We’ve been fortunate to have had numerous opportunities to learn from Howard Marks over the years, both in exclusive interviews with The Manual of Ideas and in keynote Q&A sessions at MOI Global Online Conferences.

Howard also shares his wisdom periodically in his memos, which reveal timeless insights while relating them to the realities of the market environment. The memos should be a key component of any value investing curriculum. Howard is also author of the instant classic, The Most Important Thing as well as Mastering the Market Cycle.

We are grateful to have further opportunities to learn from Howard when highly praised author William Green interviewed him at Latticework 2016 and when value investor Ethan Berg interviewed him at Latticework 2018.

Howard Marks has been one of the most generous value superinvestors in terms of sharing his knowledge and experience with the value investing community. In this regard, he has paralleled great investors like Benjamin Graham (book, lectures), Warren Buffett (book, letters), and Joel Greenblatt (book).

It may be worth noting that the willingness to share wisdom, which Howard Marks, Warren Buffett, Charlie Munger, Mohnish Pabrai, Guy Spier, and others have shown, is not automatic. It takes time and effort as well as an altruistic view of the world, in which every investor has the potential to learn and improve. Better capital allocation ultimately benefits all of us because it channels capital more efficiently toward its most productive uses.

We had the distinct pleasure of sitting down with Howard several years ago to discuss his book, The Most Important Thing.

Howard has honed his investment approach primarily in areas of the market other than public equities. Yet, his insights apply very much to those of us who focus on public equity investing. As a distressed debt investor, convertible debt investor, high-grade debt investor, and control investor, Howard has developed unique insights into investing across the capital structure. Debt investors, especially distressed debt investors often develop a more acute sense of the financial risks of a company than do equity-only investors. In this context, Howard shares an invaluable perspective in the interview we conducted with him in London in 2013.

Howard was extremely generous in letting us pick his brain on the concepts discussed in The Most Important Thing. We spent almost an hour going through the key concepts in the book and soliciting more color on them. As always, Howard was articulate and insightful, revealing many nuggets that complemented the wisdom in the book. In the following videos, we show some of the highlights of the conversation, although the entire hour could be considered a highlight.

Howard Marks on the Most Dangerous Thing to Neglect

I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it.

The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years. That is one of the reasons why we have to think of great investing in terms of a long time span. Short-term performance is an imposter. The investment business is full of people who got famous for being right once in a row. If you read Fooled by Randomness by [Nassim] Taleb, you understand that being right once proves nothing. You can be right once through nothing but luck.

The law of large numbers says that if you have more results, you tend to drive out random error. The sample mean tends to converge with the universe mean. In other words, the apparent reality tends to converge with the real underlying reality. The great investors are the people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it.

Howard Marks on the Twin Pitfalls of Overconfidence and Lack of Ego

It is not an algorithm. It is a mindset. I think that we always try to stress the danger of overconfidence. I forget if I put it in the book, but it is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind. The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off of yourself and others.

On the other hand, it is really not a good business for people who don’t have some ego because you have to do the things that Dave Swensen describes as lonely and uncomfortable. I think it was [Jean-Marie] Eveillard who said it was warmer in the crowd, in the herd. But if you only hold popular positions, you can’t do better than average, by definition. And I think you will be very wrong at the extremes.

You have to be strong enough in ego to hold difficult unusual positions and stay with them. As I say in the book, you have to have a view that is different from the consensus, and you have to be willing to stay with it, and you have to be right. If you have a non-consensus position and you stay with it and you are wrong, that is how you lose the most money.

I keep going back to what Charlie Munger said to me, which is none of this is easy, and anybody who thinks it is easy is stupid. It is just not easy. There are many layers to this, and you just have to think well. I can’t tell you how to think well. Some people get it, some people don’t.

Howard Marks on Why All Investors Should Be Aware of the “Temperature of the Market”

There is no secret method for any of this stuff. You just have to be aware of concepts, smart in their application, and it helps to be an old man so that you have the experience that helps, or an old woman…

If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

If you buy a cheap stock when the market is high, it is a challenge because, if the market being high is followed by a general decline in prices, then for you to make money in your cheap stock, you have to swim against the tide. If you buy when the market is low, and that lowness is going to be corrected by a general inflation, and you buy your cheap stock, then you have the tailwind in your favor.

