The Most Important Thing Illuminated

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February 13, 2022

The Most Important Thing Illuminated (Columbia Business School, 2013) is an update of Howard Marks’ outstanding book on value investing,The Most Important Thing (2011). The revision includes the original text plus comments from top value investors Christopher Davis, Joel Greenblatt, and Seth Klarman. There are also notes from Howards Marks himself and from Columbia professor Paul Johnson.

The sections covered here are:

  • Second-Level Thinking
  • Understanding Market Efficiency
  • Value
  • The Relationship Between Price and Value
  • Understanding Risk
  • Recognizing Risk
  • Controlling Risk
  • Being Attentive to Cycles
  • Combating Negative Influences
  • Contrarianism
  • Finding Bargains
  • Patient Opportunism
  • Knowing What You Don’t Know
  • Appreciating the Role of Luck
  • Investing Defensively
  • Reasonable Expectations

 

SECOND-LEVEL THINKING

Nearly everyone can engage in first-level thinking, which is fairly simplistic. But few can engage in second-level thinking. Second-level thinking incorporates a variety of considerations, says Marks:

  • 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 of 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 too bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

In order to do better than the market index, you must have an unconventional approach that works. Joel Greenblatt comments:

The idea is that agreeing with the broad consensus, while a very comfortable place for most people to be, is not generally where above-average profits are found. (page 7)

You can do better than the market over time if you use a proven method for betting against the consensus. One way to achieve this is using a quantitative value investing strategy, which – for most of us – will produce better long-term results than trying to pick individual stocks.

 

UNDERSTANDING MARKET EFFICIENCY

Market prices are generally efficient and incorporate relevant information. Assets sell at prices that offer fair risk-adjusted returns relative to other assets. Marks says:

I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct. In January 2000, Yahoo sold at $237. In April 2001 it was at $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. (page 9)

Marks then explains:

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct.

That’s what makes the mainstream markets awfully hard to beat – even if they aren’t always right. (page 10)

Moreover, notes Marks, some asset classes are rather efficient. In most of these:

  • the asset class is widely known and has a broad following;
  • the class is socially acceptable, not controversial or taboo;
  • the merits of the class are clear and comprehensible, at least on surface; and
  • information about the class and its components is distributed widely and evenly.

The Boole Microcap Fund is a quantitative value fund focused on micro caps. Micro caps – because they are largely either ignored or misunderstood – are far more inefficient than small caps, mid caps, and large caps. See: https://boolefund.com/best-performers-microcap-stocks/

Value investing – properly applied – is a way to invest systematically in underpriced stocks. For details, see: https://boolefund.com/notes-on-value-investing/

Joel Greenblatt explains why value investing works:

Investments that are out of favor, that don’t look so attractive in the near term, are avoided by most professionals, who feel the need to add performance right now. (page 17)

Marks decided to focus in his career on distressed debt because it was a noticeably less efficient asset class.

 

VALUE

Marks points out that you can either look at the fundamental attributes of the company – such as earnings and cash flows – or you can look at the associated stock price, and how it has moved in the past. Value investing is the systematic purchase of businesses below their likely intrinsic values.

When you buy stock, you become a part owner of the underlying business. So you would like to figure out what the business is worth, and then pay a price well below that. Imagine if you were going to buy a laundromat or a farm. You would want to figure out how much it earned in a normal year. And you would want to estimate any future growth in those earnings.

  • Many businesses are difficult to value. The trick, says Buffett, is to stay in your circle of competence: If you focus on those businesses that you can value, you have a chance to find a few investments that will beat the market. There are thousands of tiny businesses (public and private) – like laundromats – that you probably can value.

For most of us, a more reliable way to beat the market is by adopting a quantitative value strategy, which systematically buys stocks below intrinsic value, on average. Lakonishok, Shleifer, and Vishny give a good explanation of quantitative value investing in their 1994 paper, “Contrarian Investment, Extrapolation, and Risk.” Link:http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

If you do spend time analyzing individual businesses that might be good long-term investments, then another trick is to find companies that have a sustainable competitive advantage. Buffett uses the termmoat. A business with a moat has a sustainably high ROE (return on equity), which can make for a rewarding long-term investment if you pay a reasonable price. See: https://boolefund.com/notes-on-value-investing/

Marks distinguishes between value and growth.

