Howard Marks meets the Indian consensus IRRATIONAL CHOICE

Last week ace US fixed income investor Howard Marks was in Mumbai where he shared his successful approach to investing. Mr Marks, whose net worth is close to $2 billion, founded Oaktree Capital in 1995, which now manages more than $100 billion in assets. One of his ideas, popularised in his book, The Most Important Thing, is “second-level thinking”, which is nothing other than thinking differently from what is obvious. As Mr Marks describes it in his book, first-level thinking would say, “The outlook calls for low growth and rising inflation. Let’s dump our stocks” whereas the second-level thinking says, “the outlook stinks, but everyone else is selling in panic. Buy!” First-level thinking would say, “I think the company’s earnings will fall; sell” while second-level thinking would argue, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”

According to Mr Marks, “firstlevel thinking is simplistic and superficial, and just about everyone can do it. All that 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.’ Secondlevel thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account.” Put it differently, firstlevel thinking leads to easy conclusions and a consensus view. It does not take into account a range of outcomes and probabilities, including the fact that the easy consensus view is usually wrong.

These thoughts come to mind as I mull over the most popular consensus going among the smart investing community: A radically different future of India is being crafted by the current government. The consensus, first articulated by a securities house called Ambit, goes something like this: “The government is very serious in improving governance and the way capital is allocated (lower subsidies and more efficient capital expenditure). But India is a complex society. It has been misgoverned for many decades. Anyone who wants to make fundamental changes will be up against a well-entrenched system, which will fight back. Therefore the change will be long and painful. Demonetisation (even Howard Marks supported it) will reduce the creation and flow of black money, which went into real estate and gold and so is an extremely positive structural change, although it is painful in the short to medium term.” In other words, the Modi government is intent on cleansing (cause), which will create pain (effect) and since everyone’s pain has increased, we must be on the right track of cleansing. This is a fallacy and logicians have a name for it: Post hoc ergo proptor hoc. It is explained as “Y is supposed to be caused by X and since Y happened, it must have been caused by X.” What if we apply the second-level thinking to this issue? These are the questions we would be asking, paraphrased from Mr Marks’ book:

How does the current price for the asset (say Sensex), comport with the consensus view of the future, and with mine?

Is the consensus view 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?

Mr Marks writes, “First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.” Now, here is the homework to challenge the above consensus through some second-level thinking.

Government banks are burdened with bad loans and so are hampered in their lending. There has been no effort at all to solve the problem of bad loans. New bad loans continue to be generated by the same banks. Over three years many banks have consistently been headless. What does it say about governance?

This government’s vision of development is to create many new schemes, like Make in India, Startup India, Stand-Up India, Clean India, MUDRA loans etc. Government schemes are usually highly wasteful. Why will it be any different this time?

Taxes have increased under this government and cases of tax terrorism have not reduced. What does it say about the government’s intent?

There is no reduction in red tape or improvement in ease-of-doing business. How does it affect my assessment of the government?

The main job of reducing friction and improving governance lies in the states but there is no pressure even on BJP-led states to do things differently. What could be the reason?

In the Howard Marks presentation last Thursday, the room was filled with smart investors, analysts and fund managers who were listening with rapt attention to him. It would be a big irony indeed if many of them turn out to be victims of first-level thinking themselves — a blind belief that the government policies are transforming this country fundamentally, and the Indian corporate sector will soon break into an era of fast growth.