Howard Marks, Chairman of Oaktree Capital, is out with his most recent memo where he dives deeper into the importance of what he calls “second level thinking.” At the beginning of the memo, he points to a conversation with investing legend Charlie Munger, who commented that investing, and learning to think in a way that makes one successful in the field, “isn’t supposed to be easy.” That sentiment lies at the core of second level thinking which Marks describes as “deep, complex and convoluted.”
In the early stage market, often due to lack of information on historical company performance, investors who are used to poring over financial statements or reading analyst reports for public companies often fall into the trap of first level thinking when conducting diligence and making investment decisions. This first level thinking generally rears its head in a few different ways:
- Surface-level pattern matching – “He is wearing a hoodie and talks like Mark Zuckerberg.”
- Me-too investing – “Tons of wearables companies are getting funding, I need to get into one.”
- Misunderstanding early stage diversification – “70% of startups fail anyways so I don’t have to think about how I build a portfolio, it’s all about getting into hot companies in hot sectors”
Top early stage investors – whether they are individual angels or deploying capital on behalf of a fund – understand not only the need to go deeper when evaluating early stage opportunities but also have a process in place, a mental framework, for how to actually get to that second level of thinking. Below, we’ve pulled out a few pieces of the Howard Marks framework that are instructive for both new and experienced early stage investors.
If everyone else likes it, it may be time to reevaluate your interest
By the time companies, sectors, or business models are well understood by a majority of investors and are being breathlessly reported on in TechCrunch, it is likely too late and you run the risk of funding 3rd or 4th tier players in winner-take-all technology markets (remember Flywheel?) As Marks notes, if everyone likes it, it is likely that the area has been thoroughly mined. Tons of capital has already poured in and prices/valuations likely reflect the “hotness” of the vertical.
According to Marks, first level thinkers (the investing herd) like things with obvious appeal. Think social media after Facebook and Twitter IPOd and the Pinterest valuation hit the billions. To quote the memo, simply “following the trends that are popular at a point in time certainly isn’t a formula for investment success, since popularity is likely to lead investors on a path that is comfortable but pointed in the wrong direction.”
It’s probably not desirable that everything in a well-diversified portfolio performs well
This may seem a bit counter-intuitive since a portfolio with a ton of big winners would be welcome by any investor (especially in startup investing where big winners drive a considerable share of returns). In reality, this simply doesn’t happen. As Marks points out, a lack of portfolio diversification means that outperformance in one scenario likely means severe underperformance if markets go a different way.
By building an investment thesis that takes into account what you are interested in, what you understand best and where you see the world going you can make sure your view is broad enough to capture the full value of early stage innovation while still maintaining a high degree of focus.
First and foremost, having a thesis acts as a filter. Will you miss some companies? Most definitely. But you will also avoid getting involved in deals in companies or markets that you don’t fully understand which makes it easier to avoid the first level thinking traps (investing because someone else is, etc.) that we discussed above.
An example of a well-thought out thesis is Union Square Ventures, one of the top east coast VC firms, who invest in “Large networks of engaged users, differentiated through user experience, and defensible through network effects.” This thesis is sufficiently wide to allow them to invest in a diverse set of companies like Twitter, Kickstarter, and Duolingo while helping them avoid companies who don’t fit in to their view of the future and won’t fully benefit from the experience and connections of the USV team.
Emotion in an investor’s greatest enemy
In markets with more liquidity, emotion often drives investors to sell when prices plummet, allowing masters like Warren Buffet to “be greedy when others panic.” In early stage investing emotion can drive investors to pull back when market turns sightly. The reality is that great companies are founded in any market condition and investors should trust their diligence (team, product, market, etc.) while working hard to keep emotion out of the equation.
This doesn’t mean top investors are immune from the emotions that drag down their peers. As Marks notes, superior investors may not be insulated, but they manage to act as if they are.
A major pillar of Marks’ philosophy is to maintain a constant line of questioning, each time digging another level deeper. Toyota employs a similar framework, famously called the “5-whys.” Essentially, a series of 5 questions, each building off the last and delving further into the problem. Investors can learn a lot from this approach and apply it to their investment decision making process.
As a hypothetical, let’s looks at the way two different investors might evaluate a nascent food delivery startup.
A first level thinker might dismiss the company outright by asking “What if Amazon enters this market?” and leaving it at that. If you don’t look any deeper, the realization that Amazon, known for effectively infinite access to cheap capital and a strategy of undercutting every competitor they come across, would be enough to scare many investors away.
A second level thinker may follow this line of questioning:
- Q. “Well, if Amazon enters the market what will their strategy be?”
- A. “They would build infrastructure – delivery, etc. – from scratch and look to own the value chain end to end.”
- Q. “Are there any holes in an Amazon strategy that looks like this? And how can this startup exploit those holes?”
- A. “By leveraging existing players in the space — on demand delivery companies, partnerships with warehouses and food distributors, etc. — the company may be able to adapt more quickly to changes and operate with far less overhead”
- Q. “Tons of capital has entered this market in recent periods. What is this team’s secret sauce, their competitive advantage, that will help them not only outexecute Amazon, but also hold back other startups in the space?”
- A. “The team has 80% market share in the their 3 initial markets and has a city launch playbook that has helped them grab over 50% market share within three months of launching 6 new markets.”
- Q. “If they can compete with Amazon, can they be profitable, at least on a unit economics basis in order to continue scaling to keep up?”
…and so on. Eventually, you will reach a point where the investment decision, one way or the other, has been made for you through your diligent preparation and deep line of questioning.