  • For many value investors, including Buffett, the future growth of a company’s cash flows is simply a component of its value today.

Marks points out that some investors look for a business that can grow a great deal in the future; other investors focus on the value of a business today, and buying well below that value. Marks comments that the “value” approach is more consistent, while the “growth” approach – when it works – can lead to more dramatic results. Marks identifies himself as a value investor because he cherishes consistency above drama.

For value investing to work, not only do you have to buy consistently below intrinsic value; but you also have to hold each stock long enough for the stock price to approach intrinsic value. This can often take 3 to 5 years. Meanwhile, you are very likely to be down from your initial purchase price, as Greenblatt explains:

Unless you buy at the exact bottom tick (which is next to impossible), you will be down at some point after you make every investment. (page 26)

It’s challenging to own shares of a business that remains out-of-favor for an extended period of time. One advantage of a quantitative value strategy is that it’s largely (or entirely) automated, which thereby minimizes psychological errors.

 

THE RELATIONSHIP BETWEEN PRICE AND VALUE

Marks explains:

For a value investor, price has to be the starting point. 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 cheap enough. (page 29)

Marks later adds:

Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals. (page 32)

Overpriced investments are often “priced for perfection.” In this situation, investors frequently overpay and then later discover that the investment is not perfect and has flaws. By contrast, hated investments are often low risk:

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. (page 33)

 

UNDERSTANDING RISK

Marks quotes Elroy Dimson:

Risk means more things can happen than will happen. (page 39)

Because the market is mostly efficient, riskier investments have to offer higher potential returns in order to attract capital. However, writes Marks, riskier investments don’t always produce higher returns, otherwise they wouldn’t be riskier. In other words, riskier investments involve greater uncertainty: there are some possible scenarios – with some probability of occurring – that involve lower returns or even a loss.

Following Buffett and Munger, Marks definesrisk as the potential for permanent loss, which must be compared to the potential gain. Risk is not volatility per se, but the possibility of downward volatility where the price never rebounds.

Like other value investors, Marks believes that the lower the price you pay relative to intrinsic value the higher the potential return:

Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.

Dull, ignored, possibly tarnished and beaten-down securities – often bargains exactly because they haven’t been performing well – are often the ones value investors favor for high returns. Their returns in bull markets are rarely at the top of the heap, but their performance is generally excellent on average, more consistent than that of ‘hot’ stocks and characterized by low variability, low fundamental risk and smaller losses when markets do badly. (pages 47-48)

Risk ultimately is a subjective measure, says Marks. People have different time horizons and different concerns (for instance, worried about trailing a benchmark versus worried about a permanent loss). Marks quotes Graham and Dodd:

…the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.

Risk is just as uncertain after the fact, notes Marks:

A few years ago, while considering the difficulty of measuring risk prospectively, I realized that because of its latent, nonquantitative and subjective nature, the risk of an investment – defined as the likelihood of loss – can’t be measured in retrospect any more than it can a priori.

Let’s say you make an investment that works out as expected. Does that mean it wasn’t risky? Maybe you buy something for $100 and sell it a year later for $200. Was it risky? Who knows? Perhaps it exposed you to great potential uncertainties that didn’t materialize. Thus, its real riskiness might have been high. Or let’s say the investment produces a loss. Does that mean it was risky? Or that it should have been perceived as risky at the time it was analyzed and entered into?

If you think about it, the response to these questions is simple: The fact that something – in this case, loss – happened, doesn’t mean it was bound to happen, and the fact that something didn’t happen doesn’t mean it was unlikely. (page 50)

It’s essential to model the future based on possible scenarios:

The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. (page 52)

Many investors make two related mistakes:

  • Assuming that the most likely scenario is certain;
  • Not imagining all possible scenarios, even highly unlikely ones (whether good or bad).

