2nd-Level Thinking: Exploiting Inefficient Share PRICES (Supply vs Demand)
How does one make money in efficient modern-day stock markets? From other shareholders. A 3rd Alternative to Cigar Butts and Compounders for the Intelligent Investor in the modern-day.
“At its heart, value investing is simple — buying something for less than it’s really worth.”
What is Second Level Thinking? As the name implies, 2nd Level Thinking involves thinking on a “2nd level”, one step ahead of everyone else on the “1st level”. This is more colloquially referred to as thinking in terms of second-order effects. It is the stock market version of ‘thinking one step ahead’ of your opponent in chess/Game Theory strategy.
In Howard Marks’s 2015 memo “It’s Not Easy”, he discusses the value investing concept of Second-Level Thinking. Here’s how he describes it:
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."
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!"
First-level thinking says, "I think the company's earnings will fall; sell." Second- level thinking says, "I think the company's earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy?"
When Graham first introduced the idea of cigar butts, it was still novel and he could find an edge by doing that — as everyone at the time only thought of stocks as scraps of paper to be traded. By the time Buffett came along, everyone already knew about cigar butts and few businesses traded below their book value — thus eroding the competitive advantage from Graham’s cigar butt approach, in the form of higher share prices of such stocks.
Hence, Buffett came up with another novel approach in order to maintain his edge in markets — investing in Compounders (i.e. wonderful businesses). Because it was still novel at the time, markets had not priced-in the moats of such wonderful businesses. And the rest is history — Buffett was able to get away with absolute steals the likes of American Express, Washington Post, Capital Cities, Coca-Cola, Gillette; and even extended his advantage to private market transactions such as See’s Candies and Nebraska Furniture Mart.
Wonderful Business at FAIR Any Price
Okay, but how is all of this related to 2nd Level Thinking?
As with all outperforming strategies, markets eventually caught onto the Compounders strategy and began to price-in the competitive advantages of such business moats. Today, many of the obviously “moaty” businesses such as NVIDIA or AAPL trade at sky-high valuations — thus offsetting the excellent returns from their fundamental moats. (e.g. $NVIDIA at 100x PE)
As a result, the outperformance assumption of the Compounders strategy has largely been competed away in modern-day stock markets — in the same way that widespread awareness of the cigar butt strategy during Buffett’s time resulted in higher valuations in such stocks, thus arbitraging away their original competitive outperformance.
Subsequently, 2nd Level Thinking would naturally lead us to the first of Howard Marks’s quotes above:
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."
This quote perfectly encapsulates the situation that Compounder-type stocks find themselves in today. Given that modern-day stock markets have already priced-in the competitive business advantages of wonderful business with amazing moats, their share prices have subsequently been raised to a higher baseline — which arbitrages away their propensity for investment outperformance. It’s like that metaphor where if everyone stands on tiptoes, that height becomes the new baseline — late-2021 was a painful lesson to those who invested in wonderful businesses at ANY price (rather than fair prices), which is the unfortunate trap that many Compounder-type strategies fall victim to.
Thus, where 1st Level Thinking would say that investing in Compounder-type stocks is a surefire strategy to consistent outperformance due to their amazing moats, 2nd Level Thinking would force us to confront the notion that modern-day markets might have already arbitraged away such investment outperformance by assigning a higher cost-of-entry to them (i.e. higher valuations).
A good example to demonstrate this phenomenon is NVIDIA, which is currently trading at 100x trailing PE. Even the best-case scenario would likely not result in a much better lifetime yield (1% LTM earnings yield) than a typical cigar butt stock; or perhaps even a risk-free 5% Treasury bill. As Howard Marks puts it so succinctly:
This necessitates the introduction of a new investment methodology regime in order to regain our edge in efficient modern-day stock markets. As explained above, the first requirement is that it needs to be novel/different — otherwise the outperformance from such a strategy would already be priced-in by efficient markets and competed away in the form of higher prices.
