Framing Ever-Changing Business Environments

Analogies between chess and investing are somewhat frequent. What those usually fails to address is that the chess game is a closed-end system (masters usually memorize thousands of game set-ups like an algorithm so they can outplay opponents), while investments analysts and investors are required to constantly assess the ever-changing business environment. Taking a step back, sometimes the definition of what the business environment is not that linear. At the end of the day, it’s like investing is a matter of perspective and framing, not data collection and processing per se.

Additionally, it’s worth emphasizing what Heuer put brilliantly when he addressed the downside of mental models: it’s the principal source of inertia in recognizing and adapting to a changing environment.

There is a crucial difference between the chess master and the master intelligence analyst. Although the chess master faces a different opponent in each match, the environment in which each contest takes place remains stable and unchanging: the permissible moves of the diverse pieces are rigidly determined, and the rules cannot be changed without the master’s knowledge. Once the chess master develops an accurate schema, there is no need to change it. The intelligence analyst, however, must cope with a rapidly changing world. (…) Schemata that were valid yesterday may no longer be functional tomorrow.

Learning new schemata often requires the unlearning of existing ones, and this is exceedingly difficult. It is always easier to learn a new habit than to unlearn an old one. Schemata in long-term memory that are so essential to effective analysis are also the principal source of inertia in recognizing and adapting to a changing environment. 

From Psychology of Intelligence Analysis; Richard Heuer

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The Dream Machine: Competitive Advantage and the “Value” of a Company

Imagine you own the only machine (and irreplicable) in the world that manufactures product X. Demand for X is virtually infinite, so you almost certainly know all your inventory will be sold with not much effort. And in cash. As the product is so demanded, you don’t even need a salesforce to sell it. But the best is yet to come: input costs are nearly zero because you own a vertically integrated business. Ah, and there are no taxes as you are rebuilding the world and no government has been structured so far. Isn’t it the perfect business? It’s the virtually 100% net margin business with no working capital and little PP&E. Indeed. Although, when valuing it, I bet you will not get much above the risk free rate (Rf). Check the example below:

Dream Machine Example

I have assumed you haven’t exerted your monopoly power to emanate your pricing power for the sake of simplicity (although a sustainable pricing power of X% per year would still be sufficient for the price tagging example, we just need a fixed number). Suppose the available money base do not support price hikes or simply that people do not accept prices higher than 1, otherwise they come and destroy your dream machine.

So here is the key issue: how would a potential buyer agree to pay more than the 850 price tag for your company? He would have to either:

  • Increase free cash flow – (a) if he under-invest in maintenance of the machine, which would affect its future free cash flow; not that smart! or (b) if he was fortunate enough to be able to replicate the irreplicable dream machine, but that would require R&D investment and expansion CAPEX which can not be estimated today, so we will ignore it. Moreover, input costs are already 0 so he wouldn’t benefit from scale, but rather increase the available cash at the end of the period
  • Accept a lower rate of return – pretty much what we are seeing in today’s global equity market

So what is the takeaway? Yes, competitive advantages (moats) are what we look for in a company, but the perfect company doesn’t exist and if it did, it was likely priced to perfection and thus shouldn’t be a great investment, unless you can manage to increase its value over time. The perfect company has little “investment value”.The marginal buyer can’t bid it up unless he accepts a rate of return lower than risk free – by the way, why work if you are already able to earn Rf?! Thus, addressing what are the moats in place and how to sustain those in the long run are of utmost importance, but understanding how can a company possibly expand the existing moats or even create new ones (i.e., leading indicators to the increased long-term free cash flow) is what analysts should fathom.

The Investigative Reporter Handbook: Investigative Journalism Reframed to Investors

In the last post, I have advocated in favor of writing investment cases down and making explicit each linchpin assumption not only for yourself, but to the investment team. As the previous book target public ranged from students to research reporters, I took my time to read another book called The Investigative Reporter Handbook, which aims to be a reference book for investigative journalists, irrespective of which sector they cover – from the government, to healthcare and so on.