Marks describes investment results as follows:

For the most part, I think it’s fair to say that investment performance is what happens when a set of developments – geopolitical, macro-economic, company-level, technical and psychological – collide with an extent portfolio. 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. (page 54)

Marks refers to Nassim Taleb’s concept of “alternative histories.” How your portfolio performs under the scenario that actually unfolds doesn’t tell you how it would have done under other possible scenarios.

As humans, we are subject to a set of related cognitive biases. See: https://boolefund.com/cognitive-biases/

Hindsight bias causes us to view the past as much more predictable than it actually was. The brain changes its own memories:

  • If some possible event actually happens, our brains tend to think, “I always thought that was likely.”
  • If some possible event doesn’t happen, our brains tend to think, “I always thought that was unlikely.“

The fact that we view the past as more predictable than it actually was makes as view the future as more predictable than it actually is. We feel comforted – and usually overconfident – because of our tendency to view both future and past as more predictable than they actually are.

Hindsight bias not only makes us overconfident about the future. It also feeds into confirmation bias, which causes us to search for, remember, and interpret information in a way that confirms our pre-existing beliefs or hypotheses.

Thus, one of the most important mental habits for us to develop – as investors and in general – is always to seek disconfirming evidence for our hypotheses. The more we like a hypothesis, the more important it is to look for disconfirming evidence.

Charlie Munger mentions Charles Darwin in “The Psychology of Human Misjudgment” (seePoor Charlie’s Alamanack: The Wit and Wisdom of Charles T. Munger, expanded 3rdedition):

One of the most successful users of an antidote to first conclusion bias was Charles Darwin. He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one…He provides a great example of psychological insight correctly used to advance some of the finest mental work ever done.

Munger sums up the lesson thus:

Any year in which you don’t destroy a best-loved idea is probably a wasted year.

 

RECOGNIZING RISK

Marks:

Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for an asset as a result. High risk, in other words, comes primarily from high prices. Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk. (page 58)

Marks interjects a comment:

Too-high prices come from investor psychology that’s too positive, and too-high investor sentiment often stems from a dearth of risk aversion. Risk-averse investors are conscious of the potential for loss and demand compensation for bearing it – in the form of reasonable prices. When investors aren’t sufficiently risk-averse, they’ll pay prices that are too high. (page 59)

Christopher Davis points out that there are more traffic fatalities among drivers and passengers of SUVs. Because drivers of SUVs feel safer, they drive riskier. Most of us, as investors, feel more confident and less worried when prices have been going up for an extended period. Since prices that are too high are the main source of investment risk, we have to learn how to overcome our psychological tendencies. Marks elucidates:

The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in question is sure to produce profits intoxicates the herd and causes its members to forget caution, worry, and fear of loss, and instead to obsess about the risk of missing opportunity. (page 62)

Marks again:

Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. The key lies in understanding what impact things like these are having. (page 63)

Investors generally overvalue what seems to have low risk, while undervaluing what seems to have high risk:

  • When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.
  • And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk-bearing – no ‘risk premium’ – is demanded or provided. That can make the thing that’s most esteemed the riskiest. (page 69)

The reason for this paradox, says Marks, is that most investors believe that quality, not price, determines whether an asset is risky. However, low quality assets can be safe if their prices are low enough, while high quality assets can be risky if their prices are too high. Chris Davis adds:

I agree – there are a number of dangers that come from using a term like ‘quality.’ First, investors tend to equate ‘high-quality asset’ with ‘high-quality investment.’ As a result, there’s an incorrect presumption or implication of less risk when taking on ‘quality’ assets. As Marks rightly points out, quite often ‘high-quality’ companies sell for high prices, making them poor investments. Second, ‘high-quality’ tends to be a phrase that incorporates a lot of hindsight bias or ‘halo effect.’ Usually, people referring to a ‘high-quality’ company are describing a company that has performed very well in the past. The future is often quite different. There is a long list of companies that were once described as ‘high quality’ or ‘built to last’ that are no longer around! For this reason, investors should avoid using the word ‘quality.’ (pages 69-70)

