I figured there is a lot written and read about Buffett, Munger et al . So over the last few months i have been reading about some of the greatest investors the world has seen but those not often talked about. This includes:
Joe Steinberg and Ian Cumming of Leucedia
Howard Marks of Oaktree
Rales brothers of Danaher Corp
and Carl Icahn of Icahn Enterprises
Surprisingly, some like the Rales brothers’ Danaher Corp has outperformed Buffett’s Berkshire Hathway in the last 3,5,10 and 15 years! Trust me, they are all the real deal.
What i was really keen to find out was, are there any common threads to the kind of businesses these guys (and Buffett, Munger) own, or a common investment philosophy and so on.
Of course it was very clear very soon to me that the only way these guys have succeeded is by exploiting inefficiencies in the markets and individual stocks time and again. That is all they did, repeatedly.Not only that, they have all done well across different macro environments. In other words, these guys did stunningly well just picking inefficiently priced stocks all through all kinds of debacles like the asian currency crisis, 9/11, crude going to $150, the once in a lifetime 2008 financial crisis etc.
Having read them, I concluded that the motto of investment success is this: try and find mis-priced individual bets in all kinds of macro environments. And repeat.
It sounds very simplistic at first but i think its very very profound. But that’s really the easy part: theorizing how these guys succeeded.
The bigger insight i was looking for was, how do they identify mis-pricing? It isn’t easy. Let’s think about this – so you have a business called Mispriced Inc and its quoting at a price to book of 0.7 and a PE of 4. These (and other) numbers are there for everyone to see and theoretically if the mispricing is really obvious the business should very quickly trade at or near or above fair value.
But in reality, this doesn’t happen. The mispricing is rarely apparent to me and you. There is always something to worry about. Its only these investors that see the prices and situations differently, understand that it is probably mispriced and start buying – sometimes continue buying across multiple months (or years) while it remains mispriced before eventually moving to fair value and making a neat return for these "genius" investors.
How do they manage to see things differently than the rest of us?
Howard Marks spoke for all his peers and summarized this for us in three simple words: Second Level Thinking.
Marks’ contention is that a lot of people do first-level thinking, but very few can or do second-level thinking. First-level thinking is things like, " Wow, this is a nice store and it’s crowded; let’s buy the stock!" or some such thing.
Here is one of Mark’s examples:
First-level thinking says, "The outlook calls for low growth and rising inflation. Let’s dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!"
This is super profound. First level thinking ( or jumping to conclusions) is all around us:
"This stock is at 40 times earnings, so it must be a bad investment."
"This stock is at 4 times earnings, so its definitely a great buy"
" The governor will raise interest rates, i should definitely sell all my stocks"
Also bubbles in the past occur partly due to the masses stuck in first-level thinking:
1999: The internet will change the world, let’s buy internet stocks!
2007: China will grow forever, let’s buy Chinese stocks!
You can go back and look at all the bubbles and you will see a lot of first-level thinking as the cause of many of them.
After a few people made huge killings in the subprime bubble collapse, everyone seems to be looking for the next great trade by calling the macro. Right now we’re all stuck in this first level thinking "Fed will taper and our markets will crash."
Second level thinking is: "Yes Fed would eventually taper but isn’t that known to everyone? How much impact do known events generally have on prices? Should i really bother so much about it or should i just go about picking quality businesses that are mis priced?"
Listen to CNBC or read the business section of newspapers, all of media is full of first level thinking. They just state the obvious conclusions. FIIs are fleeing our markets, so you should sell too and so on.
If we want to outperform, we have to practice second level thinking. Contemplate on these:
" Could Page Industries be a great buy at 40 times current year when everyone says its expensive?"
" Infra and Realty stocks are so cheap right now. Are they really bargains?"
"PSU Banks are trading at 8% yield, they are definitely a buy."
The only way to make serious money is to have what Michael Steinhardt calls "Variant Perception" and this variant perception (a view different from the general crowd) can originate only by practicing second level thinking.
So the next time you’re buying a stock, stop and observe if you’ve put in any second level thinking into it (do i have an insight the market is not pricing in) that makes the current price inefficient.
So look at your portfolio today and for each stock you own, really validate if you have an intelligent variant perception derived by second level thinking. This is the only way our investments can meaningfully succeed.