One of the Most Powerful Mental Models - 2nd Level Thinking

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Estimated read time: 4 minutes 52 seconds

1. One of the Most Powerful Mental Models - 2nd Level Thinking

2. Analyzing Netflix's Earnings -> What Matters

Good morning and happy Monday - let's get smarter

One of the Most Powerful Mental Models - 2nd Level Thinking

Awhile back I was introduced to the concept of 2nd level thinking

At the time of learning about the concept, I didn't think much of it

But it's one of the most powerful mental models you can apply in both business in life

First level thinking looks at the surface level

"If I do x -> then y will happen"

Here is the difference between first level and 2nd level thinking:

1. First level thinking - if I get a better job -> I will make more money

2. 2nd level thinking - if I get a better job -> I will be able to make more money, which will allow me buy more investments, which can help me retire earlier

2nd level thinking looks at the effects of the effects, the longer term view of what happens of a decision or the 2nd order derivative

Everyone can do first level thinking in business and markets

One of my favorite investors and thinkers, Howard Marks, from Oaktree Capital writes in one of his memos:

First level thinking: This is a good company, let's buy the stock

2nd level thinking: This is a good company, everyone thinks its a great company, the stock is overrated and overpriced, let's sell

2nd level thinking is deep and complex. The 2nd level thinker takes many things into account

• What are the range of outcomes that could happen?

• What is the outcome I think will occur?

• What is the probability I am right?

• What does consensus think?

• How does my expectation differ from consensus?

• What happens if I am right? What happens if consensus is right?

When it comes to any type of market, buying and selling a home, buying and selling a stock, buying and selling a company, there has to be a winner and loser

It's zero sum

If I sell a stock because I think it's going to go down, and it goes up 35% the next day, I was wrong and I lost

I would challenge you when you are entering in various transactions or marketplaces, think about Howard's questions

I recently started thinking about this in terms of various things in life

What do I believe to be true? 

How could this be wrong?

What happens if consensus is right and I am wrong?

One of the most important things I am thinking about it is with respect to rate hikes

You see - the fed ("US central bank") has been raising interest rates as most people have read in order to combat inflation

Higher rates -> less borrowing -> less consumption -> fewer people chasing the same goods = lower prices

Consensus has factored in whether they will continue to aggressively raise rates in the future as you can see below

As the chart depicts, as 2022 has progressed and into 2023, consensus believes the Fed will begin to slow interest rate hikes as inflation will slow, and lower interest rates are better for GDP growth/the economy / asset prices

The question becomes

What if the fed doesn't slow interest rate hikes now that consensus has factored it in?

What if the interest rate hikes are only 1 factor and corporate profits slowing is an even bigger issue?

What if the consensus is right?

My thoughts - if consensus is WRONG and rate hikes do not slow, it just pushes us into a deeper recession in 2023

It's a challenge to start thinking "what if" everyone is wrong

"What if" my thoughts are wrong

But here's the thing

If you think and act like everyone else does in business, life, and markets, you get what everyone else gets. Going against the grain and being different is tough, you'll be wrong a lot, but those who go against the grain and are right are the ones that becomes giants among men.

Analyzing Netflix's Earnings -> What Matters

When I first got into markets, one of my favorite things to do was to trade options on earnings

I was the classic first level thinker:

Lululemon's store is so busy this holiday season, I bet they are going to crush Q4 earnings

Classic

Telling a story and first level thinking, no math, no facts = yikes

I very quickly learned that WHAT HAPPENED or the static number doesn't matter

What matters is:

1. What happened vs what consensus thought

2. Are they growing or accelerating quarter over quarter and year over year

3. What they guide to / hint at heading into the next quarter / next year

Here are some of the noteworthy items I see when reviewing this chart

1. Revenue slowed from Q3 to Q4

2. Revenue in Q4'22 is up over Q4'21 (1.9% YoY)

3. Global Streaming Paid Memberships are up 4% YoY

4. Global Streaming Paid Memberships are up QoQ

5. Netflix generating significant free cash flow compared to Q4'21

   1. Cash flow growth = how they spend on more content, pay more to acquire new customers, pay for more employees -> this is big after losing $569 million in Q4 of 2021

6. Netflix has showed guidance into Q'1 2023 that shows both QoQ and YoY revenue, operating income, and net income growth (all positive)

AND ->

Netflix missed vs expectations on earnings per share

Netflix announced it's founder Reed Hastings (usually the market responds poorly) is stepping down, and the stock was STILL up on the day

See why earnings is so hard? What will people care about? How will the stock perform? What is priced in?

Why am I bring up Netflix?

Netflix's share price was down close to $170 in early 2022 after slowing subscriber growth and now has almost doubled

When things were looking most bearish and Netflix was at an all-time low, could you the contrarian and go against the grain and see why Netflix could turn it around?

Some people did

It's the people who are willing to look stupid and can leverage 2nd level thinking that often look like geniuses later on

But not many people are willing to take that risk

Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.