We Study Billionaires - The Investor’s Podcast Network - TIP665: The Most Important Thing by Howard Marks w/ Clay Finck & Kyle Grieve

Starting point is 00:00:00 You're listening to TIP. On today's episode, my co-host Kyle Greve and I will be chatting about Howard Marks's book, The Most Important Thing, and sharing our biggest takeaways from reading the book. Howard Marks is the co-founder of Oak Tree Capital, which manages over $190 billion in assets, and he's also been a previous guest on the podcast on multiple occasions. In this episode, Kyle and I will discuss the concept of efficient markets and how that ties into being a successful investor, why the essence of successful investing is properly understanding in managing risk, the importance of understanding market cycles and investor psychology, pockets of the market where we can potentially

Starting point is 00:00:39 find bargains where the price is greatly below the value, and how investors like Poulac Prasad and Warren Buffett utilize patient opportunism to achieve market-beating returns. The most important thing has so many fundamental and key insights to investing successfully, so I think you'll really enjoy hearing some of Kyle and I's takeaways from the book. So with that, I bring you today's episode covering the most important thing by Howard Marks. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for

Starting point is 00:01:25 your hosts, Clay Fink and Kyle Greve. Welcome to the Investors, I'm your host, Clay Fink, and today I'm joined by my co-host, Kyle Grieve. Kyle, welcome to the show. Glad to be here as always. Kyle and I decided that we wanted to chat about a book that highly influenced us as investors. So, Kyle selected the most important thing by Howard Marks, and I selected The Joys of Compounding by God and Bade. On today's episode, we'll be covering Howard's book, and then on the episode that's going to be released, this Saturday, October 5th, we'll be covering Goddum Bates book The Joy's a Compounding. So, Kyle, I'll throw it over to you here.

Starting point is 00:02:13 Why'd you pick the most important thing as one of your favorite investing books? To me, it's just the best book on the practical aspects of risk that I think I've ever read. He has so many great points on the downside specifically and how it really is everything in investing. So one quote that I really love from the book was that there are old investors and there are bold investors, but there are no old and bold investors. And I think this quote just does such a great job of delineating between those who take a lot of risk and those who survive in the markets for decades. And the point being that nobody does both simultaneously.

Starting point is 00:02:47 And I think you and I are both in agreement that we're trying to survive for a long period of time. So I think that's why this book really had such a big impact on me. Another thing I love about this book is just I can pick it up when the market is really getting overly exuberant or just overly depressed. And I feel it helps ground me and makes me get a better grip. of where my own emotions are, where the market's emotions are, and makes it so that I don't really get caught up in investor sentiment. I try to be level as much as possible. So a couple of parts that really took out to me were the parts on market cycles. This is something that I've sometimes asked other investors, you know, what they think of the market using some of the lessons from

Starting point is 00:03:26 the book, specifically about not necessarily guessing where the market is going, but understanding where it stands currently. And it's interesting because I always seem to get investors that assume that I'm asking where they think the market will go, but I'm not really interested in that. I like noting the behavior of other investors, especially in concern to their risk appetite, and I think that really helps me understand where capital is flowing and if the market is most likely to be expensive or cheap. Another critical lesson on market cycles from the book was the fascinating table that he shared called the Poor Man's Guide to Market Assessment. So I'll be commenting on this later, so I won't get too into the weeds now. But it's essentially

Starting point is 00:04:02 just a simple checklist to go over that helps you determine whether you should open or close your wallet, which is a very valuable tool to use. And then a few other areas that I enjoyed were his concepts on luck and skill. So this is something that I spent a lot of time thinking about. I'm always trying to determine if my decisions are creating a good outcome and if that outcome is a product of luck and skill. Luck is always going to have a part in outcomes, but I think over the long term skill is what determines outcomes. So Buffett has said that five years are needed in order to determine if a money manager is adding value. And I'm getting close to that number now in terms of investing in stocks. I was also intrigued by other areas of the book, but let's save those for

Starting point is 00:04:43 later in this conversation. Yeah, the concept of luck and skill is certainly something I'm excited to dive into a bit later. And I think there's just some authors that when you read them, you just feel like you're getting smarter. It seems like a silly way. putting it, and it's sort of hard to explain since it's just this feeling you get when you read it. And Howard Marks is certainly one of those people because he's just such a good writer and just so effective at sharing these complex investing concepts. So jumping to the first chapter of the book here, it covers second level thinking, and it's a concept that I know you and I have both benefited a lot from over the years. Second level thinking is just essential to understand. When you get down to the

Starting point is 00:05:27 core of successful investing, much of it is really just about outthinking other people and behaving more rationally than other people. This definitely requires second level thinking. So to give a couple of examples here, first level thinking would suggest that if we see a good company, then the stock is a buy. Second level thinking would lead us to think that we see a good company and it's trading at a price that would suggest it's a great company. Then it's a sell because it's actually overpriced. And then a second example here, first level thinking says that inflation is rising, so we should sell stocks.

Starting point is 00:06:03 Second level thinking might suggest that because inflation is rising and sentiment is really poor, maybe we should buy stocks. The pattern I see with this first and second level thinking is to consider your view and then compare that to the view of others. In a way, this can be expressed through just market prices. You don't have to go out and just chat with other people. It's also easier said than done, but it can be very helpful mental model, I think, when thinking through our decisions.

Starting point is 00:06:29 So with that, Kyle, I'll throw it over to you here to discuss second level thinking. Yeah, so you really nailed it here with the importance of second level thinking, Clay. Second level thinking is just vital to being a very good investor. I think you could argue, and I think that Howard Marks would agree with me here that you probably must think in second order if you want to outperform the market. So why doesn't everyone think in second order? Everyone probably does think in second order to some extent in other areas of their life, but I don't think so much when it comes to the roller coaster ride of emotions and managing

Starting point is 00:07:03 your own money offered in the stock market and other risk assets. So thinking in second order in the stock market is where you can either get crushed by purely thinking in the first order, which is, I think, what most of the market does anyways, or you can take advantage of the market by thinking in second order. So one of my biggest mistakes was a mistake of omission. This was on a business called In Mode that I no longer own. But while I owned it, it went up about seven times from my cost basis. And this was in, I think it was about a year.

Starting point is 00:07:31 Like it was very, very fast. And so my brain was telling me, okay, great, it's going up. But the business was still improving. And since the business was undervalued in the past, now is this time to shine. And so I saw the momentum and I believe the business would continue to go up. And this is just fundamental first level thinking. huge error on my part. But since then, my selling criteria has shifted and I've tried to fix problems like these to the best of my abilities. You know, looking back, I wish I had a huge

Starting point is 00:07:59 second level thinking. Probably if I had, I would have sold the business. I would have thought since everyone is buying this and assuming that the current all-time high levels of both price and price to earnings expansion will continue rising, I should probably exit the stock before the market changes its mind. So don't worry, I still got out and it was still a multi-bagger for me, but it could have been a bigger multi-beggar. So the problem here with second-level thinking is that it takes a lot of mental energy. So Howard mentions questions that you need to ask to think in the second level. So that's questions such as what is the range of likely future outcomes?

Starting point is 00:08:31 Which outcome do I think will occur? What's the probability that I'm right? 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? So these are wonderful questions to, I think, spend. time thinking about. And as Bill Miller has said, there are three general areas of investing in which you can have an edge, which are analytical, informational, and psychological. So using second order thinking helps you improve your analytical thinking. So suppose you're doing things like thinking

Starting point is 00:09:01 in decision trees, talking other investors about what they think about a stock or an industry, coming up with contrary opinions, and actively evaluating the psychology of the stock market and yourself. In that case, I think you're ahead of 90%, maybe even 99% of the market, because I just don't think many investors think that way. Unfortunately, most investors see a stock that goes up and they're attracted to it like a moth to a flame. But you should really tend to avoid this line of thinking at all costs because there's a very, very good chance that thinking like this is going to lose you a lot of money. So Howard mentions that first level thinkers tend to oversimplify the market when buying a stock. For instance, they'll say that they had a really good experience

Starting point is 00:09:39 with a product or service, then go out and buy the stock. So Peter Lynch said something similar where understanding a product at some level is never the single reason to buy a stock. It's simply a lead. And I think that's a really good way to think of ideas. So a simple contrarian way to search for investments is to actually look at the bad news that's out there and then explore that in more detail. Much of the bad news is going to be baked into the stock price. And if you hold a view that the event that caused the stock price to go down and that

Starting point is 00:10:06 that event is going to be short lived in nature, then you will have thought in the second order and might even come up with a very, very decent investing opportunity. So I mentioned one quote from this chapter that really resonated with me. The upshot is simple. To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That's not easy. So second level thinking will help you hold non-consensus views.