I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.

Howard Marks on Adjusting Your Level of Aggressiveness Based on the Environment

If you have flexibility in where you invest, it stands to reason that you should be able to make adjustments that enable you to reach your goals. This goes back to what we said before. You said some value investors are willing to ignore the macro. They say if stocks are selling for one-third less than intrinsic value, I am going to buy it. But the question is, do you want to be equally aggressive all of the time, or do you want to play offense some times and defense at others?

I would argue that you should adjust your activities based on the climate of the market. So, that is what we do. Sometimes in a distressed debt portfolio, we want to be at the very top of the capital structure. That may be because that is where the best bargains are, it may be because the macro environment is threatened and we don’t want to live with macro uncertainty. At other times when these things are cheaper and when the environment seems less treacherous, maybe we’ll drop down into the second level on the balance sheet or maybe the third. Historically, we don’t go to the bottom of the stack very often, but I think these adjustments are worth making.

It is a great dilemma because, on the one hand you want to stick to your circle of competence. On the other hand, it is probably a mistake to say, “I do this. I don’t do that.” Because, at the same time that you want to capitalize on your expertise, you want to be flexible enough to pursue the bargains where they are, and you don’t want to be so dogmatic that you say, “I only do this,” which implies, I do it whether it’s cheap or not. So this is one of the great dilemmas.

You asked earlier where inefficiencies come from. Largely they come from people who say, “I do this, and I don’t do that.” What they are basically saying is, “I don’t do that regardless of how cheap it is.” Well, that is silly because then you just leave bargains for others. If you say, “I do this, but I don’t do that regardless of how cheap it is,” you are basically saying, “I do this regardless of how expensive it is.” That doesn’t make much sense either. This is why I think you have to be realistic. You have to be sensitive to conditions in your world, and you should adjust your tactics — offense and defense — based on conditions in your environment.

Howard Marks on Oaktree’s Circle of Competence in Distress-for-Control Investing

When I was talking about circles of competence, I think one of the elements on our side is that we have been doing it for a long time. We have a lot of experience in the things I have been discussing, and I think experience is very important. You have to learn the hard lessons. One thing I mentioned in one of my memos is that the human mind is very good at blotting out bad memories. Unfortunately, most important learning is from bad memories. We have enough institutional memory to retain the lessons of the past.

We organized our first distressed fund in 1988 and then branched out into our first distressed-for-control fund in 1994. We figured that we could identify cases — we spun that fund out because we had done it in the past — we invested in big chunks of the debt of smaller companies so that when the debt was exchanged for equity we ended up as the controlling shareholder.

The question is, number one, is this a company that you would like to control? And number two, is this a company where the creditors will get control? And then number three, which creditors? Because usually there is something called the fulcrum security, which is the first impaired class. The unimpaired will get their money. The first impaired class may get the company, and the lower impaired classes may get nothing. So it is the fulcrum, the one in the middle there, we try to identify that. We try to figure out if it will get control and how much it will have to pay for control. If it gets control at that price, will that be a successful investment? It is a very interesting area — of course, more moving parts to go wrong. The investments are by definition less liquid. I would say it’s the difference between dating and getting married. When you are a distressed debt investor, you are dating; but when you try for distressed-for-control, you get married. You have to live with the consequences, for better or for worse, richer or poorer. But, it can produce some good outcomes.

Howard Marks on How to Apply “Second-Level Thinking” to the European Crisis

…anything which has gone down in price a lot is potentially a source of opportunity. But the question is, has it declined sufficiently relative to reality? If a stock was efficiently, fairly priced five years ago at X. Today the stock is down half, but in some sense reality is also down half — then the stock is only fairly priced, lower in price but not cheaper.

What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically? The answer is, how do you know? Go back to second-level thinking. Are you capable of thinking different and better about the fate of Europe? I don’t think so. I don’t think I can. I don’t think anybody really has a good handle on what is going to happen in Europe. So then, how can gaming the Europe situation give you an edge?