I pretty much do not recommend the whole book, but there are some gems we can use in our day-to-day job, pretty practical ones. They tangle 3 main topics:

Research process:

  • Work the case from the outside in / Step back and see the bigger picture, don’t get lost in the details. What are the key questions of the case? And it can’t be more than 3, otherwise you still don’t know how to ponder what is the unknown that must be known
  • Constantly summarize the story in as few words as possible – be sharp
  • Collect both supporting and contradictory evidence
  • Parallel backgrounding: traits left by institutions lead to insights on people, and vice versa
  • “Documents” can lie just like human sources, after all, humans craft them: triangulate
  • Review primary, secondary and tertiary sources
  • Analyze power structures, both formal (likely in the form of organograms), but informal ones too (remember who actually run ANF?) – Understanding power structures gives a journalist a road map for discovering secret sources and hidden motivations
  • Since most recent evidence may make old research material relevant, periodic reviews of the case are recommended
  • Start writing as on as the investigation begins

Interviewing:

  • You must convince your sources that you are a human being and that you are interested in the as people, too. Not merely transactional
  • Interviewing is all about building bridges, maintaining them and sometimes repairing them
  • Because you might have only one shot to interview a source, it is best to wait until most documents are in hand
  • Ask WHY. Use silence in your favor. Questions that lead to yes or no answers should be avoided. Ask for potential sources, people, articles, books. Ask for what you left uncovered but that should be mentioned or analyzed

Thinking:

  • Weigh carefully what the evidence shows
  • Always question conventional wisdom
  • Investors must confront what they think and become aware of certain assumptions they have brought to their subject. Everything should be scrutinized
  • “Questions yield new dimensions for the final stories”
  • Remember not to learn something every day, but craft a new good question for the next day as well
  • An investigation story should answer the SO WHAT, as well as the WHY, WHAT, WHEN, WHERE, WHY, HOW. The answers are generally in the details. The surviving details should form a chain of facts rather than a stack of facts. INSIGHT is key
  • The effective writer should always have an essential naivete, skepticism must be balanced with innocence
  • Think visually about your story, simulate your hypotheses

The Craft of Research

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Admont Abbey Library, Austria

A while back I read a book called The Craft of Research, which approaches research projects from students to research reporters. It aims to help one out by delineating the general research process but, more importantly, it helps one organize its thinking and consequently its writing. The book pretty much helps you to build your argument (investment case, in our world) that compels others to accept your claim and how to anticipate possible questionable assumptions, premises and so on (risks, linchpin assumptions, in our case) so we can address those a priori.

Along the way, I have met people from different asset management companies and most of the time the process seems to be incidental. And by the way, it makes a lot of sense and many people make it brilliantly. My purpose here is just to approach the matter from a different perspective. I have worked both with the “Powerpoint method” and the “Investment case method” and the latter works best (for me, at least) in my opinion.

In the Powerpoint method it’s way easier to pitch a case. Why? You can use graphs (oh, those help a lot!) and make simple bullet points that can imply (too) many linchpin assumptions that are not debated if not made explicit, and so on. When you write things down, you think twice, you make your thinking visible, you to to connect the dots and at the end of the day it’s easier to spot “obvious” mistakes/fallacies/etc (cut to the chase, where you need to spend further time investigating). I really like those bullet points on the importance of writing.

That said, follows below my highlights from the book. Hope it helps.

