This blog is inspired by comment made by Tobias Carlisle, one of my favourite value investing podcast authors. In one of his recent podcasts on Value After Hours, that Tobias hosts with Bill Brewster of Sullimar Capital and Jake Taylor, the author of The Rebel Allocator,  Tobais made an off-hand comment that in the last 10 years, first level thinking has been rewarded. So what exactly is first level thinking? And is there something called second level thinking?

As it turns out, I have been aware of the idea of second level thinking for some time now, through my readings of  Howards Marks memos and his book, titled, The Most Important Thing, which has had a profound impact on my thinking on value investing.

Given the market turmoil of the past two weeks, I felt now was probably the best time to invoke what Howard calls second level thinking and put into perspective what Tobias meant when he says, the market has rewarded first level thinking for the last 10 years.

Howard Mark’s book, The Most Import Thing, starts with first chapter on Second Level Thinking. In the chapter, Howard highlights the importance of thinking differently relative to an average investor, as one of the goals for a successful investor is to be anything but average. To paraphrase him, “your goal in investing isn’t to earn average returns; you want to do better than average….. being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different.” 

Howard Marks gives the following example to illustrate what second level thinking is and why it can provide an edge towards an investors quest to beat the markets…

“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, “I think the company’s earnings will fall; sell.”
Second-level thinking says, “I think the company’s earnings will fall
less than people expect, and the pleasant surprise will lift the stock;
buy.”

Howard Marks goes on to highlight several attributes of a second level thinking and provides a list of things that second level thinker has to take into account in decision making. While I will not delve into everything that Howard talks about, I will focus on one of the items on his list: “How does the current price for the asset comport with the consensus view of the future, and with mine?” and provide an example through my own analysis of Delta Airlines, ticker DAL.

The first level thinking view of DAL in current market environment is as follows: Coronavirus will impact travel significantly, which will have an immediate impact on airline earnings and therefore I should sell DAL stock if it is in my portfolio, or even go short the stock for quick gains.

Sure enough, if you take one look at the airlines sector in general (XTN) or DAL, specifically, the sector and the stock has taken a hard beating in the last 2 weeks.

Starting from two weeks prior, 2/25/2020 through today, SPY, ETF for S&P500 index is down about 9.3 % whereas DAL is down about 16 % and the airlines sector ETF is down about 19 %.  Classic first level thinking in play!

Now lets look at actions by one of the legends in investing world, Warren Buffett. In the last week, Warren Buffett purchased 976,000 shares of DAL at average cost of $46.4. What is it that Warren see’s in Delta stock when the world is running away from airlines stock as far as they can get?

You can read more on what media thinks of Warrens purchase here. Here, I will put on second level thinking hat and rationalize why it makes complete sense to load up on airlines stock with solid fundamentals.

Lets start by asking what are the costs involved in flying an airplane? Lets look at the fixed costs: (a) Pilot, need some one to fly the plan and (b) fuel, cant go far without fuel and (c) some what fungible, the staff, which include air hostesses, maintenance crews, accountants, administrators and everyone else who is required to make that airline function.

According to this article in the MEL magazine,  personnel cost about 32 % of all costs, where as fuel contributes to about 22 %. Not much can be done about personnel cost. However, price of fuel varies quite a bit and as such can significantly impact the net income produced per trip. Corona virus has equally impacted the oil sector and oil is quite cheap. Given that airlines lock in the price that they pay for oil through futures market, most airlines will lock in the low oil prices on offer today through various hedging strategies.

Looking, lets say two quarters out into the future, I would presume the impact of coronavirus will start to wear off and folks will start flying again. The boost in revenue coupled with low cost of oil, will provide an excellent multiplier effect to siginificantly impact net earnings on the upside and sure enough markets will react strongly on the upside. Therefore, now would be an excellent time to buy airlines stock, when it is being offered on the cheap.

In summary, to again quote Howard Marks: “For your performance to diverge from the norm, your expectations—and thus your portfolio—have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.” (emphasis is mine).

Video/Book/Article/Audio for the Week

• Video: Andrew Brenton of Turtle Creek Asset Management talk at ValueDACH on being a different kind of value investor.
• Article: Fascinating article by Geoff Gannon on the compounding approach by Warren Buffett, and difference between long-term winners and losers