How Physics, Chemistry, and Biology Can Make You a Better Investor w/ Kyle Grieve (TIP749)

Summary

• Scientific Mental Models: The podcast emphasizes the use of scientific mental models from physics, chemistry, and biology to gain a fresh perspective on investing, recognizing patterns, anticipating risks, and identifying opportunities.
• Relativity in Investing: The concept of relativity is applied to investing, highlighting how different investors, like value investor Vince and speculator Steve, can perceive the same investment opportunity differently due to their biases and experiences.
• Inertia and Momentum: The discussion covers inertia and momentum as mental models, explaining how great businesses tend to remain great and how momentum in business fundamentals can lead to significant investment returns.
• Leverage and Catalysts: Leverage is explored as a tool for achieving greater results, while catalysts are described as events that can unlock value or accelerate change in investments, such as management changes or regulatory shifts.
• Ecosystems and Niches: The podcast draws parallels between ecosystems in biology and business environments, emphasizing the importance of identifying companies with strong ecosystems or niche markets that provide competitive advantages.
• Signals and Incentives: Honest and dishonest signals in the market, such as insider buying and share buybacks, are discussed, along with the role of incentives in shaping management behavior and investment outcomes.
• Continuous Learning: The key takeaway is the importance of continuously learning and refining mental models to better understand complex market systems and improve investment decision-making.

Transcript

(00:00) The power of all of these scientific  mental models lies in their ability to give   us a fresh lens through which to view  the investing landscape. These models   enable us to recognize things like patterns,  anticipate risks, and identify opportunities   that many would otherwise overlook. By  borrowing ideas from scientific areas   such as physics, chemistry, and biology,  we're reminded that markets, just like the   natural world, are complex adaptive systems. (00:23) And just as in nature, survival and   success often belong to those who understand the  forces at play and can adapt the quickest. [Music]   Hey, real quick before we jump into today's  episode. If you've been enjoying the show,   please hit that subscribe button. It's totally  free, helps out the channel a ton, and ensures   that you won't miss any future episodes. (00:46) Thanks a bunch. Today, we'll discuss   three broad scientific concepts and their  underlying mental models. I'll be referencing   many from the great metal models volume 2 by  Shane Parish which focuses on three like I said   areas of science which are physics, chemistry  and biology. And I'll be adding a few of my   own personal favorites as well from these three  areas of science as well throughout the episode.  (01:11) So we'll focus mainly on what these metals  are and how we can use them in the context of   investing. We'll start with physics, then move  to chemistry and then finish with biology. My   personal favorite area of science from which  to pick up mental models. Don't worry if you're   not knowledgeable in any of these fields. (01:25) I'm sure as heck not, but I'll be   simplifying these concepts as much as possible  throughout the episode to make it easy for you   to understand. So, we're going to start  here with physics. Let's dive right into   the concept of relativity, which basically  means that there's more than one way to   perceive something. It's really that simple. (01:39) So, two people can observe an event   and come to completely different conclusions.  not only because they're viewing the event from   various angles, but also because of the  internal biases that we all bring to the   table as well as our previous experiences. The  theory of relativity can be understood very well   through thought experiments which I covered in  detail on tip 740 which I'll be sure to link.  (02:00) The book covers two thought experiments  though, both presented by noted physicists. I'm   going to focus on the first one here by  Galileo. So, Galileo concluded that two   observers moving at constant speed and direction  will obtain the same result for all mechanical   experiments that they perform. Let's pretend  that we're on an airplane 35,000 ft in the air.  (02:21) A young child has a bouncy ball that he's  chasing after in the aisle next to us. Anyone on   the aircraft will see the ball bounce on the  ground and then come right back up. The child   drops it vertically, it will appear to bounce  back up vertically. But if we were a bird at the   same height and looked into the window, the  ball would appear to be moving horizontally   as the airplane passed by. This is relativity. (02:42) Two different observers perceive the same   event in different ways. Relativity is prevalent  in investing. Let's take an extreme hypothetical   example to illustrate this. Let's say we have  two investors. We'll call them value investor   Vince and speculator Steve. So, a random micro  cap comes across their desk and they decide to   spend a few minutes looking at the opportunity. (03:03) Let's say it's a hot AI stock, call it   Clara Technologies. This is a real business, by  the way. So, this business has $133 million market   cap and has appreciated by 24,000% year to date.  