Second-Level Thinking

Howard Marks is a well respected investor and the founder of Oaktree Capital Management. In a recent letter to investors, he introduced a concept that he calls 'Second-Level Thinking'. In his words:

This is a crucial subject that has to be understood by everyone who aspires to be a superior investor. Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . .

For your performance to diverge from the norm, your expectations have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.

Second-level thinking is deep, complex and convoluted.

Certainly, he sets a high mark for how to stretch our thinking.

In the context of the technology industry, I would use the following examples to contrast first-level and second-level thinking around building products:

First-level thinking says, “Clients are asking for this; this functionality will fill a need.” Second-level thinking says, “It’s something that our clients are asking for, but everyone is asking for that. Therefore, every competitor is pursuing that and its just a race to the finish and will quickly commoditize; let’s go in a different direction.”

First-level thinking says, “The IT analyst firms say this market will have low growth and most companies already have the capability. Let’s focus on a different market.” Second-level thinking says, “The outlook stinks, but everyone else is abandoning it. We could reinvent how clients are consuming in this critical area. Double down!”

These are rudimentary and simple, but hopefully sufficient examples for how Second-Level Thinking may apply in the technology industry.


Market Forces at Work

We are in an unprecedented business cycle. Protracted low interest rates have discouraged saving, and therefore money is put to work. At the same time, the rise of activist investors has altered traditional approaches to capital allocation. Public companies are being pushed to monetize their shareholders investments, either in the form of dividends or buybacks (and most often both). Because of this non-relenting pressure on public companies, investment has begun to flow more drastically towards private enterprises (at later and later stages), leading to the 'unicorn' phenomena. These 'unicorn' companies, which have the time and resources in their current form, are doing 3 things:

1) Paying anything for talent, causing wage inflation for engineers and some other roles.
2) Attempting to re-invent many industries, by applying technology and in many cases, shifting them to a pay-as-you-go (or as-a-service) model.
3) Spending aggressively, in any form necessary, to drive growth.

Public companies, in some cases, are crowded-out of the investments they would normally make, given this landscape. But, a central truth remains: at some point, an enterprise must make money. That timeline is typically compressed when capital begins to dry up. The term 'unicorn' was first used to connote something that is rarely seen. The fact that they are now on every street corner is perhaps an indication that time is short.


The Impact

1) "Winter is coming" for the engineering wage cycle. Currently, this inflation is driven in part by supply/demand but more so by the cult of "free money" and nothing else better to do with it. At some point, when 'hire at any cost' dissipates, we will know who has truly built differentiated skills.

2) The rise of cloud and data science will eliminate 50% of traditional IT jobs over the next decade. Read more here. The great re-skilling must start now, for companies that want to lead in the data era. Try this.

3) As-a-service is a cyclical change (not secular). The length of the cycle is anyones guess. And, as with most cycles, it will probably last longer and end faster, than most people believe. Much of this cycle is driven by the market forces described above (less money for capex, since all of it is being spent on buybacks/dividends). At some point, companies will realize that 'paying more in perpetuity' is not a good idea, and there will be a Reversion to the Mean.

4) Centralized computing architectures (cloud) will eventually diminish in importance. Right now, we are in a datacenter capital arms race, much like the Telco's were in 1999. But, as edge devices (smartphones, IoT, etc.) continue to advance and the world is blanketed with super computers, there will be less of a need for a centralized processing center.

5) Machine Learning is the new 'Intel inside'. This will become a default capability in every product/device, instrumenting business processes and decision making. This will put even more pressure on the traditional definition of roles in an organization.

6)There is now general agreement that data is a strategic asset. Because of this, many IT and Cloud providers are seeking to capture data, under the notion that 'data has gravity'. Once it is captured, the belief goes, it is hard to move, and therefore can be monetized. While I understand that in concept, its not very user centric. Who likes having their data trapped? No one. Therefore, I believe the real winners in this next cycle will be those that can enable open and decentralized data access. This is effectively the opposite of capturing it. It's enabling a transparent and open architecture, with the ability to analyze and drive insights from anywhere. Yet another reason to believe in Spark.


It's debatable if the 6 impacts above represent Second-Level Thinking. While they may to some extent, the real thinking would be to flesh out the implications of each, and place bets on the implications. These are bets that could be made in the form of financial investments, product investments, or "start a new company" investments.

IT and the Oracle (of Omaha)

I started following Warren Buffett in college. I don't recall how or why I got interested, but I did, and promptly started reading everything I could find about him. The highlight of my formal education came when he visited the business school at The University of Florida. Doing what is now commmonplace, he promptly conducted an unscripted 2 hour Q&A on any and all topics related to business. It was fascinating and I became an unabashed 'groupie'.

