Howard Marks New Memo: It’s Not Easy

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Howard Marks New Memo: It’s Not Easy

In 2011, as I was putting the finishing touches on my book The Most Important Thing, I was fortunate to have one of my occasional lunches with Charlie Munger. As it ended and I got up to go, he said something about investing that I keep going back to: “It’s not supposed to be easy. Anyone who finds it easy is stupid.”

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As usual, Charlie packed a great deal of wisdom into just a few words. Let’s take the first six: “It’s not . supposed to be easy.” While it’s pretty simple to achieve average results, it shouldn’tP be easy to make . superior investments and earn outsized returns. John Kenneth Galbraith saidLsomething similar years ago:

There is nothing reliable to be learned about MANAGEMENT,makingmoney.Ifthere were, study would be intense and everyone with a positive IQ would be rich.

. What Charlie and Professor Galbraith meant is this: EveryoneRESERVEDwantstomake money, and especially to find the sure thing or “silver bullet” that will allow them to do it without commensurate risk. Thus they

work hard (actually, study is intense), searching for bargain securities and approaches that will give them an edge. They buy up the bargains and apply the approaches. The result is that the efforts of these

market participants tend to drive out opportunities for easy money. Securities become more fairly priced, and free lunches become harder to find.CAPITALItmakesno sense to think it would be otherwise.

And what about the next seven words: “AnyoneRIGHTSwhofinds it easy is stupid”? It follows from the above that given how hard investors work to find special opportunities, and that their buying eliminates such
prospects, people who think it can be easy overlook substantial nuance and complexity.
Markets are meeting placesOAKTREEwherepeopleALLcome together (not necessarily physically) to exchange one thing (usually money) for another. Markets have a number of functions, one of which is to eliminate
opportunities for excess returns.

Ed calls me and bids©$10,000 for my car. Then he offers to sell it to Bob for $20,000. If Ed’s lucky and we both say yes, he doubles his money overnight. To put it simply, anyone who expects to make money easily trading cars this way either thinks (a) Bob and I are idiots or (b) the market won’t function in a way that enables us to know about the fair value of my car. If these conditions were met, it would be an
“inefficient market.”

But if Bob and I have access to market data on used car pricing, Ed’s chances of pulling off this deal are greatly reduced. In most markets, transparency tends to reveal and thus preclude obvious mispricings. (Thanks to the incredible gains in access to data by way of the Internet, this is certainly more true today than ever before.) In my view, this is a good part of the basis for Charlie’s comment: anyone who thinks it’s easy to achieve unusual profits is overlooking the way markets operate. This memo is largely about the challenges they present.


Second-Level Thinking

I always thought that when I retired, I would write a book pulling together the elements of investment philosophy discussed in my memos. But in 2009, I got an email from Warren Buffett saying that if I’d write a book, he’d give me a blurb for the jacket. It didn’t take me long to move up my timing.

Columbia Business School Publishing had been talking to me about a book, and when I told them I was ready, they asked to see a sample chapter. For some reason, I was able to sit down – without previously having given the topic any organized thought – and knock out a chapter about the importance of something I labeled “second-level thinking.” This is a crucial subject that has to be understood by everyone who aspires to be a superior investor. And yet I’ve never covered it explicitly for the readers of my memos. I want to correct that now.

In what ended up being the book’s first chapter, I introduced the subject as follows: . .P Remember your goal in investing isn’t to earn average returns; you wantL 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 others may be smart,MANAGEMENT,well-informedandhighly 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.anecessary condition for investment success, but it won’t be sufficient. YouRESERVEDmustbemore right than others . . .
which by definition means your thinking has to be different. . . .

For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge fromCAPITALthenorm,and you have to be more right than the consensus. Different and better: that’sRIGHTSapretty good description of second-level thinking.
Second-level thinking is what immediately pops into my mind when I think about Charlie’s observation.

And it’s a good general heading under which to discuss the great many things that make superior investing a challenge. OAKTREEInshort,toborrow from Charlie, anyone who thinks it’s easy must be a first-level thinker. Let me use some simpleALLexamples from the book to illustrate the difference.
· 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 far less than people expect, and the pleasant surprise will lift the stock; buy.”

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in, “The outlook for the company is favorable, meaning the stock will go up.”
© Oaktree Capital Management, L.P. All Rights Reserved
Second-level thinking is deep, complex and convoluted. The second-level thinker takes many things into account:

· 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?

. The bottom line is that first-level thinkers see what’s on the surface, react to it.simplistically,P and buy or

sell on the basis of their reactions. They don’t understand their setting as Lamarketplace where asset prices reflect and depend on the expectations of theMANAGEMENT,participants.Theyignore the part that others play in how prices change. And they fail to understand the implications of all this for the route to
. For example, when I lived in Los Angeles, a stockbrokerRESERVEDoftenspokeon the radio station I listened to while driving to work. His advice was simple: “If there’s a company whose product you like, buy the

stock.” That’s first-level thinking. How seductively easy. But also how error-prone, in that it ignores the possibility that a company with a good product can have a bad business; the good product can become
obsolete; or the stock can be priced too CAPITAL high to be a good investment.

On the other hand, second-level thinkers doubleRIGHTS-think(and triple-think) every angle of every situation. A good example can be seen in the hypothetical newspaper contest John Maynard Keynes wrote about in
1936. Readers would be shown 100 photos and asked to choose the six prettiest girls, with prizes going
to the readers who choseOAKTREEthegirlsreaders voted for most often. Naive entrants would try to win by picking the prettiest girls. But note ALLthatthe contest would reward the readers who chose not the

prettiest girls, but the most popular. Thus the road to winning would lie not in figuring out which were the prettiest, but in predicting which girls the average entrant would consider prettiest. Clearly, to do so, the winner would have to be a second-level thinker. (The first-level thinker wouldn’t even recognize the

difference.) © Wikipedia points out that one vying to win the contest might go beyond this distinction:
This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other agents.

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, The General Theory of Employment, Interest and Money, 1936).

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