So, speculator Steve loves the name immediately   just because it has risen significantly and he  buys into the story and thinks that it's just   getting started. He looks at websites. (03:25) He sees robots on the websites,   AI and AI coaching and just falls in love with  the name. He doesn't bother looking at their   financials and buys a big chunk of shares.  Next is value investor Vince. He's already   kind of hesitant to look at it because he thinks  AI is in a pretty big bubble, but he decides to   spend a few minutes looking at their financials  in case this one is some sort of hidden gem.  (03:46) The first thing he sees on the balance  sheet is that the business has $40,000 in   tangible assets. Okay, well, it's asset light.  He justifies it as he plays devil's advocate. He   then examines the revenue and sees that over the  last 9 months, the business has generated only   $26,000 in revenue. So if we annualize it  over the year, he gets to about $35,000.  (04:04) The company is therefore trading at $3,800  times revenue. So he knows this is an easy pass,   but he checks to see if the business might  be profitable just purely out of curiosity.   Unsurprisingly, they've incurred a loss  of $165,000 over the last 9 months. He   quickly discards the business idea. (04:21) Now, while most listeners of   the show will probably resonate with value  investor Vince, it's essential to understand   the perspectives of both sides to see why anyone  might bother being interested in a business like   this in the first place. So, a crucial point to  remember about relativity is that a significant   degree of subjectivity is inherent in it. (04:38) That means people will have different   opinions due to their inherent biases and  experiences. If we look at say speculator Steve,   let's say he's a software engineer who works  in AI and has had success investing in one of   these pre-revenue startups that he's heard from  a friend in the past. So he tends to overlook the   fact that he has also lost, you know, maybe  hundreds of thousands of dollars in similar   startups which have still left him in the red. (05:02) However, since he's understands AI   better than the average person, he  has decided to focus primarily on   AI for potential investments. and Clare  technology got him very excited because   it reminded him of his one big winner  but at a slightly earlier stage of its   growth cycle. With this background,  you can get a better understanding   of where speculator Steve is coming from. (05:20) When we examine value investor Vince,   he's different. He went to Columbia and he  took value investing courses there. He has   every version of Benjamin Graham's margin  of safety as a collector's item. While he   will invest in technology businesses, he  prefers one that everyone hates and are   trading at bargain bin basement prices. (05:38) even if they have decent growth   metrics. He's allergic to companies that trade  for double-digit PE multiples and has had massive   success sticking to his low PE principles.  So, you can see how these two avatars are   just night and day and would come to a completely  different view on the business. While I resonate   personally a lot more with value investor Vince,  many investors are going to deeply resonate with   specular Steve and that's completely fine. (06:02) But as an investor, we can use this   information to understand why a business  might be priced the way it is in the market.   It may be purely for entertainment purposes,  such as the way I view Tesla, but it's still   useful. If we believe a business we own is  drifting further and further away from reality,   then it might be time to sell out of that company  before reality comes for its pound of flesh.  (06:21) Another great example is Warren Buffett  and Benjamin Graham. While Buffett idolized   Graham because of his investing principles,  they actually didn't always see eye to eye   during Buffett's tenure at Graham Newman. So,  Graham had been burned badly by the depression.   This drove much of his investing strategy towards  stocks that were trading below liquidation value.  (06:40) Graham always feared that  another depression was just around   the corner and this kept him away from a ton  of opportunities. Buffett, on the other hand,   was born during the tail end of the depression and  didn't necessarily fear that another one was just   around the corner because he never experienced  it firsthand. So, he was more likely to go out   and find good opportunities that might not  have the same margin of safety that Graeme   wanted, but were still great investments. (07:01) The next mental model I want to cover   from physics is inertia. So inertia is a product  of Isaac Newton's first law of motion stating that   an object at rest stays at rest and an object  in motion stays in motion with the same speed   and in the same direction unless acted upon by an  unbalanced force. So Renee Decartez in his book   principles of philosophy simplified it even more. (07:24) Each thing as far as it is in its power   always remains in the same state. And that  consequently when it is once moved, it always   continues to move. So inertia means things tend  to just stay the same. If things are constantly   changing, they will likely continue to do so.  And the same applies to things that are still.  (07:41) Now, inertia is a great mental model to  use in investing. When I think of inertia, one of   my first thoughts goes right to Pulak Prasad's  great book, What I Learned about investing   from Darwin. So, Prasad examined a study of the  Fortune 500 from 1955 to 2015. Interestingly, this   study suggests that there's a plausible case for  about 40 to 45% of businesses from 1955 to have   sustained their excellence for a full 60 years. (08:05) This is not a number that you would   expect. Where inertia plays a role here is the  fact that great businesses tend to remain great   and average or below average companies  tend to stay average or below average.   There's some ability for upward and downward  mobility, but it's pretty tough. Pulak also makes   the point that a lot of information can be found  from the businesses that did not survive, such as   those that were not found on the Fortune 500 list. (08:30) Pulak asks us to imagine 10,000 potential   companies, both private and public, that could  have made the Fortune 500 in 1955. He estimates   10,000, but out of those, only about 300  made it. That's low single digits. So 97   to 99% of businesses failed to stay great over 60  years. Therefore, stasis tends to be the default.  (08:52) Another interesting way to view inertia  is by considering momentum. Depending on the   type of investor you are, you may view momentum  differently than I do. A trader views momentum as   the continuous movement in a stock price. When  I think about momentum, I try to focus more on   the momentum of a business's fundamentals. And  more specifically, I'm looking at the pace at   which a company is growing its intrinsic value. (09:14) If a business has an EPS of let's say a   dollar and a year later has an EPS of $1, to  me it lacks momentum. One of my primary goals   in investing is to avoid these situations.  While my businesses won't grow EPS linearly,   if I zoom out over a multi-year time period, it  should approximate my forecast or, you know, be   above my hurdle rates. Since my goal is to double  my capital every 5 years, the average business in   my portfolio should grow EPS at approximately 15%. (09:41) I'll definitely be wrong. I've been wrong   in the past and I'll be wrong in the future.  Which means that I will have companies that   fail to achieve this benchmark. But when I'm  right, I'll also have businesses that far exceed   this benchmark by crushing my goal of 15%. For  instance, one of my biggest winners, Topicus,   has compounded EPS at about 30% perom since it  had normalized earnings around December of 2022.  (10:05) Since that time, my compounded  annual returns have been 39% on the stock.   You can also view inertia through the lens of  your investing strategy. Since it's human nature   to remain in stasis, you should audit what you  are doing today and what is helping your strategy   versus detracting from it. If you're honest with  yourself, you may find that there are some habits   that maybe you have sticking around simply  because they're the path of least resistance.  (10:26) One great example of an investor  who escaped this inertia was Adam Cecil,   the author of Where the Money Is. So, he observed  that traditional value investing principles had   evolved in line with the times. And since many  value investors were just stuck, you know,   focusing on gap accounting without making  adjustments, they were actually missing out on   some incredible opportunities in stocks that were  actually punished for investing in themselves,   primarily through intangible assets. (10:50) So rebalancing inertia is another   strategic blunder in my books. Many funds are  forced to take this route because they lack   a steady stream of new capital. However, if  you're a retail investor who still works and   consistently adds cash to your account, then you  don't actually need to make the same move. Fund   managers often have to make this move as they need  to find funds somewhere if they have a great idea.  (11:11) But if you're not in the same  circumstances, then you don't need to   be a victim of rebalancing inertia. You can hold  your best positions and never sell a share. The   final example of inertia I have for you concerns  selling inertia. I was a victim of this one. So,   my reading and researching into investing  has often allowed me to spotlight investors   such as Warren Buffett and Charlie Mer. (11:29) A large part of their success stem   from making a few big bets that paid off very well  and could be held for an extended period of time.   My thought process was that I should be looking  for businesses like these. And while I may have   one or two of these in my portfolio today, I have  lost a significant amount of money by attempting   to hold on to losers, allowing inertia to keep me  anchored to a thesis that just is no longer valid.  (11:52) I know I often criticize Alibaba,  and I don't plan on stopping anytime soon.   I thought this was a business that I could  keep as a long-term compounder. Unfortunately,   I was probably about 10 years too late on that  assumption. To combat the selling inertia,   I now assume I'll have a shorter holding period. (12:08) This gives me a cushion to be incorrect   without beating myself up over it. And I  take a pretty data centered approach. So,   over 40% of the decisions that I've made  have actually cost me money. There's no   point in allowing that fact to deter  me from holding on to businesses that   are unlikely to succeed in the future. (12:25) Another mental model in physics   that I found to be highly useful and think about  very regularly is momentum. It's not mentioned in   the book, but I believe it's a mental model  that is highly useful in investing in life.   So momentum is mass times velocity. It's  elementary. It's hard to get things moving.   