We Need Some New Mental Models

I’m not going to say that investors lack creativity. But as a group, we seem to have latched on to a certain set of “Mental Models.” And although we talk about them a lot, I’m not sure that the discussion has evolved much over time. I’ve written before about how ubiquitous the “Margin of Safety” concept is in engineering. As an engineer by training, I can attest that many concepts could be helpful in investing: redundancy, avoiding single points of failure, work and energy, friction and wear, as well as fundamental analysis and problem-solving skills.

Biology also offers interesting lessons for investors. Compounding is a core concept in investing, but it appears everywhere in biology. Cell division is an exponential process. Think of how a fetus starts as a single fertilized cell and ends with a baby containing trillions of cells. Or a model I like to think of as reverse compounding: virus replication. A virus needs a host cell to propagate. I often think about this when looking at companies with problems. Imagine one disgruntled employee and how they might affect members of a team. A common - but misguided solution - is to transfer them to another department. Where they can infect another group anew. Similarly, chemistry abounds with concepts that should apply to investing: critical mass, activation energy, conservation of mass, and conservation of energy, to name just a few.

I have enjoyed a book called 101 Things I Learned in Architecture School for years. I find architecture interesting. It is based on physical and mathematical concepts - but married to creativity. It feels a lot like what investing should be like. I’ve been pondering the idea of positive and negative space. Positive spaces are purposefully defined by the objects around them - a classic example is the quad formed between buildings on a college campus. Negative space is left unformed by the objects around them. I find this to be an interesting model when I think about companies. There are things that a company does and does not do. But how considered are they in thinking this through? Many companies suffer from revenue creep - if they feel they can make money doing something, they do it. They are not explicitly defining their opportunity set. Other companies are relentless in their focus - the quintessential story of Steve Jobs returning to Apple and forcing management to focus on only four things. I’m attracted to companies that design the space they operate in. One strategy is a company that enters a space at the “low end,” competing with incumbents on products defined by low unit costs, margins, and low ticket prices compared to other operating costs. By carefully defining their space, they limit the ability and desire of incumbents to compete. They would rather cede market share in the low-cost space than spend the time, money, and energy to defend it. The new entrant, focused on profits where they are meager, becomes cost-focused and efficient. This builds an effective organization that, over time, can move up the value chain and compete on higher-margin products.

So the next time you talk to someone about one of your investments, and you are about to say something about driving 10,000 lb trucks over a bridge designed to hold 50,000 lbs… stop yourself. Dig deeper. Think about biology, chemistry, or ramjet and rocket propulsion! Carpentry! Dance! You might surprise yourself with what you discover.

Feel free to drop any unique and interesting mental models you may use in the comments. We can all learn something new!

I wonder if this is a Corbel Arch Bridge? Courtesy of Engadin Valley, Switzerland