Sunday, September 25, 2011

Second-Level Thinking

Howard Marks is a well-known fund manager with very good returns over the long term in the corporate bond market (distressed etc...) and has been writing great memos to investors for a long time.  They do float around on the internet so when I do find one I spend time reading it and there is always something to learn from them.  He is definitely the real-deal.

He came out with a book recently that is an edited collection of the memos to his investors.  I just got it and started reading it and haven't finished yet.

But the first chapter is so dead-on that I wanted to write a post about it.  I don't want this blog to be full of investment platitudes and whatnot, but some things are really great and I feel I have to post it.  I do seem to spend a lot of time emailing and talking to people about this topic so I can't not mention it, and the way Marks puts it is so perfect.

Anyway, Howard Marks' book is called "The Most Important Thing: Uncommon Sense for the Thoughtful Investor".    (There are so many investment books published every month, every week, and most of it is garbage.   This is definitely not one of those).

The first chapter is called "Second-Level Thinking". 

This is so, so important in the investment world and many people do not seem to understand it. 

Marks' contention is that a lot of people do first-level thinking, but very few can or do second-level thinking.   First-level thinking is things like, "Gee, this is a nice store and it's crowded; let's buy the stock!" or some such thing.

Here are some of Mark's examples:

First-level thinking says, "It's a good company, let's buy the stock".  Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not.  So the stock's overrated and overpriced; let's sell.

First-level thinking says, "The outlook calls for low growth and rising inflation.  Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!

This is what I've always thought for a long time and always warned people against acting on first-level thinking, but I never thought of this problem as first-level thinking and second-level thinking.  It's a great way to put it.

Bubbles in the past occur partly due to the masses stuck in first-level thinking:  The internet will change the world, let's buy internet stocks!   China will grow forever, let's buy Chinese stocks!   You can go back and look at all the bubbles (that I've mentioned in other posts too) and you will see a lot of first-level thinking as the cause of many of them.

I posted about theme investing, and that also falls into that category of first-level thinking unless more work is done to determine if an investment idea is sound.  Just looking at the bright future of an industry or sector is not enough.  Sure, solar energy may be a large part of the answer to our energy problems, but choosing the right solar energy company that will do well is an entirely different question (like trying to pick the internet winners in 1999 or auto company winners in the 1920s, or PC companies in the early 80s etc...).

Right now, I tend to think we are in sort of a macro-calling bubble.   After a few people made huge killings in the subprime bubble collapse, everyone seems to be looking for the next great trade.  It seems almost like everyone has John Paulson and/or Michael Burry envy.   (Paulson and Burry are two of a small group of people who made out really well in the subprime collapse.)

But a lot of this thinking seems to be first-level thinking.  Bernanke and Geithner will destroy the dollar, therefore avoid U.S. dollar denominated assets, or buy a lot of gold and commodities.  There is way too much debt in the world so sell stocks etc...

Much of the commentary you see in the financial press seems to be full of this first-level thinking. 

Gold seems to be in this sort of first-level thinking phase too; the only way to avoid a depression is for the Fed and other central banks around the world to print more money.  This is inevitable, and politicians will not cut spending for fear of increasing unemployment.  Therefore inflation, if not hyper-inflation is inevitable.  But this is still all first-level thinking.  Where is the mispricing in the market?

Just because the market validates a view in the short term does not make it correct (internet stocks in the 1990s and Japanese stocks in the 1980s too went up for a while defying common sense).

This is not to say that gold is in the final stages of a bubble like internet stocks were in 2000 (but the fact that more than twice as many people thought gold is a better investment than stocks in a recent survey is a bit worrisome).  I have no idea what will happen to gold prices;  I just want to make the point that the arguments of the gold bulls, to me, just sound first-level-ish.

Anyway, it's important also to note that Paulson and Burry both did far more than just predict the housing market collapse and financial crisis.  There were quite a few people who did predict that.  But most people who called the collapse didn't make money on it.  This is because they were stuck in fisrt-level thinking and did simple trades like short housing stocks and bank stocks.  Even with the collapse in the stock market, it is notoriously difficult to make money shorting stocks; just look at how fast bank stocks rebounded after the March 2009 low. 

Paulson and Burry did predict a collapse, but they went on to the second-level thinking and actually found the right trades to put on.  Where was the big mispricing in the marketplace?  They found that in the subprime mortgage derivatives market.   Others didn't.  So the difference between the gloom and doomers (that are usually on CNBC often telling us that the end of the world is near) and Paulson/Burry is that Paulson/Burry did enough work to actually find the right trades (second-level thinking).

In any case, when you have an urge to do something, like sell stocks because you read in the papers that Greece will default and French banks will go bust, or you want to sell perfectly good stocks at decent valuations because consumers won't be able to increase spending due to too much debt, or because the economists are lowering their GDP growth estimates for the second half of the year or next year,  I would think very hard if you are about to make an investment decision based on first-level thinking or second-level thinking.

I have a feeling that I will be referring back to this post a lot in the future...


  1. Marks is overrated...a guy that doesn't invest in stocks, and that tells you he doesn't invest in stocks, is basically just repeating what we've already heard from Warren Buffett. C'mon, there are a ton of frauds out there and it's something about Mr. Marks that I just don't trust.

    1. Well, OK. I suppose some people feel that way and that's cool. But ironically, Marks probably has a better track record investing the way he does than most 'pros' invest in stocks!

      If I have time, I may actually look into that (Marks performance versus stock fund managers). It might be an entertaining post! Thanks for the idea.

      Anyway, we all have different views of the various 'stars'. Some people think Buffett is over-rated and is a fraud. Well, that's cool. We have a right to free thought.