And once things get moving, it's hard to stop. (12:45) It's very similar in some ways to inertia,   but it's not the exact same. So one way I  like to look at momentum is as a flywheel.   This is where there are self-reinforcing elements  that keep the flywheel moving and provide it with   momentum. You see flywheels in businesses all the  time. One of my favorite flywheels in business is   the model of being a successful serial acquirer. (13:06) So, here's how being a successful   serial acquire works. First, the serial acquirer  purchases a business. Second, they understand the   business model well and have the right personnel  in place to improve the business's margins and   this means additional cash flow is made after  they purchase it. And third, the business that   they purchase do not require much reinvestment. (13:24) This means the parent company can   reinvest that cash flow into an additional  business. Once they buy a second one,   they now have cash flows from two  businesses instead of one. That   provides even more cash flow to deploy,  and the cycle continues. You can also view   momentum in terms of a business's culture. (13:42) Does a company's culture foster   growth or stagnation? If you listen to my  episode on Netflix's culture on tip 748,   you learn that part of Netflix's recipe for  success has been their ability to cultivate   high amounts of innovation because they have a  culture that has a lot of momentum. Their founder,   Reed Hastings, was very intentional about how he  built Netflix's culture, knowing that innovation   would be one of the keys of Netflix's success. (14:06) So, where many businesses go wrong is   when they decide that they can just rest on their  laurels. If a company has grown to be a giant,   that's often due to innovative products  or services. But some businesses become   monopolies where their customers have just no  other options, and the company can then cut   costs, providing a poorer service while  maintaining or even increasing prices.  (14:25) You see this all the time in utilities and  other slowmoving monopolies. Buffett likes these   businesses because he knows they don't need to  reinvest in themselves and they have them out. So,   it's very unlikely that competition is going  to steal their customers away. However,   someone like Adam Cecil would actually refer  to these types of businesses as rent seekers,   where the company sits on a product that  generates cash and does as little work as   possible to enhance the customer experience. (14:49) I'm not saying who is right or wrong.   Still, it's essential to view businesses  through the lens of momentum to see if you   can observe whether a company is gaining  momentum or if it's slowly losing steam   due to the forces of capitalism. One area  of momentum that has been top of my mind   for me in 2025 is just business momentum. (15:07) Businesses like culture go through   periods of high momentum, but this momentum  can actually slow down. While I'd prefer a   business where momentum is actually speeding  up, this is incredibly difficult to find. And   if a company is picking up momentum, it also  attracts a lot of attention. In businesses,   attention can be really a double-edged sword,  especially when selling a commodity type product   or something that is easily imitated. (15:29) The other challenging aspect of   investing is distinguishing when a business is  truly losing momentum versus merely experiencing   temporary fluctuations. This may be one of the  most challenging aspects of investing. Many   investors will sell a name going through a poor  quarter only to realize years later what a mistake   that was once the business has become multibagger. (15:50) In investing, stock prices are the primary   source of noise that can confuse investors.  My primary strategy for combating this is to   remove the stock price from the equation  and think of a business like a business   owner would. I'll ask myself questions such as,  you know, is the business getting better? Good,   then I'll keep it. And since the market does  silly things like sell companies that will   have a single bad quarter, you should try to  avoid taking part in this herd-like behavior.  (16:14) Instead, focus on the business's KPIs  and whether it will generate higher profits or   cash flows in the next few years. If you  think it will, then selling's a mistake,   even if the stock price is currently  being punished. The size of a business   also has significant impact on its momentum.  Remember, momentum is mass times velocity.  (16:33) If a company has large scale, it becomes  increasingly complex for competitors to slow down   that highly scaled business. Because their mass  is so large, some of these major tech businesses   are just incredibly difficult to compete with.  The usual suspects, Microsoft, Amazon, Alphabet,   and Meta, for example, have these massive  operations that are very, very difficult to stop.  (16:52) And you can use this as a strategy  to find great businesses. One thing I like   to focus on is finding businesses that are  building mass and velocity. That's why I   tend to like smaller companies. Some of these  larger companies reach a point where they can   no longer add significant mass or velocity simply  because they're already at a substantial size and   serve a substantial portion of the market. (17:12) These businesses can still be decent   because it's difficult for competitors to stop  them completely, but they also won't move fast   enough to really keep me interested. Stock prices  also contain a significant amount of momentum.   