Starting point is 00:10:29 From there, you just have to do the work and to make sure that you're accurate on those views. I've personally found that one of the more difficult parts of investing is that almost everything I look at isn't black or white. And Munger famously said that great opportunities are rare. So if you aren't looking at a great opportunity, you might be looking at a decent or a good opportunity. And for those, it can be somewhat hard to assess the mode, the market's expectations, and such.

Starting point is 00:10:55 One tool that I think might be useful for our listeners is a reverse DCF model. So simply put, a reverse DCF really just allows an investor to determine how fast the market expects the company's earnings to grow in the future. and then you compare that to what you expect earnings to grow at. So let's say the market has priced a company to the point where it expects earnings to grow at say 5% over the next, say, 5 or 10 years. But you feel pretty confident that earnings are going to grow well above 10%, then that might be an opportunity worth diving deeper into.

Starting point is 00:11:30 I'm curious, Kyle, what are some of the most common reasons you think a company can be mispriced? Yeah, this is a really good subject to think a lot about. And while I personally love value investing and I also love quality businesses, so there's definitely a difference there because prominent quality businesses spend a lot of time trading at a premium, which some people might think are at odds with value investing. But the thing is, is that these premium prices that they trade at don't actually happen all the time.

Starting point is 00:11:58 So the best time to look for mispricings and quality businesses is to optimize your understanding of them. So many of our listeners will be familiar with a business called Topicus, a business which I own. I think it's probably the highest quality business in my entire portfolio. But let's examine the share price here. So I went off in chat and looked at the drawdowns. And so from between March of 2022 until April of 2023, this business had drawdowns in excess of 40%.

Starting point is 00:12:25 So companies that are obviously of high quality do go on sale. And in Topicus's situation, I think it was basically being lumped together with a tech sell off that happened in 2022. So this is kind of a prime example of throwing the. baby away with a bathwater. It's during these market busts that very high quality businesses like Topicus can be had for very steep discounts. But if we back up even more and look at businesses that aren't maybe of such a high quality compared to a business like Topicus, we can see that there's many other reasons that a business can be mispriced. Reasons might be

Starting point is 00:12:57 that it might be going through temporary headwinds, which are underappreciating the long-term earnings power of the company. It could be a business that isn't maybe well known by the investing community as a whole. It could be that the business is in an unloved industry and maybe that industry will become loved once again. But, you know, that type of benefit only goes to the people who are willing to be patient and wait out that change in sentiment. So if you're a long-term investor, you should always observe the events that can really punish the share price of what you own. And if you're a net buyer stocks, you should be monitoring for these types of events to add to your best positions because these are the types of times and they're very concentrated where

Starting point is 00:13:36 you can really lower your cost basis and increase your returns. Yeah, I think this ties in pretty well with Chapter 2 where Marks discusses his thoughts on the efficient market hypothesis. And what you said in relation to mispricings is still so difficult. I think about many of the stocks I own, those that execute and those whose earnings increase, the stock price increases with it. And those who maybe are going through some headwinds, earnings really aren't going anywhere, then the stock price really isn't going anywhere.

Starting point is 00:14:04 it can be hard to find those mispricings, but it can be obvious at times when you see earnings continuing to march upward, but the share price for whatever reason is just coming down. Those are some of the things I like to try and look for from a very basic level. So chapter two is on the efficient market hypothesis. And to some extent, the efficient market hypothesis does make sense because there's millions of investors. They all have access to instant information online and such. and many of these investors are very smart, very hardworking, which Howard dives in deep into on his book.

Starting point is 00:14:37 On the other hand, you read in the book about how Yahoo in January of 2000 was trading for $237. And then in April of 2001, just over one year later, it was trading for $11. I'll share a quote here from his book. Anyone who argues that the market was right both of those times has his or her head in the clouds. It has to have been wrong on at least one of those occasions. So with that said, how about you give us an overview of some of the lessons you learned from marks on efficient markets? So I think a lot about efficient markets because on the one end, I do not think that

Starting point is 00:15:14 the market is always efficient, as you kind of pointed out there. But if you're a value investor and you are looking for inefficiencies, you have to actually have some belief in the efficient market hypothesis. Otherwise, the gap between price and value may never close. So I would say that I guess I'm a partial believer in the efficient market hypothesis. I think it works a lot of the time because like you said, the market has many participants that if there's any arbitrage, they close it off real quick. And as people like Michael J. Mobison have shown one of the optimal ways to reduce noise

Starting point is 00:15:44 is through the consensus of a large number of people. And I think the market is really just that. It's a consensus tool that evaluates stocks in real time. But here's the thing that Marx really focuses on. The key to overperformance is holding non-consensus views. It's at the times when you disagree with the consensus that the best opportunities really lie. A simple example of this, I think, is Buffett's great investment went to Apple. Yes, I realize he's been cutting some of his Apple's sake lately, but the important part

Starting point is 00:16:11 about his Apple investment is when he bought it. He bought it at low double-digit multiple, and that was when many investors were exiting the business, and it dropped 50% or so in price when he got interested. The multiple is now over three times. what he paid for it. And Apple is a massive company that is followed by numerous analysts and is very well known by the general public. I'm sure you and I both have Apple phones or Apple devices. So this points out that the market as a whole can be wrong. And if you had the non-consensus view that Buffett did on Apple back in 2016, you would have done very well if you'd held

Starting point is 00:16:42 onto your stock. So the other important point here is that non-consensus views work just as well in markets that have gone up as in markets that have gone down. I think marks might argue that they're even more important in up markets. The reason is simple. In euphoric markets, the consensus view tends to be positive, rosy, and open to taking risks. Now, these are not the market conditions that we want to take part in. All of the largest bubbles in history have happened when the consensus thought that good conditions would last forever. For instance, John Kenneth Galbraith mentions that speculative bubbles are often associated with the very dangerous term this time is different. But if enough of the market believes the term to be true, then the condition

Starting point is 00:17:23 Consensus will drive up the prices up to just astronomical levels that you'll see in bubbles. So holding a non-consensus view during these times is actually very, very important. If the key to being a successful investor for the long-term survival, you must be able to avoid partaking in bubbles. And if you have non-consensus views on bubbles, that hopefully will help you avoid taking part of them. So Marx makes a very good point, that theory should inform our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it's possible to know more than everyone else and to regularly beat heavily populated markets.

Starting point is 00:17:59 We can buy securities for their return, but ignore their risk. So while it's okay to use theory to, I think, aid in decision making, we must also be careful not to use it as a crutch because that crutch can be kicked out from under you and cause some really, really big falls. It's also important to recognize that if we were to fully embrace theory, there really is no point in picking individual stocks because the theory does state that returns we get should track the market due to the embedded efficiencies. I already mentioned that we'll be getting to luck and risk later, but since you mentioned Apple,

Starting point is 00:18:32 I first got into stock investing when I was in college and literally had next to no idea what I was doing. And I had an iPhone at the time and I saw Apple stock going up. So I decided to buy some Apple stock. I would definitely consider that a very, very lucky decision because I would definitely consider that, a very, very lucky decision because I ended up holding on to it for a number of years. But the investment that is more difficult to bring up is an offshore oil driller that my friend told me about. And his uncle, that was a stockbroker, he had bought the stock and recommended

Starting point is 00:19:00 it to him and whatnot. I'm like, oh, it sounds like a good idea. Oil prices are low. Eventually, they'll come back. Well, that investment essentially went to zero. It ties in well to what we were saying with Chapter 1 earlier, this very first level type thinking that can really burn us. But luck also is a big part of investing, and I'm very excited to chat about that later. But sticking with the efficient market hypothesis, one of my issues with it is that I think it assumes that investors are rational and that they're all largely taking this fundamental viewpoint of each particular stock. I just don't think this is really the case.

Starting point is 00:19:35 There's plenty of technical traders. There's plenty of momentum traders that really don't care much, if at all, about the fundamentals. And there are funds out there that just purely trade on momentum. And these momentum funds may push a hot stock higher and higher, like Nvidia, for example, and the crowd starts to believe that the fundamentals are just unbelievable because the stock just keeps going up. So there's a lack of sellers, more and more buyers coming in, which helps create that inefficiency in some companies from time to time.