Since then, I have continued to consume everything I can find on Buffett, including, but not limited to, the following highlights:

-His original partnership letters from the first 20 years of his career
-The Essays of Warren Buffett
-CNBC transcripts from his increasingly frequent appearances
-Annual Letters

I'm certainly no expert, but I've done enough homework to credibly speculate on why, after a career of never investing in information technology (IT), he is now the largest shareholder in IBM.

Did Warren Buffett change, did IT change, or did IBM change? I think the answer lies within that multi-part question.

I'll approach the question in 3 steps: 1) Buffet's investment philosophy, 2) How IT has changed, and 3) My answer to the multi-part question.

Investment Philosophy

If anything has been consistent over the past 80+ years, its Warren Buffett's investment philosophy (Note: I think it astutely captured in Pilgrimage to Warren Buffet's Omaha and Secrets in Plain Sight). For the sake of brevity, I'll simplify to 3 overarching points:

1) Chapters 8 and 20 of the Intelligent Investor. These chapters focus on a margin of safety and using the market to serve you, not instruct you.

2) Buy businesses that you understand and accordingly, you can be certain that the company earnings will be materially higher 5, 10, and 20 years from now.

3) Buy major brands, with an extended track record and reputation. He often cites this as an early lesson he learned in his career, which resulted in his purchase of Coca-Cola. It's also among the reasons why companies like American Express, Wells Fargo, and the Washington Post have been ever present in his portfolio.

How IT has Changed

There was a time when IT was a side project in most companies. This is not as long ago as many people think. In fact, I would say the "IT as a side project" era was 1985-1995. No business leader truly cared about IT and it was an afterthought in all strategic and operational planning. Note: there were very few CIO's in this era.

As the internet evolved and the phrase e-business was coined, IT began to transition into the "IT as a function" era (1996-2008). This was the timeframe in which the CIO role was created (often as an unequal among peers). I dont think CIO's really had a voice in the boardroom until the end of this era.

By 2008, we entered the "IT as a Line of Business" era. This is when IT became an indispensible function of the business, arguably as critical for competitive advantage as the products, marketing, sales, logistics, etc of each company. While I estimate this era as starting on the heels of the 2008 financial crisis, I would assert that we are still in the early stages of that evolution. (In baseball parlance, we are in the top of the 2nd inning and we may play extra innnings.) My view on this fundamental shift in IT and the role of IT is why I have written so much about Big Data and the impact it will have on every business globally.

Ill admit that my definition of the era's and timeframes are debateable, but I believe they are approximately right, for the purpose of this analysis. In short, my conclusion is that IT has changed from a department/role/ an essential. IT is as essential to an organization as electricity in the buildings, clients, quality products, efficient supply chains, business and financial controls, and people/management. Even more, in most cases, IT is an critical enabler of each of those items, which makes it "THE" thing for most companies. This is a stark change in the last 20 years.

Did Warren Buffett change, did IT change, or did IBM change?

If there is one thing we know from history, it's that while Warren Buffet may change/evolve his thinking, his principles of investing do NOT change. Hence, I'm confident we can rule out the first part of the question. If you don't agree with me on this one, you need to read some of the sources I highlighted at the outset. His first partnership letter espouses the same themes you see in the most recent Annual Letter.

IT has changed. The technology has changed, the role of the function has changed, and it's no longer SOME THING a company does; it's often THE THING and the enabler of everything. Coming back to Warren Buffet, he has a history of investing in what I think of as the fabric of the economy. This includes things like railroads (transportation), utilities (electricity), insurance (everyone needs it), credit cards (its money in a different form), etc. Over the past 20 years, IT has become the fabric of the economy. It did not happen over night and it will only become more pronounced (think Big Data). In fact, Buffett alluded to this in one of his recent CNBC interviews, when he said that he bought IBM after he talked to many of his Berkshire Hathaway companies and realized how critical IBM was to their ability to operate.

Lastly, IBM has changed and will continue to do so. However, I don't think this was the fundamental driver of Buffet's investment thesis. It's well documented that IBM has made a huge step forward on financial transparency (think: earnings roadmaps). This certainly appeals to Buffet's desire to be able to predict earnings power over 5, 10, 20 year timeframes. This may explain why he chose to buy IBM over other IT companies.

However, despite all of the possible reasons for his investment, I think it boils down to one key insight: IT has evolved from interesting to essential.


Please contact me if you want a copy of the original Buffett Partnership Letters.