Howard Marks has written a book called The Most Important Thing: Uncommon Sense for the Thoughtful Investor. The book has been well received. Marks is well known for his client memos which are considered must reading by investors. They receive high praise from the likes of Warren Buffett and Seth Klarman.
The most important thing turns out to be numerous important things. The table of contents lists twenty.
However, in his July 1, 2003 memo, Marks stated, “The most important thing – above all – is the relationship between price and value.”
If you want to beat the market, you need to consistently buy securities that are cheaper than the market. This means that what you get in return for putting out your cash – the present value of the sum of all current and future earnings – is greater than what you would get if you bought an index fund or ETF.
Investing is not so much like scientific research where you are constantly pushing the boundaries of knowledge through the application of the scientific method, as it is like basketball where the best players spend countless hours in the gym honing fundamentals – shooting, dribbling, passing, conditioning – which are substantially similar to what players were working on thirty or forty years ago.
Buying cheap is the sine qua non of investing fundamentals.
Too many investors look for their edge in some special insight into a given security rather than patiently waiting for Mr. Market to offer it on the cheap. Stock investment websites spew forth investment ideas by the truckload. Truly great investment ideas are hard to find.
Here’s Marks again from the same memo quoted above, “During the course of my 35 years in this business, investors’ biggest losses have come when they bought securities of what they thought were perfect companies – where nothing could go wrong – at prices assuming that degree of perfection . . . and more.”
Discipline yourself to buy cheap. Unless there is a compelling reason, why not wait until a security you like shows up on the 52-week low list? Also, have some dry powder to buy more if it goes even lower. Mr. Market frequently way overshoots the mark when he gets in a lousy mood. Walter Schloss – who averaged 20% (before fees) for five decades – liked to buy stocks trading near the low of the past few years.
Don’t compromise on price or you will lock your capital up in mediocre investments. This is not a formula for beating the market. Most of the time, the market’s prices are reasonably well aligned with business values. Have the patience to wait for those times when the gap between price and value is screaming. A feeling of revulsion – if not by you, at least by the crowd – is usually a pretty good tell.
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Horizon Asset Management (now Horizon Kinetics) has done an interesting analysis of the price-to-book value of the S&P 500 compared to that of Berkshire Hathaway. It’s worth a careful read.
Here’s the Reader’s Digest version (all data is as of 4/11/2011):
The S&P’s P/B ratio is 3.68x.
Berskhire Hathaway’s P/B ratio is about 1.3x.
The P/B ratio is a backdoor way of forecasting future return-on-equity expectations. For example, holding constant for other variables, in an environment where the expectation for high-quality long-term corporate bonds was around 6%, we might expect companies expected to earn an ROE of 20% to trade in the range of 3x to 3.5x book value.
The market is in effect projecting average ROEs in the S&P 500 to be 20% or more on a going-forward basis. This is noteworthy because not only is it high per se, but also is builds off a foundation of near record profit margins in many of the major component companies.
Investors should ponder that the market is saying that the ROE expectations for the S&P 500 are 2.85x that of Berkshire Hathaway. This is all the more interesting when put it in historical context. As Horizon states, “The highest ROE ever sustained for the longest time period by any company is, of course, that of Berkshire Hathaway at about 20% per annum.”
The market is either very optimistic about the S&P 500 or companies are being purchased for non-economic reasons, such as inclusion in index oriented mutual funds or ETFs. On the other hand, the market seems to be very pessimistic about Berkshire’s future and is overlooking what I judge to be numerous structural advantages.
Here’s the complete analysis.
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The third idea to improve your investment process is to not focus on the outcome. One of the interesting ironies of most activities is that if you focus on the outcome, you’re less likely to achieve it.
A few years ago, Michael Lewis wrote a book called Moneyball. The book tells the story of how Billy Bean built the Oakland A’s into a winning baseball team in spite of having an undersized payroll. Bean worked side by side with a wizkid from Harvard named Paul DeDodesta. Together they used creative thinking and statistical analysis to find undervalued players for the A’s to draft.
For a few years, DePodesta maintained a blog on baseball called “It Might Be Dangerous… You Go First”. In one memorable post, he wrote about the relationship between process and outcome. He tells the story of an evening in Las Vegas where he observed a game of black jack. He saw a player draw a seventeen and then, to the surprise of the dealer, ask for a hit, which is a sub-optimal choice. The player drew a four and won the hand. The dealer responded, “Nice Hit!”
DePodesta spent the rest of the evening thinking about what he had observed and the relationship between process and outcome.
He concluded that the blackjack player had had a good outcome, but a bad process.
It’s easy to fall into the trap of overemphasizing the outcome. After all, results are what matter and people mistakenly believe that a good outcome implies a good process. That’s a false assumption.
The best hope for a good outcome is a good process. You should focus on what you can control. The odds are stacked in favor of the casino, but it doesn’t win every hand. The casino is profoundly interested in a good outcome, but to achieve it, it maniacally focuses on the PROCESS.
A bad process can also lead to a good outcome, as we saw in the blackjack story. This is, according to DePodesta, the “wolf in sheep’s clothing” that “allows for one-time success but almost always cripples any chance of sustained success.”
FOCUS ON HAVING A GOOD PROCESS
What you should be after is “deserved success” which is a good outcome that results from a good process. This is where championship sports franchises like the Patriots or the Steelers live, or great investors such as Warren Buffett or Seth Klarman.
Even great achievers experience failure and make mistakes. Having a good process and getting a bad outcome is a tough reality of operating in areas that involve uncertainty and luck, such as investing. Nevertheless, focusing on a good process is the best path to sustained success.
It’s tough to admit that you’re lucky when you undeservedly get a good outcome, but it’s critical in order to improve. According to Paul DePodesta, Billy Beane was successful because he was quick to notice the role of luck “embedded” in a good outcome. Beane refused to congratulate himself when this happened.
This is what Buffett is getting at when he says that you don’t know who’s swimming naked until the tide goes out. When everything’s going up, there are a lot of folks running around who confuse luck and skill.
You need to guard against this tendency to judge a decision based on the outcome rather than the process of what went into it.
In his 2010 letter to shareholders, Buffett commented on his process for selecting a new chief investment officer. He wants someone with a good track record, but he’s even more focused on HOW the record was achieved.
“It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial…” [emphasis added]
Focus on the process, not the outcome, and you’ll improve your chance of sustained success.