Mastering the 'Second Level' Is Key for Your Investment Success

Howard Marks is extremely good at being in the right place at the right time...

Marks is probably the world's greatest distressed-debt investor. He buys the debt of companies when it trades for pennies on the dollar... then profits when the companies are able to pay off the debt.

His timing has been impeccable. In March 2008, for example, Marks raised more than $10 billion to invest in distressed debt. Up to that point, it was the largest distressed-debt fund ever.

Just six months after Marks began amassing his war chest... the investment bank Lehman Brothers collapsed, taking the debt and equity markets down with it.

From mid-September to the end of 2008, he deployed around $75 million a day... gobbling up the best assets for pennies on the dollar. By New Year's Day 2009, he had invested more than 70% of his $10 billion fund.

Marks made a killing. By 2012, he returned the full principal and promised returns to his investors. After fees, Marks' distressed-debt funds have returned 16% per year on average over the past 30 years.

Marks attributes much of his success to what he calls "second level" thinking. As he points out to his clients, this means: in order to outperform the market, you must behave, react, and think better than others.

Today, I'll discuss how to harness this thinking... and how, like Marks, we can make big profits by buying the debt of companies that most stock investors have left for dead.

Let me explain...

Most people are first-level thinkers. They behave in typical ways, so their investment performance is average.

Marks made a killing. By 2012, he returned the full principal and promised returns to his investors. After fees, Marks' distressed-debt funds have returned 16% per year on average over the past 30 years.

In contrast, second-level thinking, Marks warns, is deep, complex, and convoluted...

"What is the range of likely future outcomes?"... "Which outcome do I think will occur?"... "What's the probability I'm right?"... "What does the consensus think?"... "How does my expectation differ from the consensus?"... These are the kinds of questions the second-level thinker asks.

The bottom line is that first-level thinkers see what's on the surface, react to it simplistically, and buy or sell on the basis of their reactions. Second-level thinkers double-think (and triple-think) every angle of every situation.

It's human nature to "go with your gut"... But as Marks has shown over his career, you always need to second-guess yourself.

Let me give you two examples from our corporate bond newsletter, Stansberry's Credit Opportunities.

In one case, we had a chance to invest in a company we loved. The other company had lousy prospects (and still does).

Both had bonds trading at substantial discounts to par value. This just means that they traded well below the $1,000 "face value" typical of bonds. We look for these opportunities because no matter how much you pay for the bond at the outset, the company is still obligated to pay you the full $1,000 when it matures... as well as interest along the way.

You might think we decided to buy the bond from the company we loved... and ignore the company we hated. But as Marks knows, second-level thinking reveals that loving a company is not the same as loving its bond.

At the time of our analysis, the company we loved generated about $25 billion in annual sales. It had huge profit margins. And while its sales were slowing, it was still projected to grow around 4% that year.

Meanwhile, its balance sheet was a fortress. It had $45 billion in assets, including $7.6 billion in cash on hand. With a total of only $7.5 billion in debt, the company could've cut a check the next day to pay off all its debt.

That seemed to make its bonds virtually a no-risk proposition.

Our proprietary Stansberry credit-rating system gave the bond we investigated a super-safe "9" (one notch below our highest rating). Credit-ratings agency Standard & Poor's rated it as an "A," and credit-ratings agency Moody's rated it as "A1" – solidly investment-grade.

The bond was trading with a yield to maturity ("YTM") of around 6%. Bonds with similar ratings typically were yielding less than 2%.

A super-safe bond yielding an extra 4% looked like a real coup. We loved the company, and its bond looked great... Recommending it would've been the easy choice.

But our second-level thinking moved us to the sidelines...

The company had just been taken over. Its new parent company raised $50 billion in additional debt to fund the deal. And importantly, all of it would end up having priority in the capital structure over the bond we were investigating.

In short, if something were to go wrong and the company's loans defaulted, bondholders in the new entity would have been standing in the front of the line to get their principal paid first. Meanwhile, existing bondholders – which would've included us – would have been left with little or no recovery.

