Strategy:

Success in the sharemarket requires better thinking than many people bring to it

Greg Hoffman Second-level thinkers

Change has been a constant within the Trump White House. As I write, tensions have been rising between Trump and North Korean dictator Kim Jong-un. The president has also raised the possibility of military intervention in Venezuela.

In response to such uncertainty, investors have recently turned to gold, a traditional safe haven. In mid-August, the gold price had risen around 7% over the previous month. And the share prices of Australian-listed gold miners – the likes of Newcrest (ASX: NCM), Northern Star (NST) and Evolution (EVN) – followed suit.

Buying such stocks equates to “first-level thinking”, when sharemarket success demands something more. Billionaire investor Howard Marks explained it well in his book The Most Important Thing:

“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 computerised, 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.”

That background explains why “first-level thinking” won’t cut it for us small investors. Marks says first-level thinking “is simplistic and superficial” and that almost anyone can do it. “All the first-level thinker needs is an opinion about the future, as in ‘The outlook for the company is favourable, meaning the stock will go up.’ ”

He then differentiates between first-level and second-level thinking using several examples:

“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.’ ”

“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!’ ”

CRUCIAL INSIGHTS

For those of us trying to beat the market, these are crucial insights. One edge that you and I have over larger, “well-informed and highly computerised” professionals is an ability to buy smaller stocks that they can’t.

And in Swick Mining Services (SWK) I think we have a situation combining that advantage in small stocks with second-level thinking. The result is a speculative proposition that could be poised for strong returns in the current environment. Here’s why.

Swick provides drilling services to mining companies in Australia, the US, Canada and Europe. Almost 90% of revenue in 2016 came from underground diamond drilling. Despite what it may sound like, this does not typically involve drilling for diamonds but drilling

with diamonds. Specifically, diamond-encrusted drill bits which take long, cylindrical core samples. These

Secondlevel thinkers are wondering if the panic over Amazon is an overreaction

samples are then analysed, typically in a lab, to help mining companies plan their mines more effectively.

Swick’s customers mine for nickel, tin, copper, manganese, zinc, lead and silver. But gold mines are the largest customer segment, making up almost half of Swick’s revenue, and that’s where the second-level thinking comes in.

Rather than simply buying gold or gold mining companies, we can say that if the gold price rises further, then gold miners will be incentivised to mine more quickly, explore for new ore bodies and reconsider previously uneconomic sites. All of this will require more core samples, which should equal more work for Swick.

In May, Swick told investors that it expects rig utilisation in its key underground diamond drilling division to be about 100% by June. So we can assume that it has started the current financial year on a high.

The company’s largest profit to date was $11.3 million in 2013 and I think it has a shot at getting close to that figure if conditions remain favourable. Perhaps not quite in 2018 but the year after that.

Dividing an $11.3 million profit by almost 232 million shares on issue, we arrive at 4.8¢ in earnings per share. At the time of writing, Swick’s share price is 31¢. So that would be an attractive price-earnings ratio of 6.5.

Put another way, if investors were to pay a price/earnings multiple of 12 at that point, the share price would be 57¢, an 84% gain over a couple of years for today’s investor. And the potential upside doesn’t end there.

Swick recently moved to 100% ownership of Orexplore, which has developed a scanner enabling on-site analysis of core samples. Instead of trucking the samples to a specialist lab – running the risk of the cores deteriorating or being damaged – the process can be conducted much more efficiently.

The Orexplore technology is a logical add-on for Swick’s existing clients. And it’s a known quantity for Swick, which first invested in the business in 2013 and has funded its research and development in the meantime. A prototype of the technology operates at the Boliden copper mine in Finland (Orexplore was founded in neighbouring Sweden).

Dreaming bigger, it’s possible that Orexplore becomes standard at mines all around the world. That kind of success would be nice gravy on top of this investment. But it’s not necessary for things to work out well.

THE INVESTMENT STORY

Part of second-level thinking is understanding the difference between a “business story” and an “investment story”. First-level thinkers focus on the business story while second-level thinkers look at the overall picture, taking the stock price into account.

For instance, first-level thinkers are focused on the impact that Amazon’s arrival in Australia will have on retailers. No doubt this is bad news for many local retailers. But consider that many stocks in the sector have halved over the past year. These include Baby Bunting (BBN), Shaver Shop (SSG), Adairs (ADH), RCG Corporation (RCG), Vita Group (VTG), The Reject Shop (TRS) and Myer (MYR).

First-level thinkers are running scared and the question for second-level thinkers is whether that panic is an over-reaction, at least in some cases, and therefore creating investment opportunities.

An important caveat here is that second-level thinking can only ever lead to potential investment ideas. The kernel of something that might grow into a fully fledged idea once researched.

At this point, for me, these retail stocks remain just that – potential investments. I haven’t yet conducted deep research. But Swick is a stock I have followed for many years (and is owned by portfolios I manage). So when the second-level thinking angle of Trump-inspired higher gold prices presented itself, I was in a position to know that the investment case was already an attractive one.

At a time when the leader of the free world appears to epitomise first-level thinking, it may pay more than ever to take our own thoughts to a higher level.

Greg Hoffman is an independent financial educator, commentator and investor. He is also chairman of Forager Funds Management.

Disclosure: Private portfolios managed by Greg Hoffman own shares in Swick Mining.