We can encapsulate this phenomenon in the term “Contrarianism” — a trait which defines many of Buffett’s pillar investments, including Wells Fargo, GEICO and arguably even Apple (which has gone on to become Berkshire’s most profitable investment in absolute terms). In the article below, I explain how Buffett’s thesis for AAPL 0.00%↑ in 2016 was likely Contrarianism — rather than its Moats:
The good news is that the underlying value investing principle which informs both Graham’s cigar butt and Buffett’s Compounder’s investment approaches remains timeless and enduring, even to this day. This principle is Margin of Safety — which I have gone to great lengths to justify as the cornerstone of value investing in an earlier article. Graham’s following quote fully validates the legitimacy of this timeless investing principle:
"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." — Benjamin Graham
If we marry this with Howard Marks’s aforementioned quote, we begin to synthesize the catalyst for a new novel approach to Margin of Safety that can be reliably practiced in modern-day markets. My personal interpretation of this — after countless years of experimenting and immersing myself in the lessons of the value investing greats — is perfectly encapsulated by Howard Marks’s quote from above:
"For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough." — Howard Marks
In essence, what he is saying here is that Valuation (relative to fundamental value) trumps all other investment considerations. Whether the underlying business is a cigar butt or a Compounder, it possess a given fundamental business value — and what matters more than the mere presence of competitive business advantages (moats) is the Margin of Safety between (share) Price and (business) Value. Even a wonderful business with unscalable moats will not justify its higher business value if the investor overpays for it.
Even the Oracle of Omaha agrees with this notion. Buffett’s landmark quote refers to buying “wonderful businesses at fair prices”, not “wonderful businesses at any price”. Wonderful businesses are indeed superior to cigar butts when compared apples-to-apples — but only if the same Margin of Safety is observed. If valuation is not observed with care, it is still possible to overpay for a Compounder-type business — despite its moats and greater business value. This is further justified by another Buffett quote:
“Price is what you Pay, Value is what you Get.” — Warren Buffett
Now this may sound obvious — isn’t buying a dollar for 50 cents the entire point of investing? Yes, but it may surprise you to discover how underfollowed this raison d'etre is. The essential reason behind why many market participants don’t follow it is the same reason why stock markets tend to be voting machines in the short-term — good bargains only tend to be offered in unpopular assets.
Since prices are a function of supply vs demand, there is a natural self-balancing relationship between the price of an item and the quality of its value — in any market, whether stock, fish or housing market. For instance, you are probably unlikely to find good bargains when buying a house in a good location — since everyone already knows that it’s in a good location, and will bid up its price until market supply vs demand reflects its fair value. Similarly, you are unlikely to find good bargains in wonderful businesses if everyone already knows how wonderful its competitive advantages are — since market supply vs demand will automatically adjust its share price upwards until supply and demand balances.
Thus, the objective of investing in stock markets is not simply to look for wonderful businesses to invest in per se — but to exploit mispricings in market supply vs demand! This can happen in both cigar butts or Compounders — but is most likely to be present when the stock in question is deeply unpopular. Remember, our goal is to exploit inefficiencies in supply vs demand (which is based on fundamental value) — and as you can imagine, the greatest pricing inefficiencies appear when there is excessive emotion involved in markets — both to the upside (irrational exuberance) and to the downside (point of maximum pessimism). Obviously, as investors we are more interested in exploiting the latter (i.e. deeply unpopular) rather than the former (deeply popular).
This is not to say that there are no longer bargains to be found in wonderful businesses — simply that everyone has already figured out how to look for moats in them, and have already bid up the valuations of Compounders to reflect their fair value (e.g. NVIDIA at 100x trailing PE). Thus, the average investor’s chances of finding undervalued Compounders in modern-day stock markets have become dramatically lower than when Buffett first introduced it — when it was still novel.