If you don’t have control over something, superior insight — I don’t see control in the sense of being able to make it work — if you don’t have superior insight, then how can something be to your advantage? One of the tenets of our philosophy — you named number one, which is risk control — number five is, we don’t bet on macro forecasts. It is very hard to consistently be above average in correctness with regard to the macro.

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The following transcript has been edited for space and clarity.

MOI Global: You have published a book with the title The Most Important Thing, which has received praise from Warren Buffett and, and according to Joel Greenblatt, is destined to become an investment classic. Before we get into discussing some of the concepts in the book, tell us, what was your motivation for writing the book in the first place?

Howard Marks: I have been writing memos to my clients for 22 years. I started in 1990, and I frankly can’t remember what the initial motivation was; it was too long ago. I also can’t remember what kept me going for the first ten years, because the first ten years I wrote these memos and I never had a response. I never had one response in ten years. So, as I say, I can’t remember what kept me going, but something did.

Then, on the first day of 2000, I wrote one called “bubble.com,” which talked about tech being a bubble and turned out to be right soon thereafter. So, as I say, after ten years, I became an overnight success. I have been publishing the memos continuously ever since. I always thought that when I retired I would pull it together into a book. My retirement is some years off, but then I got a letter from Warren Buffett a couple of years ago, and he said “If you will write a book, I will give you a blurb for the jacket.” That was the deciding factor, so I wrote it. I was also approached by Columbia about doing it, and those two factors convinced me to write it in 2010, and then it was published in 2011.

MOI: You start the first chapter with a rather inauspicious but profoundly true statement that few people have what it takes to be great investors. You go on to introduce the concept of second-level thinking. Help us understand, what is that and how can it help us as investors.

Marks: The interesting thing about investing is what I call the perversity. The point is that it is so not intuitive. It is so not obvious — investing. A great example lies in the fact that, people think that to be a good investor, you have to understand companies. But the market has an understanding of companies, and if you understand the company the same as the market does, even if the market and you are right, you are not going to make any special profits.

The success, which is doing better than the market in a risk-return sense, comes from understanding things better than the market. Most people don’t understand things better than the market, and most people don’t understand the need for understanding things better than the market. As I say in that chapter, not only do I not want to try to simplify the process of investing, I want to show how not simple it is. Too many people try to simplify it.

I mentioned in that chapter the guy on the radio who says, “Well, you go into a store and you buy a product and if you like it, buy the stock.” That is so wrong, because liking the product has either nothing to do with making a good investment or it is just very, very first step of many steps. So you really do have to think, as I say in that chapter, either I mean or probably both better than the average better and at a higher level.

MOI: So how can we actually improve our chances of thinking different from the consensus while also being right? What is the impact of nature versus nurture, if you will?

Marks: You have to understand that, first of all, the consensus has an opinion, and you have to understand that the consensus is not a moron. So, much of the time the consensus is about right.

If to do better than the consensus you have to think differently than the consensus, it means you have to find the times when the consensus is wrong. It doesn’t mean that the consensus is always wrong and just thinking differently is the key to success. You have to find the time when the consensus is wrong, and then you have to think differently, but not just differently, differently and better, because you could think differently and worse. It is not just holding a non-consensus opinion. That is not the secret. It is having a correct non-consensus opinion when the consensus is wrong, which is not all the time.

I mentioned in the book when my son comes to me, who is a budding hedge fund investor, he gives me an idea, a stock, macro trend, or something like that, the first question I always ask is the same: Who doesn’t know that? That is really the question. When you think you know something, the question is whether the market knows it too. And if it does, then your idea has no relative superiority.

MOI: In the investment industry, where lucrative careers can be build just based upon consensus thinking, what types of work environments are conducive to develop ones second-level thinking abilities? How do you ensure that you have such an environment at Oaktree?

Marks: I think that the people there have to be deep and stimulated and stimulating and interested in discussing. I try very hard to create an environment where one person’s success doesn’t have to come at the expense of another. In fact, everybody collectively can be more successful than they would have been separately. I think these things are important. You have to start with smart people who are also wise or introspective. For example, I don’t get the concept of trading to make money. So I like to surround myself with other people who don’t get the idea of trading to make money. By the way, there are probably some people out there who trade to make money. I don’t say my way is the only way, but it is the way for us.