• The elements of a report – its structure, style, and methods of proof – are not empty formulas for convincing readers to accept your claims: they help us test our work and even discover new lines of thought
You accurately judge the research of others only after you have done your own and can understand the messy reality behind what is so smoothly and confidently presented in you textbooks or by experts
• Most of all, experienced researchers know how to get from start to finish not easily, perhaps, but as efficiently as the complexity of their task allows. (…) In fact, they create two kinds of plans: one helps them prepare and conduct their research; the second helps them draft their report of it
• That plan for a draft helps researchers write, but created with their readers in mid, it also helps readers read
Write to remember, to understand, and to TEST YOUR THINKING
• Try to anticipate your readers’ inevitable and critical questions: how have you evaluated your evidence? Why do you think it’s relevant? What ideas have you considered but rejected? When in writing to meet their readers’ expectations, they found a flaw or blunder in their thinking or even discovered a new insight that escaped them in a first draft written for themselves. You can do that only when you imagine and then meet the needs of expectations of informed and careful readers. When you do that, you create what we call a rhetorical community of shared values
• “Roles” are worth thinking before you write a word
Consider your audience: When you do research, ou learn something that others don’t know. So when you report it, you must think of your reader as someone who doesn’t know it but needs to and yourself as someone who will give her reason to want to know it
• They expect you to be objective, rigorously logical, able to examine every issue from all sides. Above all, they will care about your documents only if you can show how they serve as evidence that helps you answer a question important to understanding
Ask about the history of your topic: how does it fit into a larger developmental context? Ask about its structure and composition (execs and owners) Ask how its categorized (Compare to and contrast with). Turn positive questions into negative ones. Ask What if and other speculative questions. Ask questions suggested by you sources.
Avoid dead-end questions. Once you have a few promising questions, try to combine them into larger ones
• Think of it: What will be lost if you don’t answer your question? How will not answering it keep us from understanding something else better than we do? Start by asking So what.
• Write summaries, critiques, questions, responses to your sources. Keep a journal in which you reflect on your progress. Break the task into manageable steps.
Skimming: search for key words, check first & last paragraphs, read the last chapter, check the bibliography and foot notes
• When you look beyond the standard kinds of references relevant to your question, you enrich not only your analysis but your range of intellectual reference and your ability to synthesize diverse kinds of data, a crucial competence of an inquiring mind.
Don’t accept a claim just because an authority asserts it (Thanks Feynman for that one!)
• You’re more likely to find a research problem when you disagree with a source
• What new insights can it provide? Is there confirming evidence the source hasn’t considered? (the best ones are the contradictory ones though)
Don’t try to find every last jot of data relevant to your question. That’s impossible.
• To learn what works, you must know what doesn’t
• You do not plagiarize a source when you borrow its logic
• It’s risky to attach yourself to what any one researcher says about an issue. It is not research when you uncritically summarize another’s work. Even if your source is universally trusted, be careful.
What’s my claim? What reasons support my claim? What evidence supports my reasons? Do I acknowledge alternatives/complications/objections, and how do I respond? What principle makes my reasons relevant to my claim? (we call this principle a warrant)
• Readers judge your arguments not just by the facts you offer, but by how well you anticipate their questions and concerns. In so doing, they also judge the quality of your mind, even your implied character, traditionally called your ethos.
• When you learn to make one kind of argument, don’t assume that you can apply it to every new claim. Seek out alternative methods, formulate not only multiple solutions but multiple ways of supporting them, ask whether others would approach your problem differently
Nothing damages your ethos more than arrogant certainty. Limit your claims to what your argument can actually support by qualifying their scope and certainty
When you candidly acknowledge weak spots in your argument, you seem more credible by showing readers that you are trying to make an honest case and dealing with them fairly
Facts are shaped by those who collect them and again by the intentions of those who use them
• Any one person’s version of the truth is complicated, usually ambiguous, and always contestable. They will think better of your argument and of you if you acknowledge its limits.
• When you respond to alternatives with reasons and evidence for rejecting them, you thicken your argument, making it increasingly rich and complex
What you don’t say says who you are
• Hemingway said you know you are writing well when you discard stuff you know is good

What video games have to teach us about research?

“So learning here is social, distributed and part and parcel of a network composed of interconnected people, tools, technologies and companies.” “The power of distribution – of storing knowledge in other people, text, tools and technologies – is really the way that all these things are networked together. The really important knowledge is in the network – that is, in the people, their texts, tools and technologies, and, crucially the ways in which they are interconnected – not in any one node, but in the network as a whole. Does the network store lots of powerful knowledge? Does it ensure that this knowledge moves quickly and well to the parts of the system that need it now? Does it adapt to changed conditions by learning new things quickly and well? These are the most crucial knowledge questions we can ask in the modern world.”



How to Compose a Successful Critical Commentary – Daniel Dennett

Remember that last hot investment case debate you had in your firm? How could you politely address that making it smoother for everybody of the team, which at the end of the day yields a more productive meeting?

  1. You should attempt to re-express your target’s position so clearly, vividly, and fairly that your target says, “Thanks, I wish I’d thought of putting it that way.”
  2. You should list any points of agreement (especially if they are not matters of general or widespread agreement).
  3. You should mention anything you have learned from your target.
  4. Only then are you permitted to say so much as a word of rebuttal or criticism. 

– from Intuition Pumps and Other Tools for Thinking