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Second-level thinking:

asking the right questions

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Shiraaz Abdullah

Global Equity Analyst, Sanlam UK

The investment world is teeming with smart and talented individuals – both professionals and laypersons – all striving to do well and outperform the market. To get ahead of the pack means not only doing things differently to everyone else, but also thinking differently. It means moving beyond what American investor and writer Howard Marks has coined ‘first-level thinking’ to a second level characterised by contrarian thinking, questioning conventional wisdom, digging deep and above all, asking the right questions.

Reading Moneyball: The Art of Winning an Unfair Game by Michael Lewis provides many insights into the human mind. The chapter that struck a chord with me relates to the labels baseball scouts use to describe players’ attributes. Epithets include ‘good face’ – referring to someone who looks like a star (what does this even mean?), ‘hose’ – meaning a person has a strong arm, ‘wheels’ – a fast runner, and ‘make-up’ – emotional stability.

From an investment perspective, these catch-all phrases sound eerily familiar. Investment professionals and investors alike use many labels to help them make sense of the markets. For example, ‘cheap’ means a company trades on a low price-earnings (PE) ratio, while ‘expensive’ refers to a high PE ratio. ‘Good management’ means many things but inevitably relates – incorrectly in our view – to medium-term share price performance. ‘Stable’ refers to a low-growth company that is a must-have for a portfolio. ‘Platform company’ is a relatively new term that generally describes technology businesses with seemingly limitless potential.

Psychologists Daniel Kahneman and Amos Tversky have written extensively about how these neat labels we create for the sake of efficiency often lead to poor outcomes. They make investments easily palatable to clients (and unfortunately sometimes also to investment professionals) but in truth, the market is not as simple as they suggest.


Let’s take the example of Daisy, a dairy cow, whose value we can reasonably assume is based on the milk she produces – in this case, R10 per litre. Assuming the price of milk doesn’t change and we ignore costs, the value of the cow is simply a function of expected production over a five-year period (I don’t know for how long cows actually produce milk). So what should a person pay for Daisy?

  • In the first year, Daisy produces 100 litres, so the owner receives R1 000. If this rate of production is the status quo for the remaining four years of Daisy’s milk-producing life, she should accrue R5 000 to her owner.
  • Farmer X bids R7 000 for Daisy as he or she expects Daisy to drastically increase her production over the period due to the nutrient-rich patch of grass she feeds on.
  • Farmer Y thinks Daisy has had an above-average year in terms of production, and he thus bids R3 000 for Daisy.

The point is that even in the case of a single dairy cow and very limited assumptions, the value of an asset will swing wildly based on your view or guess of what the future holds. Since there are so many more views and variables to account for when analysing a company, the stock market – and the prices paid – becomes a meeting place for expectations, especially in the short to medium term. It’s only after year five that we’ll truly know who made the better bid for Daisy.

It’s clear that figuring out what we need to pay for an asset is an exceptionally difficult task. We need to spend more (or less) time thinking about certain variables in order to assess whether a market price for an asset is fair or not. If we engage in first-level thinking, we’ll struggle to outperform the market. First-level thinking tends to assume a ‘good’ company is a good investment. Despite the logic to this argument, it’s often not the case. If the butcher, the baker and the candlestick maker all know that company X is a good business, shouldn’t we expect that this will be reflected in the share price?


The father of value investing, Ben Graham, illustrates two pitfalls in buying only ‘good’ companies: ‘The first is that common stocks with good records and good prospects sell at correspondingly high prices. The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgement as to the future may prove wrong.’

Graham’s words were penned in 1949, and yet we still fail to heed the lesson. Shoprite – over the last five years – is an excellent example of a good company failing to earn market-beating returns. In 2012, the company traded at a higher share price than it currently does:

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Since the share price peaked in 2012, it has underperformed the market by 7.5% per year. Investment analysts and suppliers in the retail space would all agree that this is a very good company, but the price paid was not. I accept that I’m cherry-picking the extreme point here, but even if one bought at R100 in 2010, before the mania, you’d have received a return equal to the All Share Index today. The real investment opportunity in Shoprite started in 2003, long before Sandton residents envisaged buying wine and cheese from a Checkers store.

The correct, second-level questions to ask about Shoprite between 2010 and 2012 were: What are the market expectations regarding the company’s growth? Were these expectations realistic? What are our expectations relative to market consensus? What will happen to the stock price if we’re right? What are the chances that we’re right? Why would our estimates be incorrect? What’s the competitive environment like?


First-level thinking uses the investment labels referred to earlier, and digs no deeper. People need these ‘decision-making tools’ to make their lives easier, but investment jargon can be very misleading. These are the questions we need to ask:

  • Cheap stocks: Why is it cheap? Will it recover? Does the market expect it to recover? Remember that cheap stocks can easily become even cheaper if there’s a flaw in the business model or the product is obsolete. If you mechanically invest without assessing all the variables beforehand, would you have the conviction to buy more of a genuinely cheap stock after it goes down?
  • Expensive stocks: The questions relating to Shoprite are relevant here. Remember that an expensive company can turn out to be very cheap in the long run if your expectations for the company are greater than those of the market. Naspers is a good recent example.

First-level thinking looks for a method that will work in all scenarios – something simple and foolproof. The allure of this level of thinking is that it works for periods of time and can even lead to periods of outperformance. The Nifty Fifty stocks in the 70s and 80s, the tech boom in the 90s, and the mining boom in the 2000s were all good times for first-level thinkers – until things came crashing down and led to permanent capital losses. Second-level thinking will always guard against losing money.


At this point you may be wondering if anything works in investing. This piece is not intended to remove hope of outperformance, but to remind investors that there’s no simple way to outperform. The simple way may work for a period, but history has shown it always ends badly. Investing is not a science – or people much smarter than us would be successful at it. It requires an ability to continue to ask the right questions as well as an understanding of human nature. Over the long term, superior thinking will manifest itself in superior results. At Sanlam Private Wealth, we are under no illusions regarding the difficulty of the task ahead of us to maintain our track record – but we relish the opportunity to build on it.

To conclude with the words of American investor and businessman Charlie Munger: ‘It’s not supposed to be easy. Anyone who finds it easy, is stupid.’

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