For those few of you who still come back to this blog, I am alive. No activity
for over a year probably had you thinking otherwise. Not much has happened
investment wise over the last year, I didn't find any securities that matched
my selection criteria. Hence the inactivity.
Today, I
am writing about second-level thinking. This is a topic that many of you who
are experienced value investors are already familiar. This is a post that is
probably more useful to the non-investing or the non-value investor
crowd.
Howard
Marks, a renowned distressed debt investor, wrote about second-level thinking
in his book "The Most Important Thing: Uncommon Sense for the Thoughtful Investor". The book is an edited version of his memos (all his memos are here) that he has been
writing to his shareholders for nearly two decades. I highly recommend reading
the book. My favorite chapter is the first one: "Second Level
Thinking".
Marks
contention is that a lot of people do first level thinking, but very few seem
to understand second level thinking. He considers the ability to exercise
second level thinking of utmost importance to achieve market beating returns
over a longer term. What is second level thinking? Let me give you some
examples.
First
level thinking says: "I love this company's products, it has a great
culture. Let's buy the stock." Second level thinking says: "The
company is doing well, but the expectations that its going to do well is
already backed into the price and some more. The company is overrated. Let's
sell."
First
level thinking says: "I think the company's earnings will fall, let's
sell." Second level thinking says: "I think the earnings will fall
less than people expect, so the stock will go up because of the surprise. Let's
buy."
Both of
the above are rather simple examples, thinking at the second level is not too
difficult. So, now that you understand the concept, let me use a real world
discussion I have been having with a colleague (Mr. Page) in my professional
life as an engineer. I consider this colleague to be among the very few smart and
thoughtful people I know of.
Page:
"You know S&P 500 returns over the most recent decade have been
really poor"
Gosalia:
"Yeah, but historically, all "lost decades" have been followed
by attractive returns for the following decade. Look at the data."
Gosalia:
"This time may be different, but I would not use the most recent decade's
poor performance as the reason for staying away from equities."
Page:
"There are a lot of hidden details behind the numbers you don't see in the
graph that are important to observe. You could look at WWI, New Deal, WWII,
Federal Reserve Act, War on Poverty, Federal Reserve actions (specifically in
1937), Gold Reserve Act, 1971 complete disconnect of the US dollar from Gold,
women entering the workforce, invention of 401(k), real estate easing, general
population getting access to the markets, dot-com bubble, and the real-estate
bubble."
These are
really good observations by Page. But then he makes a first-level thinking
observation, in my opinion: "The government's fiscal situation is
terrible. It's ability to continue to prop up the economy will be limited going
forward. You also have the baby boomers retiring. Baby boomers are the largest
demographic in the country. These retirees, as they pull their money out, will continue
to drag market returns for the next twenty or so years. I don't expect the
economy to go anywhere for the next few decades."
I assuming that his conclusion to the above first-level observation is to avoid equities going forward, but if I am incorrectly interpreting his conclusion. my apologies Mr. Page. Here is my response which I believe is second-level thinking:
"Yes, baby boomers will be
retiring and looking to "pull" out their money. But geez, where will they stuff this money into. Taking all this capital out and putting it into their
"mattresses" is not an option. When capital disappears from one part
of the system it shows up somewhere else. One thing retirees really need
is regular income. Will they pour their massive capital base into fixed
income. That will surely kill any aspirations they have for any regular income.
More money into bonds will bid up bond prices and lower their yields. Combine
it with the fact that yields are already near zero, putting retiree capital
into fixed income is as good as stuffing into their mattress.
I think
its more likely that retiree 401(k) capital will move into high dividend yielding
stocks to support their need for regular income. Hmm, where I am to look for
high dividend stocks. REITS pay out large dividends, don't they? But that's
first level thinking. Everyone knows they pay out all their earnings in
dividends, so the stock prices are currently bid up causing effective
yield rates to be lower. Second level thinking tells me that I should be
looking for companies that have very low dividends currently but have a very
long runway for dividend growth. Wall Street is not expecting them to raise
dividends anytime soon, so their stock price don't account for it.
Hmm, so
what kind of stocks can raise their dividends but haven't done so yet. How
about the banks? Banks don't need much capital to grow, as long as they are
well capitalized, the rest of the capital can be returned to shareholders. The
Fed has explicitly capped dividends for many of the large banks that have
been recipients of bailouts. First level thinking: so you want me to
invest in these "evil-doer" bailed out banks run by irresponsible
managers? Second-level thinking: There are some 7000 banks in the US, and
only a few were responsible for the "evil-doing". In addition, the
Fed "bailed" out many banks that weren't under duress during the
financial crisis to disguise from the general public the banks that were really
under duress.