Starting point is 00:20:05 And I'm not one to say whether Nvidia is overvalued or undervalued. I think it's just an example that's definitely in the limelight nowadays. The other great point he makes is that when there is efficiencies, this can lead to great opportunities for the intelligent investor, but it can also lead to abysmal returns for a greedy investor. So when tech stocks only went up in 2020 and 2021, investors who really didn't know what they were doing, they were piling into these stocks. And this inefficiency led to them getting well below average returns relative to the overall market, and, you know, that makes sense. If everything's officially priced, then most investors

Starting point is 00:20:45 would be getting an average return. So some investors that take advantage of the mispricings to one direction, they tend to outperform the market. And then investors who think they're taking advantage of a mispricing can be burned because they're buying overpriced stocks. So to some extent, mispricings are creating winners and losers. So the seller of an overvalued stock is considered a winner in a mispricing. And the buyer of an undervalued stock is also considered a winner, of course. And Marx has the poker analogy that I loved and wanted to share here, I quote, in every game, there's a fish. If you've played for 45 minutes and haven't figured out who the fish is, then it's you. The same is certainly true of efficient market investing, end quote.

Starting point is 00:21:27 And admittedly, I've been the fish in the market for a number of years starting out, and who knows, I might still be a fish today. So let's move on here to the subject of risk. And risk is definitely a big part of the book and something that Marx is pretty well known for in addition to market cycles. Marks dedicates three chapters to risks, so there's understanding risk, recognizing risk, and controlling risk. He outlines three areas of risk that all investors should understand. So first is risk is bad, so trying to avoid it is smart. Second, risk and return are intimately connected. And third, any good investment requires the assessment of the risk involved with making it. So, Kyle, what were some of the key takeaways you had with regards to understanding risk

Starting point is 00:22:12 that chapter in this book? Yeah, so one of my favorite Mark's sayings on risk was concerning that second point that you made there on the relationship between risk and return. So Marks shares a risk reward graph where the slope goes up linearly to the right, showing that an increase in risk results an increase in rewards. But Marx wrote, risk your investments absolutely cannot be counted on to deliver higher returns. Why not? It's simple. If riskier investments reliably produce higher returns, they wouldn't be riskier. So how does Marks kind of consolidate all this to give a better representation of risk? He says risky investment has more to do with the probability of the distribution of returns. He outlines three

Starting point is 00:22:52 possibilities. One, higher expected returns. Two, the possibility of lower returns. And three, the possibility of losses. So this makes sense to me. My preference personally in investing is to attempt to increase the probability of making a higher, expect a return while simultaneously decreasing the possibilities of losing money. And it's not easy, and I've definitely been wrong in the past, and I know I'll probably be wrong again in the future, but I think it's a good way of looking at risk and return. One other addition I'll make here is concerning volatility. So finance theory loves discussing volatility as the primary component of risk. But Marks points out that he doesn't necessarily think that volatility is a risk that most investors actually

Starting point is 00:23:33 care about. So he discusses how he's never heard any of his colleagues say that they wouldn't buy something because it has a wide fluctuation in price or if it's going to have a single down quarter. But he does mention that his colleagues will avoid buying something because the returns maybe just aren't good enough or they'll lose too much capital making that bet. So for Marx, risk is the likelihood of losing capital. And this is exactly how all great investors kind of think about investing. It makes me think directly of Monish Pabry and his is asymmetric bets. If the bad scenario happens and you don't lose much and the good scenario happens and you make a lot, then that is what good investors would consider a good investment.

Starting point is 00:24:14 They would not be worried about the volatility of that investment if they thought the chances of permanent capital destruction are very, very low. They'll wait out market volatility or take advantage of it to decrease their cost basis. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year,

Starting point is 00:24:52 bringing together activists, technologists, journalists, investors, and builders from all over the world. many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals, dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to but end up having dinner with. Over three days, you'll experience powerful mainstage talks, hands-on workshops on freedom tech, and financial sovereignty, immersive art installations, and conversations that

Starting point is 00:25:39 continue long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Osloof Freedomforum.com with patron passes offering deep access, private events, and small group time with the speakers. The Oslo Freedom Forum isn't just a conference. It's a place where ideas meet reality and where the future is being built by people living it. If you run a business, you've probably had the same thought lately. How do we make AI useful in the real world? Because the upside is huge, but guessing your way into it is a risky move. With NetSuite by Oracle, you can put AI to work today. NetSuite is the number one AI cloud ERP,

Starting point is 00:26:25 trusted by over 43,000 businesses. It pulls your financials, inventory, commerce, HR, and CRM into one unified system. And that connected data is what makes your AI smarter. It can automate routine work, surface actionable insights, and help you cut costs while making fast AI-powered decisions with confidence. And now with the NetSuite AI connector, you can use the AI of your choice to connect directly to your real business data. This isn't some add-on, it's AI built into the system that runs your business. And whether your company does millions or even hundreds of millions, NetSuite helps you stay ahead.

Starting point is 00:27:02 If your revenues are at least in the seven figures, get their free business guide, demystifying AI at netsuite.com slash study. The guide is free to you at netsuite.com slash study. NetSuite.com slash study. When I started my own side business, it's such a few. Suddenly felt like I had to become 10 different people overnight wearing many different hats. Starting something from scratch can feel exciting, but also incredibly overwhelming and lonely. That's why having the right tools matters.

Starting point is 00:27:34 For millions of businesses, that tool is Shopify. Shopify is the commerce platform behind millions of businesses around the world and 10% of all e-commerce in the U.S. from brands just getting started to household names. It gives you everything you need in one place, from inventory, to payments to analytics. So you're not juggling a bunch of different platforms. You can build a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions

Starting point is 00:28:03 and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing... Sign up for your $1 per month, trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Turning here to how to recognize risk, Howard likes to look at risk, sort of from a market cycle point of view. And risk to him means more things can happen

Starting point is 00:28:47 than will happen. So it's important to understand when the market is expressing that risky behavior. When we can recognize risk, we can make sure that we're making investments at that proper time. So some people view this as market timing, but I really don't think it is. And the reason for that is market timers attempt to buy and sell based on where they think the market will go, as you mentioned earlier. Marks is saying recognizing risk just helps you determine when there will be more or less risk embedded in the market. And I think that recognizing recognizing risk is very, very important and also just kind of underutilized. So let's look at an example of an interaction that I had recently.

Starting point is 00:29:29 So I have a friend. He's not an investor, but he knows that I work for TIP, and he also wants to generate wealth for himself. So we were talking a little bit about stocks one time, and the conversation shifts to a subject that everyone's aware of, which is what's happening with AHA lately. And because of that, he mentions a stock that probably everyone knows that you already mentioned here, which is NVIDIA as a potential investment. So my friend is a smart guy, you know, he has a master's degree, but he doesn't spend even a fraction of the time thinking about investing compared to someone like you or me.

Starting point is 00:30:00 So the concept of risk doesn't necessarily compute as it's just, you know, not something that goes through his head. So I think what most investors see when they look at a stock is how far that stock has gone up and then they daydream about how much farther it can go up after they buy it. And here's where Marx's concept of recognizing risk just comes into play. So if we look at Dataroma for 13F news on Nvidia, there's been about 27 submissions in the last year. Nine of those are buys and 18 of them ourselves. So what I would hypothesize here is that many of these great investors who own or did own Nvidia probably recognize that the price is becoming overextended. And as a result, they're probably starting to realize that Nvidia is starting to actually

Starting point is 00:30:42 increase in risk as the price goes higher and higher. But the market has had this recent history of here bidding the price. price up more and more as more investors get interested into that business. So the key here is that not all of the investors on Dataroma are selling. Some of them are buying. So risk tolerance on even very, very good investors that are featured on Dataroma, maybe that's coming down. It's kind of hard to say. Yeah. To put it really simply, what Marks is really getting at in this chapter is that prices, when they get too steep, when prices get too high, he's just looking at the prospective returns and that's just something that really doesn't interest them when prices get elevated.