MOI: You have applied second-level thinking to great success in inefficient markets, which have been a focus for Oaktree. What types of mispricings are your favorite hunting grounds, and have they changed over time?

Marks: Thirty-four years ago when I started Citibank’s high-yield bond fund, it was easier because the investing world was much more narrow-minded at the time. Many, for example pension funds or endowments, had a rule: We won’t invest in any bonds that are rated below investment grade, below BBB.

Almost on the surface, if everybody says “We won’t do that,” then that is probably going to be cheap. The world has changed in this time since, and now most people will do anything to make money. Of course, the world has filled up with hedge funds whose job is to do everything. So it hasn’t gotten easier and arguably it has gotten harder, but, on the other hand, not necessarily because I think our margin of superiority versus the higher-yield bond averages has remained about the same.

We think the ability to make money in the distressed debt business still exists. I think there is this process that I call “efficientization” that in theory should happen and hasn’t really happened as fast as I thought it would, and I think it is all down to the foibles of people. Many are — people individually and markets — are ruled by emotion, and as long as emotion takes over, then efficiency will not be realized.

MOI: With a trend toward compression of time horizons in the investment industry, do you see a growing inefficiency in the pricing of longer-duration securities or securities that may lack a so-called catalyst?

Marks: It makes sense. When everybody thinks one way, then there should be a reward for thinking the other way. When I started off as an investor forty-three years ago, we used to think about holding things for five years or ten years, and now five months would be a long time, and maybe it is five days or five weeks.

On the one hand, there should be a return for thinking longer. On the other hand, a lot of people say that the long term is just a series of short terms. I would say that is one of the things working on the side of the patient investor, is the fact that he has a longer time frame. On the other hand, we don’t explicitly — there is a new phrase — time arbitrage. We don’t explicitly pursue time arbitrage, but we have patient capital, and we are patient people. In our distressed debt funds, for example, the money is locked up for ten or eleven years. So we can be patient. Again, if you are the only person in the world who is open to making Investment X, then maybe it will be available to you cheaply. Having patient capital is a great advantage.

MOI: You state that an accurate estimate of intrinsic value is the indispensable starting point for investing to be reliably successful, but for you that is not enough. One needs to hold the view strongly enough to be able to hang in and buy even as a price decline suggests that you were wrong. How do you build such confidence in an uncertain world, and how do you walk this fine line between confidence and the overconfidence? Do you have any mental models or any check lists that are helping you and Oaktree in navigating this?

Marks: I really think the things in the book have been our models for the last seventeen years since we started the company and longer when we were working together before starting the company. It is not an algorithm. It is a mindset. I think that we always try to stress the danger of overconfidence. I forget if I put it in the book, but it is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind. The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off of yourself and others.

On the other hand, it is really not a good business for people who don’t have some ego because you have to do the things that Dave Swensen describes as lonely and uncomfortable. I think it was [Jean-Marie] Eveillard who said it was warmer in the crowd, in the herd. But if you only hold popular positions, you can’t do better than average, by definition. And I think you will be very wrong at the extremes.

You have to be strong enough in ego to hold difficult unusual positions and stay with them. As I say in the book, you have to have a view that is different from the consensus, and you have to be willing to stay with it, and you have to be right. If you have a non-consensus position and you stay with it and you are wrong, that is how you lose the most money.

I keep going back to what Charlie Munger said to me, which is none of this is easy, and anybody who thinks it is easy is stupid. It is just not easy. There are many layers to this, and you just have to think well. I can’t tell you how to think well. Some people get it, some people don’t.

MOI: You devote three chapters of the book to the concept of risk — how to understand it, recognize it, and how to manage risk. You take particular issue with the traditional risk-return graph, which you say communicates the positive connection between risk and return but fails to suggest the uncertainty involved. Tell us how your interpretation of the risk-return relationship helps you avoid the losers to achieve better performance?

Marks: First of all, as you know from reading the book, we define risk primarily as losing money, the potential for losing money. We don’t want to lose money. Our clients don’t want us to lose their money. They don’t mind if we experience volatility — we have patient capital which permits us to live through volatility. In the end, they don’t want to lose money.