Using only first-level thinking, we loved the bond. Its YTM was three times greater than the other companies with a similar safety rating. But our second-level thinking told us the bond carried more risk than appeared on the surface. So we stepped aside.

It can work in the opposite way, too...

For example, Marks-style second-level thinking uncovered a great opportunity this past June. It was a bond of a lousy company – a large department-store retailer with shrinking sales...

I'm talking about JC Penney (JCP).

Our first-level thinking – or "gut" – told us to stay away. The retailer had already been through several failed "turnarounds" to save its dying business. Meanwhile, the company was saddled with $4 billion of debt. Investors were convinced JC Penney was headed for bankruptcy. That's why its bonds were trading at big discounts to par value.

Our first-level thinking wasn't wrong. The retailer's business can't be saved. We can't envision a scenario where it doesn't eventually go belly-up.

But our second-level thinking told us JC Penney had at least a few years left before it would file for bankruptcy...

Despite its problems, JC Penney could easily pay all of its interest. And it had no significant debt maturing over the next three years. On top of that, it could borrow another $1.4 billion from its banks if needed.

We saw that one of the company's bonds – a small $100 million bond due in less than a year – was yielding 30% at the time. It was yielding more than JC Penney's $500 million bond due in 2097.

That's not a typo... A small bond due next year was yielding more than a large bond due in 78 years! That made no sense.

So we recommended the bond due next year to our subscribers. We were confident the company could pay us on time and in full next year. And as bondholders, that's all we care about.

The bond market finally came to its senses a few months later. After JC Penney reported improved quarterly numbers, the bond we recommended began trading much higher. We sold it early near par value and pocketed a 54% annualized return last month.

In short, first-level thinking led us to a bond that yielded less than 6% and was much riskier than it appeared. Second-level thinking led us to a safe bond that returned nine times as much instead.

It's this second-level thinking that drives our results in Stansberry's Credit Opportunities...

Since launching the newsletter in November 2015, we've averaged an annual return of 20% across 22 closed positions. For comparison, you would have earned a return of only 8% investing in the overall "junk" bond market (as measured by the iShares iBoxx High Yield Corporate Bond Fund (HYG)).

We even beat the return of the stock market while taking on far less risk. An investment in the S&P 500 Index returned about 17% during the same period.

So the next time you're looking at an investment, we encourage you to follow Marks' playbook and go beyond first-level thinking. By using second-level thinking, you'll stay focused on what's really important... and ask yourself all the questions you need in order to succeed.

Regards,

Porter Stansberry and the Stansberry's Credit Opportunities team

Editor's note: Right now, you can get instant access to Stansberry's Credit Opportunities at a 50% discount. It's the lowest price we've ever offered for this service at Stansberry Research... Plus, until midnight tonight, we're throwing in a special "holiday bonus" worth $1,200. Get started right here.

Further Reading

"It's a way to earn equity-like returns with far less risk than investing in stocks," Mike DiBiase says. If you're worried about an overdue market crash, you can still capture the upside of this market volatility and protect your potential downside... Read more here.

"People say that finding safe, deeply discounted distressed debt is impossible," Mike writes. Most folks will tell you that outliers in this market are akin to searching for Bigfoot. But he disagrees... Learn more here.

Market Notes
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When everyone is talking about a stock, excitement builds… the price shoots up… and even more speculators pile onto the bandwagon. That cycle breaks when no one is left to buy, because at that point, shares have only one place to go – down. Take a look at this company…

Tilray (TLRY) was the first pure-play marijuana company listed on a major U.S. stock exchange. It hit the Nasdaq in July 2018 with an initial public offering (“IPO”) price of $17. The company soared more than 1,100% in two months – then crashed. Any discouraging news, however slight, sparked another sell-off… For example, last fall, TLRY dropped 16% in a single day just because beverage giant PepsiCo (PEP) mentioned it wouldn’t invest in pot.

Today, TLRY shares are almost all the way back down to their IPO price, the lowest point since public trading began… And they’re still falling. When everyone is crowded into a hot fad stock, crashes like this are almost inevitable…