Starting point is 00:31:21 Or said another way, when prices do get really elevated, the perception of the risk present is quite low, which coincidentally makes it one of the riskiest times to invest. So in 2005 and 2006, financial experts believed that a nationwide decline in housing prices just wasn't possible. And this is what led to housing prices getting overextended, getting overvalued, and this sowed the seeds for a nationwide decline in housing prices. So we should be careful listening to anyone try to explain how times aren't as risky as they once were in the past. And to your example on Nvidia, I'd be curious to know how many investors talking about Nvidia are discussing things like the underlying value and the potential downside instead of all the upside that lies ahead and how much Jensen Wong is just a total. genius, which I'm not doubting that he is. What's also interesting is that Marx believes that risk is actually unmeasurable. So it's not like there's a formula for it. But that doesn't

Starting point is 00:32:24 mean that risk isn't important. His antidote to dealing with this is try to determine the mood of the market. So when he feels that investors are too optimistic and they're making these riskier investments, then he wants to act with more caution. And if investors are becoming overly pessimistic and they're fleeing from your typical stocks for things like blue chip value stocks, gold or treasuries, for example, then that is the time that he believes that the pendulum swung the other way and it's time to get more aggressive given that more attractive prices are available. And I almost think of any stock, it lies on like a risk and a return spectrum. So many people will say, for example, Apple's worth $300 a share or apples going to $300 a share. And my question

Starting point is 00:33:09 is, well, what rate of return are you embedding in that stock price? Each person has different expectations for what they're looking to get out of a stock. So a stock can really trade at any price. There's an expected return that's embedded in each one of those stock prices. So in theory, the lower a stock price goes, the higher your expected return. And a stock price is strongly influenced by both the fundamentals as well as the sentiment. Let's move on here to the third chapter on risk, which is controlling it. At the end of the day, as investors, this is really what we're trying to do. Marks talks a lot about his investment style and where he feels he adds the most value to his investors. He says in up markets, he's generally going to track the market, which

Starting point is 00:33:53 really doesn't require much skill in a lot of cases. But he believes that his edge as an investor or where his skill comes in is during the bear markets. Because Marks, he just thinks so much about risk throughout any point in the market cycle. And this really goes to show during the bare markets. His portfolios are generally going to go down less than the overall market. So for instance, if the market were to go down 10%, he gives the example of his portfolio only going down 5%. So in Marx's view, this is what highly skilled investors are really capable of doing. I'll throw it back over to you, Kyle, to chat about controlling risk. Yeah, I think he's obviously completely correct about the role of skill.

Starting point is 00:34:36 market. So in a recent video that he made titled How to Think About Risk, he showed five potential investor profiles. So the first one here is where the investor basically tracks the market perfectly in both up and down cycles. So in this case, the portfolio manager is adding zero value. The second one outperforms in bull markets, but underperformed in bare markets to the same degree. So again, in this case, the manager is adding zero value. Sure, they're taking risk and they're outperforming in bull markets, which is great. But when the tie turns, their high levels of risk, I end up punishing them and bringing them back down to earth and can often result in overall underperformance.

Starting point is 00:35:13 So the third example here, underperforms in bull markets and outperforms in bare markets to the same degree. So just like the previous example, this manager is once again adding zero value. So now is when things get interesting, which is when you show what skill can do to help generate value. So the fourth outperforms the market in bull markets and tracks the market in down markets. So you can see there that over a long period time, they're going to outperform. And then the fifth and final option, which is what Marks kind of compares himself to,

Starting point is 00:35:41 as you already alluded to, is where they track the market in bull markets, but they actually outperform in bare markets. So to your example there, you know, say the market goes up 10%, Mark's probably going to go up 10%, market goes down 10%. Marks is only going to go down 5%. So that's where he gets his outperformance and that's where he shows his skill. The most skillful investors are going to obviously be in that fourth and fifth bucket. So while Marks admires bucket five the most, you can obviously still succeed in bucket four.

Starting point is 00:36:08 But I think that many value investors specifically will probably be in bucket five. And it just makes a lot of sense because they're buying cheaper stocks, which hopefully have less risk. And because they're cheaper, they're less likely to be punished, I think, in bear markets. So Marks also made a really good point that awards for risk control are never given out in good times. So he says, the reason is that risk is covert, invisible. Risk, the possibility of loss, is not observable. What is observable is loss. And loss generally happens only when risk collides with negative events.

Starting point is 00:36:43 And I think this is why just so few investors think about risk. It's really easy to think about how much money you're going to make in good times. But imagining how much money we can lose during bad times is just not a very enjoyable simulation to think about. But as Marks would probably say, it's very important to try and understand how much risk you are bearing. And if you bear a lot of risk unknowingly, which investors unfortunately do all the time, they are punished for taking that risk when they least expect it. Now, the final point here on risk control I'd like to make is in regards to performance during bear markets. I think a lot of investors want to think that their investments will go up each and every year that they're in the market.

Starting point is 00:37:22 but it doesn't take very long to go back and look at other investors track records to understand that this is not how it works in real life. So there's going to be bare markets. And during these bare markets, you will 100% of the time encounter periods when your entire portfolio goes down in price, but not necessarily down in value. It's just a part of investing that you have to live with. But Marks has some very good advice on this. So long-term investment success runs through risk control,

Starting point is 00:37:52 more than aggressiveness. So I think this just goes to show you that you need to make sure that you're always focusing on what could possibly happen on the downside. And if you do that long enough, you know, you're going to survive and you'll end up with a very nice track record, hopefully. The second point here is that investors results will be a function of how many losers they have and how bad those losers are over the greatness of their winners. So this is super important because in investing we're going to be wrong a lot of the time. But if you can make it so that the times that you're wrong, you don't end up losing too much money, well, then the rest of the times when you're right, those ones are going to make up for all those losses that you potentially have.

Starting point is 00:38:31 So this just kind of goes hand in hand with position sizing, making sure that you're somewhat diversified. I mean, we're not going to go into that too much here just because that's a whole other rabbit hole. But the key point there is just make sure that if you are losing, you're hopefully not losing your entire portfolio, because that's something that's really hard to come back from. And then the final one here is that skillful risk control is the indicator of a superior investor. And so if you deem yourself to be a superior investor or you're looking at somebody else as a superior investor, you should look at how they're controlling risk.

Starting point is 00:39:06 And I think one of the most important points here is if you're looking at your own track record or if you're looking at someone else's track record, use a long time horizon, right? because if you find someone taking a lot of risk during a bull market, they're going to outperform the market. And that's just the way it is. But you have to then look at how they perform during bear markets as well. So according to Marx, if the market, say, goes down 20%, and your portfolio only goes down 10%, that's a win. And I think Buffett would also agree with that. Buffett would tell you to think of the market as kind of a yardstick. If you can go a full market cycle of both an up cycle and a down cycle and your head of the market in totality, then you are expressing some

Starting point is 00:39:44 level of skill. And comparing this yardstick analogy to Marx's examples, you can see how the fourth and fifth option would yield outperformance, while the first three would yield similar or inferior results to the market. Yeah, I think you're probably right that most value investors are in bucket five. And it's sort of an interesting thought experiment because I think value investing itself has evolved in more recent years because you just think of how for many years in the 2010s, we were in a lower interest rate environment and it was sort of a confusing time period. for a lot of investors with generally elevated asset prices and a lot of multiple expansion across many stocks. I think back to how companies like MasterCard and Microsoft, they were treating at

Starting point is 00:40:24 low double-digit PE multiples in the early 2010s. And some experts were calling for a double-dip recession. And we'll be chatting a lot about quality stocks during our next conversation on the joys of compounding. But getting quality at a good price in today's market can be pretty difficult, especially if you're looking at U.S. markets, I think. And Marks are reminds us that even the highest quality companies can be terrible investments if you're paying too high of a price. And the lower quality companies can actually turn out to be great investments if you get at a depressed valuation. And that's why understanding price is essential. So shifting gears here to market cycles actually covered Marx's other book, mastering the market cycle back

Starting point is 00:41:04 on episode 559 for those that are interested in checking out his other book. In thinking about market cycles, with how it relates to companies at least, I personally like to try and avoid avoid cyclical businesses, if I can. But I think that essentially all businesses are subject to some level of cyclicality in relation to the broader market at least. So look at March 2020, the U.S. dollar was bidding during a liquidity crisis. So you'll see pretty much every single stock in the market is going to fall during a period like that, even if the fundamentals are improving rapidly. And Marx writes here that in investing, as in life, there are very few sure things. Values can evaporate. Estimates can be wrong. Circumstances can change and quote-unquote,

Starting point is 00:41:51 sure things can fail. However, there are two concepts we can hold to with confidence. So rule number one, most things will prove to be cyclical. Rule number two, some of the greatest opportunities for gain and loss come when other people forget rule number one, end quote. So I read this and I think about how a couple of members in our mastermind community, one member did a presentation on his portfolio and he's capitalized on this trend in met coal and uranium, both of which are highly cyclical, but have shown the potential for a lot of upside if you're able to time that cycle right. So I'll give you a chance here to chat about market cycles. I find market cycles fascinating for a few reasons.

