It’s natural to make decisions without considering the knock-on effects or second-order consequences: it’s what most people do, most of the time. You’re hungry, so you make a sandwich. It’s hot, so you wear shorts. Straightforward, easy: our brain’s first impulse, in an increasingly complex world, can be to keep it simple wherever we can.
But when it comes to intelligent investing, that first-level thought should not be your last. Investor Howard Marks offers a succinct explanation in his book The Most Important Thing:
"First-level thinking is simplistic and superficial, and just about everyone can do it. All the first-level thinker needs is an opinion about the future, as in ‘The outlook for the company is favorable, meaning the stock will go up.’
Second-level thinking is deep, complex, and convoluted. First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’"
Recognizing the subsequent impacts of events and decisions can be difficult at first. And of course, it all becomes much easier to understand in hindsight, after the fact. For those beginning to engage with second-level thinking, clarity can be sought by persistently asking, “And then what?”
For example, Three Things readers will recall our story earlier this week of Amazon increasing its digital advertising rates on the back of very strong demand. Now, taking this a step further, would you believe that increased digital ad spending can often lead to more bakery items and at-home meal kits being sold at your local grocery stores?
Here’s why. Many of the biggest consumer goods brands spend big competing for the exact location of their products within your local supermarket, with companies paying premiums to appear at eye-level in high-traffic spots. Companies that pay the highest slotting fees are placed in locations that garner the most consumer attention. These fees can range from a few grand to hundreds of thousands of dollars, forming a key source of profits for supermarkets, which historically operate with razor-thin margins.
But with the pandemic-fueled surge in online e-commerce, brands are spending more on digital advertising and less on supermarket slotting fees. Because these fees account for a large portion of their margins, supermarkets have to find new, higher-margin products to sell, to offset the loss. As a result, many stores turn to bakery and baked goods items, and at-home meal kits, which have very healthy margins, typically over 40%. (This is a big part of the story behind Albertsons’ acquisition of Plated, Kroger’s acquisition of Home Chef, and other deals between supermarkets and meal kit providers.)
The first-level thinker would see the news about Amazon’s advertising price hikes and think solely about its impact on Amazon’s profit margins. The second-level thinker sees a whole network of events knocking on from that single news item, discerning outcomes that appear unpredictable at first glance, but make logical sense when thoughtfully gamed out.
When it comes to investing, generating superior investment performance requires different thinking, processing, and decision-making. At Titan, second-order effects are a key component in driving our variant perception. Second-order thinking can be a differentiator in your decision-making process, too.