It took me awhile to catch up on my reading, and even though it has been published for a while now, the last memo by Howard Marks (Trades, Portfolio), titled "It's Not Easy," is a great reminder of what second-level thinking is and how it can (or should) be used to beat the market. Howard Marks (Trades, Portfolio) comments on his own previous remarks:
"Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others which by definition means your thinking has to be different.
"For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking."
Also, Marks gives us some pretty good examples on how second-level thinking gets commonly overlooked:
"What has to be remembered is the defining role of price. Regardless of whether the fundamental outlook is positive or negative, the level of investment risk is determined largely by the relationship between the price of an asset and its intrinsic value. There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe). This is one of the greatest examples of counterintuitiveness. Only those who are able to see its logic can hope to be superior investors. "
For me, these critical factors popped out as I was reading the memo. First, the statement of the common goal that we have as investors, which is to beat the market or average return. However, by trying to achieve the same thing as others, we ourselves become the average. So the question that Marks poses is critical, What do I need to do to beat the market? As he explains, not only must our portfolio be different from that of the market, which by logic means having a very different set of companies than the major indices, but also our investment theses need to be right in order for the appreciation to take place in our holdings. Different and better is a great way to narrow down the idea, which I believe is easier said than done, simply because as the quote goes: It is always warmer in the crowd. Not all of us have the ability to withstand being apart from consensus and hold to our theses when we face adversity. That is why I believe Charlie Munger mentions that everyone has the brainpower to invest successfully but not everyone has the stomach to do so.
Another key point is that there are not unattractive assets, but unattractive prices. A great company might be selling at a very expensive price relative to intrinsic value and therefore, make it a bad purchase. However, an out-of-favor company might be selling for a great discount, offering a wide margin of safety and become a great company to hold in one's portfolio. When we understand and apply this principle, we become true value investors, as I believe this is one of the key tenets of value investing, given the flexibility and practicality that it offers. As Marks mentions, this is generally counterintuitive, which goes hand-in-hand with second-level thinking.
What do you think of Marks' comments?