Number one, we don’t empathize with the view that risk is variability and that variability is the thing to be avoided per se. Every once in a while, especially in good times, I hear people say the way to make more money is to take more risk — and that is ridiculous, in my opinion. Taking more risk should not be one’s goal. One’s goal should be to make smart investments even if they involve risk, but not because they involve risk. That is a very important distinction.

The figure I draw in the book — called 5.2 — shows that what risk means is a greater range of outcomes, some of which are negative. You have to bear in mind, when you make investments, the presence of the potential of negative outcomes. You have to only make investments where you are rewarded for taking that risk and where you can withstand the risk. That requires diversification, patient capital, and eventually being right in your ideas.

MOI: There is another profoundly insightful chart on page two of the book, which shows how the risk-return graph is affected by historically low interest rates in the U.S. With thirty-year Treasuries priced to yield 3%, what investment implications do you draw from this?

Marks: It is very difficult. When thirty-year treasuries yield 3%, that kind of sets the bar for everything else. Everything else trades off of that, which means not at very high returns. That means we are in a low-return environment. One of the things I believe is we must understand the environment we are in, understand the ramifications — and accept it in the sense of accept the reality.

One of the hardest things is to make high returns in a low-return world. If you insist on doing so, you can get into trouble. If you say, “Well, Treasuries used to be 6% and high yield bonds traded at 500 [basis points] over, so I made 11% with ease on the average high-yield bond. So even though Treasuries are now 3%, or 2% on the ten-year, I still want 11%, and I am going to get my 11%.” Then you end up making investments that may appear poised to pay 11%, but because you now need 900 [basis points] over [Treasuries], you may take greater risks than you used to take to get the same return. So just insisting on making the same return that you used to make can be very dangerous.

Peter Bernstein once wrote brilliantly, or maybe he passed on a quote from Elroy Dimson, who said that the market is not an accommodating machine. It will not give you high returns just because you need them. You have to realize that. If you say, “I used to get 11% and I still need 11%, so I am going to take more risk,” you can do that. But the key is to recognize that you have to take more risk to do it, and to make a conscious decision that you are going to do it. Blindly accepting more risk to get the return you used to get in a high-return world can be a big mistake.

MOI: In this context, how worried are you about the potential risk of inflation as a result of this low-interest rate environment in the U.S. and the actions of the Federal Reserve? How do you ensure that you still keep up with the purchasing power ability for your capital?

Marks: It is very difficult. A lot of our investing is in fixed income. Fixed income, by definition, doesn’t adjust to inflation. If we buy 8% bonds today with inflation at 3%, and inflation goes to 6%, we still have that 8% bond, [but] our real rate return has gone down. Period. There is no adjustability in fixed income…

I am personally not worried about a return to hyperinflation. Inflation is modest and could go higher. Everybody would like to see it go higher because usually higher inflation is associated with prosperity. I would like to see that. Governments around the world would like to see it so they can pay their debts with low-value currency. I don’t think we are going to have hyperinflation.

I always get in trouble with I stray into the macro, and I am far from an economist. But, where does inflation come from? Demand pull comes from too much money chasing too few goods. I don’t think we have that or will anytime soon. The cost push comes from an escalation of the cost of the factors of production. For the most part, I don’t see that unless the Chinese crowd us all out in terms of buying currencies. Most of the possible sources of inflation I think would come from international considerations like that — like the guy that works in China for $0.60 a day demanding $1.20 a day. It could happen, but I don’t think it is going to be pervasive enough to pitch us into hyperinflation.

MOI: Risk control is Oaktree’s first tenet in its investment philosophy. I hear you make an important distinction between risk control and risk avoidance. Help us understand this distinction, perhaps, by way of an example.

Marks: The greatest example is this: If you went to the horse races, would you always bet on the favorite? The favorite, assuming the crowd is intelligent, which usually it is, is the horse with the highest probability of winning. That doesn’t mean that the favorite is always the best bet. You might have another horse that has a lower probability of winning but the odds are so much higher, that’s the smart bet — leaving alone anything specific that you know about the horses.

