In Chapter One of the Howard Marks (Trades, Portfolio) famous book The Most Important Thing, Howard talks about the importance of second-level thinking. To achieve better returns, you need “either good luck or superior insight.” Not only do you have to think differently, but also you have to think better.
No doubt most readers on this forum have read Howard’s book and are familiar with the concept of second-level thinking. However, many of us are the victims of this famous quote by Yogi Berra – “In theory, there is no difference between theory and practice; in practice there is.”
I will not repeat what Howard has correctly and shrewdly pointed out in his book. What I want to touch on in this article is the “trick” Howard taught his son Andrew whenever he analyzes a stock. This trick is a simple question – and who doesn’t know that? From my personal experience, I would add another question – are the things that matter really knowable?
Let’s take a step back and think about this routine. When most of us analyze a stock, we usually go through the annual and quarterly reports and read anything that is related to the company we are analyzing. Then we put together our thesis along with our valuation. Some of us may add the consensus view and come up with an argument for why the consensus is wrong. But I rarely read an investment write up that addresses the question “and who doesn’t know that” or “are the things matter really knowable?”
Why is this important? Well, let me again use an example. A while ago I read some articles on a few leverage coal companies. Although the companies differ, the theses are similar
- The coal companies are beaten down because natural gas is so cheap.
- These companies are highly leveraged.
- Coal is still cheaper than gas to generate power.
- U.S is building coal export terminals in the west.
- Railroads shift more carloads to oil so transportation is constrained in the PRB.
- Regulatory concerns and environmental concerns.
- All of the above except for the regulatory and environmental issue are temporary issues and will be solvable in the future. Therefore, coal companies are cheap.
Now let’s ask the question – who doesn’t know that? The consensus view is pretty much known by everybody who follows these coal companies. So we can be reasonably sure that almost everyone knows the negatives. What about the contrarian view though? Namingly, natural gas may be more expensive; U.S export may accelerate after those terminals are built; Railroads may ship more coals when they have more locomotives and when there are less oils to ship.
If you ask the question, "Who doesn’t know that?" for each of the contrarian factors listed above and do some quick research, you will find plenty of articles or reports that share the same contrarian view such as this one. This means the contrarian view may also be widely known, and, therefore, the price has also reflected this contrarian view already.
Then we ask the question, “Are the things matter really knowable?” I remember Warren Buffett (Trades, Portfolio) famously said that he had the faintest idea of what natural gas will be trading in the next couple of years. If the Oracle of Omaha doesn’t know, I think we should be prudent and acknowledge that we don’t know either. Same goes for the railroads constrain. Do we really know whether the capital spending that big railroads such as BNSF and Union Pacific made is for solving the coal transportation bottleneck in PRB as opposed to expanding capacity for oil shipment in the Bakken Field? If the answer is yes, do we have enough evidence to back up or is our answer based on intuition? What about the U.S. coal export terminal that is being built in Oregon? Does that mean China will get more coals from the U.S.? If so, why and what are the probabilities of other possible outcomes?
After this seemingly laborious exercise which involves uncomfortably asking some unorthodox questions, how do you feel about the coal companies now? Do you think they are still cheap or do you think there are too many unknowables to make an educated decision?
Let me end with the same message that Howard Marks (Trades, Portfolio) conveyed at the end of the second-level thinking chapter:
Those who consider the investment process simple generally aren’t award of the need for – or even the existence of – second-level thinking. Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available for second-level thinkers. To consistently achieve superior investment returns, you must be one of them.
