Why It is Important to be a Second-Level Thinking Investor
Have you ever made a seemingly no-brainer decision that led to unintended and regretful consequences? A real-life scenario for me was heating a savoury pastry in the oven, which created a mini ball of fire due to the oil that dripped down… That is an example of first-level thinking (and absolute kitchen disaster).
In investing, to earn superior returns, it’s not enough to be right — you must be more right than others. It requires deeper second-level thinking. What is it, and how do we demonstrate this in investing? Let’s find out with examples of recent trades I made.
Second-Level Thinking
Second-level thinking is a concept that Howard Marks, co-founder of asset management firm Oaktree Capital, coined in his book “The Most Important Thing”. The book is a collection of client memos published over the years, full of investment wisdom and insights, which I follow and enjoy immensely. For Marks, being a second-level thinker is imperative to achieve superior investment results.
Second-level thinking means looking beyond the surface of a problem and considering a wide range of possibilities to infer the best fit solution. Why is this important? Because one cannot do the same things as the next investor and expect to outperform. To outperform, one must be different AND better.
This assumes you aim to have above average returns. If earning the market returns is sufficient (a sound choice for many investors), index investing is the way to go. As an active investor who practices barbell strategy (stable dividend-paying picks and high-growth potential stocks), I aim for above average returns.
As such, it is necessary to train myself to see things differently, learn things that others don’t or do a better job of analysing companies — ideally all 3. A second-level thinker takes these into account when looking at an investment:
- What is the range of likely future outcomes?
- Which outcome do I think will occur?
- What is the probability I am right?
- What does the consensus think?
- How does my expectation differ from consensus?
- Is the consensus psychology incorporated in the price too bullish or bearish?
- What will happen to the asset price if the consensus turns out to be right, and what if I’m right?
Applying It in Investing
A first-level thinker: “this is a good company, let’s buy”
A second-level thinker: “this is a good company, but everyone thinks it’s great. It’s possibly overrated and overpriced, let’s sell”
A first-level thinker: “earnings will fall, let’s sell”
A second-level thinker: “earnings will fall less than expected, pleasant surprise will lift the stock, let’s buy”
Second-level thinking requires one to sift out qualities that others may not see and is not reflected in the price (i.e. different) and ultimately have his/her perception turn out to be true (i.e. better).
My Recent Trades — Fiverr
To put what I learned into action, I recently practiced second-level thinking on 2 trades I made last week. First up — a company I have previously written an analysis on.
Last week, the online gig economy marketplace company announced its Q2 results. Across the board, numbers exceeded expectations, with revenue growing an impressive 60% y-o-y. This is already on top of the 82% growth in Q1.
The strength of the business is evidenced by the fact that Fiverr continued acquiring buyers at a rapid pace (43% y-o-y growth) while retaining existing buyers and increasing their average spend (23% y-o-y growth).
So, I was shocked when price nosedived 25% on Friday. This was due to the adjustment of guidance to a lower revenue growth in Q3 and overall FY 2021. Management reasoned that given increased vaccinations and reopening of the economy, they predict reduced online activity for H2 2021.
This does not signify any change to the underlying business fundamentals. Yes this is lower than prior guidance, but the long-term outlook and massive addressable market remain positive and intact.
Using second-level thinking, I believe the Fiverr management is being prudent. Setting lower expectations now gives them more room to exceed expectations later. In my opinion, although they expect reduced online activities, the reality is that many Americans, especially Gen Z, have turned to freelancing during the pandemic and will not return to full-time jobs anymore.
In 2020, there were 59 million or 36% of the US workforce freelancing. By 2028, this may increase to 90 million. This is a permanent livelihood for freelancers. Corporate business models have also been changing to adapt to this new ways of working. Therefore, I don’t see reopening as a hugely negative event — we are in a new normal and Fiverr underpins this transformation.
This is demonstrated by Fiverr’s successful upmarket strategy. High-value buyers (annual spend > $500) in Q2 represents 61% of Fiverr’s core marketplace revenue, up from 59% in Q1. New partnerships were formed with Salesforce and Wix — dedicated programs to access qualified freelancers on Fiverr after a specialized training. This portends future business models for other companies to incorporate flexible hiring.
All in all, I believe the consensus psychology that led to a 25% drop in price was far too bearish and not reflective of the long runway ahead. Thus I am happy to add on at this low entry price. In fact, this gives me an even better margin of safety as I patiently wait for the underlying value to present itself.
My Recent Trade — Tencent
Another example of recent negative sentiments: Tencent has wiped off almost 50% of its value last month. This is a company that needs no introduction, I refer to well-written articles from Dr. Wealth with extensive analysis done on the business model and fundamentals.
In short, Tencent is a well-diversified, resilient and cash-rich company with market leading positions (within China) in all of its segments. It is akin to a venture fund or ETF, with over 30 full or partial ownership in both domestic and foreign companies.
In particular, Tencent’s management seems to be very responsive and cooperative. After official government remarks that gaming is a “spiritual opium”, Tencent immediately responded with measures to curb usage for underaged population. Post that, the Chinese state media softened its tone by emphasizing “the need for government, schools, families and broader society to work together to better protect children from excessive gaming”.
During this period of turmoil, Tencent continued its acquisitions, including domestic search engine Sogou on July 13 (‘unconditional approval’ from the state antitrust bureau) and a UK gaming company on July 19. This tells me that the CCP isn’t out to destroy the tech giants, but wants growth within their scope of control.
Using second-level thinking, China fundamentally wants to increase its global sphere of influence. To achieve this, it is important to support foreign investments and disseminate Chinese content overseas. Recent regulations will likely enable closer partnership between Tencent and the state, allowing Tencent to emerge stronger in the long run.
A point I want to add is that the current issue with minor gaming is an exceptional case as this impacts the Chinese social fabric. However, as of Q4’20 minors aged under 18 accounted for only 6% of Tencent’s China online game gross receipts.
Therefore, based on my understanding of macro themes, the crash is overly bearish and has lowered my risk to the extent I am comfortable to initiate a small investment into Tencent last week.
Concluding Thoughts
To practice second-level thinking, I try to ask myself multiple “so what” and think beyond the superficial statements or initial perception. I also dig deeper into other events, analysis and figures to support possible future outcomes. Backed with research, I can gather more conviction about the alternate realities and understand why the consensus is different.
How would you demonstrate second-level thinking? Are you a second-level thinker? I end off with a pertinent quote.
It’s not supposed to be easy. Anyone who finds it easy is stupid.
Charlie Munger
Disclaimer: Financial Avocado is a personal investing blog of a millennial who is passionate about personal financial education. By reading this article, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or your personal life. I currently have a vested interest in Fiverr and Tencent. Holdings are subject to change at any time.
