#164 How Howard Marks Invests
What I Learned from reading “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor ” by Howard Marks.
Today’s Chapter is based on the book “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor ” by Howard Marks.
Howard Marks is an American investor, author, and co-founder and co-chairman of Oaktree Capital Management, the world’s largest investor in distressed securities. Renowned for his investor memos, Marks emphasizes risk control, second-level thinking, and market cycles over chasing returns.
Here’s what I learned:
Second-Level Thinking
“Failing to consider second- and third-order consequences is the cause of a lot of painfully bad decisions, and it is especially deadly when the first inferior option confirms your own biases. Never seize on the first available option, no matter how good it seems, before you’ve asked questions and explored.”
— Ray Dalio
Howard Marks believes that successful investing is far more demanding than most people realize. It requires seeing beyond the obvious surface-level analysis that everyone else is doing. Marks argues that merely matching the market is easy, but outperforming it requires superior insight, which he calls second-level thinking. He writes, “Anyone can achieve average investment performance—just invest in an index fund that buys a little of everything. That will give you what is known as “market returns”—merely matching whatever the market does. But successful investors want more. They want to beat the market.”
As such, in Marks’ opinion, the definition of successful investing is to do better than the market and other investors. He adheres to the fact that “To accomplish that, you need either good luck or superior insight. Counting on luck isn’t much of a plan, so you’d better concentrate on insight.”
The core challenge is that not only do you need to have a contrarian approach, but your thinking must surpass the collective intelligence of the market. Other participants are smart, informed, and equipped with powerful tools, so you need an edge they lack.
“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 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.”
— Howard Marks
Marks mentions that second-level thinking is not linear or simple. It involves weighting probabilities and comparing your view to the consensus. A second-level thinker must take many things into account such as:
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 for 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 bearish?
What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
Howard Marks reminds us that investing is a competitive endeavor. To win consistently, you cannot follow the crowd. You must train yourself to question assumptions, probe deeper, and stay disciplined when your view diverges from the majority. Marks makes it clear that this higher-level cognition is the foundation of lasting outperformance. He writes, “Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half. To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?”
“If your behavior is conventional, you’re likely to get conventional results—either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average.”
— Howard Marks
This contrarian approach to investing reminds me of what we have learned from Alan Greenberg from Bear Sterns who had a contrarian approach to business. As a matter of fact, he was famous for hiring talented people, whom he called number one draft picks, when other companies were having hiring freeze during recessions. Greenberg explains that “We are not panicking; we are not laying off people, but we are making a real effort to cut expenses. The other side of the coin is we have hired a large number of number one draft picks in the last few months. This is the time to hire good people. We have followed this policy in the past, and I am convinced that we will be proven correct once again.”
Furthermore, while other companies focused on hiring individuals with MBA degrees, Greenberg enjoyed hiring people with PSD degrees — poor, smart and a deep desire to become rich. A great example of how Greenberg was a contrarian. He writes, “Our first desire is to promote from within. If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees. They built this firm and there are plenty around because our competition seems to be restricting themselves to MBA’s. If we are smart, we will end up with the future Cy Lewises, Gus Levys and Bunny Laskers. These men made their mark with a high school degree and a PSD. * PSD stands for poor, smart and a deep desire to become rich.”*
Being a contrarian in business is certainly a great way of finding a competitive edge over the competition. This is equally right in investing as from the famous saying of Warren Buffett: “Be fearful when others are greedy, and greedy when others are fearful.” However, while being a contrarian in itself isn’t hard — anyone can say the opposite of what crowd believes, you must also be right to have an advantageous divergence in investing and in business. This can be extremely hard. Not only that, timing is also an important factor for a successful contrarian approach.
“Here we go again. Business is tough. The Dow Jones index dropped almost 200 points a month ago. Firms are announcing major layoffs. What is our posture at this time? Your executive committee feels we should be hiring, not firing. This is the time to pick up great people. This position may amaze some newer associates, but those of you who have been exposed to our culture will not be surprised by this move. Being a contrarian has worked for us in the past and it will work again. Spread the word—we are hiring, not firing. The flip side is that our associates should be relieved and maybe the people who work here will even appreciate what a great place this is to build a career.”
— Alan Greenberg
Understanding Risk
“Risk comes from not knowing what you are doing.”
— Warren Buffett
Howard Marks believes that one of the most important trait of a great investor is the ability to understand risk. In fact, outstanding investors are defined as much by how well they manage risk as by the returns they generate. Marks teaches that risk is not primarily volatility but the permanent loss of capital which is often born from being overly optimistic or paying too much for an asset. Success in investing also requires attentiveness to cycles and understanding the pendulum-like swings of sentiment in stock prices. Marks writes, “The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.”
