First-Level Thinking, Second-Level Thinking

Howard Marks is a legend of the investment industry. For those uninitiated, Marks is a US value fund manager who cofounded and co-chairs Oaktree Capital Management, overseeing $100bn in capital. His net worth is approximately $2bn according to Forbes. Marks is known for this insightful quarterly memos to investors. They fall into the 'must read' category, so much so, that Warren Buffett has said that when the memo reaches him, he drops whatever he's currently holding (grandchildren excluded) and goes straight for it.

Two days ago, Marks published his latest thoughts, it's fascinating reading encouraging caution, however, it reminded me of a memo he sent out last year that separated investors into two types, 'first-level thinkers' and 'second level thinkers'. Anyone who thinks investing is easy, is using superficial and simplistic thinking, first-level thinking. I feel the best way to explain 'first-level thinking' and 'second-level thinking' is via examples, with the first one coming straight from Marks' 2016 memo, and for a bit of fun, I've thrown in some AFL examples as well, to help footy fans ascertain whether they fall into the first-level thinking or second-level thinking category.

  • Marks - "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 far less than people expect, and the pleasant surprise will lift the stock; buy".

  • First-level thinking says, "That player has had a breakout year, do whatever it takes and get them to our club". Second-level thinking says, "let's wait and see if they can maintain their performance after the opposition put time into them, which is a sign of a good player".

  • First-level thinking says, "JB Hi-Fi is packed. I can't move amongst all these shoppers. They must be making a heap of money. Buy!." Second-level thinking says, "Better check what their profit margins look like before buying their shares. Revenue is one thing, profits is another."

  • First-level thinking says, "They have lost one of their great players (e.g. Geelong - G Ablett Jnr, Hawks - Buddy, W Bulldogs - Griffith), they're finished." Second-level thinking says, "Roles will have to be switched around and we don't know whether as a whole, the team is better off with players performing strongly in other roles".

  • First-level thinking says, "BHP Billiton reported a four billion dollar profit, that's a big number, their shares will go up today." Second-level thinking says, "four billion dollars is a big number, but what was the market expecting them to report. If expectations were higher than that, their shares will go down."

  • First-level thinking says, "That particular forward averages 3.2 goals per game. They must know where the goals are." Second level thinking says, "That's a good goal-to-game ratio, but when did they kick those goals? Was it whilst the game was hot, or was it during junk time with the heat was out of the game?".

  • First-level thinking says, "That company director told me something interesting, I'm buying the stock." Second-level thinking says, "What has the share price performance been like on the day of a good announcement in the past, and if they are open to me, who else are they saying something interesting to".

In summary, above attempts to illustrate that the first thought that pops into your head might not necessarily be the correct one, when it comes to investing and football.


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