 

CONTROLLING RISK

Risk control is generally invisible during good times. But that doesn’t mean it isn’t desirable, says Marks. No one can consistently predict the timing of bull markets or bear markets. Therefore, risk control is always important, even during long bull markets. Marks:

Bearing risk unknowingly can be a huge mistake, but it’s what those who buy the securities that are all the rage and most highly esteemed at a particular point in time – to which ‘nothing bad can possibly happen’ – repeatedly do. On the other hand, intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments – even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations. (page 75)

Marks later writes:

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a ‘black swan’ will materialize. But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,’ we’d be frozen in inaction. (page 79)

You can’t avoid risk altogether as an investor or you’d get no return. Therefore, you have to take risks intelligently, when you’re well paid to do so. Marks concludes:

Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. (page 80)

Daniel Pecaut and Corey Wrenn, inThe University of Berkshire Hathaway,point out a central fact about how Buffett and Munger have achieved such a remarkable track record:

More than two-thirds of Berkshire’s performance over the S&P was earned during down years. This is the fruit of Buffett and Munger’s ‘Don’t lose’ philosophy. It’s the losing ideas avoided, as much as the money made in bull markets that has built Berkshire’s superior wealth over the long run.(page xxi)

Buffett has made the same point. His best ideas have not outperformed the best ideas of other great value investors. However, his worst ideas have not been as bad, and have lost less over time, as compared with the worst ideas of other top value investors.

See:https://boolefund.com/university-berkshire-hathaway/

 

BEING ATTENTIVE TO CYCLES

Marks explains how the credit cycle works when times are good:

  • The economy moves into a period of prosperity.
  • Providers of capital thrive, increasing their capital base.
  • Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
  • Risk averseness disappears.
  • Financial institutions move to expand their businesses – that is, to provide more capital.
  • They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants. (page 83)

This is a cyclical process. Overconfidence based on recent history leads to the disappearance of risk aversion. Providers of capital make bad loans. This causes the cycle to reverse:

  • Losses cause lenders to become discouraged and shy away.
  • Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
  • Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
  • Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
  • This process contributes to and reinforces the economic contraction. (page 84)

People and financial institutions become overly pessimistic based on recent history, which leads to excessive risk aversion. Many solid loans are not made. This causes the cycle to reverse again.

Marks, in agreement with Lakonishok, Shleifer, and Vishny (1994), explains why value investing can continue to work:

Investors will overvalue companies when they’re doing well and undervalue them when things get difficult. (page 86)

Marks:

When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever. (page 87)

It’s important to point out that there can be structural changes in the economy and the stock market. For instance, interest rates may stay relatively low for a long time, in which case stocks may even be cheap today (with the S&P 500 Index over 2400).

Also, profit margins may be structurally higher:

  • There is a good Barron’s interview of Bruce Greenwald, “Channeling Graham and Dodd”. Professor Greenwald indicated that Apple, Alphabet, Microsoft, Amazon, and Facebook – the five largest U.S. companies – have far higher normalized profit margins and ROE, as a group, than most large U.S. companies in history.
  • In brief, software and related technologies are becoming much more important in the global economy. This is another key reason why U.S. stocks may not be overvalued, and may even be cheap. See: http://www.barrons.com/articles/bruce-greenwald-channeling-graham-and-dodd-1494649404

 

COMBATING NEGATIVE INFLUENCES

Marks discusses the importance of psychology:

The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of a 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. (page 97)

Marks observes that the biggest mistakes in investing are not analytical or informational, but psychological. At the extremes, people get too greedy or too fearful:

Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation, and all the other elements that might otherwise keep investors out of trouble. Instead, 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 counterpart of greed is fear – the second psychological factor we must consider. In the investment world, the term doesn’t mean logical, sensible risk aversion. Rather fear – like greed – connotes excess. Fear, then, is more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should. (page 99)

The third factor Marks mentions is the willing suspension of disbelief. We are all prone to overconfidence, and in general, we think we’re better than we actually are. Charlie Munger quotes Demosthenes:

Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.