Starting point is 00:42:33 The first is that I find it so interesting how many market participants are interested just in predicting which way the market is likely to go. And the second is that I enjoy gaining insights from where we are today in the cycle, which I feel is a much more useful and practical signal. I think it's useful here to delineate what Marx is saying. So market cycles are an observation tool, not a predictive tool that any investor can use to better understand things like risk appetite.

Starting point is 00:43:00 An example that I recently thought of was just a telescope. So let's imagine that you are a general in a war 200 years ago. You're sitting on your horse, on a hill, a safe distance away from any harm. But in front of you are thousands of your men going to battle against your enemy. They march towards each other and they engage in battle. But the battlefield is large. You pull out your telescope to observe how the battle is going. You can tell that your side of the battle is winning.

Starting point is 00:43:28 And you can tell this by just simply observing, you know, maybe your side having more soldiers on the other side. Or maybe your side has more advanced technology than your opponent. Maybe you're using guns and they're using swords. Perhaps you observe that your enemy is fleeing the battlefield. So this is all obviously a really good indication that you have won this particular battle, but it doesn't give you enough information to tell you if you will win or lose the entire war. And that final distinction is what's so important.

Starting point is 00:43:55 You can observe things that will give you a picture of where things stand right now. But your predictive powers on where they are likely to go or how fast things will likely move is going to be very, very weak at best. So let's look at how Marx assesses credit cycles starting from a period of prosperity. So providers of capital thrive and they increase 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 business, that is to provide more capital. They then compete for market share by lowering the demand of returns, lowering credit standards,

Starting point is 00:44:33 providing more capital for a given transaction and easing covenants. So these are the things to look out for during bull markets, and these are areas where you might be at the top of the credit cycle, and in Marx's opinion, would not be the time that you want to deploy money. So now let's look at the other side. Let's say we're at the peak of a bull market. So once you're at the peak, the only direction you can go from there is down. So as things start to unfold, cracks begin forming.

Starting point is 00:44:59 So here's how that part of the cycle forms. So losses cause lenders to become discouraged and shy away. Risk-averseness rises and along with it, interest rates. Less capital is made available and at the trough of the cycle, only the most qualified of the borrowers if anyone has access to credit. Companies then become star for capital. Borrowers are unable to roll over their debts, which can end up leading to defaults and bankruptcies.

Starting point is 00:45:24 This process contributes to and reinforces the economic contraction. So, kind of as Clay alluded to during the great financial crisis, this second scenario is kind of what unfolded. And this is where Marks noted that this was the best possible time to deploy money. But you have to be aware that all of these bad things are happening. And kind of going back to holding non-condensis views, you have to be willing to go in and deploy money where everyone else is selling. And that takes a lot of courage. So what are some of the practical ways in which market cycles can apply to us? us as investors?

Starting point is 00:46:00 So the mixture, I think, of observing market cycles and then using that with risk is just a really powerful combination. And I think it's where the tool of market cycles is most useful. So as I previously mentioned, Marx thinks that successful investors will have fewer losses that have a lower impact on the totality of their portfolios. So if we analyze success by inverting and instead consider success through a lack of large failures, we should strive to make investments that accomplish a few key things. One, they have a low probability of bankruptcy.

Starting point is 00:46:34 So these are going to be businesses that are probably flushing cash, is generating large amounts of cash, and is unlikely to require capital injections from bank or equity markets in the future for sustaining or for growing the business. The second one here is that they should have a robust or anti-fragile business models that can hopefully survive and flourish during economic downturns. And the third one here, just to your point about pricing, is that they should not be ridiculously overpriced. So if we search for investments that meet these three criteria, we should be able to hold

Starting point is 00:47:05 them through bare markets and come out perhaps even better on the other side once that bear market shifts to a bull market. But here's where cycles, I think, come into play. If we observe where we are in the credit cycle, we can observe a few keys about business. We can see which businesses are on the edge of bankruptcy because they have no access to capital. You can do this just by simply looking at a company's balance sheet. Do they have large amounts of debt and no cash? And are they not generating cash flow? Well, then how are they going to service that debt in the future? Whereas a good investment, you might look at the balance sheet,

Starting point is 00:47:35 might have no debt, might have a ton of cash and it might be continuing to cash flow into the future. That's obviously a business where the likelihood of going into bankruptcy is going to be very, very low. So you can see here that the fundamentals of the business are all going be visible to you, you can just use the financial statements to help you make that decision, and then you can just observe what's happening in those businesses. So if we analyze the credit cycle and we see that credit markets are very risk-averse, there is a good chance that prices will also be very, very depressed. And this is why someone like Buffett deploys a lot of capital during economic downturns. If you go back to the great financial crisis, Buffett invested billions

Starting point is 00:48:14 into businesses like Goldman Sachs and Mars. And he did this because he was very aware of where the market was in its cycle. He could better identify these just significant opportunities. So instead of cowering in fear, like a lot of market participants, he ended up buying businesses that were likely to continue performing really, really well, and they were very, very cheap, which obviously reduced risk and increased prospective returns. And then he then profited, of course, from the way he structured the deals and because he was able to extend credit in just really favorable terms for Berkshire Hathaway. So in 2008, Marks wrote, the last several years, years have provided an unusually clear opportunity to witness the swing of the pendulum. And how

Starting point is 00:48:55 consistently most people do the wrong thing at the wrong time. When things are going well and prices are high, investors rush to buy forgetting all prudence. Then when there's chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so. So my big takeaway is that you can use market cycles to help you determine if it's a good time to deploy capital or maybe just hoard cash. If you're managing smaller sums of money, you may be able to always stay invested. That's how I invest. But again, you know, the credit cycle still has its usefulness.

Starting point is 00:49:30 You can use it to look at where the market is and to try to kind of figure out where your businesses are priced and that can help you determine if maybe now is a really good chance to add to a position or maybe now is just a good chance to hold on to a position and wait for better opportunities in the future. I do agree with you that understanding market cycles can really help us know when we should be more aggressive or more defensive. But I think for me personally, since I'm earlier on in my investing journey, I tend to have a pretty strong bias towards being fully invested. And I think you're fairly similar. I mentioned the 2010s and this is a period of very low interest rates,

Starting point is 00:50:07 elevated valuations. And I'm sure many people thought, you know, stocks were expensive for much of that period and they might have sat on the sidelines. And I, I would say for most people, I think this was a mistake, but this is, of course, hindsight bias at play as well. And similar to the efficient market hypothesis discussion earlier, I think that most of the time, stocks are not priced at the extremes. So price way too high or way too low. Usually there's somewhere in normal territory, whatever normal means. And in my opinion, we shouldn't wait for a correction that might not happen for, say, multiple years. And some investors to try and solve this issue, they like to use assets that are almost like a cash or a bond proxy if they aren't able to

Starting point is 00:50:54 find good opportunities within individual stocks or whatever market they're in. Some people like to use Berkshire Hathaway, for example, since it's highly defensive, it has one-fourth of its market cap and cash. Other people like things like a value ETF or an index fund or even the S&P 500 just to ensure that they are fully invested for the most part. So his memo that was titled, The Limits of Negatism, he shared a bit about his experience during the great financial crisis. And it's something you sort of see over and over again when you go through his work. So prior to the GFC, Marks, he started to use some leverage in his fund. And it was a pretty conservative amount is much less than many of the other players in the industry. And once asset prices started to collapse and

Starting point is 00:51:40 Lehman Brothers went bankrupt, all the assets that Marks owned, like anyone else, they were dropping to just unprecedented levels. So Marx needed to raise money to ensure that he wasn't going to get margin called. I'm sure he had developed some strong relationships and he knew he'd be able to get more capital from investors. And the markets really just turned into this massive liquidity event. You know, there's all these margin calls and massive sellers and no buyers in sight. And prior to the GFC, the types of bonds that Howard Marks owned, they rarely sold below 96 cents on the dollar. And after Lehman collapsed, they fell to 70 cents on the dollar.

