Think Again

John Lim

“WHO DOESN’T KNOW that already?” That’s the question we should ask when making an investment decision.

Take Tesla. It builds wonderful cars. It’s an innovative company led by a visionary CEO. Its sales are growing by leaps and bounds. Question: Who doesn’t know that already?

If the attributes of a company are widely known, more than likely its stock price reflects that. The question for investors isn’t whether Tesla is a great company. Rather, the question is whether Tesla is a great investment. Two very different things.

Famed distressed-debt investor Howard Marks discusses this notion in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. First-level thinking is commonplace, second-level thinking far less so. In Marks’s words, 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.”

Second-level thinking requires an appreciation of intrinsic value. In the words of Warren Buffett, “Price is what you pay; value is what you get.” Conflating the two is a common mistake of first-level thinking.

Second-level thinking is probabilistic thinking. So much of investing is about the future and hence uncertain. It isn’t easy to simultaneously hold a variety of scenarios in our mind and assign probabilities to each. But that’s what second-level thinkers must do. Second-level thinkers are also like world-class poker players, adept at appraising their opponents. They understand the importance of investor psychology and the way it shapes the investing climate. Consider some examples of first- and second-level thinking.

First-level thinking: The economic data suggest the economy is slowing, maybe even headed into a recession. The Federal Reserve is intent on raising interest rates, which will be a further headwind. Time to sell stocks.

Second-level thinking: The possibility of a recession looms, but stocks have already fallen quite a bit. While there may be further downside, investors are forward-looking and stocks have already priced in a mild recession. Moreover, while a recession is possible, it’s not a foregone conclusion. Time to start buying.

First-level thinking: China is a mess. A renewed lockdown has wreaked havoc on its economy. GDP growth is at multidecade lows. Recent crackdowns by Beijing remind us that the rule of law is tenuous. Avoid investing in China at all costs.

Second-level thinking: Yes, China is a mess. Yes, economic growth has slowed sharply. But all this is widely known and has been priced into Chinese shares. Historically, there’s been a low correlation between a country’s GDP growth and its stock market returns. Investors have scant enthusiasm for Chinese and other emerging market stocks. As a result, emerging markets are dirt cheap relative to U.S. stocks. It’s time to raise our allocation to emerging markets.

First-level thinking: The war between Ukraine and Russia has led to soaring energy costs across Europe. Inflation and geopolitical uncertainty are major threats. It’s time to sell. Once the dust settles, I’ll buy back into European stocks.

Second-level thinking: There’s great uncertainty in Europe. But this has been reflected in falling stock prices and a weakened euro. There’s a danger the conflict widens, which would likely mean further losses for stocks. But this uncertainty presents a long-term buying opportunity. By the time the dust settles, share prices will be much higher. Start buying European stocks today.

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