Or as the physicist Richard Feynman put it:

The first principle is that you must not fool yourself, and you are the easiest person to fool.

Marks later quotes Warren Buffett’s remark to Congress on June 2, 2010:

Rising prices are a narcotic that affects the reasoning power up and down the line.

The fourth psychological tendency is conformity with the crowd. Swarthmore’s Solomon Asch conducted a famous experiment in the 1950’s. The subject is shown two lines of obviously different lengths. There are a few other people – shills – pretending to be subjects.

All the participants are asked if the lines are the same length. (In fact, they obviously aren’t.) The shills all say yes. In a high percentage of the cases, the actual subject of the experiment disregards the obvious evidence of his own eyes and conforms to the view of the crowd.

So it is with the consensus view of the market. Most people simply go along with the view of the crowd. That’s not to say the crowd is necessarily wrong. Often the crowd is right when it comes to the stock market. But occasionally the crowd is very wrong about specific stocks, or even about the market itself.

The fifth psychological influence Marks notes is envy. As Buffett remarked, “It’s not greed that drives the world, but envy.” Munger has observed that envy is particularly stupid because there’s no upside. Buffett agrees, joking: “Gluttony is a lot of fun. Lust has its place, too, but we won’t get into that.” Marks:

People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do. (page 102)

The sixth psychological influence is ego. Investment results are compared. In good times, aggressive and imprudent decisions often lead to the best results. And the best results bring the greatest ego rewards, observes Marks.

Finally, Marks highlights the phenomenon of capitulation. Consider the tech bubble in the late 90’s:

…The guy sitting next to you in the office tells you about an IPO he’s buying. You ask what the company does. He says he doesn’t know, but his broker told him it’s going to double on its day of issue. So you say that’s ridiculous. A week later he tells you it didn’t double… it tripled. And he still doesn’t know what it does. After a few more of these, it gets hard to resist. You know it doesn’t make sense, but you want protection against continuing to feel like an idiot. So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO… and the bonfire grows still higher on the buying from converts like you. (page 106)

Technological innovation drives economic progress. But that doesn’t mean every innovative company is a good investment. Joel Greenblatt comments:

Buffett’s famous line about the economics of airlines comes to mind. Aviation is a huge and valuable innovation. That’s not the same thing as saying it’s a good business. (page 108)

 

CONTRARIANISM

Sir John Templeton:

To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.

Most investors are basically trend followers, writes Marks. This works as long as the trend continues.

Marks quotes David Swensen’s Pioneering Portfolio Management (2000):

Investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

…Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. (page 115)

Marks sums it up:

The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and thus the price is low) or you’re selling when everyone else is buying (and thus the price is high). (page 116)

Marks concludes:

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. (page 121)

It’s important to emphasize again what can happen when certain assets become widely ignored or despised: The lower the price goes below probable intrinsic value, the lower the risk and the higher the reward. For value investors, some of the highest-returning investments can simultaneously have the lowest risk. Modern finance theory regards this situation as impossible. According to modern finance, higher rewardsalways require higher risk.

 

FINDING BARGAINS

Marks repeats an important concept:

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.

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, get most investors into trouble. (pages 124-125)

What creates bargains? Marks answers:

  • Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
  • Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, 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.
  • Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
  • Usually its price has been falling, making the first-level thinker ask, ‘Who would want to own that?’ (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean. First-level thinkers tend to view past price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
  • As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it. (pages 125-126)

Marks continues by explaining that to find an undervalued asset, a good place to start looking 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. (pages 127-128)

In brief:

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. (page 128)

Seth Klarman:

Generally, the greater the stigma or revulsion, the better the bargain.

