Second-Level Thinking

History
Investing
By
Patrick Labbe, CFA

I recently discovered an amusing story from the period of British colonial rule in India. Because they were concerned about the large number of venomous cobras in Delhi, British viceroys decided to pay for dead cobras. Some of Delhi’s more enterprising residents began breeding cobras, which they killed and traded for cash. Once the British discovered this scheme, they ended the bounty, which led the cobra breeders to set the snakes free. The end result was an increase, not a decrease, in Delhi’s cobra population. There are many useful ways to think about this story, but I want to focus on what is often called second-level thinking. Compared to first-level thinking, which is superficial, easy and available to most anyone, second-level thinking involves digging below the surface, asking questions and sometimes requires unique expertise. On its surface, the “cash for cobras” plan was a logical solution, yet a second-level thinker might have foreseen a different outcome by simply asking, “Then what?”

This is also an important lesson for investors seeking exceptional performance, because they need to think differently and more effectively than others. Second-level thinking offers a useful way to both think differ­ently and uncover new ideas or trends that others may miss. For example, if a company reports disappointing operating results, investors looking only at the surface of things may conclude that the company is a bad bet and should be sold. A second-level investor looking beyond the latest report may conclude, after studying the company, its history, the industry and its compet­itors, that the recent troubles are likely temporary. This analysis may convince this investor to buy shares in the company if enough sell orders—driven by first-level thinkers—push the price low enough.

Another example may be a company that announces an investment in new equipment that will reduce costs. On the surface this seems great: Lower costs should increase profits, and increased profits should result in a higher stock price. Some analysts might rush to upgrade their view of the company, pushing shares higher. But an analyst asking “Then what?” might determine that the benefits of investments in new equipment are not limited to any single company, and that at least some competitors will pursue similar cost-saving plans. This second-level thinker might go on to conclude that unless a company possesses a sustainable pricing advantage, any cost savings are likely to be competed away, and the benefits of such investments are probably temporary at best.

If second-level thinking sounds challenging and perhaps counterintuitive, it is. A commitment to digging below the surface adds complexity and doesn’t always yield straight-forward, actionable results. Further, behavioral finance tells us that forcing ourselves to question the consensus and think deeper about things goes against much of the decision-making processes humans typically rely on. But because we wish to set ourselves apart from others, we believe consistently questioning the easy conclusions of the consensus is quite useful.