An excellent company can be a disappointing investment. Its business may grow while its share price falls, because investors originally paid for even more success. Howard Marks separates what an asset is from what it costs. A genuine bargain sits below a defensible estimate of its worth, with risks the buyer understands and can bear. Finding one also requires an explanation of why other informed investors have left it available.
Competition makes that difficult. Intelligent investors study the same information, buy apparent bargains and sell assets that look expensive. Their trades remove obvious discrepancies. But a price can quickly incorporate the crowd's interpretation without making that interpretation correct. Marks takes market efficiency seriously as an obstacle to finding bargains, while leaving room for mistakes. The burden falls on the prospective buyer to explain what the seller, or another buyer, has missed.
Hard work is insufficient when competitors also work hard. An advantage needs better information or a better interpretation of shared facts. Detailed research into a company or security offers more plausible scope for that advantage than confidently predicting the entire economy. Simply choosing different stocks from an index changes the risks you take; it promises no extra reward for those risks.
Marks calls the deeper comparison second level thinking. Saying a company's earnings will grow is a beginning. What growth do other investors expect, and how much does today's price already assume? Consider several possible outcomes, their likelihoods and what each would mean at the purchase price. Even falling earnings can accompany a good investment if the market expected something worse. Disagreement helps only when the overlooked quality proves real or wins recognition. Being unconventional can produce unusually bad results too.
The reference point is intrinsic value, an estimate of economic worth. Assets, brands, management and prospects matter chiefly through their capacity to generate earnings and cash flow. Expected growth belongs in that estimate, so growth and value investing overlap. The farther into the future the hoped for success lies, the harder the forecast becomes. Predicting growth correctly offers little advantage if the buyer has already paid for it.
Marks encountered the danger early. In nineteen sixty eight, as a summer employee at First National City Bank, he saw an approach built around the Nifty Fifty, admired companies with exceptionally promising earnings growth. The belief was that sufficiently good businesses would grow into almost any price. Their reputations seemed to make valuation less urgent.
In Marks's account, many favorites reached prices of eighty or ninety times annual earnings. That means paying eighty or ninety dollars for each dollar the company earned. When market conditions deteriorated in the early seventies, those multiples fell to eight or nine, producing losses of roughly ninety percent in affected stocks. Their productive capacity did not have to fall by nine tenths. Investors had paid a price that left them exposed to a drastic change in what others would pay for the same earnings.
Christopher Davis adds a consequential qualification in this edition's commentary. The portfolio bought in nineteen sixty eight eventually beat the market by the time he wrote, but recovery took decades and depended on Philip Morris's exceptional performance. A rare business can compound for long enough to overcome an expensive purchase. That possibility does not remove the cost of waiting or make every admired company a survivor. Marks also describes how technological change later damaged Kodak and Polaroid. Shares can benefit from decades of expanding business value; a bond's promised payments offer no comparable unlimited upside.
Marks encountered the opposite error when he began managing high yield bonds in nineteen seventy eight. These were debts issued by companies with lower credit ratings, reflecting a greater danger of failing to repay. Many institutions were barred from owning them, while trustees feared the embarrassment of knowingly buying a borrower that failed. A whole category could be rejected without asking what price would compensate for its weaknesses. Admired businesses had been accepted almost regardless of price; troubled borrowers were rejected the same way.
Such constraints can keep a discrepancy from being corrected. Neglect and stigma deserve investigation when they make perceptions worse than reality. An unpopular asset can still deserve its low price, and some risks remain beyond a buyer's expertise or tolerance. Seth Klarman, another commentator, warns that reassuring ratings cannot replace independent research. As acceptance and attention change, competition can also change; once buyers recognize a bargain, their purchases can bid away the discount.
Cheapness therefore needs an independent foundation. Comparing today's quote with yesterday's, or one market price with another, does not establish value. Continuing business losses can consume the assets behind an apparent discount. Obsolescence can destroy the earning power. These are reasons to revisit the estimate, rather than defend it merely because the original purchase looked inexpensive.
When the estimate is sound, buying below value offers a way to profit as price approaches worth, without requiring the next buyer to overpay. Even then, the gap may persist. The valuation may be wrong, value may decline, sentiment may worsen, or recognition may take longer than the investor can wait. A market capable of mistakes also lets buyers overpay. Finding a genuine bargain means supporting both the estimate of worth and the explanation for its discount, while leaving room for what that analysis may have missed.