When I am asked by someone what book they should read first to learn about investing I often suggest Howard Marks’ The Most Important Thing https://www.25iqbooks.com/books/207-the-most-important-thing-illuminated-uncommon-sense-for-the-thoughtful-investor-columbia-business-school-publishing
The book does not take too long to read and the points Marks makes are simple and understandable. The Most Important Thing is currently a top five rated book on my book discovery web site https://www.25iqbooks.com/. Warren Buffett has said about this book: “This is that rarity, a useful book. When I see memos from Howard Marks they’re the first things I read. I always learn something and that goes double for this book.” The only reason I might hesitate in making The Most Important Thing my first recommendation is that some people may need to read a survey book on investing first to learn some terminology and basic concepts. For that primal level and survey type introduction to investing I usually chose one of the books by the Bogleheads or John Bogle himself.
This post is not a book review. What I will do in this post is explain how to identify situations where you can apply the ideas in the book.. The key skill you need to acquire to do this well is pattern recognition. The more you work at applying these ideas, the better you will get at applying these principles, the more fun you will have with the process, the more you investing skill you will acquire [repeat]. What I just described is an example of a positive feedback loop. As Mae West once said: “Too much of a good thing can be wonderful.” Improving your investing results is a very good thing indeed.
Howard Marks is a value investor. Someone might say: “What does value investing have to do with other investing systems?” The answer to that question is: “All intelligent investing is value investing.” Who said that? Charlie Munger. Why did he say that? Because the foundational principles of value investing are universal. The need for a margin of safety, a business valuation process and phenomena like moats are universally applicable to any style of investing. These principles do not apply to speculation, but that is a subject for another post.
To convey my points in this post I decided to take an investing style that many would consider to be very different from value investing and show that they are in fact based on the same principles applied in different ways to different types of assets. That other investing system I will discuss here is venture capital. Venture capitalist and entrepreneur Andy Rachleff has said: “My investment idol is a guy named Howard Marks, who runs a hedge fund in LA., you might know called Oaktree. He’s as well known for his writings as he is his returns, which are very, very good. He once wrote an article about investing which I think relates well to entrepreneurship as well.”
As always on this blog, the words written or spoken by the subject of the post (in this case what Howard Marks wrote in his book The Most Important Thing) are in bold.
1. “The expected result is calculated by weighing each outcome by its probability of occurring.” Once upon a time in 1999, Sergei and Larry were looking to raise some capital for a business they were calling Google. One of the venture capital firms the Google founders pitched in seeking an investment was Kleiner Perkins, which saw hundreds of other pitches that year, just like they do every year. Out of all of the firms Kleiner considered that year they made 85 investments. One of those 85 was an investment of $12.5 million in Google (another venture capital firm named Sequoia made the same bet). This Kleiner IX fund also invested in AutoTrader and Martha Stewart Living Omnimedia Inc. in 1999 but it is not much of an exaggeration to say that the Google investment was all that mattered in that venture capital fund and in Silicon Valley in general that year.
In making a decisions like Kleiner did in 1999, the venture capital firm performs an “expected value” analysis which is: the weighted-average value for a distribution of possible outcomes. In other words, expected value is calculated by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes. As Buffett likes to say: “take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.” Venture capital firms have a hard problem in that it is not easy to make the expected value calculation since there is a great deal of risk, uncertainty and ignorance related to the decision. You will sometimes hear venture capitalists say that they make decisions based on their gut instinct, but this really is an investor making an expected value calculation using rough inputs determined in many cases in their head based on pattern recognition skills. Precise inputs are not required to make an expected value calculation and the math can be done in your head if you know it well and you are seeing a substantial bargain that more than covers any mistakes on your part. Michael Mauboussin lays out a key part of the task for any investor in his usual clarifying manner in his essay “Ruminations on Risk”:
“Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur. As Robert Hagstrom notes, the textbooks on Bayesian analysis suggest that if you believe that your assumptions are reasonable, it is perfectly acceptable to make your subjective probability of a particular event equal to a frequency probability. Thinking about the investing world probabilistically is critical to the margin of safety concept.”
2. “Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.” They key point is this is that Kleiner and Sequoia did not know that Google would be a tape measure financial home run. It was enough that they thought it had a significant chance to do so and that the potential payoff was massive. So how does a venture capitalist deal with this uncertainty about the future? Warren Buffett describes the approach:
“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”
This approach employed by venture capitalists outlined by Buffett is essential given the nature of convex bets. As I have written in previous blog posts, the value that is uncovered by venture capital is achieved through a process that is based on trial and error by the entrepreneurs. There is no absolute certainty in investing. Ever. There is no future. What exists now and in the past is what we have and when we look forward all we should think about is a probability distribution. What this means is that when it comes to the future, there is no “there there” yet. For this reason investing of all kinds is inherently a probabilistic activity. In any form of investing you can be wrong even though you made the right decisions based on probability. And vice versa. Venture capital investing is unique in that the bargains being discovered are convex and outcomes that result in financial success being determined by very few winners. Startups are not the sort of undervalued asset that a traditional value investor seeks. But both types of assets should be considered using the same basic principles.