Starting point is 00:52:21 And margin calls were just flowing in and prices continued to collapse and no buyers were in sight. And since the prices kept falling, he went out and tried to raise more and more money to try and capitalize on these just amazing opportunities, some of the best opportunities he's ever seen as an investor. So he approached a pension fund that was one of his investors, but they were worried about the possibility of loan defaults. And then Howard, of course, he's thought of this. He went on to explain that even if they saw the worst default rate in the history of high-yield

Starting point is 00:52:54 bonds, their fund would still make money just because the prices were so, so attractive. So essentially, this particular pension fund was just really scared. They were extremely pessimistic on the. economy. And Howard's insight was that when you're in this really negative environment, people are just going to assume that extremely negative things are going to continue to happen because they're just extrapolating the recent past. I think recency bias is something Z over and over again when you study these past cycles. And during panics, people spend 100% of their time making sure they're not going to lose money. And this is the exact time that you should instead be worrying

Starting point is 00:53:33 about missing out on great opportunities. So that pension fund, they ended up not investing with Howard at that point. And ironically, this is when Howard was making some of the best investments in his career because the prices were just so, so absurdly cheap. Before we move away from market cycles, I'd like to share just a really interesting table that Mark shares in the book from the chapter titled Having a Sense for Where We Stand. So the table has several prompts that you can go through and check off where you think we are in the cycle, which I think can help you. hold onto your wallet or open it up. So here are a few of the line items and characteristics

Starting point is 00:54:07 to observe. This is just a fraction of them. There's a lot. But the first one here is the economy. Is it vibrant or is it sluggish? And what's the outlook? Is it positive or is it negative? How is capital flows happening? Is it plentiful or is it scarce? What are interest rates like? Are they high or are they low? What's investor's sentiment? Is it optimistic? Are they eager to buy or are they pessimistic and uninterested in buying? And what's the recent performance of the asset. Is it strong or is it weak? So if you check these off and your checks are leading to the left, Mark says it's a good time to hold on your wallet and wait until it moves to the right. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk

Starting point is 00:54:49 and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, VANTA gives you continuous automation across more than 35 security and privacy frameworks. Companies like Ramp and Riter spend 82% less time on audits with VANTA. That's not just faster compliance, it's more time for growth. If I were running a startup or scaling a team today, this is exactly the type of platform

Starting point is 00:55:36 I'd want in place. Get started at Vanta.com slash billionaires. That's Vanta.com slash billionaires. Ever wanted to explore the world of online trading but haven't dared try? The futures market is more active now than ever before, and plus 500 futures is the perfect place to start. Plus 500 gives you access to a wide range of instruments. S&P 500, NASDAQ, Bitcoin, gas, and much more. Explore equity indices, energy, metals,

Starting point is 00:56:08 4x, crypto, and beyond. With a simple and intuitive platform, you can trade from anywhere, right from your phone. Deposit with a minimum of $100 and experience the fast, accessible futures trading you've been waiting for. See a trading opportunity, you'll be able to trade it in just two clicks once your account is open. Not sure if you're ready, not a problem. Plus 500 gives you an unlimited risk-free demo account with charts and analytic tools for you to practice on. With over 20 years of experience, Plus 500 is your gateway to the markets. Visit Plus500.com to learn more. Trading in futures involves risk of loss and is not suitable for everyone.

Starting point is 00:56:50 Not all applicants will qualify. Plus 500, it's trading with a plus. Billion dollar investors don't typically park their cash in high-eal. savings accounts. Instead, they often use one of the premier passive income strategies for institutional investors, private credit. Now, the same passive income strategy is available to investors of all sizes thanks to the Fundrise income fund, which has more than $600 million invested in a 7.97% distribution rate. With traditional savings yields falling, it's no wonder private credit has grown to be a trillion dollar asset class in the last few years.

Starting point is 00:57:30 Visit fundrise.com slash WSB to invest in the Fundrise income fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. Wonderful. So turning here to probably one of my favorite chapters, it's on appreciating the role of luck. And investing is one of those fields where you really don't know if your good results are

Starting point is 00:58:19 primarily a result of luck or primarily a result of skill. So someone who's extremely knowledgeable can achieve poor results and look like a fool, and someone who knows next to nothing about stocks can have the best results out of everybody because they got purely lucky. So I try to remove the role of luck when I'm looking at someone's track record, for example. Ideally, they have a track record of at least 10 plus years and then see how their performance is varied over different time periods if they have a long track record. For example, what worked in the 2010s might not work as well in the years that followed. And it reminds me, I've recently, interviewed Richard Lawrence from Overlook Investments, and he has a track record of 14.3% over 30 years.

Starting point is 00:59:02 He had wrote in his book titled The Model that I recently read that they outperformed when the fund was small, they outperformed when the fund was mid-sized, and they outperformed when they had a large fund. So I would say that when it came to stock selection, he had a pretty dang good process that nailed down that skill set of picking great companies at great prices and minimize the role of luck in this process. And they also really enjoyed learning more about the role of luck from Nassim Taleb's book, fooled by randomness. Taleb believes that a substantial amount of success in the field of investing is driven by luck. And it's just really difficult, if not impossible, to distinguish luck from skill when looking at anyone's track record. And another key lesson that

Starting point is 00:59:44 Teleb helped me better understand was survivorship bias. So if you have five million people enter the world of investing, it really shouldn't come as a surprise that one of them would turn out like Warren Buffett. And if millions of people are starting businesses, working like crazy, really smart people, you're bound to have an Elon Musk and a Jeff Bezos come out of that. And the danger is that these outliers can almost deceive us into thinking that what they did was easy and can be easily replicated and ignore the countless people that failed that we never even heard of. So nobody would go out and say that Buffett's success was purely luck, but it certainly played some sort of part in it. So I'll throw this over to you to share your takeaways on luck.

Starting point is 01:00:31 My first introduction into the role of luck and skill was in reading this exact book. And one of my favorite quotes was, I always say that the keys to profit are aggressiveness, timing and skill. And someone who has enough aggressiveness at the right time doesn't need much skill. So I think we've already talked a lot about the role of skill here and how over the long time periods it's required in order to consistently outperform the market. But I remember back in 2020 when I was following a number of tech stocks such as meta on Seeking Alpha. And I would get just bombarded with updates from different hedge fund letters that had tagged meta as one of the stocks that they owned. So I'd open up the letter and I'd eagerly check their performance for the

Starting point is 01:01:11 year. And I was often just blown away because the fund as a whole would be up in excess of say, 40%, sometimes even 50%. And I will admit that I definitely had some envy, but luckily, I didn't pull the trigger on many of these types of investments other than Alibaba, but that's another story. But I was lucky that the most important thing was one of the first investing books that I ever got my hands on, because I understood well that investors' returns will go through periods of over and underperformance. And the quote above really stuck in my head because I believed in the next bear market, there

Starting point is 01:01:42 was a pretty good chance that some of the funds that owned a lot of these high-flying tech stocks would massively underperform in the next bear market. Whenever that would happen, I obviously had no idea. And then, you know, fast forward to 2022. And that's basically exactly how it played out, unfortunately, with a lot of these funds. The S&P 500 decreased by 19%. And many of these same funds that I was admiring were now down, say, 30, 40 or even 50% or more. So this example does just an excellent job, I think, of showing Howard's points on risk taking. You know, you can take lots of risks and be lucky where the outcome will be outstanding, but then when the market turns, the risk you took comes to light, and the outcome to the

Starting point is 01:02:22 downside just wipes away the excessive performance that you previously had on the upside. So here's what Marks says happens during boom times. The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn't, say anything about them being the best investors. The critical takeaway is that we can't attribute high skill levels to outperformance in a bull market. Now, this applies to everyone from institutions to retail investors. While it's great to look at your performance during bull market and feel elated because of how well you're doing, emotions have to be controlled because it's during these boom times

Starting point is 01:02:58 that the potential downside risk needs to be at the forefront of people's minds. I tend to be a buy and hold investors, so I have no problem holding during bull and bear market. But I think that it's really essential to regularly monitor your portfolio to see if any of your holdings are exhibiting bubble like behavior or even less severe. You should note just if your business are getting too expensive that your body is exhibiting any signals causing, you know, pain or discomfort. If you can't sleep because you're thinking about how expensive one you're holding is, then that's a really good signal that I think you should address.

