The Most Important Thing (TMIT) Chapter 1: Second Level Thinking

“deliberate engaged reading”

The idea is to take the book " The most important thing illustrated" ( it’s Howard Mark’s most recent book with useful comments from great investors and teachers)

We cover one chapter at a time. We try and answer in our own words

  1. What were the key messages?
  2. Where have I seen this in real life? ( kind of applied learning)
  3. What questions come up as I reflect? What would I like to know more?

The outcome

  1. We are reading very deliberately and tuning ourselves to the 19-20 risks Mr.Marks would like us to understand.
  2. We have internalised the learnings as we are going to write each chapter’s key learnings, interpretation and questions that pop up.
  3. In a few weeks we have all “very” well read the book and created a repository to further investment learning

Q. What are the key messages?


Investing (like economics) is more art than science and that means things cannot be made fixed and mechanical - things can get messy -and that it requires one to be adaptive and intuitive.

Getting above average returns, versus average returns that could be achieved via index funds, would require one to have superior insights.

“In basketball they say, “You can’t coach height,” meaning all the coaching in the world won’t make a player taller. It’s almost as hard to teach insight.”

In investing the key trait required is perceptive thinking, in other words second level thinking.

Consistently above-average results would require, superior insight, intuition, sense of value and awareness of psychology. Howard Marks thinks that one could achieve consistent above average results by applying second-level thinking.

Since other investors 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.

Example of second level thinking

“First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy".

“First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”

Howard Marks urges the investor to go deeper than the simplistic first level thinking to find a variant view.

“Second-level thinking is deep, complex and convoluted.”

Second-level thinking requires one to take a lot of considerations into account: some excellent questions are provided as a sample…

  • What is the range of likely future outcomes?

  • Which outcome do I think will occur?

  • What’s the probability I’m right?

  • What does the consensus think?

  • How does my expectation differ from the consensus?

  • How does the current price for the asset comport with the consensus view of the future, and with mine?”

  • “Is the consensus psychology that’s incorporated in the price too bullish or bearish?

  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?”

First-level thinkers are looking for simple formulas and easy answers.

Second-level thinkers know that success in investing is the antithesis of simple.

“First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.”

“The problem is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.”

“If your behavior is conventional, you’re likely to get conventional results—either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average.”

“Joel Greenblatt: The idea is that agreeing with the broad consensus, while a very comfortable place for most people to be, is not generally where above-average profits are found.”

“Those who consider the investment process simple generally aren’t aware of the need for—or even the existence of—second-level thinking.”“Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers. To consistently achieve superior investment returns, you must be one of them. (second level thinker ).


Q: Where have I seen this in real life? ( kind of applied learning)

In the recent past demonitization created money to flow into the banking system.

First Level thinking - Buy the banks as their cost of funding is going to go down.

Second Level thinking - Maybe the banks might find it more difficult to retain their existing margins as costs of funds go down for all banks and they are forced to act more competitively. Maybe the banks cannot lend so rapidly.

A bank makes money from lending.

The bank is flooded with liquidity and forced to pay interest to its depositors. Will the costs go up in the short term? ( as all this money cannot be immediately be lent)

If the demonetisation dents the “animal spirits” necessary for corporates and consumers. Will demand be dented and therefore make it difficult for the banks to lend?

If money is available more abundantly with all the banks, will this create banks to compete more aggressively in their lending? In other words, will the margins suffer?

Can the government create an alternative cheaper or free transaction platform that would start eating into the fees that the banks charge for transactions?

As many banking services get commoditised will the competitive intensity dramatically increase as new technologies and technology enabled companies offer same or similar services?

In other words, asking the second level questions we may come to a different conclusion than that arrived at by level offered at first level thinking.


Q. What questions come up as I reflect? What would I like to know more?

Is it really possible to outthink and win? Will there not be potential for level 3 and level 4 thinking that one has not even considered?

Is there potential for big losses coming from level 2 thinking? One may have made a coherent thesis based on assumptions that change.

Sometimes we have seen the simple things work spectacularly. e.g. A winning company that keeps on winning. Does it always require a second level thinking to win?

Does second level thinking create its own pitfalls? e.g. I hold on to a position as intellectually I want to prove that I am right?

In second level thinking, how does one incorporate factors like luck, good fortune, coming together of circumstances etc. that seems to be playing out in many winning investments? e.g. In the case of Eicher motors, most people built their thesis on the truck business driving the business to success versus the motorcycles.


To be honest, I haven’t read up/brought-myself-up soaking-in HM Memos, or attempted to read TMTI before. The reasons are probably two-fold 1. I have always been more interested in How-To or Investment Process books (as I tried to learn the craft) and in HM’s own words his book (collection of memos) does not offer much on financial analysis or Investment theory, or Superior Business 2. I remained quite illiterate on Risks (Risk to me always was a) margin of safety being absent, and b) inferior understanding of the business).