To be clear, I am not saying that the Compounders approach has stopped working today. There certainly remain plenty of undervalued stocks with esteemed business moats; but they also tend to be super unpopular (and therefore undervalued) rather than popular (which is quite the opposite of what people usually associate with Compounders today). On a related note, I’ve also been noticing a troubling trend where market participants have misinterpreted Buffett’s advice of investing in “wonderful businesses at fair prices” for “wonderful businesses at ANY price”. This is a clearly a contravention of Buffett’s own advice about investing in Compounders.
A Practical Solution for Modern-Day Markets: “Underperformers”
In a recent Institutional Investor interview to promote the 7th edition of Security Analysis, legendary value investor Seth Klarman echoed my sentiments above about the renewed importance of observing market prices/valuations (i.e. supply vs demand) in modern-day stock markets — and their increasing role in redefining investment success today as compared to Graham’s time.
So how does one become an Intelligent Investor in modern-day stock markets? I would like to propose a 3rd alternative for modern-day value investors beyond the duality of cigar butts and Compounders. It adheres faithfully to the everlasting value investing principle of Margin of Safety, and delivers a higher preponderance of investment success than both in modern-day markets — given the supply vs demand (i.e. prices) context we’ve discussed above — for one simple reason. It remains novel.
For lack of a better term, I shall simply refer to this investment strategy as the ‘Underperformers’. I find this to be the best way to describe the approach, as that is what these stocks tend to appear like in the short-term — i.e. underperforming businesses.
However, such ‘Underperformers’ are also where the most inefficient mispricings tend to appear in stock market valuations, for the reasons we’ve discussed above — i.e. markets being excessively depressed about the prospects of the underlying underperforming business. Examples include META 0.00%↑ late last year, or INTC 0.00%↑ today — the former has since rebounded by almost +250% from its trough last year:
As we’ve mentioned, the objective of the ‘Underperformers’ strategy is to look for opportunities with the greatest margin between price vs value, i.e. Margin of Safety. However, there is one additional secret ingredient involved in this strategy — ensuring that you won’t lose money even if you end up wrong (i.e. George Soros’s quote). The idea here is to only secure positions where, to the best of your ability, there is a complete absence of estimable downside — owing primarily to the fact that the share price has already fallen to excessively depressed levels even relative to their underperforming business fundamentals. This implies that the Underperformance has already been priced in, putting a natural floor on further downside risk.
The reality is that these ‘Underperformers’ aren’t actually persistently underperforming businesses (i.e. cigar butts) — they’re just facing some sort of temporary setback in the short-term (e.g. <5 years). However, the short-term can often feel like the long-term to the “voting machine crowd” — which is why I deliberately named this strategy ‘Underperformers’, after how these stocks tend to look like in the short-term.
The idea here is to exploit circumstances where markets as a whole are wrongly (i.e. inefficient) extrapolating a stock’s short-term underperforming prospects into perpetuity — where the share price has fallen to such excessively depressed levels that it has more than priced-in said short-term prospects. Meanwhile, it hasn’t priced-in any upside at all — exposing investors to both low risk & high reward (asymmetric risk:reward) at the same time. I discuss this phenomenon in greater detail in the article linked below:
Of course, the natural counterargument to this approach would be “how do you know you’re not wrong, especially when doing something different from everyone else”?
This is where 2nd Level Thinking kicks in. First-level thinking would dictate that if a certain business is underperforming now, it will continue to underperform — and if everyone thinks it will continue to underperform, then perhaps its depressed share price indeed reflects fair value. However, 2nd Level Thinking would subsequently lead one to ask, “Okay, but what is the further downside for the share price?”