3. “Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, 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.” “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That’s not easy.” It is provable mathematically that you cannot beat the market if you are the market. To outperform the market you must take positions that are at odds with consensus and be right about that decision. As an example, in the spring on 1995 Tom Alberg was asked to be an investor in a startup created by Jeff Bezos by the name of Amazon. Alberg wasn’t sure whether to make that investment:
“Bezos hadn’t launched the site yet. He had a good business plan that was solely focused on books. It was going to break even in year two. Sounded attractive. The other thing, I loved bookstores…. I met with him, and I thought he was a very smart guy and intrigued. I said: Well, I am potentially interested but let me think about it. The next week I went to Barnes & Noble bookstore. I was trying to buy a book for my son, who was starting a business. And I had that sort of bookstore frustration where the salespeople didn’t know. I finally figured out the book I wanted and they didn’t have it. So, I said maybe there is room for online. Then, every month for the next couple months, they launched it in June, I think, Jeff would send me an email and say: ‘Gee, we’ve now sold books in eleven states.’ And then I get an email and it said: ‘Revenues are up to $70,000 a week.’ And: ‘We just sold our first book to a European customer.’ I met with him a couple more times, and invested.”
Lots of people turned Jeff Bezos down that year. I know one such person and it impacts his investing to this day since it causes him in my view to write too many checks. For better or worse I was not asked to invest. But I know seven people who said yes.How did it workout for the people who invested?
Jeff Bezos: “The riskiest moment for Amazon, was at the very, very beginning. I needed to raise $1 million at a certain point, and I ended up giving away 20 percent of the company for a million dollars.”
Charlie Rose: “A helluva a deal for somebody.”
Jeff Bezos: “A lot of people did very well on that deal (laughs). But they also took a risk, so they deserve to do very well on that deal. But I had to take 60 meetings to raise $1 million, and I raised it from 22 people at approximately $50,000 a person. And it was nip and tuck whether I was going to be able to raise that money. So, the whole thing could have ended before the whole thing started. That was 1995, and the first question every investor asked me was: ‘What’s the Internet?’”
4. “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.” “A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.” “The 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.” “The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.” To find something that is undervalued you need to be looking where others are not looking. It has been said that the best venture capitalists are looking for something that is half crazy. Why? Well, people are generally fearful of investments that are even part crazy and that fear on the part of others can create some bargains due to mis-pricing. Something that others do not believe is valuable, or better yet, is not yet on anyone’s radar, can be offered to a venture capital investor at a bargain price. A venture capitalist is just looking for a different type of asset available at a bargain than a typical value investor. Venture capitalists are looking for a chance to purchase an asset that is highly “convex,” which means there is a huge upside and a relatively small downside. For example, a venture capitalist is not buying something like a well-known consumer product brand at less than intrinsic value. They are instead is looking for convex bets that can be bought at less than their true value. As is the case with any other financial asset a venture capitalist can pay too much for an asset that has convexity. But there were some people in the venture capital business who though the valuation of Google in 1999 was too high and passed. The 1999 investment in Google by Kleiner and Sequoia had tremendous convexity (massive upside and relatively small downside). The most these two venture firms who invested in Google in that round could lose is what they invested. Similarly, early seed round investors in Amazon could only loose what they invested. If they still owned those Amazon shares, the total gain would greater than ~38,000%.
5. “I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.” To discuss risk you must first start with a definition. My favorite definition is from the work of Richard Zeckhauser who teaches at Harvard:
Zeckhauser explains an important take away from those chart:
“The returns to UUU investments can be extreme. We are all familiar with the Bell Curve (or Normal Distribution), which nicely describes the number of flips of a fair coin that will come up heads in a large number of trials. But such a mechanical and controlled problem is extremely rare. The standard model often does not apply to observations in the tails. So too with most disturbances to investments. More generally, movements in financial markets and of investments in general appear to have much thicker tails than would be predicted by Brownian motion, the instantaneous source of Bell Curve outcomes. That may be because the fundamental underlying factors produce thicker tails, or because there are rarely occurring anomalous or weird causes that produce extreme results, or both. Nassim Taleb and Benoit Mandelbrot posit that many financial phenomena are distributed according to a power law, implying that the relative likelihood of movements of different sizes depends only on their ratio. Power distributions have fat tails. In their empirical studies, economists frequently assume that deviations from predicted values have normal distributions. That makes computations tractable, but evidence suggests that tails are often much thicker than with the normal.”
The key point is that venture capital is all about exceptions and phenomenon that express themselves in power laws. It is not an investing discipline that is ruled by a Bell curve, but it is still a probabilistic activity.