As such, Marks argues that risk often comes from excessive enthusiasm. He explains that “The most dangerous investment conditions generally stem from psychology that’s too positive. For this reason, fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.” While we often hear that high return is correlated to taking high returns, Marks genuinely believes that both can be done simultaneously if we buy things at a lower valuation than they’re worth.
“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.”
— Howard Marks
Furthermore, Marks believes that cycles are inevitable in the stock market and that ignoring them is perilous. As a matter of fact, he argues that successful investors need to identify what is the sentiment of the market towards the company and where in the cycle is the company’s stock price trading at. He explains that there are two concepts that he hold with complete confidence: Rule #1: Most things will prove to be cyclical; Rule #2: Some of the greatest opportunities for gain and loss come when other people forget rule number one.
He compares market moods swing to a pendulum. Eventually, things regress back to the norm in an upward or downward fashion. He writes, “The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.”
“The road to long-term investment success runs through risk control more than through aggressiveness. 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. Skillful risk control is the mark of the superior investor.”
— Howard Marks
Finally, Marks believes it is necessary to clarify that risks need to be taken to obtain superior return. Recognizing risk is one thing and controlling it is another. A good investor does not avoid risk but control it. He writes, “I want to make clear the important distinction between risk control and risk avoidance. Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well. Once in a while I hear someone talk about Oaktree’s desire to avoid investment risk and I take great issue. Clearly, Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price.”
This reminds me of Mohnish Pabrai’s concept of Dhandho investing, the idea that high returns do not necessitate high risks. Instead, Pabrai advocates for a mindset that seeks asymmetric bets, those with significant upside potential but minimal downside risk. This principle, encapsulated in the phrase “Heads, I win; tails, I don’t lose much”, is a cornerstone of the Dhandho framework and reflects his belief that disciplined investors can achieve extraordinary results by carefully selecting opportunities with favorable odds.
As a matter of fact, Pabrai explains that “We have all been taught that earning high rates of return requires taking on greater risks. Dhandho flips this concept around. Dhandho is all about the minimization of risk while maximizing the reward. The stereotypical Patel naturally approaches all business endeavors with this deeply ingrained riskless Dhandho framework—for him it’s like breathing. Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.”
To demonstrate the power of Dhandho, he mentions the story of how Richard Branson built Virgin Atlantic with zero capital. In fact, although the airlines businesses is known to be capital-intensive and highly regulated, Branson was able to identify a service gap and exploited it with minimal initial capital outlay, leveraging creativity over cash. The potential upside was building a global brand; the downside was limited because so little equity was risked upfront.
“My take on Virgin Atlantic is simply this: if you can start a business that requires a $200 million 747 jumbo jet and a boatload of employees in a tightly regulated industry for virtually no capital, then virtually any business that you want to start can be gotten off the ground with minimal capital. All you need to do is replace capital with creative thinking and solutions. Branson found a service gap and went after it. By the time that gap narrowed and British Airways and his other competitors woke up, he had already built a strong brand. Even today, Virgin Atlantic offers a very unique product in a very tough industry. The Virgin Atlantic business model is pure Dhandho. Heads, I win; tails, I don’t lose much!”
— Mohnish Pabrai
Pabrai explains that the reason why the Dhandho approach works is due to the fact that investors often confuse risk with uncertainty. He mentions that “Low risk and high uncertainty is a wonderful combination. It leads to severely depressed prices for businesses—especially in the pari-mutuel system-based stock market. Dhandho entrepreneurs first focus on minimizing downside risk. Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. You end with the classic Dhandho tagline: Heads, I win; tails, I don’t lose much!”
As a matter of fact, Pabrai loves comparing investing in the stock market to the pari-mutuel system. As such, he encourages investors to adopt a probabilistic mindset, akin to Charlie Munger’s approach to betting at the race track. Pabrai mentions that “If you went to a horse race track and you were offered 90 percent odds of a 20 times return and a 10 percent chance of losing your money, would you take that bet? Heck Yes! You’d make that bet all day long, and it would make sense to bet a very large portion of your net worth with those spectacular odds. This is not a risk-free bet, but it is a very low-risk, high-return bet. Heads, I win, tails, I don’t lose much!”
The lesson here is clear: investors should seek opportunities where the downside is limited, and the upside is substantial, and be willing to act decisively when such opportunities arise. This approach requires a deep understanding of probabilities and a willingness to wait for the right moment, much like a seasoned gambler at the pari-mutuel betting system.