The point is, this is second level [thinking] again. First level says, “Native Dancer is going to win the race. It has always won. So we should bet on Native Dancer, even if the payoff is 6 to 5.” You put up $5, and if it wins you get $6. Maybe the better bet is Beetle Bound, which nobody expects to win and, consequently, it has a lower probability of winning but if it wins it will pay four to one. So it’s the same thing. You have to make investments where the risk can be assessed, diversified, and where you’re highly paid to do so.

The book is full of explanation of why so-called safe, so-called high-quality investments are not always and, in fact, maybe are rarely the best bet. That is what this distinction is all about. We want to make intelligent bets. We don’t want to invest in high quality or safe things because a so-called safe thing at bad odds is a bad investment. Sometimes I think the word “quality” should be banished from the investment business if you want to make money.

MOI: In today’s environment, there is a lot of talk about U.S. Treasuries being a safe haven and it is proving true. Do you see that as an example of what we just talked about?

Marks: U.S. Treasuries — Jim Grant called them “certificates of confiscation” — are a great example. They are a safe investment in the sense that the outcome is known and not really subject to variation. I think they are not a good investment because the known outcome is an unattractive one. Today you can buy the ten-year [Treasury] and with no risk, lock up the certainty of 1.9% return for ten years. Is that really a good thing to lock up? Under what circumstances will that turn out to have been an attractive investment? The answer is, in my opinion, deflation or depression. I don’t think we are going to have those things, or we can’t plan on having them. So the range of outcomes under which that safe asset turns out to have been a smart investment is rather narrow. I was on a panel two days ago in Los Angeles with Jeremy Grantham, and he said, people talk about the risk-free return. Treasuries are the return-free risk. I think he has got something there.

MOI: You talk about the importance of being attentive to cycles and the pendulum-like oscillation of investor attitudes and behavior. However, most value investors tend to ignore macroeconomic events and investors sentiment, often relying on a measure of normalized through-the-cycle earnings and relying on their own convictions. How do you define being attentive, and how do we ensure we do not become too attentive?

Marks: First of all, all your questions start with the word “how.” It is very hard to answer that. There is no secret method for any of this stuff. You just have to be aware of concepts, smart in their application, and it helps to be an old man so that you have the experience that helps, or an old woman…

If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

If you buy a cheap stock when the market is high, it is a challenge because, if the market being high is followed by a general decline in prices, then for you to make money in your cheap stock, you have to swim against the tide. If you buy when the market is low, and that lowness is going to be corrected by a general inflation, and you buy your cheap stock, then you have the tailwind in your favor.

I think it is unrealistic and maybe hubristic to say, “I don’t care about what is going on in the world. I know a cheap stock when I see one.” If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.

MOI: You say that the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. Where do you think perception has potentially reached such a level? Is the eurozone a potentially fruitful hunting ground for Oaktree?

Marks: You keep using the word “potential,” which gives me a good out because anything which has gone down in price a lot is potentially a source of opportunity. But the question is, has it declined sufficiently relative to reality? If a stock was efficiently, fairly priced five years ago at X. Today the stock is down half, but in some sense reality is also down half — then the stock is only fairly priced, lower in price but not cheaper.

What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically? The answer is, how do you know? Go back to second-level thinking. Are you capable of thinking different and better about the fate of Europe? I don’t think so. I don’t think I can. I don’t think anybody really has a good handle on what is going to happen in Europe. So then, how can gaming the Europe situation give you an edge?

If you don’t have control over something, superior insight — I don’t see control in the sense of being able to make it work — if you don’t have superior insight, then how can something be to your advantage? One of the tenets of our philosophy — you named number one, which is risk control — number five is, we don’t bet on macro forecasts. It is very hard to consistently be above average in correctness with regard to the macro.

MOI: You say knowing what you don’t know can provide a great advantage as an investor. Warren Buffett calls this the circle of competence. What is Oaktree’s circle of competence? More importantly, can you give us an example of what lies just outside that circle?

Marks: We have been making credit-based investments since I started Citibank’s high-yield bond fund. We went from high yield and converts to international converts and European high yield to distressed debt, to distressed for control, to distressed mortgages, to mezzanine finance. So a lot of what we have done, although not all, has been credit based. We consider that, to use your term certainly, one of our greatest circles of competence.

