The Book in Three Sentences

You can’t do the same things others do and expect to outperform. The most dependable way to outperform the market is to buy something for less than its value. It is price, not quality, that determines value: high-quality assets can be risky, and low-quality assets can be safe.

Book Summary

Experience is what you got when you didn’t get what you wanted. Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk.

Second Level Thinking

Being too far ahead of your time is indistinguishable from being wrong.

Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:

  • What is the range of likely future outcomes?
  • Which outcome do I think will occur?
  • What’s the probability I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future, and with mine?
  • Is the consensus psychology that’s incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple. Extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on. To beat the market you must hold an idiosyncratic, or nonconsensus, view.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

Understanding Market Efficiency

Efficient Market Hypothesis

There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed. Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other. Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong. Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.

Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another—or between one person’s portfolio and another’s—is attributable to differences in risk.

In fact, the author believes that assets are often valued at other-than-fair prices, and that an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes. The author tries to limit his efforts to relatively inefficient markets where hard work and skill would pay off best.

For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that “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 inefficient market investing.

  • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
  • Do you really know more about the asset than the seller does?
  • If it’s such a great proposition, why hasn’t someone else snapped it up?

Value

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope. Buy at a price below intrinsic value, and sell at a higher price. Of course, to do that, you’d better have a good idea what intrinsic value is.

Value Investing & Growth Investing: Value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

  • Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply. Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.
  • Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

The Relationship Between Price & Value

Investment success doesn’t come from “buying good things,” but rather from “buying things well.” No asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.

“Well bought is half sold.” By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves. If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

  • Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.
  • An investment approach based on solid value is the most dependable. In contrast, counting on others to give you a profit regardless of value—relying on a bubble—is probably the least.

Understanding Risk

“Risk means more things can happen than will happen.” — Elroy Dimson

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

  • Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do. “There’s a big difference between probability and outcome. Probable things fail to happen — and improbable things happen — all the time.” That’s one of the most important things you can know about investment risk.
  • When you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks. Riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!
  • Loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment. Negative events often can be more negative than we imagine.
  • Risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset—a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town—can make for a very successful investment if bought at a low-enough price. High risk, in other words, comes primarily with high prices. The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high.
  • Most investors think quality, as opposed to price, is the determinant of whether something’s risky. High-quality assets can be risky, and low-quality assets can be safe. Quite often “high-quality” companies sell for high prices, making them poor investments.

Recognizing Risk

“My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.” — Myron Scholes

  • Investors shouldn’t plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so, and risk compensation will disappear.
  • Risk cannot be eliminated; it just gets transferred and spread.
  • When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

Controlling Risk

Great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little — unless you can do it for many years, in which case that perceived “high risk” either wasn’t really high or was exceptionally well managed.

  • Risk control is invisible in good times but still essential, since good times can so easily turn into bad times. Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.
  • Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

Being Attentive to Cycles

“What the wise man does in the beginning, the fool does in the end.”

  • I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.
  • In the world of investing, nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens.
    • 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. Stocks are cheapest when everything looks grim. When the market is on its backside and everyone else is selling things at giveaway prices — that’s the time to buy.
  • The most dependable cycle is the “credit cycle” (borrowing and lending).
  • Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction. Bubbles are capable of arising on their own and need not be preceded by crashes, whereas crashes are invariably preceded by bubbles.

Awareness of the Pendulum

Investment markets follow a pendulum-like swing — between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.

  • The main risks in investing are two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.
  • The three stages of a bull market
    • The first, when a few forward-looking people begin to believe things will get better
    • The second, when most investors realize improvement is actually taking place
    • The third, when everyone concludes things will get better forever
  • The three stages of a bear market
    • The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
    • The second, when most investors recognize things are deteriorating
    • The third, when everyone’s convinced things can only get worse
  • The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever (although when it’s positioned at its greatest extreme, people increasingly describe that as having become a permanent condition).

Combating Negative Influences

  • To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.
  • People who might be perfectly happy with their lot in isolation become miserable when they see others do better. High returns can be unsatisfying if others do better, while low returns are often enough if others do worse.

Contrarianism

  • Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.
  • The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.

Finding Bargains

“Investment is the discipline of relative selection.”

  • First, the process of investing has to be rigorous and disciplined. Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there. Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.
  • The raw materials for the process consist of:
    • A list of potential investments
    • Estimates of their intrinsic value
    • A sense for how their prices compare with their intrinsic value
    • An understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled
  • I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

Patient Opportunism

  • There aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism — waiting for bargains — is often your best strategy.
  • You’ll do better if you wait for investments to come to you rather than go chasing after them. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low. You want to take risk when others are fleeing from it, not when they’re competing with you to do so.
  • Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.
  • You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns—and give back your profits in the process. If it’s not there, hoping won’t make it so.
  • Missing a profitable opportunity is of less significance than investing in a loser.
  • The key during a crisis is to be:
    • Insulated from the forces that require selling, and
    • Positioned to be a buyer instead.
  • To satisfy those criteria, an investor needs the following things:
    • Staunch reliance on value
    • Little or no use of leverage
    • Long-term capital
    • A strong stomach
  • Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

Knowing What You Don’t Know

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.” — Amos Tversky

  • Overestimating what you’re capable of knowing or doing can be extremely dangerous — in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know — and working within those limits rather than venturing beyond — can give you a great advantage.
  • The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage.
  • Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead.

Having a Sense for Where We Stand

Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions? When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive. So look around, and ask yourself: Are investors optimistic or pessimistic?

The seven scariest words in the world for the thoughtful investor — too much money chasing too few deals — provided an unusually apt description of market conditions.

Appreciating the Role of Luck

  • The truth is, much in investing is ruled by luck. This is why it is all-important to look not at investors’ track records but at what they are doing to achieve those records. Does it make sense? Does it appear replicable? Why haven’t competitive forces priced away any apparent market inefficiencies that enabled this investment success?
  • One year with a great return can overstate the manager’s skill and obscure the risk he or she took. Yet people are surprised when that great year is followed by a terrible year. Investors invariably lose track of the fact that both short-term gains and short-term losses can be impostors, and of the importance of digging deep to understand what underlies them.
  • The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.

Investing Defensively

“An investor needs do very few things right as long as he avoids big mistakes.” — Warren Buffett

  • Professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that an opponent can’t return. But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost.
  • Defensive investing actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.
  • Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events.
  • Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.
  • Many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often — not because they don’t have enough winners, but because they have too many losers.
  • Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.

Avoiding Pitfalls

  • A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.
  • Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads — in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns.
  • One way to improve investment results — which we try hard to apply at Oaktree — is to think about what “today’s mistake” might be and try to avoid it.
  • When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

Adding Value

Two important terms from investment theory:

  • Beta (β): a measure of a portfolio’s relative sensitivity to market movements.
    • A portfolio with a β above 1 is expected to be more volatile than the reference market, and a β below 1 means it’ll be less volatile.
    • Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve, omitting nonsystematic sources of risk. If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).
  • Alpha (α): Personal investment skill, or the ability to generate performance that is unrelated to movement of the market.

According to theory, then, the formula for explaining portfolio performance is y = α + βx, where x is the return of the market. The market-related return of the portfolio is equal to its beta times the market return, and alpha (skill-related return) is added to arrive at the total return (of course, theory says there’s no such thing as alpha).