When first-order thinking is better
A discussion of when investors are too smart and ignore the obvious. My Simple views to both the inflation outlook and the Twitter stock.
“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 is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in ‘the outlook for the company is favorable, meaning the stock will go up.’
Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account.” - Howard Marks
Howard Marks has 123k followers on Twitter. His last interview video on Goldman Sachs’ YouTube channel has nearly 2 million views, widely known as a lot of views: both for Goldman’s channel but also for boring stuff like finance. There are just a few more mainstream people on the Street than Marks, so it’s hard to think about anything he writes or says as unknown wisdom because once he says it, it’s known to everyone.
No one goes there anymore, it’s too crowded!
If you buy my characterization that everyone on the Street has significant Marks influence, then what you will find out is that if an analyst goes to her PM and says “It’s a good company, let’s buy the stock”, then what will happen is that instead of having the stock on the book, her PM will give her a lesson on the importance of triggers, valuation, a good story, the macro and so on: the second-order stuff.
What I notice is that investors create absurds to explain the inexplicable instead of keeping stuff simple. The most recent and obvious is the “inflation is transitory” story.
I heard a significant amount of smart arguments on why inflation wasn’t transitory: a significant part of it was used cars, there was a huge fiscal and monetary stimulus, but there wouldn’t be one in 2022, COVID would go away, kids would go to school and people would go back to the labor force… All smart arguments. But wrong.
I think that many investors would benefit from simplifying a bit and taking the other side of many of these bets. If you see someone pitching Alcoa on March 1st, 2022 (a day Aluminum price and Alcoa itself made new all-time highs) based on many complex stuff like the economies of the US and China, carbon taxes, and resource nationalism, maybe it’s smart to keep it simple instead of complex and recall: it’s a commodity producer near the peak of the cycle. I mean, it wasn’t bad for him. People liked it and pushed AA further by 20% after the show, he hopefully got new clients and current clients were pleased for listening to his wisdom on the show. In the end, it generated some fun, but it was a small 2% position and he actually was long Microsoft, CSX, and Union Pacific. The complex stuff generates the fun, but it's Microsoft who pay the bills.1
The objective of this post is to list some first-order thinking thesis of mine to illustrate how I think nowadays people are being overly clever and how being straightforward actually is being contrarian. If you have more securities you think people are being too clever, leave them in the comments. As always, this isn’t financial advice and you really shouldn’t listen to anons on the internet.
Macro: there’s no pivot in the horizon
Here’s my first take: inflation is too high and the Fed will need to fight inflation for an extended period of time.
My first evidence is JPow himself.
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
The U.S. economy is clearly slowing from the historically high growth rates of 2021, which reflected the reopening of the economy following the pandemic recession. While the latest economic data have been mixed, in my view our economy continues to show strong underlying momentum. The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers. Inflation is running well above 2 percent, and high inflation has continued to spread through the economy. While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down.” - Fed Chairman Jerome Powell, August 2022 Jackson Hole speech
In my view, it’s very hard to be more straightforward than that.
What JPow is seeing is basically the chart below:
Weekly initial jobless claims are making new multi-month lows
There are two unfilled job vacancies for every unemployed person
To add on all of that, wage growth is running at above 6%, albeit some decrease over the past few months, the last 3 months annualized is running near 5% per year.
Back in the day, when I was taking Econ 101, my professor used to joke that he could explain the world with a supply and demand chart. What I am going to explain is incredibly simple and pure first-order thinking:
There’s a supply chock and aggregate supply goes from AS1 to AS2.
Prices go up from P1 to P2. But at the same time, there’s a recession because output goes from Y1 to Y2
To bring prices down, a central banker must tighten financial conditions so that aggregate demand goes down. This means prices will go from P2 towards P1, but the output will decrease even further from Y2! (not in the chart)
So first of all, the central bank hiking into a recession is exactly what one should expect after a supply shock. The whole idea is to make the recession ever bigger so that prices of goods and services go down and you aren’t caught on an inflationary spiral.
