that unlikely events occur more often than expected. Such “tail events” happen more frequently than the normal distribution of risk would predict. This creates an inconsistency between what the crowd expects, and what actually occurs. This inconsistency can therefore be exploited by the knowledgeable, risk-conscious investor, deep value investor.
Howard Marks Investment and Cycles
The word “cycle” is a familiar one to most of us. In a financial context, it usually refers to an economic or business cycle. However, as is clearly evident from the below, the Howard Market investment approach recognises more than just this type of cycle:
“I think it is important to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.”
The message here from Howard Marks’ investment strategy is clear — the only certainty in life is that things will change. This fact is true of everything on planet earth. In fact, it is even written into our genetic code by means of DNA and evolution! Unsurprisingly, therefore, the financial markets do not get a pass in this instance. The damaging effects that come with ignoring the existence of market cycles are highlighted by Marks next:
“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true.
The first time rookie investors see this phenomenon occur, it’s understandable that they might accept that something that’s never happened before — the cessation of cycles — could happen. But the second time or the third time, those investors, now experienced, should realize it’s never going to happen, and turn that realization to their advantage.”
What Marks is referring to here, namely the inevitable reversibility of trends, is something more commonly known as mean reversion. What goes up must come down, what goes down must come back up. Like before, financial or non-financial, there are no exceptions to the rule of mean reversion. And, unless every professional and non-professional investor goes out and gets a degree in psychology (unlikely) and/or suddenly develops perfect rationality (impossible — as humans are inherently irrational, or at least imperfectly rational), this will not change.
Howard Marks Investment and Contrarianism
The final aspect that of investing that we will discuss, and upon which the Howard Marks Investment approach places a great deal of importance, is that of contrarianism. Defined by Tobias Carlisle (in his book — The Acquirer’s Multiple) as “zigging while others zag”, contrarianism is a hugely important aspect of deep value investing.
Here is Howard Marks’ take on contrarianism:
“Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable — although the experienced contrarian takes comfort from his or her position outsider the herd. Whenever the debt market collapses, for example, most people say, ‘We’re not going to try to catch a falling knife; it’s too dangerous.’ They usually add, ‘We’re going to wait until the dust settles and the uncertainty is resolved.’ What they mean, of course, is that they’re frightened and unsure of what to do.
As is often the case with deep value investment opportunities, much of that opportunity arises due to the fear of the broader market. Taking advantage of that fear is what contrarianism is all about.
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 is our job as contrarians to catch the falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view 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 returns earned with the least risk.”
As Marks says, the most worthwhile and ultimately successful investments are, more often than not, also the hardest. The reason for this is that the best time to buy something is when it is at its cheapest. While this is obvious, and is in-keeping with the idea of marrying price and value, it is also extremely difficult to do. Securities are falling and subsequently at their cheapest when there are more people selling them than there are buying them. This means that the best investing opportunities occur, not only when nobody else wants them, but also when the financial media is telling you not to like them. It is in fact this exact mentality and psychological bias that deep value investing strategies like net net investing try to overcome.
Final Thoughts on Howard Marks
It is highly unlikely that anyone referred by Warren Buffett is going to be a slouch when it comes to investing. Howard Marks undoubtedly lives up to this.
However, it is still somewhat surprising that Marks is not revered more than he currently is by deep value investors. As a hugely successful investor, and one that has so graciously published his entire philosophy into a single book, it is a wonder that Marks’ name is not in lights with those of Warren Buffett and Benjamin Graham.
However, in true value investing fashion, I will leave you with this — the ignorance and consequent loss of the common investor is the deep value investor’s gain. Use your new-found wisdom to exploit the irrationality and ignorance of the financial markets and to generate profits worthy of the Howard Marks Investment approach.
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