One of the most important things to get right when it comes to investing is second-level thinking. If you are going to outperform the market on a risk-adjusted basis, then in addition to being right, you have to be more right than others, and thus different.
This is put most elaborately in my opinion by Howard Marks in his book, “The Most Important Thing.” Here are his three examples of second-level thinking:
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 a panic. Buy!”
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 far less than people expect, and the pleasant surprise will lift the stock; buy.”
The Long Term Edge
One of the few advantages that small investors have over big investors when it comes to being both right and different is the freedom to plan and invest with a longer time horizon.
Money managers have bosses and/or clients they need to update frequently, and if they underperform for a few quarters, their clients start to leave and their bosses get less friendly. They face pressure to be correct in the short term. This is known as career risk.
Smaller investors have less research horsepower and fewer tools, but for the disciplined ones, the freedom they enjoy to invest over the course of years and decades rather than months and quarters can give them an edge.
In particular, small investors get to separate volatility from risk. In financial circles, risk and volatility are often thought of as the same thing. However, another way to define risk is the probability of permanent capital loss, which is separate from mere volatility. A company can be volatile but not too risky, or it can risky without being volatile, when thought of in this way. The two concepts are correlated but not identical.
Companies that are volatile but fundamentally sound regularly give small investors good opportunities to buy at a bargain. One of the best examples of this in my opinion is Discover Financial Services.
Keep Discover Financial Services On Your Radar
Discover Financial Services (DFS) operates the smallest of the four major credit card networks in the United States.
Like American Express, Discover operates a closed-loop system where they are both the issuing bank and the owner of the payment network (unlike, say, the relationship J.P. Morgan Chase has with Visa when it issues its cards). Visa and Mastercard are pure networks and do not carry any credit card deb themselves. Issuing banks they partner with carry the debt. For Discover and American Express, they do both.
Discover consistently receives awards for the highest credit card satisfaction in the industry. And over time, Discover has gradually achieved virtually the same rate of acceptance as the other three card brands in the United States, but still has a long way to go to being as accepted as them internationally.
A key advantage of Discover compared to most banks is that they are so lean and digital. They don’t have legacy bank branches, and thus their costs are low. When they were spun off from Morgan Stanley into a public company about 12 years ago, they pretty much just had their payment network. Over the past decade, they have successfully built out an online bank to acquire cheap deposits, and have branched into other forms of lending in a limited way. They like to describe themselves as a fintech company that actually makes money.
Discover uses the bulk of its profits to pay dividends and buy back shares at cheap prices, which gives it one of the consistently highest shareholder yields of any large or mid-sized company. Mastercard and Visa are great businesses, but everyone knows they are great businesses and they are consistently expensive.
Here is where second-level thinking comes into play for Discover. Credit cards are one of the most volatile lending activities, and thus sensitive to economic downturns. So, people want to sell Discover stock during bad times, which is first-level thinking. A second-level thinker understands this volatility but pays attention to the company’s low valuation, and buys when there is a bargain.
Every year, the Federal Reserve performs a stress test. The credit card lenders including Discover have among the highest expected loan losses during severe recession scenarios:
Chart Source: June 2018 Federal Reserve Stress Test
However, it’s important to realize that these companies are also very aware of this risk and thus well-capitalized. Discover generates superior 20%+ return on equity year after year during good times and builds up reserves, but takes a big hit during down times. That’s the nature of the credit card industry.
However, Discover is more defensive than some of the more aggressive lenders like Synchrony Financial and Capital One. Discover serves middle class consumers with solid credit scores.
Whenever I write about Discover, investors often ask me about Synchrony. I have no qualms with Synchrony stock, but for a long time I have preferred Discover stock for risk-adjusted performance. For example, two years ago I wrote about both of them here (no paywall), and stated my preference for Discover, and since then Discover’s stock performance has nearly doubled that of Synchrony:
Discover has a longer track record as a public company than Synchrony, and actually remained profitable through most of the 2007-2009 financial crisis, and recovered very strongly thereafter:
Three months ago on Seeking Alpha (here’s the article, no paywall), I highlighted Discover and JP Morgan Chase as two bullish picks. In particular, I highlighted this chart for Discover, showing its stock price deviating significantly from its earnings:
First-level thinking at the time of the article was saying to be careful of banks due to the flattening yield curve and other factors. Many investors use ETFs rather than individual stocks, so they threw out the whole banking sector. Second-level thinking was to see that so many people are concerned with banks, that they are quite inexpensive, and that if you buy the cheap-but-quality ones with less yield curve sensitivity, you’ll likely do fine. Since then, both JP Morgan and Discover have outperformed, and this is a good example of why including individual stocks can sometimes make more sense than sticking only to ETFs:
As an update, over the past couple of weeks I have now trimmed my position in Discover after the stock recovered strongly during this bull run. I remain bullish on the company’s long-term prospects, but want to buy in again when there is blood in the streets. This is a volatile company that historically sells off dramatically during bear markets, recovers magnificently during bull markets, and is often priced more cheaply than it should be. During the past year, Discover stock went over $80, then crashed to $55, then recovered back up to over $80.
I still have a small position in Discover in the equal-weight dividend stock portion of my real-money newsletter model portfolio. I haven’t changed this position at all. Therefore, whenever there is a sell-off, I will be automatically buying into Discover to get back to my target allocation.
In addition, for my larger portfolios where I did trim my Discover position, the stock is high on my watch list to refill the full position the next time we get a big sell-off. And it still currently exists as a partial position after my trim.
I recommend putting Discover Financial Services on your radar. It’s a strong, profitable, well-managed company that survived the global financial crisis on much better terms than many other financial companies. And yet, it’s very volatile and prone to big drawdowns. Buying during those drawdowns can be very lucrative for patient investors. As a credit card issuer, the company has high economic sensitivity but low yield curve sensitivity.
Keeping a watch list makes it easier to buy during sell-offs. Instead of having to figure out what to do on the spot, you’ll already have a nice list to draw from. That kind of approach can set a lot of small investors apart from some of the bigger institutional investors that have a shorter-term focus.