Starting point is 01:03:29 And then I just want to finish this part off. The thing about luck is that theoretically speaking, a monkey could throw a dart at a dartboard and let's say that aligns with a certain stock. Let's say it was Nvidia in 2020. That was the only stock they bought. They probably would have done really, really well. But in reality, they just got lucky. I know Nassim Taleb has this concept called a lucky fool.

Starting point is 01:03:49 And I would consider that exact scenario to be a lucky fool where you know, you're just kind of throwing a dart in the dark and you're landing on something good. And over that short time period, luck can obviously give you great rewards or you can be really unlucky and you can go to zero. But over a very, very long time period, I think that skill, will ultimately drive what your performance is. Yeah, and the more you're in the investing game, the more you realize just how short, like a one or two year time period can be.

Starting point is 01:04:18 You know, something can work extraordinarily well over one or two years, but can't it endure over the really long term is sort of what matters if you're going to hang on to it for that long. And in understanding luck, it's also important to understand alternative histories. So people tend to also just fixate on outcomes and not the randomness. that was associated with that outcome and also the alternative histories. And when I was thinking about alternative histories for the episode I did on Fooled by Randomness, I was reminded how when I was a kid, I watched the New York Giants beat the New England Patriots

Starting point is 01:04:53 and Super Bowl 42 in 2008. I don't know if you watched that game, but there was a play where David Tivry, wide receiver for the Giants, he had this, what I would call like almost a miracle catch. And shortly after they went on to win the game and he made that catch with like a minute left. So had that catch not been made, it's very possible that the Giants wouldn't have won. But people are going to be fixating on the outcome. So maybe many people would say, hey, I should have bet money on the Giants or whatnot. And when we look back at the history books, it's just going to show the Giants won. It'll show the score. It won't say how much luck was involved and there

Starting point is 01:05:28 won't be an asterisk that says that there's this miracle catch made with one minute left. Teleb has this really funny quote that I think ties in well here. So he says, such tendency to make and unmake profits based on the fate of the roulette wheel is symptomatic of our ingrained inability to cope with the complex structure of randomness prevailing in the modern world. And I think it's a good reminder that we really need to train our minds to try and think in these probabilistic terms and think about the alternative histories that may have played out or may play out in the future instead of just fixating on those outcomes that bring so much hindsight biased with it.

Starting point is 01:06:07 Yeah, those are some great points there, Clay. And that Talab quote does a really good job expressing of how much randomness there is in the world and just how bad we are at dealing with it. So Marks added some great commentary on alternative histories that I'd like to expand on here. So alternative histories are the other things that reasonably could have happened. Now, this is just a very powerful concept because when we look at the future, we are definitely aware that there is uncertainty. But that uncertainty just gets thrown out the window when we look at history.

Starting point is 01:06:36 as we have a clear picture of what happened. The point about alternative histories is that the narrative that played out was just one of many potential narratives, just like your Super Bowl example there. So even if your strategy worked well on what ended up happening in the past, how do you necessarily know how it would have played out in an alternative narrative? So this is just a very interesting thought experiment to use to help make just better decisions in the future. It plays very well as well with probabilistic thinking that you,

Starting point is 01:07:06 just brought up, which is a significant tenant, I think, for great investors such as Howard Marks and Warren Buffett. So let's use this theory to maybe explore some practical use cases. Obviously, we cannot change the past, but I think we can spend some time thinking about it and using alternative histories to create alternative narratives. We might then just observe what happened in previous markets during similar narratives, and I'm talking about things that actually happen in history, not alternative histories. even though we'll never be able to align an alternative history with what happened in reality, I still think it's just a good tool because at least we'll have some degree of knowledge

Starting point is 01:07:42 of how much risk maybe we were taking. Now, I want to talk about an excellent thought experiment that Marx writes about regarding decision making here. So what is a good decision? Let's say someone decides to build a ski resort in Miami and three months later, a freak blizzard hits South Florida dumping 12 feet of snow. In its first season, the ski turns out of the ski turns out of the ski. turns a hefty profit, does that mean building it was a good decision? No. A good decision is one that a

Starting point is 01:08:07 logical, intelligent, and informed person would have made under the circumstances as they appeared at the time before the outcome was known. So even though alternative histories can be taken to all sorts of places, like Mark says, a good decision must be based on the circumstances as they appeared before the outcome was known. That Miami example you mentioned is so similar to just some of the things you see in investing. So even if GameStop, for example, or any stock goes up 100% in a month, that doesn't mean it was a wise decision to buy it. Now, when it comes to investing, one of the most difficult parts is finding bargains instead of, let's say, value traps, let's call them. And oftentimes cheap stocks are often cheap for a reason. So you really have to sift

Starting point is 01:08:52 through and understand the situation quite well. Mark says a chapter on bargains. What does he suggest to how we can find bargains and take advantage of them? Bargain hunting, I think, is probably one of the most enjoyable and rewarding parts of value investing. Marks, of course, also has some very fantastic advice on where to find underprice assets. So it's important to remember here that Marks plays in the bond world, but his points on where to find underprice assets works perfectly well in the stock market as well. So he has a seven point checklist of where to look for underprice assets. So one, unknown and misunderstood. Maybe going over these in a little more detail. Two, be a little ugly on the surface. Three, controversial, unseemly or scary. Four, deem inappropriate

Starting point is 01:09:35 for respectable portfolios. Five, unloved. Six, owns a record of poor returns. And seven, higher selling pressure than buying pressure. He breaks it down further and makes it as simple as possible. To boil it all down to just one sentence, I'd say the necessary condition for the existence of bargains is that the perception has to be considerably worse than reality. This is a fundamental notion for finding bargains. You must search for businesses where a gap exists between perception and reality. Now, there's just a ton of example of this, so let's dig a little bit deeper. A simple example I've spoken about is Warren's initial purchase of American Express. It had just gone through being associated with this massive, enormous scandal, which was already baked into

Starting point is 01:10:17 the stock price. The market perceived that American Express would lose earnings power, but but Buffett did work to discover that this commonly held perception didn't actually align with reality. By going into businesses that accepted their payment cards, he found that users were still using their cards to pay for goods. The fact that the scandal happened didn't actually make people less likely to use their cards. And so we bought it and ended up doing very well on that investment. Now, this example ticks almost all of Marx's boxes except maybe 0.6, which is they owns a record of poor returns.

Starting point is 01:10:49 And I'm talking about that in the light of fundamentals, not stock price. This point is one where I don't necessarily disagree with marks, but it's an area where I don't necessarily go fishing for ideas. I don't mind a very short period, for instance, of poor returns. Again, fundamentally speaking, not stock price. You know, let's say a business, maybe it has a slowdown in growth or maybe it has a weak quarter. If I have a long-term holding that's maybe going through these types of headwinds, I don't have a problem with that. You know, it's part of the cyclicality of businesses. and a lot of times I'll use this as an opportunity to add to my position.

Starting point is 01:11:23 So Clay and I did an episode on Dina Polska, which was episode 587, which is a business that we both own. And the business right now, as of September 17th, is going through some pretty big headwinds. So the current headwinds are in relation to the price war that's going on between two of their biggest competitors. And this is causing margin compression. However, I personally believe that these headwinds will be short-lived, and I've taken this opportunity with the decrease in share price to actually add to my position rather than, sell out of fear or anything. So time will tell if my perception of Dino Polska is correct or not. Now, as I've matured as an investor, I realize that I am comfortable with a more concentrated portfolio. I'm increasingly interested in some of the characteristics that Marks listed above.

