Value Investing

Second Level Thinking

Howard Marks recently published his “Latest Thinking” memo and it provides great insights for us all into the future of the potential markets.  Warren Buffett has said about Howard Marks:

“When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something”

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As a Value Investor, Howard Marks (Oaktree Capital) has returned an IRR of 19.9% over nearly two decades, managing over $101 billion. In his latest memo he remains bullish equities, saying:

“The US economy is chugging along and Most economies are gaining steam and don’t appear likely to run out of it anytime soon ….. the catalysts for a market downturn can’t be assigned probabilities that are more than modest.”

Howard has also written a fantastic book “The Most Important Thing,” which an Investment Banking friend recommended that i read (and have). If you have not read it, it is worth your time.

There is one concept within the book that Howard has successfully used in his career called Second Order Thinking. The concept has led to his firms resounding success and so today I want to share with you, some of his thought processes that he goes through before he and the Oaktree team make an investment decision.

As Value investors, we often only appraise in terms of the now. However, second level thinking is the consequences of second round impacts. Take for example Henry Hazlitt, a great French Economist Frederic Bastiat, I admire, who in 1850 coined the “broken window fallacy” – he said –

“A glazier comes, rubs his hands and repairs glass (all that is seen). You may come to the conclusion, it is a good thing to break windows, it causes money to circulate as it encourages industry…. However, your theory is confined to that which is seen, not what is not seen….

…. The shopkeeper has spent six francs, upon one thing, he cannot spend on another like shows or books.”

This appears quite basic at first view, but we are often blind to think in the secondary manner. Howard says:

“You must think of something other investors have not thought of, see things they miss or bring insight they don’t possess… an edge… You need second level thinking”

The opposite of second level thinking is first level thinking, which is simplistic and superficial and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All first level thinkers only need an opinion about the future, such as “Bitcoin is going up, so it must continue to go up… or It’s a good company, lets buy the stock.” A second level thinker however would say “It’s a good company, but everyone thinks it’s a great company, and its not, so the stocks overrated and overpriced, lets sell.” Or… first level thinking “The outlook calls for low growth and rising inflation, lets dump our stocks”’ whereas second level thinkers “The outcome stinks, but everyone is selling in panic. Buy!’’

These examples above are quite basic to show the comparison, but keep in mind second level thinking is truly deep, complex and convoluted. Howard makes it clear a second level thinker takes a great many things into account, including:

  • What outcome do I think will occur?
  • What’s the probability I’m right
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset compare with the consensus view of the future and mine?
  • Is the consensus psychology that’s incorporated in the price too bullish or bearish?
  • What will happen to the assets price if the consensus turns out to be right and what if I’m wrong?

Answering these questions is never linear or easy. The difference in workload between first-level and second-level thinking is clearly massive.

First level thinkers think the same way other first level thinkers, also do about the same things and they generally reach the same conclusions. By definition this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.

Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half. To outperform the average investor, you have to be able to out think consensus. Are you capable of doing so? What makes you think so? Brokerage firms want you to think everyone’s capable of investing at $10 per trade and fund managers don’t want you to think you can do it, so they can actively manage your money. Yet Howard says:

“… The good news, is that the prevalence of first level thinkers increases the returns available to second level thinkers. To consistently achieve superior returns, you must be one of them”

So, I hope together we can have a relentless pursuit to always strive to be a second level thinker.

Omnium Optimi

(Latin-All the best)


Forrest Equities Pty Ltd currently holds positions in Australian Stock Exchange listed stocks: Zip Co (Z1P), Fortescue Metals Group (FMG), and Clean Teq Holdings (CLQ).