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From Chapter 4, "The Relationship Between Price and Value"
By Howard Marks,
Author of The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor

Consider the possible routes to investment profit:

  • Benefiting from a rise in the asset's intrinsic value. The problem is that increases in value are hard to predict accurately. Further, the conventional view of the potential for increase is usually baked into the asset's price, meaning that unless your view is different from the consensus and superior, it's likely you're already paying for the potential improvement.
In certain areas of investing -- most notably private equity (the buying of companies) and real estate -- "control investors" can strive to create increases in value through active management of the asset. This is worth doing, but it's time-consuming and uncertain and requires considerable expeartise. And it can be hard to bring about improvement, for example, in an already good company.
  • Applying leverage. Here the problem is that using leverage -- buying with borrowed money -- doesn't make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.And it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are depressed. Over the years leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.

Paul Johnson: This is one of the most important comments in chapter 4. This is a lesson that all young investors fail to learn at their own peril.

  • Selling for more than your asset's worth. Everyone hopes a buyer will come along who's willing to overpay for what they have for sale. But certainly the hoped-for arrival of this sucker can't be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.
  • Buying something for less than its value. In my opinion, this is what it's all about -- the most dependable way to make money. Buying at a discount from intrinsic value and having the asset's price move toward its value doesn't require serendipity; it just requires that market participants wake up to reality. When the market's functioning properly, value exerts a magnetic pull on price.

Joel Greenblatt: Eventually, the market does operate and get it "right." Read Marks's statement again; it is an incredibly useful image.

Paul Johnson: Here, Marks articulates the simple beauty behind value investing. Buying at the right price is the hard part of the exercise. Once done correctly, time and other market participants take care of the rest.

Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn't sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, "The market can remain irrational longer than you can remain solvent."

Howard Marks: Fear of looking wrong: It comes as quite a shock to many new investors how long it can take for even correct judgments to work out. One of the most important roles of your strong view of intrinsic value is as a foundation for conviction: to help you hang in until the market comes to agree with you and prices the asset where it should.

Trying to buy below value isn't infallible, but it's the best chance we have.

Excerpted from, The Most Important Thing Illuminated by Howard Marks. Copyright (c) 2012 Howard Marks. Used by arrangement with Columbia University Press.

© 2012 Howard Marks, author of The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor

Author Bio
Howard Marks,
author of The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor, is chairman and cofounder of Oaktree Capital Management, a Los Angeles-based investment firm with $80 billion under management. He holds a Bachelor's Degree in finance from the Wharton School and an MBA in accounting and marketing from the University of Chicago. He is the author of The Most Important Thing: Uncommon Sense for the Thoughtful Investor, published by Columbia Business School Publishing.

For more information please visit http://www.cup.columbia.edu/static/miti and http://cup.columbia.edu