Of course, there are many clever arguments to be dovish: commodities, rent, recession in Europe, China ZCP, wealth effect, housing market slowdown, Micron earnings cratering, Restoration Hardware wisdom, etc… But I like to keep it simple and as long I am still reading news that Amazon is raising wages by 5%, despite whatever purchase managers surveys or financial markets say, I am skeptical that the supply and demand of labor are in balance and I stick with Powell: “restoring price stability will take time”.
Twitter is worth $54.20
The world’s richest man signed a binding contract to buy Twitter for $54.20 per share or $44B. He plans to do that through a mix of committed debt by a bunch of trustworthy U.S. banks, a syndicate of fellow investors, and around $26B of his own money, which he already sold shares of his main venture to fund the acquisition. So the world’s richest man and his fellow capitalists definitely have the cash.
Here’s the problem. The world’s richest man overpaid by a significant amount. To get an idea, the world’s best-run and largest social network company, Meta Platforms, makes $119B in sales and has a $340B enterprise value. Twitter makes $5B in sales but Elon is paying $44B. This means that despite Twitter only making 4% of Meta sales, Elon and his fellow capitalists are paying 13% of Meta’s value for Twitter: they could be overpaying for as nearly as 3x! Not only that but they will be left with a company that makes just $220M in EBITDA but will have to burden nearly $12B in net debt: a leverage ratio of 50x! All of that while the ad market is going through a slowdown and Twitter just printed -1.8% revenue growth for Q2.
So Elon wants to get out. So he invented an excuse.
And then you know the stuff: bots, information rights covenants, a whistleblower. I won’t bore you explaining why it’s all fugazi here.
The problem for Elon is that in the US there’s this thing called Rule of Law and Delaware, the state where Twitter is incorporated, takes particular pride in its Rule of Law in regards to contract law. And on the contract that Elon signed, there’s no clause that if you get cold feet or the digital ad market turns south, you are allowed to leave.
In Delaware, there’s a judge (on her court she’s called a Chancellor, for whatever reason) called Kathaleen McCormick and her job is to make parties do what they agreed they would do when they signed contracts.
And that’s what she does. In 2021 a very similar case to this appeared in her court: a part decided to buy a cake company, a global pandemic surged, the buyers thought that maybe people won’t eat as much cake as they thought they would and then they tried to leave. But there was no way out of the contract. Chancellor McCormick forced the buyers to buy the cake company at the agreed price because that’s how it’s done in America (or a least in Delaware).
Not only that but the Chancellor on her pre-trial rulings2 is exhibiting a very unfriendly tone toward Musk. The first time she spoke on the first pre-trial ruling the stock went up 1% in a matter of minutes. This shows further evidence that she's likely to rule in favor to Twitter.
Finally, recent evidence released to the public showed that Musk’s own data scientists couldn’t find evidence of a bot problem, the main reason Musk gave for leaving the deal.
That’s it. Here’s our first-order thinking thesis:
The buyers have the money
Twitter didn’t do anything wrong
The judge wrote a decision in a very similar case 18 months ago in favor of the sellers
The judge shows signs of low sympathy for Musk's case
The recent evidence shows strong evidence against Musk
You get almost 30% on your cash and no macro risk
The contract says that when there are problems like this, the remedy is forcing the buyer to perform.3
But there are two main things here that cause many people to have second-order thinking.
First, it’s Twitter. The bears will say: it’s the world’s town square, the Chancellor would never allow the company to be owned by a man who hates the company, it’s too important to society! What they are saying is that there’s a doctrine that contracts aren’t valid if the company is socially important. Basically: if you sell cake, you’re not important to society, so you have rights. If you do microblogging, you’re too important, so you have less rights.