Much of this is directly related to just market  sentiment. If your business is attracting new   investors, it stock price is going to increase. (17:33) Investing is most dangerous when scores   of novice investors are investing simply because  they've seen their family and friends making   easy money by investing in stocks. This causes a  massive amount of momentum in stock prices. So the   reason this is so risky is when price momentum and  business momentum become completely disconnected.  (17:52) Consider a company like Ava Technologies.  They create specialized sensors for cars that   enable them to see the road by measuring the  distance objects, their speed, the composition of   the object primarily for self-driving and driver  assist features. It's basically LAR. However,   it's a story stock. Oh, since December of 2023,  the stock has compounded EBIT DDA at 4% while   its share price has compounded at 131%. (18:14) So, these are incredibly risky to   own because investors are betting on the  stock's momentum to generate returns. As   long as other investors are playing the role  of the greater fool and bidding up the price,   then owners will have a willing buyer of their  stock to sell to. But what happens is that   businesses like this will see their momentum dry  up eventually and then owners start selling in   droves to find other high momentum story stocks  and once they start trading the selling pressure   increases significantly and the price drops (18:40) sharply. So the following mental   model from physics that I'll be covering is one  that everyone's going to be very familiar with   and this is leverage. So leverage is simply  the ability to achieve results significantly   greater than the force put in. When you're  getting a loan from the bank to buy a home,   you're using leverage to own a home that you  would probably not otherwise be able to afford.  (19:00) When you have a long list of colleagues  and acquaintances and you need help on a   particular problem, you're using leverage  to solve that problem by tapping in to that   extensive network. And if you're a business that  can create value by acquiring other companies, you   may seek additional capital beyond your existing  cash flows or what's on your balance sheet to help   continue creating value for your shareholders. (19:20) So, Parish writes that there are three   things that we need to know about leverage. The  first one is how do I know when I have it? Second   is when should I apply it? And third is how do  I keep it? These are all great questions to ask.   And when I examine the businesses in my portfolio  that utilize debt, it provides me with a really   interesting perspective on how to view it. (19:38) So let's examine a business that I   own that isn't particularly wellknown, but I  think illustrates leverage very effectively.   So the company we're going to be looking at  is called Terravest Industries. Terravest   Industries is a Canadian-based consolidator of  niche steel focused manufacturing businesses with   operating units across HVAC, compressed gas,  processing equipment, and service segments.  (19:58) They specialize in storage vessels,  boilers, wellhead processors, and fluid   management systems. If I want to answer the first  question from the framework, how do I know when I   have leverage? I'll just simply look at Terab's  balance sheet. So, as of Q2 2025, the business   has $108 million for the current portion of  long-term debt and $828 million of long-term debt.  (20:18) So, the total debt there is about  $936 million. When I look at serial acquirers,   I really like to look at cash from operations  and owner earnings. Luckily, Terabus has a   metric that they use called cash available for  distribution, which is essentially the exact   same calculation as Buffett's owner's earnings. (20:35) The numbers for the last quarter are   cash from operations about 34 million and  cash available for distribution around 31   million. So Teravez does have some seasonality  in the business, but they also have a massive   acquisition that's going to contribute very  meaningfully to forward cash flow. The next   question regarding leverage is where and  when should I apply it? So a business like   Tervest clearly does not require debt. (20:56) Their internal cash flows serve   all of the company's needs. But as with many  serial acquires, more opportunities exist than   they have cash on their balance sheet and cash  flowing in on a regular basis. As of Q2 2025,   they only have $17 million on the balance sheet  in cash. But just before the quarters end,   they announced a US $546 million acquisition. (21:17) So if you looked at Teravest as a   business that was kind of unlikely to grow  and saw that the debt levels were this high   compared to its cash flow, you might have zero  interest in the business. But since Terabist   management has shown the ability to deliver  well over 20% returns on invested capital on   acquisitions over the last decade or so, it  brings up an investor's confidence that they   can probably continue doing it into the future. (21:41) As a result, management believes that   they should apply leverage when the  right opportunity arises. If I were   looking at a different business that  maybe had just an average return on   invested capital of let's say 5% over  the last decade, I would be running   to the exit door once I came across that idea. (21:57) A business like this is likely to just   destroy shareholder value by utilizing  debt as it can't generate high enough   uh returns over its cost of