Today I will have a very short post about second-order thinking. A term made famous by Howard Marks from Oaktree Capital. I have applied some of his principles to my investment philosophy.
To explain second-order thinking, it is always good to use an example: Imagine that you have a company that is doing well in terms of profitability and the share price returns. One who uses first-order thinking reasons that this is positive and wants to buy shares in the company. Second-order thinking, on the other hand, can come to a different conclusion. The company is competently run and does well, but all investors already think so. The company might be overvalued and the stock overpriced. The second order conclusion may therefore be that it is best to sell.
When I started investing in stocks, it was mostly first-order thinking. I never thought I would buy shares in industries where most producers were losing money. First-order thinking says a company that is losing money will probably give a negative return, and maybe risk bankruptcy. This is quite simple and straightforward. If a company spends more money on producing something than they get paid, they lose money.
For investing in most industries, this is a good practice. I used this first-order thinking in 2011 and 2012 for my investments in banks. Banks were demanded to build a capital buffer to improve their solvency to be better prepared for a downturn in the future. The newspapers were at the time saying that the banks’ interest margins were unreasonably high, and the banks took too much from customers. I thought that instead of fighting against the banks, it would be easier to become a part-owner of them. I started buying shares in the banks that had better than normal profitability. The next few years this was a great investment. Several banks saw returns of over 100%. I would consider this first-order thinking, but no one said it has to be unprofitable to do the obvious.
Second order thinking
What I try to do more of today is second-order thinking. The person most responsible for this is Rick Rule, legendary investor and CEO of Sprott U.S. Holdings. (Now retired, I am looking forward to him saying what he really thinks about companies. He has said he can talk more freely about them in retirement). He has an expression that says: “The cure for high prices is high prices”, and “the cure for low prices is low prices”. This term applies especially to the commodities sector.
If we are in an industry that experiences high prices, it will attract more players. Think of the shale oil industry in the United States when oil prices were above $100 a barrel. With several offering the same product, the supply eventually became so high that there was a surplus of the product. This in turn led to falling prices. See below for the number of operating rigs in the USA and correspondingly for the fuel oil price:
In 2014 oil production became so high, together with expectations of rising production, that the oil price dropped 50 %. It did not bottom out before the fall 2016. Leading to a long bear market in the oil market.
Similarly with low prices for a product, you will eventually lose so much supply from the market that the price of the product has to increase to attract production. If not, no one will produce the product again. There are several industries that are completely dependent on raw materials to be able to produce their end products. Electricity, cars, or pharmaceuticals, all of them are dependent on commodities.
“The cure for low prices is truly low prices.” Prices can however stay low for several years. Excess supply has to be worked off. In addition, in most cases there needs to be a triggering factor that causes prices to start moving upwards. Often there is a perceived, abrupt shortage of the product. For example, suppliers may have production stoppages due to natural disasters, wars or a pandemic. If the buyers expect that they still can get the item product, they will not bid up the price. What makes raw materials special is that when the price goes up, the demand often goes up as well. This is contrary to what economists think is rational for market participants. The damage of running out of critical raw materials in production is far higher than paying higher prices for them. (Very often the price of the raw material is immaterial for the end product. Silver is in a lot of products. Very often it is in quantities that amount to a couple of dollars. If the price goes from $25 to $50 it does not affect the end product that much).
In 2020 we had a great example of fear of running out of a product. You want to find similar opportunities in the commodity market.