This is a phrase coined by Howard Marks in his book, "The Most Important Thing". This book is truly a rarity for investors, with both new and old concepts well thought out and written clearly. The best part: the concepts are even valid for institutional fund managers. Very rarely we find something useful both for professional and retail value investors.
So one of the most intriguing concept is this Second Level Thinking. What is this all about? Well to answer that, we first need to know what is first level thinking.
According to Howard Marks, most investors possess only first level thinking. First level thinking is obvious, superficial and consensus. Examples of first level thinking would be:
"Apple is launching iPad 3 in 2 weeks, let's buy."
"Oil just went up another 5%, airlines will be hit, sell SIA."
"WD is being hit by the Thai flood, buy Seagate."
"Toyota recalls 100,000 cars! Sell sell sell!"
Almost everyone can be a first level thinker. Just read the headlines and draw the obvious conclusion. Well, this doesn't mean that first level thinking investors doesn't make money. I can hear you shouting, "If this dumb blogger have bought Apple 2 years ago when the stock price was at $300, he would be so rich that he wouldn't be blogging now."
That is obviously true. Being consensus can still help you make money, but it may not help a lot over the long run. You might make money from Apple but you might jolly well be sucked into buying Yahoo! in 1999, or Li Ning at it's finest moment, holding the Olympic torch in 2008 or Singapore's Oceanus, the abalone story that went on fire a couple of years back. Btw all 3 examples would have burnt big holes in the investors' pockets.
First level thinking won't get you very far because everyone is doing it. It derives easy and average answers. That cannot help you generate good long term return. It is even less likely that you can beat the market.
2nd Level Thinking is complex and tedious. It is about mental aerobics, in-depth research and perhaps even long, difficult discussions with like-minded thinkers. The 2nd Level Thinker asks questions such as:
1) Does the market already know this?
2) What are all the scenarios?
3) How can one invert and think otherwise?
4) Are there comparison with other situations?
5) What is the probability that I am right and the market is wrong?
2nd Level Thinking is not just about non-consensus. It has to be non-consensus and yet correct. Different and better. It has to be two steps ahead.
A good illustration of 2nd Level Thinking would be about BP and its accident in the Gulf of Mexico. For the un-initiated, BP's off-shore oil rig exploded 2 years ago and caused the world's largest oil spill that impacted millions of humans, plants and animals in the vicinity.
For those who remember the drama, it was pretty excruciating. First we see footage of the explosion, then the spills, the poor ducks, the fishermen being interviewed and for days on end, they couldn't cap the well. Oil kept gushing out. Experts opinionated everything. How BP cut corners, how the ecosystem will be irreversibly damaged, the penalties and costs will run into billions. Meanwhile the CEO went sailing with his son and got lambasted further. Major media circus.
So the first level thinkers were like, BP is going bankrupt. Let's sell BP. Or even better, short the stock dead. Meanwhile BP's market cap halved. In absolute dollar terms, it fell roughly USD 100bn. A few years ago, that is the GDP of Singapore. Even today more than 100 countries still have GDPs lesser than USD 100bn.
So the 2nd Level thinkers would be going, "Wait a minute, 100 billion? Is that right?" When was the last big oil spill? What was the final tally for costs and penalties? Did the affected co. go bankrupt? What is the Gulf of Mexico's contribution to BP? Can BP simply ring-fence its US operations? Is bankrupting BP better or would the US Govt prefers BP to continue generating cashflow to pay the costs?
Well as it turns out, penalties and costs today cannot even hit USD 50bn. Even the amount that BP already paid out: 37bn or so, might not be fully utilized. A 2nd Level thinker at that time would also have found out that the whole US operations contributes only a third to BP and ring-fencing the whole US would have made sense if penalties and costs exceed a certain amount. Certainly BP would be worth much more alive than dead, why would the US Govt bankrupt BP?
So, when the market cap fell by USD 100bn, the market went crazy thinking BP would go bankrupt. It factored in more than the worst scenario that BP will lose its entire US operations. So it was time to buy BP back then, not sell.
Today BP's market cap is USD 150bn. So a 2nd Level thinking investor made 50% or more. Perhaps with more to come.