May be, I
can find a bank run by responsible and trustworthy managers that has a
healthy balance sheet and can grow its dividends. How about Wells Fargo? They didn't use customer
deposits to gamble on derivatives trading. They weren't involved in sub-prime
lending. Their balance sheet prior to the Wachovia acquisition was relatively
clean and easy to understand. Post Wachovia, its already been a few years and
those loans are aging well. They have a lot of capital in reserve to absorb any
future expected losses, more so than going into the financial crisis.
With
strengthened balance sheets, I find it hard to envision such hard dividend caps
on the healthy banks, say 8-10 years from now worst case. Wells Fargo currently
only pays 10-20% of its earnings out as dividend. Management has clearly
indicated that they would like to grow dividend payout ratio to 50%. Combine it
with the fact that housing will eventually come back, causing earnings to grow
as well. If yields rise because of retirees pouring money into fixed income
products, that helps Wells Fargo since it is an "asset-sensitive"
bank - meaning the rate at which it lends goes up higher the rates it has to
pay on its deposits. The deposits they have are very sticky and are unlikely to leave for a higher yield. The spread leads to higher returns on capital.
Second-level
thinking question: Are any of these observations about Wells Fargo baked into
its stock price (at $23 when I purchased the stock in 2011)? Its trading at
book value and less than 10x P/E. Definitely not, Wall Street is simply
ignoring these observations. They don't have a longer time frame like I do. But
may be someone else is making similar observations. Let's check out 13-Ds. Hmm,
Warren Buffett has been buying loads of Wells Fargo stock. Is he thinking along
the same lines?
What kind of returns could I expect buying Wells Fargo at $23 a stock at book value and 9-10x P/E. Well, Wells Fargo has been doing about 1.2% to 1.3% return on assets. It is levered equity to assets by 10x. So, it is currently doing about 12% to 13% ROE. USBank, a close peer to Wells Fargo, has been able to do 1.5% ROA. If Wells can get there in a a year or two, Wells will be compounding book value at 15%. So, book value will be double in about 5-6 years. Current book value is 20-23 (as 2011 when I purchased the stock), so it could easily be at 40-45$ in 5-6 years. But a bank achieving that kind of ROE shouldn't be trading at book but at least 1.5x book value. So, the stock is worth about $65 - $70 given a 5-7 year horizon. Buying at $23, lets just round to $25, you are able to make a 2.5x return on your capital in 5-7 years or 17% compounded return. Another way to look at it is Wells is earning about 3-4$ in EPS. It could be double its EPS in 7 years, so EPS could be at 6-8$. If it pays out 50% in dividends, its paying 3-4$ dividend. Should the dividend yield of the stock be 5%, you get a price of 60-80$. Is any of this pie in the sky - not at all. We have such a huge margin for error buying at $23 that even if things didn't work out as laid out above, the buffer could easily absorb enough wrong things that could happen before I lost money. Much better than stuffing my money in the "mattress" of fixed income or any other alternative asset class (gold, silver, art, wine .. ).
So, may
be all of this second-level thinking makes sense on an individual stock level.
But how does that apply to general market returns. What will S&P500 do
over the next few decades. My response: I don't care, my job is not to predict
returns for overall market, but to make investments that produce 12% + inflation
beating returns over the longer term. Questions like what will S&P do
and what will the economy do has nothing to do with investment success at the individual level. Conclusions like "lets avoid equity" because of such and such reason don't really apply."
Howard Marks says that first level thinking is simplistic and superficial, just about everyone can do it. All first level thinking needs is an opinion about the future, as in "the outlook stinks, call for low growth and rising inflation. let's dump our stocks".
Second level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:
- What is the range of likely future outcomes?
- Which outcome do I think will occur?
- What does the consensus think?
- How does my expectation differ from the consensus?
- How does the current price for the asset comport with the consensus view of the future, and with mine?
- Is the consensus psychology that's incorporated in the price too bullish or bearish?
- What will happen to the asset's price is the consensus turns out to be right, and what if I'm right?
- ...
The difference in workload between first-level and second-level thinking is clearly massive. First level thinkers look for simple formulas and easy answers to investing problems. The problem is that extraordinary performance comes only from correct non consensus forecasts, but non consensus forecasts are hard to make, hard to make correctly and hard to act on.
I don't claim that I am a second-level thinker and someone else isn't. I know Mr. Page is a very smart man, and he may also be thinking at a second level and I am not aware of those thoughts.
Having said that, the first step is recognize what is needed for investment success. The second step is to start exercising this kind of thinking into our investment process. Currently this is a conscious effort for me to exercise this kind of thinking and not fall prey to first level thinking.