Starting point is 01:12:06 I think it's useful to examine all of the businesses that you have in your portfolio and observe possible weaknesses closely. If you deem these weaknesses as being short-lived in nature, you can monitor what happens in reality. And if a short-term event happens that you've literally already thought about and maybe had some idea that could happen, you can then use the weakness to add to your position at depressed prices. So here are some things to look for in each of Mark's points that I went over. So to the point about being unknown and misunderstood, I think you should look for businesses that have minimal or zero institutional ownership. These are the types of businesses that are often left for dead, even though they might actually be quality businesses or

Starting point is 01:12:44 growing earnings at astonishingly high rates. So these are frequently misunderstood for the very reason that very few institutions follow them, which makes them less discussed in investment circles. The second one here to do with being a little bit ugly on the surface. Some businesses may look ugly on the surface, but when you just really dig down into the depth of the businesses, you realize how strong the business really is. There's just so many examples of companies maybe that have certain segments that are holding the business down and making it look less attractive than it actually is in reality. And what often happens is they spin these poor segments off and the original business is better off for it. If you find these types of

Starting point is 01:13:24 investment opportunities, you can make some really good ones. The next point here is on being a business that's controversial, unseemly, or scary. This is a good quality because it means that other investors will not want to get involved. In TIP 651, I spoke with Scott Barbie about a business that he owned called Orzone. This business owned a mine in Burkina Faso, and that area has had a very, very rocky history in terms of internal country risk. But Squat invested there anyways because it was cheap and he thought the business was still undervalued. The best part about businesses that are scary is that it usually scares away money from

Starting point is 01:13:58 entering the idea. So if you hold a correct variant perception, you can be very well rewarded. The next one here about being deemed inappropriate for respectable portfolios. Many portfolio managers have to defend what they own to their partners. If something is inappropriate, they may get enough pressure from their partners that they actually have to sell it and never buy something in that similar industry again. And this has the effect of keeping businesses unloved, which has many additional benefits that I'll cover on next year. So unloved. Unloved businesses obviously tend to be very out of favor.

Starting point is 01:14:31 They're rarely discussed, and if they are, it's usually in a very negative light. This is why looking at newspapers can be beneficial if you are looking for potential bad news, not good news. Since the media likes to focus on specific stories in a very negative light, they often scare investors away rather than attract them to a specific idea. So the next one here is that it owns a record of poor returns. I spoke about this one above. The right business going through some temporary hiccup might have a decrease in their fundamentals that results in a reduction in the share price. Dino Polska was the example I gave. Now, the market loves momentum. And if a business loses momentum, sometimes market participants will sell out of that lower momentum and buy into higher momentum

Starting point is 01:15:11 stocks or other ideas. So this can result in a company where things aren't necessarily going perfectly fundamentally wise, but a quick regression to the mean towards normalization can often be an excellent catalyst for future returns. Then the last one here, which is higher selling pressure than buying pressure. It's quite simple. If there are more sellers of a stock than there are buyers, the share price goes down. That's just how market works. This point is generally a result of all the aspects above. If everyone is selling and you're the only buyer, you're likely to get a very, very cheap price. But you also have to have a contrarian view that defers from all the sellers and all the other people that are running for the doors. One good question to ask when the price of a stock

Starting point is 01:15:48 is cheap is why are people selling it to you? If you can answer those questions and deem that their reasoning is incorrect, you probably have a very fine investing opportunity. All very, very good points. And this ties in well to one of Howard's points he's mentioned on our podcast, which is that the point of investing isn't to buy good things, but from buying things well. It's not what you buy, it's what you pay. And it's just such a profound idea. I think it's also worth mentioning that the market almost always tends to offer opportunities at almost any point in time because there are just so many stocks and so many opportunities in the market. So while some markets are hot, other markets might be getting hammered. If all eyes are on U.S. large caps,

Starting point is 01:16:32 investors are probably overlooking other pockets of the market, whether that be in small caps in the U.S. or good companies in other areas of the world. So China today is an area that's quite unloved, and I think most investors don't want to touch China because it's just a tough market to get a handle on. And I'm almost certain that there's people out there that are finding bargains, such as Richard Lawrence's firm, like he's done for many years. Howard also made a great point in relation to high-yield bonds in his book and how people would make these just blanket statements, such as high-yield bonds or junk bonds, which obviously have high risk of default. So why would this possibly be appropriate for a pension fund or an endowment?

Starting point is 01:17:13 This blanket statement made no mention of the price that's offered by the market. So Marx came to the key realization early in his career that if practically nobody owns something, then demand for it over time is likely to only go up, and thus prices will increase. Additionally, if something goes from taboo to even just tolerated by investors, then it can still perform pretty dang well. So in relation to bargains, the last topic we're going to be chatting about today is patience. Buffett has often said that one advantage of being a stock market investor is that we shouldn't feel the pressure to act.

Starting point is 01:17:52 And it isn't like in baseball, of course, where you get three strikes to put the ball in play. So you could look at a thousand pitches and investing before swinging if you really wanted to. And that's really not out of the ordinary for someone like Buffett, who in the early days would be sifting through every page of the Moody's manual. I think acting too quickly is what a lot of investors do when they first get started. At least that's what I did. They hear a great story. They start to act on it.

Starting point is 01:18:18 And they don't really strongly consider any other opportunities. And I know I certainly did this because I didn't necessarily know exactly what. what I was looking for, I was just looking for a decent story that I could cling to in the market. So I liked how Marks built on the mental models in this chapter on patient opportunism. Because as investors, we get to choose when we get to swing at the ball, just like you mentioned with Buffett. And since we get to take advantage of this, our default stance should be that we are in the batters box with a bat on our shoulders, not even taking part. So as Marks points out, this is Buffett's version of patient opportunism.

Starting point is 01:18:56 We can circle this back around to understanding market cycle as well. When we build awareness of where we are in the market cycle, we can further determine the best time to step up to the plate and swing for fat pitches. Or if we recognize that we are in a high risk environment, we can just remain in the batters box waiting for the tide to turn. This concept of patient opportunism might be best expressed, I think, by Pooleck Prasad, who wrote one of my favorite investing books, what I learned about investing from Darwin. I spoke about this book on TIP, episode 597.

Starting point is 01:19:25 So, Poolock points out that 169 months passed between June 1st, 2007 and June 30th of 2021. His fund, Nalanda Capital, invested a total of $1.86 billion during this period of time. Now, to the naked eye, this seems completely normal, but it is the times of concentrated capital deployment that are most important here. So Prasad points out in his book that 46% of the total capital deployed was invested in a 26-month period. Or, using the Marx metaphor, Poulac, Prasad only took the bad off his shoulders and went to the plate to swing 15% of the time. And the dates that they did the swing were during severe market

Starting point is 01:20:01 downturns. If we look at COVID-19, he was even more active in an even shorter period. They invested nearly 22% of their capital in three months, meaning they deployed 22% of capital in only 2% of their existence at that time. So Poulac Prasad invests in very high-quality businesses, kind of similar to what Clay and I do here. So it really makes sense for him to use these market downturns to deploy the maximum amount of capital while remaining inactive for the majority of the time. I will say that Pooleck has structured his fund to take full advantage of these types of events, which doesn't require him to hold large amounts of cash in it. This is an incredibly intelligent move as it keeps his returns high and allows him to call on capital when it's needed at very short notice. Now, this isn't

Starting point is 01:20:43 a feature, unfortunately, that every investor can access, but I think it's a very exciting feature that I don't see utilized by very many other institutional investors. Now, all investors, I think, should practice this patient opportunism. But for my observations, it's one of those qualities that I think is very hard for every single investor to have or to even develop. I think there's some degree of inherent patience that some people either have or don't have. But even if you are an impatient person, which I consider myself to be, you can still express patience in crucial areas of your life. And for me, luckily, I'm able to express patience in investing. Yeah, what I learned about investing from Darwin. Such a phenomenal book. It's another one we should cover one day on the show

Starting point is 01:21:26 here again. And we alluded to this earlier, but Marks outlines in the chapter on patient opportunism that there really isn't an easy answer to dealing with overvalued markets. So we can invest in acceptable opportunities, focusing on the longer term, taking that good return instead of taking, say, a very attractive return, like what Pooleck's looking for. We can hold cash. We can look into different markets. But Howard suggests that the very last thing we should do is reach for returns. So essentially that means start overpaying for things. So I think that's all we had for today's episode covering the most important thing by Howard Marks. We'll be sure to get the book linked in the show notes in case you're interested in checking it out. And I also cover this

Starting point is 01:22:11 book on the show a couple years back. I can get that linked as well. Also, be sure to check out the episode coming out this Saturday. Kyle and I are going to be discussing the joys of compounding diving deep into the philosophy of quality investing. And then lastly, if you're interested in collaborating with many TIP audience members, portfolio managers, sharing stock ideas, and joining a community of like-minded investors, you may consider checking out our TIP Mastermind community. And I'll also get that linked in the show notes as well. So thanks so much for tuning in, and I hope to see you back here on Saturday. Kyle, thanks for joining me for today's episode. My pleasure.

Starting point is 01:22:51 Make sure to follow, we study billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP665: The Most Important Thing by Howard Marks w/ Clay Finck & Kyle Grieve

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.