 

PATIENT OPPORTUNISM

Buffett has always stressed that, over time, you should compare the results of what you do as an investor to what would have happened had you done absolutely nothing. Often the best thing to do as a long-term value investor is absolutely nothing.

Buffett has also observed that investing is like baseball except that in investing, there are no called strikes. You can wait for as long as it takes until a fat pitch appears. Absent a fat pitch, there’s no reason to swing. Buffett mentioned in Berkshire Hathaway’s 1997 Letter to Shareholders that Ted Williams, one of the greatest hitters ever, studied his hits and misses carefully. Williams broke the strike zone into 77 baseball-sized ‘cells’ and analyzed his results accordingly. Buffett explained:

Swinging only at balls in his ‘best’ cell, he knew, would allow him to bat .400; reaching for balls in his ‘worst’ spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

See:http://berkshirehathaway.com/letters/1997.html

 

KNOWING WHAT YOU DON’T KNOW

John Kenneth Galbraith:

There are two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.

Marks studied forecasts. Some forecasters always extrapolate the recent past. But that’s not useful. Outside of that, there are virtually no forecasters who are both non-consensus and regularly correct. Marks writes:

One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…

It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts. (page 145)

Marks restates the case in the following points:

  • Most of the time, people predict a future that is a lot like the recent past.
  • They’re not necessarily wrong: most of the time, the future largely is a rerun of the recent past.
  • On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: They’ll usually extrapolate recent experience and be right.
  • However, the many forecasts that correctly extrapolate past experience are of little value. Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of recent history. Thus if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would.
  • Once in a while, however, the future turns out to be very different from the past.
  • It’s at these times that accurate forecasts would be of great value.
  • It’s also at these times that forecasts are least likely to be correct.
  • Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s unlikely to be the same people consistently.
  • The sum of this discussion suggests that, on balance, forecasts are of very little value. (pages 145-146)

As an example, Marks asks who correctly predicted the credit crisis and bear market of 2007-2008. Of those who correctly predicted it, how many of them also correctly predicted the recovery and massive bull market starting in 2009? Very, very few. Marks:

…Those who got 2007-2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009. The overall usefulness of those forecasts wasn’t great… even though they were partially right about some of the most momentous financial events in the last eighty years.

So the key question isn’t ‘are forecasts sometimes right?’ but rather ‘are forecasts as a whole – or any one person’s forecasts – consistently actionable and valuable?’ No one should bet much on the answer being affirmative.

Marks then notes that you could have found some people predicting a bear market before 2007-2008. But if these folks had a negative bias, as well as a track record full of incorrect predictions, then you wouldn’t have had much reason to listen. Or as Buffett put it in the Berkshire Hathaway 2016 Letter to Shareholders:

American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on thenonsense they peddle. (page 6)

See:http://berkshirehathaway.com/letters/2016ltr.pdf

Marks has a description for investors who believe in the value of forecasts. They belong to the “I know” school, and it’s easy to identify them:

  • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
  • They’re confident it can be achieved.
  • They know they can do it.
  • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
  • They’re comfortable investing based on their opinions regarding the future.
  • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
  • They rarely look back to rigorously assess their record as forecasters. (page 147)

Marks contrasts theconfident“I know” folks with theguarded“I don’t know” folks. The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities. If you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going.

You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and theWall Street Journalruns your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future. (page 148)

Marks continues by noting that no one likes investing on the assumption that the future is unknowable. But if the futureISlargely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.

Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):

  • when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
  • when they assume the most likely outcome is the one that will happen,
  • when they assume the expected result accurately represents the actual result, or
  • perhaps most important, when they ignore the possibility of improbable outcomes. (pages 148-149)

Marks sums it up:

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. (page 150)

 

APPRECIATING THE ROLE OF LUCK

Professor Paul Johnson explains the main point:

Learn to be honest with yourself about your successes and failures [as an investor]. Learn to recognize the role luck has played in all outcomes. Learn to decide which outcomes came because of skill and which because of luck. Until one learns to identify the true source of success, one will be fooled by randomness. (page 161)

Once again, we consider Nassim Taleb’s concept of “alternative histories.” Marks quotes Taleb:

Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened…

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history. (pages 162-163)

In investing, you probably need many decades of results before you can determine how much is due to skill. And here we’re talking mainly about long-term value investing, where stocks are held for at least a year on average.