Thanks to folks like Dhwanil, Abhishek, and now DeepInsight I am energised to do a “deliberate engaged reading” with fellow investors to do an honest job of recording what has been probably missing from my investment armoury, more importantly how can I learn to apply, and also record my reactions to the Wisdom in his Memos/TMTI

So what do I really expect to gain from TMTI - can’t be better expressed than by HM himself

So coming to this chapter specifically: Second Level Thinking, what do I expect to gain by a deliberate read here? Aren’t we supposed to do this all the time - always go one-better than simplistic, superficial thinking??

The beauty of the TMT Illuminated (latest edition) for me is the added perspectives/reactions from 3 seasoned/revered investors, Professor Johnson, and HM himself - that is simply invaluable (also helps chasten me up, when I see myself over-reaching). That itself should encourage everyone to dump the pirated versions, and migrate to the new edition :wink:

These are sometimes the sort of reactions we ourselves have (when our individual comments start forming); these are also the sort of questions that we probably like to ask Seasoned investors when we run across them. I am hoping this deliberate reading will prompt us to more probing questions, and consequently superior insights :slight_smile:


Arriving at a correct viewpoint for delivering superior investment performance, consistently over the years.

Above quote from Paul Johnson sums up aptly what is at the heart of Chapter 1: Second Level Thinking. That we have to think differently, and better (than the average investor in the market) is a NO-BRAINER, right? So what else did I notice?

One thing I immediately loved - the multiplicity of quotes I found particularly insightful - to reflect upon (from our active experience).

No rule always works, the environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

While intrinsically I am a pattern-seeking (business superiority) decision-models driven guy, my takeaway from this - re-inforcement of my intuitive observation that the most consistently successful investors around me are highly flexible, open individuals - who recognise the importance of market cycles - are intuitive and adaptive

“Because investing is at least as much art as it is science, it’s never my goal—in this book or elsewhere—to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.”

I have been lucky that at VP we are surrounded by successful folks with very different styles. The most successful among them have constantly adapted (also as we learnt more/got exposed to refinements) and thrived - forcing me to also strive to keep adapting.

“Counting on luck isn’t much of a plan, so you’d better concentrate on insight. In basketball they say, ‘You can’t coach height,’ meaning all the coaching in the world won’t make a player taller. It’s almost as hard to teach insight. As with any other art form, some people just understand investing better than others.They have—or manage to acquire—that necessary ‘trace of wisdom’ that Ben Graham so eloquently calls for.”

This is so true, when we think of say a Hitesh Patel amongst us. At the same time, I firmly believe superior insights can also come from a lot of hard work, and energy that we bring to the table - especially collaborative energy that feeds on one another. We can manage to acquire - some traces of wisdom - if we surround ourselves with folks smarter than us, and those who work harder than us - as we all have come to know :slight_smile:


What are my Actionables then from Second-Level Thinking?

If we look back at the most successful investments in VP Portfolio say over last 5-6 years - we would probably unhesitatingly admit - The real money isn’t made in buying what other people like. It’s about buying what others underestimate, or mis-understand. As Ayush is fond of saying, there will always be objections (where folks potentially underestimate or mis-understand)

How do I look to apply ??

  1. If my Portfolio (today) consists mostly of what everybody likes, then how am I being a second-level thinker? I will surely not be able to Outperform then in the next 2-3 years!!
  2. So being super-content :wink: in adding 2 new Businesses every year (to a portfolio of 8-10 businesses) is NOT optimal. One has to do more than adding a Shemaroo, and a CCL (most folks have started liking them now), It’s gotta be more like 4-5 serious contenders, every year??
  3. So it’s more like every 2 months, I must have some serious contenders to work through - which most folks under-estimate, or mis-understand
  4. Current 2 months - do I have ideas to work through/dismiss or invest-in?
  5. What are areas/ideas that come to my mind - that an average investor in the Market is potentially under-estimating or mis-understanding?? :slight_smile:
    - Divi’s Labs??
    Most friends of mine warn me not to under-estimate the pitfalls - how even a Sun, Lupin have still not managed to come out tops - but surely that’s something that can be worked on, more data-points gathered on automation culture, quality investment mindsets, and people; impact on business and consolidation time-frames?
    - Jubilant Foods??
    No need to lay out the picture, same store growth has to return at some point?
    - Real Estate??
    Kolte Patil Developers, even the well-discovered Godrej Properties
    With curbs on easy black money transactions, RERA, and the impending consolidation in the industry, folks are working out first survivability/and then prosperity

Second-level thinkers we know are already at work at many such current ideas. Apart from establishing the Variant Perception - or, what is mis-understood, I have seen that most times the second-level thinkers work very hard at establishing what is (usually) under-estimated - the cash that the business is (undoubtedly) likely to throw out in the next 2-3 years - as things change :slight_smile:

Look forward to more participation, here. I am sure there will many more interesting takes/actionables, if all of us take this up as seriously as DeepInsight urges us to.


@deepinsight and @Donald have covered the key points quite succinctly in this chapter. Few more nuggets of wisdom from the chapters that attracted my attention

The problem is that extraordinary performance comes only from correct non consensus forecasts, but non consensus forecasts are hard to make, hard to make correctly and hard to act on.