6. “In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.” “Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.” Risk comes from not knowing what you are doing. The best way to lower risk is to know what you are doing. It’s that simple. If riskier investments could be counted on to generate higher returns than they would not be riskier is the applicable famous Howard Marks quip on this point.
7. “First-level thinking says, ‘It is a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.’ First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’ First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’” Second level thinking is about finding value that others don’t appreciate. You can’t beat the crowd if you are the crowd. Here’s Howard Marks writing in one of his wonderful essays:
“Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, 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.”
The matrix that describes the outcomes is:
8. “Cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn’t that the essence of investing?” “Processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical. 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.” “Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.” “In January 2000, Yahoo sold at $237. In April 2001 it was $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions. But that doesn’t mean many investors were able to detect and act on the market’s error.” “A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.” “It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheaply enough.” Howard Marks believes that almost everything is cyclical. And venture capital is no exception to this rule. Other people agree the venture industry is cyclical. Bill Gurley once put it this way: “Venture Capital has long been a trailing indicator to the NASDAQ. Venture capital is a cyclical business.” “Moreover, deep down most LPs know that performance in the VC sector is counter cyclical to the amount of money raised by VCs.” Andy Rachleff has similarly said: “[Venture capital is] a very cyclical business. So there was a cycle from 1980-1983 that looked a lot like 1996-1999. Only an order of magnitude smaller on every dimension.” “I don’t think a bubble is an environment where things are valued highly, I think it’s an environment where crappy companies are valued highly.” Sometimes growth is valued more than profitability by markets and sometimes it isn’t. Sometimes cash is relatively easy to raise if you have a good business and sometimes you can’t raise five cents even if you have a good or even great business. Howard Marks likes to say you can’t predict but you can prepare. Having enough cash on hand to survive an inability to raise new cash for a significant period of time helps prepare a company for adverse turns in a cycle which can’t be fully predicted.
9. “Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.” “The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable. My ‘I don’t know’ school thinks of future events in terms of a probability distribution. That’s a big difference. In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.” This is the “circle of competence” idea in all of its glory. Risk comes from not knowing what you are doing. The best way to avoid risk is to stick to situations where you know what you are doing and to work hard to expand the areas where you do know what you are doing by learning. One thing I have seen again and again in great investors is that they spend most of their time trying to determine what they don’t know. They would much rather read a book or attend a lecture on what we don’t know than listen to crackpot theories that try to predict what can’t be predicted. This “tell me what I don’t or can’t know” approach is very different from academia since there are few people who get academic tenure for proving what we don’t know or that we can’t know something. The key point is illustrated by Charlie Munger’s desire to know where he is going to die so he can just not go there. Munger’s quip is humorous because it is so true for an investor. If you just know where you are going to lose money, you can just not go there. If only that was always true.
10. “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to ‘know the knowable.’” This is the Howard Marks version of the Charlie Munger principle that “the best way to be smart is to not be stupid.” The best venture capitalists are aware of the cycle because of its impact on valuation of individual businesses but stay focused on microeconomics. They value the convexity of each business in the portfolio and give only occasional thought to Federal Reserve interest rate policy when making investments. Like Marks, a smart venture capitalist understands that they know a lot about today but nothing certain about tomorrow and the days after that. The future is not only risky and uncertain but contains the potential to reveal ignorance. By adopting a margin of safety approach one can be wrong, make a mistake and still have an acceptable result.
11. “No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly.” Venture capital is interesting in many ways, but perhaps most interesting is that it involves people who break rules. At least one key rule is broken by each entrepreneur who hits a financial home run. If you don’t do make a decision to be different in some way and are right about that decision you are unlikely to generate convex financial returns. Operational excellence is a great thing, but to generate a 10-100X financial return you can’t be doing what everyone else is doing, only better. Every time an entrepreneur breaks a rule the risk of failure rises so they don’t want to break too many rules at once. As was the case in the story in Goldilocks and the Three Bears, the founders of a startup want the “rule breaking” to be at a “just right” level.
12. “Where does an investment philosophy come from? The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed. A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons.” There is no way to get through life and learn without making mistakes. You can certainly learn a lot and avoid a lot of pain by watching and reading about the mistakes of other people. Learning vicariously not only scales better but can be far less painful. That is why I love books so much and created my book discovery site https://www.25iqbooks.com/. But there is a big difference between knowledge and skill. Acquiring skill requires at least some real world practice. In the end, to acquire skill you need to sometimes make mistakes yourself to really learn the most powerful lessons. You can only learn so much just by watching others.
My previous blog post on Howard Marks: https://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/
Kleiner’s IX fund: http://www.wsj.com/articles/SB108328387230498204
Mauboussin’s Ruminations on Risk: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf
Buffett’s 1993 Chairman’s letter: http://www.berkshirehathaway.com/letters/1993.html