We emphasize the things that have a high probability of paying off for us, albeit there are other people out there who are better than us at investing in things that have a low probability of paying off but with are very high payoff. Our emphasis is on risk-controlled situations — we are probably more competent in that than other things.

I think maybe another example of something that may be outside our competence is, we never made an investment in sovereign credit. I use sovereign debt investing as largely a political analysis rather than economic analysis. I don’t know how to do it. I hope it can be done, and maybe one of these days we will go out and find somebody who can do it and maybe we’ll add that competence to what we do.

We would be silly to bet on the bonds of peripheral Europe just because they have gone down if we are not capable of superior second-level thinking. How would we know enough to out-think the person who is selling them to us and to have a high probability of a successful outcome?

MOI: In addition to corporate and distressed debt, a considerable amount of Oaktree’s portfolio is in a category you define as control investing. Help us understand better how you approach distress-for-control situations and what you think makes Oaktree more successful here versus other funds.

Marks: When I was talking about circles of competence, I think one of the elements on our side is that we have been doing it for a long time. We have a lot of experience in the things I have been discussing, and I think experience is very important. You have to learn the hard lessons. One thing I mentioned in one of my memos is that the human mind is very good at blotting out bad memories. Unfortunately, most important learning is from bad memories. We have enough institutional memory to retain the lessons of the past.

We organized our first distressed fund in 1988 and then branched out into our first distressed-for-control fund in 1994. We figured that we could identify cases — we spun that fund out because we had done it in the past — we invested in big chunks of the debt of smaller companies so that when the debt was exchanged for equity we ended up as the controlling shareholder.

The question is, number one, is this a company that you would like to control? And number two, is this a company where the creditors will get control? And then number three, which creditors? Because usually there is something called the fulcrum security, which is the first impaired class. The unimpaired will get their money. The first impaired class may get the company, and the lower impaired classes may get nothing. So it is the fulcrum, the one in the middle there, we try to identify that. We try to figure out if it will get control and how much it will have to pay for control. If it gets control at that price, will that be a successful investment? It is a very interesting area — of course, more moving parts to go wrong. The investments are by definition less liquid. I would say it’s the difference between dating and getting married. When you are a distressed debt investor, you are dating; but when you try for distressed-for-control, you get married. You have to live with the consequences, for better or for worse, richer or poorer. But, it can produce some good outcomes.

MOI: Listed equities are a rather small portion of Oaktree’s overall portfolio. Are those investments a residual of distressed-for-control strategy, or do you also target equities particularly. How you end up with equities in your portfolio?

Marks: We established a couple of strategies to invest in listed equities because we thought markets were inefficient or less efficient. The first case was in the middle of 1998 when we decided to go into emerging markets. So we formed an emerging markets long/short hedge fund that we have ever since.

Tenet number three of our investment philosophy says we are active in less efficient markets only. We probably wouldn’t do a hedge fund for large-cap New York Stock Exchange firms because the tendencies are that those would be more efficient than others. But emerging markets, yes. Japan, yes. It didn’t work out so well — the world’s cheapest market has continued to get cheaper.

So it is not a residual of some other activity. We never pass securities from one strategy or portfolio to another… Just a few markets where we’ve concluded that it was worth investing in equities, despite the fact that our main circle of competence is credit.

MOI: You make a distinction between playing defense and offense when investing; in other words, limiting risk and striving for return. Does Oaktree’s ability to invest across the capital structure enable it to get the balance more right in terms of defense and offense versus other investors that may be more constrained?

Marks: If you have flexibility in where you invest, it stands to reason that you should be able to make adjustments that enable you to reach your goals. This goes back to what we said before. You said some value investors are willing to ignore the macro. They say if stocks are selling for one-third less than intrinsic value, I am going to buy it. But the question is, do you want to be equally aggressive all of the time, or do you want to play offense some times and defense at others?

