Book Review: Billionaire Howard Marks' 'The Most Important Thing Illuminated'

If Warren Buffett, Christopher Davis, Joel Greenblatt and Seth Klarman recommend a book, it might—just might—be worth reading. It certainly got my attention.

Warren Buffett calls Howard Marks’ The Most Important Thing Illuminated “that rarity, a useful book.” And as a researcher with a library of a couple hundred books myself, I couldn’t agree more.

For those unfamiliar with Howard Marks, he is the Chairman and cofounder of Oaktree Capital Management, an investment firm with $77 billion under management. The Most Important Thing Illuminated, published in 2013, is an update to Marks’ original, published in 2011, though in Illuminated Marks has help. Greenblatt, managing partner of Gotham Capital and author of The Little Book That Beats the Market, offers his own commentary throughout the pages, as do Christopher Davis, portfolio manager of the Davis Large Cap Value fund, and Seth Klarman, president of The Baupost Group and a well-respected value investor. Marks keeps good company.
I had high expectations when I picked up The Most Important Thing Illuminated, and I wasn’t disappointed. This isn’t yet another “how to invest” book or a tired rehashing of received investment “wisdom” that looks more like something found in a fortune cookie and which rarely seems to hold up in practice.
Instead, Marks gives us the insightful thoughts of a man who struggles with his own investing decisions on a daily basis. There are no shortcuts, formulas or easy tricks. But there is a wealth of experience and thoughtful contemplation from a real “in the trenches” investor who has been doing this a long time.
Marks starts the book with a chapter on “second-level thinking,” and I consider this one of the most valuable lessons in the entire book. Having a good understanding of this chapter alone will put you head and shoulders above most of your peers.
Mechanical trading rules work really well…right up until the point that they don’t. And why don’t they work consistently over time? As Marks explains,

The reasons are simple. No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.

Investing, like economics, is more art than science. And that means it can get a little messy.

“Messy” is not a technical term, but it is accurate and descriptive hear. Markets are driven by people and by ever-changing real-world events. Trying to cram this into a mechanical trading model or a black box is a recipe for disaster. And frankly, it’s mentally lazy and reflects an unwillingness (or inability!) to grasp complexity.
This brings me to Marks’ points about second-level thinking. What exactly is “second-level thinking.” Perhaps it is best explained by example:

• “First-level thinking says, ‘It’s 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.’”

Call it contrarian thinking, applied game theory or just being clever, but this is the mindset that is required to be a successful investor over time. It’s also a skill that few investors have or have the mental discipline to use.
It’s not easy going against the grain and taking views that are contrary to the consensus. But then, no one ever said that investing should be easy.
Market Technicals and Psychology
As a value investor, Marks is not a fan of technical analysis (i.e. charting) but he does stress the importance of understanding what he calls “market technicals,” or non-fundamental factors that affect the supply and demand for a security. Failing to understand these can lure an investor who looks at value alone.
What are some examples? Marks lists two specifically: the forced selling that takes place when a market crash trips margin calls, which forces leveraged investors to sell at any price, and the cash inflows that go to mutual funds that are usually invested irrespective of price. To these I would add short squeezes, secondary stock price offerings that dilute shareholders, and buyout offers.
These technical factors are often closely related to market psychology. And as Marks writes, “The discipline that is most important Is not accounting or economics, but psychology…

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.

Need an example? Think of Apple’s performance over the past few years. Apple was the “must own” stock of the 2010s. Everyone owned it—individual investors, mutual fund managers, hedge fund managers…you name the investor, and chances are good that Apple made up a good-sized chunk of their portfolio.
There were cases of focused hedge funds having 20-30% of their portfolio in Apple. Even now, after Apple’s massive slide, the stock accounts for nearly 15% of the Technology Select SPDR, one of the most popular ETFs for investing in the tech sector. Apple’s position in the ETF is bigger than Google’s and IBM’s combined.
It’s not a figure of speech to say that there was no one left to buy Apple. No matter how great a company is, there is a limit to how high a percentage of investors’ portfolios it could comprise.
And we all know what followed. Apple’s share price fell by over 40%, and may or may not be finished falling.
A pure value investor wouldn’t have seen the risk in Apple. Based on popular metrics such as price/earnings or price/sales, Apple wasn’t particularly expensive. It actually looked pretty cheap compared to the broader market.
But if you had taken market technical and investor psychology into account, you would have known to be wary. You almost certainly wouldn’t have timed the top perfectly, but you would have known that caution was warranted.

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