Note: This article formed part of the May 2015 Special Report sent to subscribers of our premium newsletter Value Investing Almanack.
That’s precisely what Howard Marks did with his book –The Most Important Thing: Uncommon Sense for the Thoughtful Investor. He runs Oaktree Capital, a $90 billion hedge fund, and has more than four decades of investing experience. Just like Buffett he has been writing memos to his investors for last twenty five years.
These client memos contain insightful commentary and a time-tested philosophy about sensible investing. Howard Marks is not only a super investor but a thoughtful author too. His writings are not to be missed and that’s what Buffett seems to say in this statement –
When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something, and that goes double for his book.
In this post, I try to draw one big lesson from his writings and offer them to you for reflection. The big idea for today is contrarian investing. Let’s dive in right away.
What is contrarianism?
Can you guess one of the popular mantras during bull markets? It’s – Trend is your friend. The irony is that a trend is a product of social proof i.e. it’s the direction where the crowd is going. And it’s quite natural for people to feel comfortable being part of a herd. Why?
Thousands of years ago when Homo Sapiens was evolving(they still are albeit the changes are unnoticeable), staying in a herd and following your group ensured safety from predators and hostile environment. However the modern world doesn’t have the risks that plagued the hunter-gatherer environment of our ancestors.
Alas! the evolutionary instincts haven’t had a chance to fade away completely. Human beings still crave the comfort and safety of a herd. And to a large extent this behavioural bias is very useful in most of the social context.
In stock market, following the crowd is usually considered safe albeit it leaves you with mediocre results. But occasionally, when the mania sets in, the crowd stampedes off the cliff. And this is the time when going against the crowd (backed by independent thinking, and not just to prove that you are a contrarian) can potentially generate extraordinary profits.
Contrarianism starts with an attitude of healthy skepticism. Skepticism doesn’t just translate to questioning the delusional optimism during market euphoria. It also means questioning the excessive pessimism during market depression.
Marks writes in his book –
Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008 – and in retrospect it seems obvious – that sometimes skepticism requires us to say, “no, that’s too bad to be true.”
Contrarianism is profitable!
It’s interesting as well as funny that even though the crowd creates the highest and lowest points in the market, at these very inflexion points the crowd itself is wrong. Obviously the sensible thing to do at these times is to diverge from the herd opinion.
Contrarianism might seem like an act of valor but there is a sound reasoning behind it. The heart of value investing is identifying assets at prices less than their true value. If everybody comes to know about the mispriced asset, market efficiency kicks in to quickly close the gap between price and intrinsic value. Hence converging of popular opinions about an investment idea eliminates its profit potential. So, by definition, a profitable strategy has to be a contrarian one to begin with. Marks explains –
If everyone likes it, it’s probably because it has been doing well. 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.
During a severe market selloff, you don’t only get a desired low price but you can also build sizeable positions because of high available volumes, which is hard to get during stable market conditions.
In the following quote, Warren Buffett effectively urges us to be contrarians –
The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
When markets are moving sideways, following the crowd generates an average return. But when markets are going through inflexion points, following the crowd can turn out to be extremely dangerous for your financial health.
Of course the market extremes are a rarity and it’s not advisable that you always wait at sidelines for these extremes in the hope of deploying the contrarian strategy. However, an awareness about these opportunistic moments can boost your long term performance.
But it ain’t easy!
Talking about contrarianism is easy but practicing it can be hard. Our super investor writes –
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.
There are several reasons which make contrarianism a difficult game to play. Holding a contrarian view is uncomfortable and can be emotionally taxing. It’s a lonely job and a game of patience. The only thing that can sustain you in this game is confidence in your own decision-making process. For that matter, a contrarian strategy is a by-product of sound thinking and rational analysis. Marks writes –
Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. Usually – and certainly at the extremes of the pendulum’s swing – being part of the herd should be reason for worry.
In fact it won’t be an overstatement for a beginner if I say that a contrarian view which doesn’t make him or her uncomfortable isn’t a contrarian view at all. The good thing is that once you become an experienced contrarian investor, your comfort zone shifts to a position outside the herd. That’s why most of the superinvestors have repeatedly labeled the depressed markets as less risky environment.
A word of caution from Marks –
…we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction…we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond)…however, because of the variability of the of the many factors that influence markets, no tool – not even contrarianism – can be relied on completely.
Contrarianism shouldn’t be practiced for its own sake. You must know why the crowd is wrong.
Reminds me of this incident which happened with a senior citizen who was driving down the highway when his mobile phone rang. Upon answering, he heard his wife’s voice urgently warning him, “Honey, I just heard on the news that there’s a car going the wrong way on the highway. Please be careful!”
“Hell,” said the old man, “It’s not just one car. It’s hundreds of them!”
Don’t be the only one driving on the wrong side. The disaster would be inevitable.
Consider what Warren Buffett wrote in his 1990 letter to investors –
…[It doesn’t mean], however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russells observation about life in general applies with unusual force in the financial world: Most men would rather die than think. Many do.
