Howard Marks (Trades, Portfolio) is one of the most famous investors of all time, but his skill and experience are often overlooked because he's made his money in the relatively dull world of distressed debt.
Marks founded Oaktree Capital in 1995 and deployed a strategy of using the firm's cash to buy distressed assets at a significant discount. This strategy is very similar to the traditional value investing style pioneered by Benjamin Graham and Warren Buffett (Trades, Portfolio).
Oaktree looked for investments with a set payoff, such as a bond, which usually redeems at par or $100. As long as the issuing company is financially sound, there is usually a high chance bonds will be redeemed or trade back up to fair value. By acquiring the asset at a significant discount to its fair value, Oaktree made handsome profits.
Two qualities helped the firm outperform and take advantage of opportunities when they presented themselves. The first was the ability to act quickly. During the 2008 financial crisis, Marks and his team raised an unprecedented $10.9 billion fund to buy distressed assets. Then, as the rest of the financial world was reeling, Oaktree became a buyer of distressed assets, some of which were trading for as little as 50% of their fair value.
The second invaluable quality Marks and his team possessed was the ability to think differently. When the rest of the market was selling assets, Oaktree was buying. This required a different mindset. The firm needed to keep a cool head in all environments and act quickly, with conviction, when an opportunity presented itself.
Second-level thinking
One of the strategies Marks uses is something he has called second-level thinking. Second-level thinking is the necessity to think better than others, at a higher level, finding an edge not possible to the rest of the market. As Marks wrote in a memo to investors in 2015:
"You have to think of something they haven't thought of, see things they miss, or bring insight they don't possess. You have two react differently and behave differently."
He went on to give an example of first and second-level thinkers reviewing a business. He noted that if a first-level thinker thought the company was good, he would buy the stock. However, the second-level thinker would question why the corporation is good and ask if it is worth buying if everyone else has the same opinion.
Second-level thinking is not just about having a contrary opinion to the rest of the market. It should also seek to ask why one should have that opinion and if it is the right one. Second-level thinking requires a critical and non-bias analysis of the market's opinion of a company and the opinion of yourself. In a 2015 memo, Marks finished with the following summary:
"The bottom line is that first-level thinkers see what's on the surface, react to it simplistically, and buying or sell on the basis of their reactions. They don't understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all of this for the route to success."
Unfortunately, there's no shortcut or simple process one can use to analyze the markets with a second-level viewpoint. It requires time, effort, emotional maturity and continual critical analysis as well as learning. The first step to building a second-level mindset is to spend more time asking why something is acting the way it is and stop taking investment performance at face value.
Disclosure: The author owns no share mentioned.