So one of the most intriguing concept is this Second Level Thinking. What is this all about? Well to answer that, we first need to know what is first level thinking.
According to Howard Marks, most investors possess only first level thinking. First level thinking is obvious, superficial and consensus. Examples of first level thinking would be:
"Apple is launching iPad 3 in 2 weeks, let's buy."
"Oil just went up another 5%, airlines will be hit, sell SIA."
"WD is being hit by the Thai flood, buy Seagate."
"Toyota recalls 100,000 cars! Sell sell sell!"
Almost everyone can be a first level thinker. Just read the headlines and draw the obvious conclusion. Well, this doesn't mean that first level thinking investors doesn't make money. I can hear you shouting, "If this dumb blogger have bought Apple 2 years ago when the stock price was at $300, he would be so rich that he wouldn't be blogging now."
That is obviously true. Being consensus can still help you make money, but it may not help a lot over the long run. You might make money from Apple but you might jolly well be sucked into buying Yahoo! in 1999, or Li Ning at it's finest moment, holding the Olympic torch in 2008 or Singapore's Oceanus, the abalone story that went on fire a couple of years back. Btw all 3 examples would have burnt big holes in the investors' pockets.
First level thinking won't get you very far because everyone is doing it. It derives easy and average answers. That cannot help you generate good long term return. It is even less likely that you can beat the market.
2nd Level Thinking is complex and tedious. It is about mental aerobics, in-depth research and perhaps even long, difficult discussions with like-minded thinkers. The 2nd Level Thinker asks questions such as:
1) Does the market already know this?
2) What are all the scenarios?
3) How can one invert and think otherwise?
4) Are there comparison with other situations?
5) What is the probability that I am right and the market is wrong?
2nd Level Thinking is not just about non-consensus. It has to be non-consensus and yet correct. Different and better. It has to be two steps ahead.
A good illustration of 2nd Level Thinking would be about BP and its accident in the Gulf of Mexico. For the un-initiated, BP's off-shore oil rig exploded 2 years ago and caused the world's largest oil spill that impacted millions of humans, plants and animals in the vicinity.
For those who remember the drama, it was pretty excruciating. First we see footage of the explosion, then the spills, the poor ducks, the fishermen being interviewed and for days on end, they couldn't cap the well. Oil kept gushing out. Experts opinionated everything. How BP cut corners, how the ecosystem will be irreversibly damaged, the penalties and costs will run into billions. Meanwhile the CEO went sailing with his son and got lambasted further. Major media circus.
So the first level thinkers were like, BP is going bankrupt. Let's sell BP. Or even better, short the stock dead. Meanwhile BP's market cap halved. In absolute dollar terms, it fell roughly USD 100bn. A few years ago, that is the GDP of Singapore. Even today more than 100 countries still have GDPs lesser than USD 100bn.
So the 2nd Level thinkers would be going, "Wait a minute, 100 billion? Is that right?" When was the last big oil spill? What was the final tally for costs and penalties? Did the affected co. go bankrupt? What is the Gulf of Mexico's contribution to BP? Can BP simply ring-fence its US operations? Is bankrupting BP better or would the US Govt prefers BP to continue generating cashflow to pay the costs?
Well as it turns out, penalties and costs today cannot even hit USD 50bn. Even the amount that BP already paid out: 37bn or so, might not be fully utilized. A 2nd Level thinker at that time would also have found out that the whole US operations contributes only a third to BP and ring-fencing the whole US would have made sense if penalties and costs exceed a certain amount. Certainly BP would be worth much more alive than dead, why would the US Govt bankrupt BP?
So, when the market cap fell by USD 100bn, the market went crazy thinking BP would go bankrupt. It factored in more than the worst scenario that BP will lose its entire US operations. So it was time to buy BP back then, not sell.
Today BP's market cap is USD 150bn. So a 2nd Level thinking investor made 50% or more. Perhaps with more to come.
Excellent Article!! This article will set many people thinking at a deeper level. Many People see headlines and make their conclusion. There is more than meets the eyes. Or shall I say it as There are more opportunities that one can see.
ReplyDeleteThanks for sharing the article.