Intrinsic Value
“We define value investing as buying dollars for 50 cents.”
— Seth Klarman
If second-level thinking is the engine of superior investing, then value is the compass that guides it. Marks is unapologetically a value investor, and he makes clear that without a reliable estimate of intrinsic value, an investor is simply guessing. Marks writes, “For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.”
This emphasis on intrinsic value is not about finding companies with strong brands or impressive growth trajectories. It is about understanding what an asset is truly worth and then comparing that to the price at which it is available. As a value investor, Marks elaborates that “an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.”
Nonetheless, Marks warns that while value investing is a path to consistently produce favourable results in investing, it is not easy. For one, you need to be able to provide an accurate estimate of value, if not, you are likely to overpay for a company. And, Marks mentions that if you overpay, “it takes a surprising improvement in value, a strong market or an even less discriminating buyer (what we used to call a “greater fool”) to bail you out.”
To make it even harder, Marks mentions that even if you are right in your valuation, you need to be patient enough to be proven right by the market. As he once said, “An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. This one statement shows how hard it is to get it all right.”
“If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.”
— Howard Marks
Finally, Marks mentions that price should be the ultimate starting point for any value investors. Often, investors are ready to overpay for higher quality assets, but Marks who has experienced the Nifty-Fifty warns us that “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.”
This was a liberating insight for Howard Marks. By understanding that a wonderful company can be a terrible investment if you overpay, and a mediocre company can be a fantastic investment if you buy it cheap enough, Marks operates Oaktree Capital with a simple philosophy: “Well bought is half sold.” He explains that at Oaktree, “we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves.”
“The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.”
— Howard Marks
This reminds me of what we have learned from Lawrence Goldstein at Santa Monica Partners, who believes that investing in overlooked companies requires patience in order for their value to unlock. In fact, Goldstein once said “I believe that neglected stocks win hands down over longer periods of time and with less risk. Clearly, patience is the key to investing successfully in our kinds of securities.” As such, he frequently advocates for a long-term perspective, emphasizing to his partners in his shareholder letters that true value creation takes time. As he once wrote, “My belief of course is that patience is a virtue to be rewarded.”
By having a long-term perspective, Goldstein is able to ride out market volatility without panicking. He recognizes that short-term price fluctuations are inevitable but he doesn’t let them distract him from his long-term goals. Similarly, he reiterates to his partners that “Riding out the volatility and noise is essential to successful long-term investing. Put another way, we must keep control of our stomachs (though others around us may not) when sailing through stormy seas.”
By consequence, Goldstein practices an investment methodology that prefers holding investments for the long haul and allowing them to compound over time. By consequence, Santa Monica Partners have an “extremely low turnover [of companies in the portfolio] is the norm for us, of course, as ‘buy and hold’ is not just my preference and practice, but something that permeates my very being.” This low turnover not only reduces transaction costs but also allows him to defer capital gain taxes, further enhancing returns.
“For all we are concerned with is the long-term beyond the horizon. When we invest we like to think in terms of forever. We can care less about a quarter or a year and rather focus on the far away pot of gold on the distant horizon. Sometimes we reach it sooner because of the occurrence of a value-creating catalyst. Most of the time it is because the company over time just grows like a weed or like topsy and in the fullness of time we reach the horizon and the great value realization outs.”
— Lawrence J. Goldstein
For Goldstein, patience is not about idleness but about allowing compounding to work its magic. He cites examples like Balchem, a stock that became a “92-bagger in 20 years,” and Compass Knowledge, which quintupled in value in just two years. These gains were only possible because Santa Monica Partners held these investments through periods of stagnation and volatility, trusting that their underlying value would eventually surface. As Goldstein once said, “Patience and courage too is also important so as to be able to look across the investment valleys and beyond the peaks in order to make and be willing to hold on long-term to achieve what may be very successful and at times extraordinary investments.”
“Once in a blue moon you find one which is really a great one but to the ignorers ‘too small’ or ‘too closely held’ or its variations ‘doesn’t trade enough’ or is ‘illiquid’ or too this or too that. In almost all cases these companies don’t deserve their undervaluation. How do we as investors profit? Value will out in time. It always does.”
— Lawrence J. Goldstein
Beyond the Book
Read "Second-Order Thinking: What Smart People Use to Outperform" by Farnam Street
Read "Memos to Oaktree Clients: The Complete Collection" by Howard Marks
Listen to "#53 Howard Marks: Luck, Risk and Avoiding Losers" by The Knowledge Project