Think as a Second-Level Investor

 | Dec 13, 2013 | 1:00 PM EST
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One of my favorite sayings is that if you sit at a poker table and can't figure out who the fish at the table is in the first five minutes, then the fish is likely to be you. In other words, if you are evaluating your environment based only what you see, you are likely to be operating with incomplete information.  

Poker players are characterized by the level at which they think about the game. A first-level player simply plays his hand against the table. A second-level player considers the hands of his opponents and the value of his hand against that. A third-level player not only thinks about the opponent's hand, but also asks, 'what hand do they think I have?" This level of thinking is what defines the world class poker player.  

The level of thinking applies to the investment process. Just as in poker, many investors are level-one thinkers. These are the investors that ask the very basic questions and no more. A level-one investor simply says, 'this is a good company so I will buy the stock.' That's as far as that investor takes his thought process. Guess what? Amazon (AMZN) was a great business back in the late 1990's but it was a terrible investment. Cisco (CSCO) was a fantastic company back in the late 1990's, but it was a bad investment.  

The second-order investor on the other hand thinks differently. Instead asking the level-one question, this investor asks:  "this a good company but how is it priced relative to future expectations?" In other words, the second-order investor thinks counterintuitively -- she's not thinking about simply about the business but the price of that business against the future expectations for that business. Second-level investors don't take their investment hands at face value; they consider the other possible scenarios that could create a winning or losing bet.

Let's consider this thought process against today's market environment. At face value it's easy to say stocks have run up so they are due for a pullback. At some point that will indeed happen. But money has to go somewhere and today's zero rates make cash and bonds unattractive investments. It is equities that remain the most attractive. Against that backdrop, you can take the thought process further.

 Companies like Potash (POT) and Mosaic (MOS) are at depressed prices because of the shake up in fertilizer prices and a strong corn corp. But perhaps the question should be "what will the market think when the cycle turns?" Or take General Motors (GM), which I liked a lot when it was trading the mid $20's. Most investors where thinking that GM was a government-owned company. The second- order thinker says: "GM has emerged as much leaner company, auto sales are coming off record lows but the share price does not reflect any of this."

How do you know if you are a second-level thinker? You have found a company you like, which appears to have bright prospects. Then ask yourself how your assessment could be wrong, and spend some time thinking about that question. If you do that, you are well on your way

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