Similarly, to judge individual investment decisions, you have to know much more than whether a specific decision worked or not. You have to understand the process by which the investor made the decision. You have to know which facts were available and which were used in the decision. You have to estimate the probability of success of the investment decision, whether or not it actually worked. This means you have to account for all the possible scenarios that could have unfolded, not just the one scenario that did unfold.

Marks gives the example of backgammon. A certain aggressive player may need to roll double sixes in order to win. The probability of that happening is one out of thirty-six. Say the player accepts the cube – doubling the stakes – and gets his boxcars. Many will consider the player brilliant. But was it a wise bet?

You could find similar situations in other games of chance, such as bridge or poker. There are many situations in which you can calculate the probabilities of various scenarios. So you can figure out if the player is making the most profitable decision, averaged out over time. Some percentage of the time the decision will work. Some percentage of the time it won’t. A skillful player will consistently make the the most profitable long-term decision.

Value investing is similar. Good value investors are right 60% of the time and wrong 40% of the time. If their process for selecting cheap stocks is solid, then risks and losses will be minimized while gains are simultaneously maximized.

Marks writes:

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 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. (page 168)

As Buffett advised, we have to focus on what’s knowable and important. That means focusing on individual companies and industries within our circle of competence. Many companies may be beyond our ability to value. They go in the “too hard” pile. Focus on those companies we can understand and value.

 

INVESTING DEFENSIVELY

As in some sports, in investing you have to decide if you want to emphasize offense, emphasize defense, or use a balanced approach. Marks:

…investors should commit to an approach – hopefully one that will serve them through a variety of scenarios. They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers. They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times. Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets. (page 174)

The vast majority of investors should invest in quantitative value funds or in low-cost broad market index funds. Most of us will probably maximize our multi-decade results using one or both of these approaches. Buffett:https://boolefund.com/warren-buffett-jack-bogle/

Regarding the balance of offense versus defense, Marks observes:

And, by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for. (page 175)

Marks believes that a focus on avoiding losses will lead more dependably to consistently good returns over time. As we noted earlier, Buffett has said that his best ideas have not outperformed the best ideas of other value investors; but his worst ideas have not done as poorly as the worst ideas of other value investors. So minimizing losses – especially avoiding big losses – has been central to Buffett becoming arguably the best value investor of all time.

 

REASONABLE EXPECTATIONS

Setting reasonable expectations can play a pivotal role in designing and applying your investment strategy. Marks points out that you can’t simply think about high returns without also considering risk. In investing, if you aim too high, you’ll end up taking too much risk.

Similarly, when buying assets that are declining in price, you should have a reasonable strategy. Marks:

I try to look at it logically. There are three times to buy an asset that has been declining: on the way down, at the bottom, or on the way up. I don’t believe we ever know when the bottom has been reached, and even if we did, there might not be much for sale there.

If we wait until the bottom has passed and the price has started to rise, the rising price often causes others to buy, just as it emboldens holders and encourages them from selling. Supply dries up and it becomes hard to buy in size. The would-be buyer finds it’s too late.

That leaves buying on the way down, which we should be glad to do. The good news is that if we buy while the price is collapsing, that fact alone often causes others to hide behind the excuse that ‘it’s not our job to catch falling knives.’ After all, it’s when knives are falling that the greatest bargains are available.

There’s an important saying attributed to Voltaire: ‘The perfect is the enemy of the good.’ This is especially applicable to investing, where insisting on participating only when conditions are perfect – for example, buying only at the bottom – can cause you to miss out on a lot. Perfection in investing is generally unobtainable; the best we can hope for is to make a lot of good investments and exclude most of the bad ones. (page 212)

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here:https://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.