I would argue that you should adjust your activities based on the climate of the market. So, that is what we do. Sometimes in a distressed debt portfolio, we want to be at the very top of the capital structure. That may be because that is where the best bargains are, it may be because the macro environment is threatened and we don’t want to live with macro uncertainty. At other times when these things are cheaper and when the environment seems less treacherous, maybe we’ll drop down into the second level on the balance sheet or maybe the third. Historically, we don’t go to the bottom of the stack very often, but I think these adjustments are worth making.

It is a great dilemma because, on the one hand you want to stick to your circle of competence. On the other hand, it is probably a mistake to say, “I do this. I don’t do that.” Because, at the same time that you want to capitalize on your expertise, you want to be flexible enough to pursue the bargains where they are, and you don’t want to be so dogmatic that you say, “I only do this,” which implies, I do it whether it’s cheap or not. So this is one of the great dilemmas.

You asked earlier where inefficiencies come from. Largely they come from people who say, “I do this, and I don’t do that.” What they are basically saying is, “I don’t do that regardless of how cheap it is.” Well, that is silly because then you just leave bargains for others. If you say, “I do this, but I don’t do that regardless of how cheap it is,” you are basically saying, “I do this regardless of how expensive it is.” That doesn’t make much sense either. This is why I think you have to be realistic. You have to be sensitive to conditions in your world, and you should adjust your tactics — offense and defense — based on conditions in your environment.

MOI: The title of the book is The Most Important Thing, but, as your readers will know, all of the concepts in the book are important and leaving out even one of them will likely lead to not optimal performance. So if all of these concepts — and we have touched on a few, risk, the relationship between value and price — if they are all important to achieve superior performance, what is the single biggest mistake that you think keeps investors from reaching their goals?

Marks: First of all, let me mention that I think the twenty things listed in the book are all the most important thing, and then I thought of the twenty-first. So later on this spring, I think we will be coming out with the new electronic edition of the book called The Most Important Thing Illuminated, which will include comments on the content of the book from Seth Klarman and Joel Greenblatt and Paul Johnson and Chris Davis, in addition to myself, and a new twenty-first chapter, which says that the most important thing is realistic expectations. Because I think that people tend to get in trouble in investing when they have unrealistic expectations, especially when they have the expectation that higher returns can be earned without an increase of risk. That is a very dangerous expectation.

Which is the thing which is most dangerous to omit? I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it.

The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years. That is one of the reasons why we have to think of great investing in terms of a long time span. Short-term performance is an imposter. The investment business is full of people who got famous for being right once in a row. If you read Fooled by Randomness by [Nassim] Taleb, you understand that being right once proves nothing. You can be right once through nothing but luck.

The law of large numbers says that if you have more results, you tend to drive out random error. The sample mean tends to converge with the universe mean. In other words, the apparent reality tends to converge with the real underlying reality. The great investors are the people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it.

MOI: Thank you very much for your time and the insights you have shared.

Marks: It was a great pleasure for me, and I appreciate your interest in the concepts.

This conversation was recorded in 2012.

Since the formation of Oaktree in 1995, Mr. Marks has been responsible for ensuring the firm’s adherence to its core investment philosophy; communicating closely with clients concerning products and strategies; and contributing his experience to big-picture decisions relating to investments and corporate direction. From 1985 until 1995, Mr. Marks led the groups at The TCW Group, Inc. that were responsible for investments in distressed debt, high yield bonds, and convertible securities. He was also Chief Investment Officer for Domestic Fixed Income at TCW. Previously, Mr. Marks was with Citicorp Investment Management for 16 years, where from 1978 to 1985 he was Vice President and senior portfolio manager in charge of convertible and high yield securities. Between 1969 and 1978, he was an equity research analyst and, subsequently, Citicorp’s Director of Research. Mr. Marks holds a B.S.Ec. degree cum laude from the Wharton School of the University of Pennsylvania with a major in finance and an M.B.A. in accounting and marketing from the Booth School of Business of the University of Chicago, where he received the George Hay Brown Prize. He is a CFA® charterholder. Mr. Marks is a Trustee and Chairman of the Investment Committee at the Metropolitan Museum of Art; Chairman of the Investment Committee and Board of Trustees of the Royal Drawing School; and an Emeritus Trustee of the University of Pennsylvania where from 2000 to 2010 he chaired the Investment Board.