Second, it’s Musk. The bears will say: he never complies with the law, he once made a joke that he was going to buy a public company and he got away with that, what are they going to do, put him in the Chancery jail? The point here is that the doctrine is different depending on your wealth. If you are poor enough that you can only buy cake companies for $500M, you get the law treatment, if you can afford to pay $44B for microblogging websites, you get a free pass.4 Alternatively, some say Musk can get a conviction and try to not comply.
Are they right? Maybe? I don’t think so, I would put a less than 10% probability to the two arguments above hold true.
Why do I think it trades where it trades? Well, you can go to your boss and say “here’s a security that is worth $54.20, it’s trading for $38, let’s buy it”. He will ask what you’re seeing that the arbs and special situations guys aren’t, what you know about corporate law, what you think Twitter’s intrinsic value is if the deal doesn’t go through, and so on.
Disclaimer: I own a bit of TWTR.
KISS - Keep it simple, stupid!
If you are in the business of active investing, a lot of times you will find yourself in situations where prices reflect a first-order thinking narrative and you should ask yourself if there isn’t a bigger truth if you think a little bit more.
But there are other moments when prices reflect a complex second-order thinking narrative. If you are wondering if the price reflects reality, can it be the case that the complex narrative is wrong? As they say in software: KISS: Keep it simple, stupid!
The first type of second-order thinking keeps you out of trouble. Obviously I am being greedy here with Twitter. If overthinking about risks causes you to miss 30% returns when Musk goes around taking public companies private, that’s not a big problem, you’re not actually losing money. Of course, you can’t overthink too much that you don’t buy anything, but it’s ok to have a high hurdle.
The second type of second-order thinking is more dangerous. It can be used to justify Cloudflare’s $68B valuation, to continue quantitative easing during a period of high inflation, and to justify buying assets when the people at the steering wheel are employing complex narratives as to why they are continuing with quantitative easing during a period of high inflation. Here you have complex reasoning justifying the unjustifiable.
To summarize:
Keep it simple. Use your big brain to manage risks, but be careful with stuff that is too out of the common to work out.
Use significant second-order thinking to find holes in your thesis. Be paranoid here.
If nonetheless, you have a position that involves complexity, try to check whether the complexity isn’t itself consensus and whether you just believe in it because other people believe in it too. Price drives narrative and can be particularly stuff with complex narratives.
I hope it didn’t cause a bad impression of Mandelblatt. I enjoyed a lot him on the podcast and I think Patrick should interview him more. It's one of my favorite episodes of ITLB. It’s more of a critic of who aped after him and bought after the episode.
Before the trial, the parties will do the discovery process. But sometimes Twitter will ask for Musk’s all Signal messages, Musk' will say there are no Signal messages, and Twitter will find evidence that actually there are Signal messages. Then they schedule a hearing with the Chancellor to ask her what the parties should do. This isn’t the only type of pre-trial ruling, but it’s procedural stuff like that one.
It’s easy to see how it caused incredible damage to Twitter: lots of employees are leaving, advertisers are being told by Twitter would-be owner and top 5 user that it’s all a fraud, and Musk said he would create a competitor if he can’t buy Twitter. One could argue that Musk could pay monetary damages for these problems but 1) it’s very hard to calculate the monetary value of these damages 2) the contract limits monetary damages to $1B and 3) the contract says that specific performance is the solution. If Musk is forced to pay for the damages and ends up not owning Twitter, it’s unfair. But if Musk bullies Twitter and Twitter remains a public company only getting $1B, it’s also easy to see how it’s unfair.
Some years ago, Boston Scientific a company with a $51B market cap was forced to buy another company by the Court of Chancery. Musk’s wealth is still significantly higher than that, but if it was something to do with the law don’t work for the wealthy, BSX should have got better treatment. Perhaps it’s because Musk is an individual and it’s hard to enforce the law when individuals try to buy companies, so Musk gets a pass? I don’t know. If that’s the case, I think we should expect less M&A where an individual is the acquiring party.