The present moment is a unique combination of a health crisis and a sudden-stop economic shock. This mix has not been seen before in modern financial history, and so is confounding a lot of investors’ attempts to search for a historical precedent.
There is an awkward truth at the root of most cognitive biases: humans are lazy. Our big brains take a lot of energy to get fired up, so wherever possible we like to use the quickest shortcut that we can find. This is the efficient path, so it makes sense most of the time. But in moments of great change – like this one – efficiency can lead us deeply astray.
We have seen this with world leaders that applied the wrong analogy to the virus itself: “it’s just a flu”. Or to investors in February that applied the wrong analogy to the economic impact: “this is just going to be a blip like SARS in 2003”. During the depths of despair in March we also saw the wrong economic analogy: “this is the Great Depression all over again”.
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Reasoning by Analogy
The problem with all these takes is that they are reasoning by analogy. We take one thing that looks kind of like another thing, and treat them as being the same. This is one of our brain’s favourite shortcuts. We humans absolutely love reasoning by analogy. Reasoning by analogy is simple, quick, and efficient.
Once we have truly grasped the fundamentals of a situation, we can use analogies to explain our understanding to others. They also help to solidify the understanding in our own minds. At its best, analogy allows us to learn things from each other incredibly quickly. At its worst we arrive at Godwin’s law: the longer an online argument continues, the probability of one side making an analogy comparing the other to Nazis or Hitler approaches 100%.
Analogies are so powerful that we should be careful when they are the only tool being used to convince us. You can find an analogy to fit any argument. If there is a public debate about gun control, the pro-gun lobby will argue that guns are a tool, like knives, and so like knives, should not be banned. The anti-gun lobby will argue that guns kill people, like poisons, and so, like poisons, should be banned. Both of these analogies are tools of explanation, but not tools of fundamental understanding.
The mental shortcut of using an analogy can be incredibly valuable. It saves our precious brainpower. But efficiency is a problem when we quickly travel to the wrong destination. When we are facing something new or different, we should be careful to make sure that the analogy truly fits.
If you are trying to explain a particular view to someone, use an analogy. If you want to improve your understanding of the world, there is a better tool to use.
First-principles thinking
Reasoning from first principles dates back to Aristotle. It is a cornerstone of mathematical and scientific progress. First-principles thinking requires us to question everything until we have reduced the problem down to its most fundamental truths. Once we have those, we can then build back up to a solution.
Elon Musk is a famous proponent of first-principles thinking. When Elon created Space-X, he had a problem: spaceflight was too expensive. There was no way we could become a space-faring civilization with the cost of spaceflight being so high. If Space-X had reasoned by analogy it would have looked at all the rockets that had been launched before and concluded that low-cost launches were impossible. That was not an acceptable answer. It was time to question everything.
Elon broke the problem down to its most fundamental parts: and asked his engineers to calculate the weight of different materials that make up a rocket: steel, copper, hydrogen etc. and then compute the total cost based on spot prices for those commodities. He could see that radical cost savings were possible. The Space-X team of engineers got to work designing a low-cost launch system from the ground up.
One of the most famous examples of this approach was the development of reusable rockets. Before Space-X, rockets were extremely expensive to produce, and only ever used once. When a rocket blasted off for space it jettisoned huge chunks of itself in stages and sent them crashing back to Earth. Elon asked, why? If Space-X could land and re-use the rocket it would cut up to 75% of the cost of manufacture. In December 2015 Space-X achieved what was previously thought impossible – landing a rocket back on the landing pad. Today, a rocket returning smoothly to earth has become so commonplace that it barely makes the news.
How do we apply first principles thinking to the current investment landscape?
We first need to determine what the fundamental truths are of this crisis, and then reason our way up from there. In late February that primarily meant considering the nature of the virus itself. Now we need to combine this with an understanding of the sudden-stop economic shock. What has been directly locked down? Which activities are no longer happening? Which activities are customers most eager to restart? What psychological impacts will lock down have? Are they temporary or permanent? Once we have some understanding of that, we can then reason our way up from there.
This process is not easy. We don’t just need to consider the fundamental truths of how physical particles behave. Since we are dealing with business and financial markets, we also need to consider some fundamental truths of human psychology. It’s not rocket science, it’s much harder. Thankfully there are some tools we can use to address that.
But first, let’s look at two examples where simple assumptions could have led us astray: funeral services, and cruise ships.
Funeral services
Invocare has around 25% share of the Australian funeral services industry. While most of the market was falling in March, Invocare shares rallied 15% as traders speculated that COVID19 would bring a spike in Australian deaths. It was a pretty morbid and short-term trade idea. It was also poorly thought out.
Traders were reasoning that COVID19 would be analogous to previous increases in the death rate that typically benefit Invocare. The logic hinged not just on more deaths, but on more funerals. Did that make sense? Funerals are the type of gatherings where COVID19 are likely to spread, and therefore one of the most likely to be restricted. Indeed that is exactly what happened. The Australian government limited funeral attendance to just 10 people, and Invocare’s share price fell sharply.
Cruise ships
Meanwhile, the Diamond Princess was the subject of huge media attention as it was one of the first recorded major outbreaks outside of the borders of China. The close quarters of a cruise ship made containment very difficult. Despite the crew’s efforts, over 700 of its passengers ultimately caught the virus, and at least thirteen of those passengers tragically passed away. Sydney saw it’s own controversy with the Ruby Princess. In total over 25 other cruise ships have reported cases of COVID19.
A lot of people concluded that the cruise ship industry was over, and compared it to other 20th Century industries that disappeared as the world progressed. But so far it seems they would be very wrong, as the Los Angeles Times reported:
“In the last 45 days, CruiseCompete.com, an online cruise marketplace, has seen a 40% increase in bookings for 2021 compared with 2019, said Heidi M. Allison, president of the company. Only 11% of the bookings are from people whose 2020 trips were canceled, she said.”
What did folks predicting the end of the cruise ship industry get wrong? For starters they ignored that cruise ships have been dealing with health questions for years. Between 2008 and 2014 over 120,000 cruise ship passengers were infected with the gastrointestinal illness known as norovirus. The worst outbreaks made headlines around the world. Yet tens of millions of people still embarked on a cruise, reasoning that those outbreaks were infrequent and unlikely to cause them any harm. Should it have been a surprise that people that love cruise ships would want to return quickly once a one-in-a-hundred-year pandemic had subsided?
Not understanding how cruise ship passengers think is also a symptom of a larger problem that afflicts forecasting. It seems that most (all?) of the people saying that nobody will ever cruise again, were also people that just didn’t like cruises and might have never actually been on a cruise themselves. It is easy to think that an activity will stop after a disaster if you never thought it was attractive to do anyway. Who would want to cruise anyway, especially after a pandemic? Tens of millions of people, it turns out.
Which brings us to one of the most important tools in our investing arsenal: the power of observation.
Escaping our filter bubbles
These examples highlight the importance of not just arriving at a first-principles hypothesis, but also testing it. Once we have an idea we must then ruthlessly search for disconfirming evidence. Is there any information that we can find that will prove our hypothesis is wrong? Space-X doesn’t just run with the first rocket design it comes up with, it tests hundreds or thousands of designs to arrive at what works.
This is particularly important in the present day due to how easy it is for us to avoid interacting with people that have different viewpoints. The more that our activity moves online, the more time we spend in warm little bubbles of our own creation.
Whenever we search for new information on the web, or social media, we are almost always viewing the world through the bias of our own filter bubble. The algorithms of search engines, and social media sites, have been trained by hundreds of thousands of our responses to only show us results that we engage with. These algorithms become our Magic Mirror in Snow White and the Seven Dwarves: “Facebook, Facebook, on the wall, whose opinions are the fairest of them all?” They become a filter on our reality, only showing us what we want to see and reinforcing our chosen tribal identities.
As investors it is critical that we can step outside of our own cozy little bubble, and test whether our view of the world is accurate. It requires what we consider to be one of our four pillars at Maven Funds Management: Deep Research. A core part of that research is to talk with customers, competitors, distributors, and suppliers for our target companies – not just with management.
We should seek to understand the most fundamental truths about a business’ operations and then build our investment thesis up from there. This allows us to gain a firm grasp of how each business is affected by the sudden-stop economic shock, and it will allow us to value the fundamental cash flow impacts.
Crucial to this research is canvassing widely. Speaking with people from different domains, and with different areas of expertise. Each tile of information may not seem too useful on its own but by piecing together thousands of them we are able to create a mosaic of understanding that better represents reality.
We are fortunate to have investors with a wide array of real-world experience. We have already talked to investors excited to join us at launch that are executives, professionals, business owners, CEOs, CFOs, and other domain experts. Which is why I’m excited that tomorrow we’ll be introducing a way for those that are willing to share, to put that collective knowledge to work for the benefit of all of us.
Meanwhile, we are putting the final touches on the Maven Smaller Companies Fund and are incredibly excited to be opening in May – next month! We will have more to share about our launch process in the next few weeks. Until then, avoid the analogy trap, reason from first principles, get out of your filter bubble, and if you think you might have stumbled upon some part of the world that is tipping past a fundamental inflection point – get in touch!
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