If an Underperformers share price has fallen to a level below even the fair value of its underperforming fundamentals (due to Mr Market’s mood swings as aforementioned) — then even if its fundamentals were to worsen further, there is actually a built-in floor to downside risk by virtue of its undervaluation alone! (i.e. inefficient market pricing to the downside)
In this way, the value investor in such an ‘Underperformer’ stock puts a cap on his downside — while also leaving room for future possible upside. Crucially, he doesn’t have to be right about the upside — he recognizes that by being contrarian there will always be a possibility of him being wrong. But he can afford to be wrong on the upside. Meanwhile, he is overtly preoccupied with mitigating downside risk — where even if he is wrong by virtue of taking a contrarian stance, he will not lose money! This fully embraces the wisdom as encapsulated by George Soros in his following quote:
“It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong.” — George Soros
In other words, the value investor in such an Underperformer stock is exposed to greatly asymmetric risk:reward — where he makes money if he is right, but doesn’t lose money if he is wrong! (“Heads I win, tails I don’t lose much” — Monish Pabrai)
Imagine holding 20 such stocks in a diversified portfolio. You can see how it’s quite possible to reliably achieve a 15% CAGR at the aggregate portfolio level with acceptable risk — no matter what happens in the wider macroeconomic environment. If you’re interested to learn more about this Value Investing portfolio strategy, I explain it in further detail in the articles below:
Practical 2nd-Level Thinking for Intelligent Investors in the Modern-Day
To clarify, Underperformers are different from cigar butts in one important way — they tend to be underperforming businesses only in the short-term (which markets have assigned excessive pessimism to); whereas cigar butts tend to be persistently underperforming businesses. On the surface however, it can be easy to confuse the two — since they are both underperforming businesses in the short-term, and therefore look similar in the short-term.
This is why Underperformers must also fulfill the criteria of ‘not losing money even if you end up wrong’ as described above, independently of their liquidation value (unlike cigar butts). The only way to achieve this in modern-day markets is when the stock price has already fallen to levels way below even the underperforming earnings/FCF power of the business, which provides a built-in floor to downside risk by virtue of their undervaluation alone.
In this way, Underperformers do not merely represent the condition of business fundamentals, but more importantly fulfills the criteria of ‘promises safety of principal’ as required by Graham’s definition of an investment. By exploiting inefficiencies in (stock) market supply vs demand, we can secure the best (share) PRICE (relative to fundamentals) as investors.
Of course, there are also many other ways of practicing 2nd Level Thinking beyond such an Underperformers strategy — I am simply providing an example of how thinking in terms of second-order effects can be an extremely powerful tool in stock markets.
This is especially so in the face of the Compounders strategy no longer being novel in modern-day markets — leading to many such stocks becoming overvalued despite their moats. Many investors of wonderful businesses at ANY price would be well-served to practice 2nd Level Thinking, which would naturally lead them to ask how much they would actually make when overpaying for wonderful businesses — even if they were to be correct about future business outcomes. In the most ironic fashion, many Compounder-type stocks today (high quality businesses) have become low quality investments (“heads I lose, tails I don’t win much”) in modern-day stock markets by virtue of their gross overvaluation — the opposite scenario to my Underperformers strategy.
If you really think about it, exploiting mispricings in inefficient markets (as described in the Underperformers strategy above) is actually making money as an investor from other shareholders! Identifying the fundamental business value of a stock will always remain important, but only inasmuch as it allows you to identify whether its share price is grossly undervalued relative to its fundamentals. By acquiring shares of seemingly underperforming businesses in the short-term (which might actually recover over the long-term), you are not only making money from the business — but at the same time from other shareholders!
Oh, and there’s one last thing. This Underperformers strategy? It’s actually not novel at all. This investment approach towards exploiting market supply vs demand in the form of stock prices is simply what many legendary value investors have been practicing for eons, including Howard Marks, Seth Klarman and David Einhorn. Its competitive advantage simply never gets eroded away over time because it is contrarian in nature, and runs counter to the predisposition of human nature to lean into the crowd — and be fearful of taking the unbeaten path alone. Perhaps I should have christened this strategy the ‘Unpopulars’ instead.
Marks turned me onto this sort of thinking, and I have never, ever looked back. Great thought piece here!
You are so correct in noting the any price phenomenon. Many are over compensating for past errors of not slightly paying up. Like Munger said, “ investing is hard”. Great article.