I find this very relevant. To me it means, the odds of my succeeding at making right non consensus forecast is low. This is a construct which is quite powerful. Inference I draw from this is that If I am finding actionable ideas too often…that means I may be falling in to trap and either the forecast is a consensus (and I am interpreting it as non consensus) or I am not right in my forecast. Thus, HM hints at having enough rigor in our work before we act on what we believe is a “right non consensus forecast”. In the earlier paragraph he makes this amply clear

The difference in workload between first- level and second- level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former.

  • Second point that struck me most and where I am still unclear is…so HM talks about buying against consensus to achieve superior performance. However, over a period of time as our hypothesis/judgement is validated and market start accepting it…non consensus will turn into consensus. I am sure we all have experienced the same…in terms of P/E re-rating of the business. So, what should we do then? Sell out irrespective of business quality? If we do so…from time to time…aren’t we exposing ourselves to re-investment risks? If we indeed take this approach…aren’t we missing out on great compounders if we have found it?

If I remember one of the hypothesis that Prof. Bakshi has propounded and I too have been testing it with data that market quite often undervalues the great businesses in the long term…even if we take very optimistic assumption on DCF. If that is the case…does it make sense to base the selling decision just because now you are riding with the market in terms of consensus?

  • Third point that I find quite interesting …he talks about the need for exceptional ability, insight or foresight to find bargain in an efficient market> Here is the quote from HM

_The attractiveness of buying something for less than it’s worth makes eminent sense. So how is one to find bargains in efficient markets? You must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.

What is interesting is that he brings foresight into picture…which is inherently forward looking and hence more uncertain. HM is known for his views of how futile it is to forecast. When he uses Foresight…how does he differentiates that from forecast and won’t it suffer from similar weaknesses as that of forecast?


Thanks Dhwanil…beautifully articulated…this thread is becoming interesting now :slight_smile:

This is how I like to think about this issue. If I go back to HM basics - I shouldn’t have a dilemma with this at all, in fact that is my biggest takeaway. That I have to continuously strive to increase the proportion (perhaps even allocation after due deliberation) of non-consensus candidates in my portfolio (as more contenders move from non-consensus to consensus). Just 2 non-consensus additions a year to a 8-10 stock portfolio, is NOT adequate for sustained outperformance.

If strong Business Quality/Management Quality and Competitive Strategy outlook on a business gradually becomes the consensus view of the Market, then obviously returns have to average. There can’t be any real outperformance.

Having said that, I find it useful to contextulise HM comments for Indian Market in general and our investing style in particular. Most of us focus on small and medium size businesses (rather than large caps) where even when consensus develops, and therefore returns can only mirror business performance, we can still deliver 25%+ cagr returns as the businesses continue to deliver 25% cagr+. I see no reason to change that (holding on to our winners) because 25% cagr is still Outperformance, in the larger market context.

Secondly we have some rich data-points now from the VP experience over last 6 years about the trajectory of non-consensus to consensus migration. In bear-markets like 2009-10-11 this migration is slow. In bull-markets like from 2014 onwards, this migration is fast - so outperformance-ability lasts shorter :wink:

I find in our universe of small emerging businesses we can continue to ride our winners for a long time and outperform, even as consensus develops quickly, so long as the few unique businesses (hopefully well-chosen with self-reinforcing loops) that we focus on continue to outperform business-wise w.r.t the larger market. Needless to say our vigilance has to be that much greater on business-performance visibility.

No-gainsaying the accent on more non-consensus candidates have to be much greater - for out-performance sustainability.


This is a great observation Dhwanil. A good poser for all HM fans to reflect on.

I have only started reading HM. So pardon me, I have my own independent views on how Foresight (enormous work-load) differs from Forecast (more of alternate scenario planning).

Don’t you think Dhwanil - since HM always advocates a range of scenarios - so that we get it roughly right vs getting it precisely wrong - he essentially differentiates Forecasting from Foresight in very fundamental ways? Forecasting essentially has to follow the Foresight exercise??

Foresight for me - hinges on working very very hard to establish - Competitive Strengths/Positioning - Is the business likely to get stronger or weaker, as it continues to execute. To keep things simple, I keep the horizon to next 2-3 years, although the runway is much longer.


I have started reading the book TMIT and having a hard time of it. For one thing its too heavy to digest with a lot of repetitive things coming on and on. And secondly if you have read books by other authors or have experienced market euphorias and seen the consequences then there’s nothing new in what I read here.

But the one thing it does well is to keep an investor grounded and makes you very very conversant about risk. The main message boils down to not paying too high a price for a company one is buying. And not getting caught in market euphorias which in laymen’s language is aptly termed as FROTH.

As Dhwanil pointed out the first thing that struck me is the contradictions that this can induce in our investment philosophy. Where guys like Buffett advocate extreme long term horizons, the message I get here is to be very careful about valuations. Different investors will have different styles with which they can identify and be comfortable with. For me its somewhere between the above two styles.

Usually I complete books quite fast but this one does take time and a lot of reflections after reading the stuff. PETER LYNCH anytime for me. Any number of times.:slight_smile: