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The problem with linear thinking

Congratulations for actually reading this post, most people saw the title and clicked away thinking "I don't do that, it's not for me."  This post isn't breaking any new ground.  Maybe a few will learn something new, and while it's important to keep learning, it's also important to continue to refresh existing knowledge.  This is a refresher post.

Linear thinking is a shortcut for completely thinking through a problem.  It's easier to look at quarterly earnings of $.25 and multiply by 4 rather than estimate what they might actually be due to seasonal fluctuations.  Linear thinking and estimations are everywhere, a casual read of the news or research papers would leave one with the impression that we live in a linear world.  The problem is we don't, often trends reverse, or change due to some inflection point.  I think people like linear trends because it makes them feel like they can guess what the future might look like.  No one knows the future no matter how hard we try to predict it.

My favorite example of linear thinking is personnel assignment for projects.  If a project is estimated to take one person 80 hours there's this widespread myth that assigning two people will get it done in 40 hours, and four people in 20 hours.  The problem is that doesn't account for overlap, or communication overhead.  At a certain point adding an extra person on the team actually lengthens the time needed to finish a project.  There's a book on this topic dealing specifically with software engineering, but the principles are universal, The Mythical Man Month.

Mythical man months and linear thinking are everywhere in investing.  Just go back to any article from 2006 and you'll see the economy and stocks will follow a nice smooth path upwards forever.  I don't know why people accept this sort of reasoning.  Anyone who's lived for even a little bit knows it's not true.  Growth comes in spurts, a child grows very quickly the slows down with bits of fast growth.  Most businesses are similar, they grow fast for a while then mature.  Even nations grow in spurts, the baby boom in the US was a large spurt, the echo-boom a smaller one.  Between those population booms were years of lower than trend birth rates.  With regards to birth rates linear thinking abounds, every few months a story will appear saying Russians will disappear in 400 years, or the Japanese will cease to exist in 300 years at current rates.  When birth rates are high articles are written discussing when the world will run out of capacity, or strategies to slow down growth.

Very few companies have linear growth, for me this is the downfall of DCF calculations.  How do you model lumpy growth?  Some companies do have this predictability, I worked for one that signed all customers to long term contracts with 5% increases each year.  So for them it would be appropriate to model out 5% growth to eternity.  Or at least growth until technology blows up their market.

Warren Buffett, or his followers talk about only buying companies if you know what they will look like in 10 years.  This is great sound bite material for CNBC, but it's unrealistic.  Did Buffett really know what investment banking would look like in 2018 when he made his Goldman Sachs investment?  I doubt it.  We often look at things in a linear fashion when trying to estimate far into the future, and it can be a downfall.  The problem with a linear thought is it blinds us to uncertainty and potentially negative consequences.  The strong moat of Eastman Kodak in 2000 was worthless in 2010, but how many predicted digital cameras would be in cell phones in every pocket back in 2000?  I know I sure didn't.  I remember seeing my first digital camera in 1993, it could fit 100 pictures on a 3.5in floppy disk.  That means each picture was around 14k, the camera was huge and bulky, it was a hobby thing.  Serious photographers used film cameras.  Now about 20 years later I have a camera in my iPhone that's probably 100x or 1000x better than that bulky digital camera and at 1/10th of the cost or less, not to mention the size difference.

Some companies that look strong in the moment fall quickly to technological, or cultural shifts.  MySpace was the king of social networking a few years back.  Who would have thought they'd be complete irrelevant now?  I own a franchise company (Mastercard) and I think about this often.  They have a strong network, but very quickly a competitor could emerge and turn the industry on its side destroying Mastercard's moat.  My concern is that I'll spot this too late after my investment is impaired.

A parting thought before moving on is that the average lifespan of a company has shrunk from 67 years in 1920 to 15 years in 2012.  So when someone says to think 10 or 15 years out that means thinking about the successor or bankruptcy of the company you're examining, a sobering thought.

When I considered doing this post my first intention was to bring awareness to thinking that could be harmful to our investments.  The second goal was to show how this could be exploited.

I find that investors have a very strange fondness for linear thinking thar's often not found outside of investing.  When two sport teams play each other a non-committed bystander usually roots for the underdog.  A very common plot for American movies is an underdog achieving greatness against all odds.  Yet when it comes to an underdog company the standard expectation is it will just decline into oblivion in a straight line.  Conversely great companies like Apple or Starbucks will just grow to the sky forever with investors enjoying sunny days and endless dividends.

When presented with a tight situation people are able to dig down and find resolve to face a tough situation.  Ideas and strength not found in everyday life present themselves and can come to the rescue.  Not every desperate situation works out well, but enough do solely on human perseverance that others in dire straits can remain hopeful.  Investing in cigar butt companies can be similar to a down and out individual.  Not much needs to go right for things to change.  If the negative trend merely stops that can sometimes be enough.

Linear thinkers believe that all net-nets go to zero, why else would a company trade for less than NCAV?  Of course the evidence says otherwise.  Linear thinking says that big giant companies with steady growth will continue to grow forever, a quick look at the Dow over the past 100 years says otherwise.  Beware of linear thinking, and take advantage of it when the opportunity presents itself.

Talk to Nate

8 comments:

  1. Nice post. I totally agree.

    It's crazy how quickly a narrative gets built around events and then everyone accepts it.

    I guess it's kind of like "social proof". Just like how if you walk past 5 people looking at the sky, you'll look at the sky because there must be something interesting there. If everyone believes something, there's a lot of momentum behind it so others simply believe it too.

    It's perhaps what makes contrarian investing profitable long term, and momentum investing profitable short term.

    Completely different topic: I mentioned GPG to you on twitter and you did a great write-up. I ended up selling mine after the 30% runup. Any plans for yours now that management has basically confirmed that they're buying back all stock until the only asset left is Coats?

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  2. Thanks for the comment, narratives are fascinating, you're right, they're built quickly, and often on no hard facts.

    As for GPG, it's a tough call. It's almost a full time job keeping up with the news flow from them. In my original thesis I figured that the full value of GPG wouldn't be realized until Coats is fully exposed. It seems that the market has more than realized the value of GPG's assets and now the value includes some of Coats. The debt and liabilities are being paid off, but it's tough to know how much longer I'd have to hold to realize the full value. I'm up 32% as well, I just read all the releases, I need to think about this for a few days.

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  3. Great article Nate!

    Floris

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  4. Great post Nate. Really enjoyed reading it.

    Thanks.

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  5. great post nate, where did you get this piece of data?

    "A parting thought before moving on is that the average lifespan of a company has shrunk from 67 years in 1920 to 15 years in 2012."

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  6. Here is where I got the stat on company lifespan: http://www.bbc.co.uk/news/business-16611040

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  7. Great post Nate! It's definitely a sobering thought, and something extremely important to investing. I don't know if you've read The Most Important Thing by Howard Marks, but he talks about this as mean reversion, or "the pendulum."

    One thought. I know you're probably just going to think "oh, he's just another mindless Buffett fan" but I really think it's more than a sound bite when Buffett says he would only buy a company if he knows what it looks like in 10 years. It's not that he only buys it if he knows exactly how operations will look, but if he can get a feel for earnings in 10 years. I think Buffett looks at it as a probability bet, and he probably looked at Goldman and said "at these prices I'd have a large margin of safety if x was fair value, so I'll only buy if fair value is clearly x or higher. Then he looked at what the earnings of Goldman would have to be for the next 10 years to merit that valuation, and he said Goldman is extremely likely to be AT LEAST earning that much, so I'll take the bet"...not likely those quoted words, but I think that's the essential thought process I have when following that advice. While you can't think precisely 10 years into the future, the point of the idea is to find inherently predictable businesses, where the economics, while not linear, is still easy to follow throughout various market cycles. The idea of mean reversion, however, is crucial to value investors in this case because you can look at stocks that have fallen dramatically whose business economics are strong and say "they aren't going bankrupt! buy!" and look at stocks whose prices are for perfection and say "this is impossible! short!". Idk if you've seen David Einhorn's short thesis on Chipotle, but I thought it had a lot to do with this idea that nothing goes on forever.

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