When your hypothesis is diverging from crowd, it must be grounded on reasons and analysis. In Marks’ words –
Your view of value has to be based on a solid factual and analytical foundation, and it has to be held firmly. Only then will you know when to buy or sell. Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day.
There is a huge difference between being a contrarian and being a blind contrarian. In one of his recent interviews, Professor Bakshi clarifies the difference –
To me contrarian investing is not about betting against the crowd. It’s about having an independent mind….Some people mistakenly believe that automatically betting against the market i.e. being a blind contrarian is a good investment strategy. That’s a foolish way to think about it and the functional equivalent of driving on the wrong side of the road – which is sure to eventually cause an accident.
Contrarianism as a strategy is apt at the time of market excesses and most of the time there aren’t any market excesses. So it’s should not be relied on all the time.
The current environment is quite upbeat and people are riding on a bull market but this is the time when you should heed the advice from people who have seen this before not once but multiple times. Howard Marks warns –
Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.
I am confident that the insights from Howard Marks’ hard-earned wisdom can create a superior long term investing performance for every investor.
For that matter, any investor who is serious about learning the art of value investing should read (and re-read) all the client memos written by Marks and goes without saying that his book – The Most Important Thing – should become your constant companion.
In the tradition of Howard Marks, Co-founder of Oaktree Capital Management, I present the most important letter in investing.
FV=PV(1+〖i)〗^n
One of these letters is not like the others.
At university, for the better part of four and a half years’ time, I worked on countless problems involving the above formula and various spin-offs of it. To the untrained eye, this formula is pure gibberish. Hour after hour, I solved hypothetical questions about the growth of said bank deposits, the present value of some annuity, the internal rate of return of a proposed business endeavor, ad infinitum.
Eventually, rather shortly actually, I got to a point where it did not take much time at all to work out the basic problems lobbed at me gently by my professor of finance. I could with robotic precision solve the easy examples by hand when necessary, but the preferred method was by HP 10BII+ calculator, the practitioners’ tool.
The faster one could punch and press the satisfyingly resistant keys of the device, the faster the answers could be revealed upon its display. In the early years of my formation, and probably to this day, my professor was the unequivocal queen of rapidity, pressing those keys violently faster than any one of us neophyte students.
Rightly, so.
For the time period between when a mathematical problem is presented and when it is solved is for everyone elongated in the beginning. First, one must acquire the mental framework to comprehend the nature of the problem and the steps involved in solving it. Once acquired and understood, it can be performed speedily and in repetitive succession.
She was a jovial lady, my professor, for whom financial concepts were second nature. Indeed, she grasped even the more difficult concepts so well the class had to tell her to slow down and repeat from time to time. This was certainly the case more often than not in my later years of study. Some of it still eludes me.
The effortlessness of her mind to comprehend and eagerness to solve seemed uncanny to me at the time. I will recount one such instance. On this occasion, midday through one of our daily hourly sessions, she submitted to the class a seemingly complicated problem for the class to work through.
Although I could not see the faces sitting ahead of me, I imagine a number of eyebrows were raised and puzzling faces expressed. Just minutes earlier, she had walked us through a similar problem, but our minds had not fully weighed the elements involved. Scarcely ten seconds had passed before she demanded an answer.
Huh?
Preposterous!
One student remarked to me after class he had barely gripped the edges of his calculator before the words “Does anybody have the answer yet?” were uttered from the podium.
In those short seconds, I too had not expended very much energy like my reaching classmate. In fact, I had expended even less than him.
I was still reading the question, my hands and body firmly entrenched in place with my eyes doing the only moving. I had perhaps re-read the question three times before the time was up.
It was not until a few years after university I realized the supreme importance of the formulas as it related to investing. After much rumination, I can say without doubt that one of the above variables or letters is vastly more important than the others to a person such as myself.
1. I have not very much money to my name at present (PV)
2. Nor have I any uncanny abilities to compound money (i). (Although I think I can)
I suspect most of the populous surrounding me are of similar background and position.
As a relatively young individual, the only advantage I have in that formula is time (n). And by young I include anyone with at least 30 years left before retirement.
To me, it is a surprising fact that one can end up quite wealthy without having the advantages of being a master compounder like Buffett or already possessing a large sum of money. One can be average or slightly above average in all other variables to begin with if one has the time to compound. This is a prolific fact, one that is overlooked in the pursuit of risky one-off bets. The easiest way to be average is to index.
It is most remarkable what a paltry sum with dividends reinvested into a broad index can result in over time.
Nice post Anshul. Keep the good work going. I wanted to know one thing. I was looking for the book by Howard Marks and came across two books 1) the most important thing and 2) the most important thing illuminated. Are they both same? Thanks
Thanks Ram!
The “Illuminated” version has commentary (annotations spread throughout the book) from many other noted investors including Seth Klarman and Joel Greenblatt. I suggest the “Illuminated” one.
Thanks Anshul