Second Order Thinking
“First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. The problem is that extraordinary performance comes only from correct nonconsensual forecasts, but nonconsensual forecasts are hard to make, hard to make correctly and hard to act on.” Howard Marks, The Most Important Thing
Bill Ackman, one of the most vocal activist investors out there, recently opined: It’s hard to make a lot of money if you’re doing what everyone else is doing. Having a contrarian outlook should not be the end goal but rather the way you think about investing.
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!”
First- level thinking says, “I think the company’s earnings will fall; sell.” Second- level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”
The inability of people to think about second order effects can be traced back to the British rule in Colonial India. Ever heard of the Cobra Effect?
Popularized by Horst Seibert, a German Economist, the term cobra effect originated when the British government was concerned about the number of venomous cobras in Delhi, and thus the government offered a bounty for every dead cobra. It initially proved to be a successful strategy as large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the award. When the government became aware of this, the program was done away with, causing the cobra breeders to set the now-worthless snakes free. As a result, the cobra population further increased. The apparent solution for the problem made the situation even worse.
The idea then, and the idea now, is to think about what your actions will result in before taking the action itself. Questioning (and curiosity), at its heart, is the core of a good investment analyst.
“The key thing in economics, whenever someone makes an assertion to you, is to always ask, “And then what?” Actually, it’s not such a bad idea to ask it about everything but you should always ask, “And then what?”” Warren Buffett
The idea behind finding a bargain in the market is to find an asset that is trading at less than its intrinsic value. Often, you will find such investments which are quoting at significant discounts to their intrinsic value owing to one of many things like a temporary blip in the market because of some “negative news” (think of how Demonetization affected the valuation of many listed Indian companies overnight) or because it is not yet covered by any major research houses. A first level thinker will see the negative news and decide to sell his position, while a second level thinker will decide how relevant this piece of information is. In the second case, a first level thinker will think the company is probably no good and not worth covering, while a second level thinker will dig in and find value.
Think of 2008 – good companies, with solid fundamentals, were beaten down owing to the crisis that affected the whole world. Fire sales resulted in companies quoting below net asset value. A dart throwing monkey could have made superior returns had he held on to his holdings till date. But a first level thinker was too busy finding buyers to his sellers. Because second level thinkers are outnumbered by first level thinkers – the former find better investments.
Think of the recent debate that the investment community is talking about – active vs. passive investing. Hedge funds and asset management firms are called out for their high fee structure and underperformance as a bunch relative to the markets. Index funds and managers like BlackRock and Vanguard have hundreds of billions of dollars being pumped into them. But it’s this very reason, why active investors and hedge funds are finding the market to be riper for investing – they are finding better restructuring plays to invest in.
The greatest of investors have been advocating index funds for the financially illiterate to compound their savings. And we have seen a stellar rise in the AUMs of these funds – to the tune of trillions.
However, as far back as 1996, we have Bill Ackman displaying second level thinking: “We’ve heard a lot of discussion about how institutions and individuals use index funds, but to the extent that more and more capital becomes indexed — and if you think about index fund managers as really being a computer, then in terms of the voting of shares for instance — the more stock that is held by people who don’t care about individual corporations, the more there is a significant societal detriment to have capital in the hands of people who are just seeking average performance.”
This level of thinking has helped him and several other investors (institutional and retail) to find investments in a market where everyone believes indexing is the answer. Second level thinking, like successful investing, is not supposed to be easy. If it was, everyone would be doing it. It requires deep and slow thinking in a world where getting first is the standard norm.