capital which is  just value destructive. It's just math. You   don't want any of these in your portfolio. Now  the third question is how do I keep it? So in   the case of Tervest leverage will remain within  the company as long as it sees potential to deploy   capital at high rates of return. (22:20) As I mentioned earlier,   businesses with high leverage that cannot create  shareholder value should be avoided at all costs   and even serial acquirers that pile on debt  for significant uh acquisitions can create   additional risk. Where I find comfort is in  the trust I have in Teravest CEO and CIO who   are just masterful capital allocators. (22:39) I have very little doubt this   new acquisition is going to pay off in a  big way in the long run. And even though   Teravest added debt to their balance sheet to  make the acquisition, my future projection of   cash flow shows that they're going to be able  to service that debt. Now, let's suppose they   had an acquisition that just seriously failed. (22:56) That might make me less likely to stay   invested in the business. But in Teravest's  case, no event has yet occurred. Now,   leverage is interesting because it has this kind  of intoxicating allure to offer better returns   than a business could achieve without its use.  This is why individual investors use margin on   their trades or why corporations will look for  loans to improve their business at a faster rate   than their internal cash flows would allow. (23:19) But there's undoubtedly a dark side   to leverage. If a company cannot service its debt  and continues to pile on more, it is increasing   the risk to its business. In that sense, leverage  is very bad and can rapidly increase the risk of   an investment. Another way to look at leverage is  as a force multiplier. So as individuals, we all   possess unique qualities that make us who we are. (23:40) And leverage can amplify these strengths.   If we look at someone like Warren Buffett,  he used a lot of leverage in these qualities   that he had to make himself who he is. Look at  Buffett's reputation for instance. It was not   built overnight. It was built over many decades  just brick by brick. And that reputation let him   buy businesses simply with a phone call  and an oral commitment. That's leverage.  (24:00) That's real power. And it came from acting  ethically, consistently, and rationally. However,   if you possess the opposite qualities of Buffett,  such as, you know, vanity or foolishness or   impulsiveness, then you're more likely to leverage  those qualities into risky outcomes. So, take a   look at the qualities that define you and try  to ensure that you're leveraging the right ones   and avoiding the ones that could lead to ruin. (24:22) Now, let me pose a question. Have you   ever owned a business that you think is just  doing a superb job, but won't budge in terms   of price? But you own it. You courageously hold  on to the name knowing that the market can't   stay irrational forever and will eventually  close that price and value gap. Then boom,   over the next few months, the stock price doubles. (24:40) That moment of sudden movement often   comes from the invisible hand of catalysts. So  catalysts originate from the world of chemistry,   a domain I personally don't understand too well,  but catalysts are something that I can easily   wrap my head around. I think you can too. So  catalysts do the following things. They accelerate   change and they increase the rate of reaction. (25:00) To put these directly into investing,   they might show up as, you know,  not altering the underlying value   of a stock but unlocking the recognition of  it. Or it might show up in time. You know,   a catalyst can collapse time in investing.  Something that maybe would happen in 5 years   can happen in one year. So, Meta  is an example of how a catalyst   can unlock the recognition of value. (25:18) So, let's rewind back to 2022.   Meta experienced a 76% draw down as a result of  its CEO Mark Zuckerberg's announcement that they   would invest about $10 billion into the metaverse,  an unvalidated part of the business that investors   just didn't seem to be very excited about.  However, at the same time, Meta's underlying   advertising business would continue to improve. (25:41) It increased its revenue by 17% in 2022,   and there was just no signs of it slowing down.  So, while the metaverse spending would have   an effect on cash flows in the short term, it  wasn't a case of will this investment bankrupt   the company, Meta's free cash flow also plummeted  in 2022, declining from 40 billion to 19 billion,   which also spooked investors. (26:00) As a result of all this,   Meta's stock price dropped to around $90, but just  2 years earlier, it was sitting at $380. Then,   in 2023, Meta announced it would be a year of  efficiency. They cut costs and largely refocus on   the core advertising business that was their cash  cow. And the results were absolutely spectacular.  (26:18) So here are some of their KPIs since  2022. Advertising revenue has chugged along   at a 19% kegger. Free cash flow has exploded to a  46% kegger. The PE multiple doubled from 14 to 28.   And the stock price has increased by an over 100%  kegger going from 90 to 780 nearly a nine bagger   in only 3 years which is all the more impressive  considering Meta is now worth $2 trillion.  (26:42) So some other examples of catalyst in  investing include things such as management   changes. You might look at a new CEO who has a  really good track record. You know someone like   Sacha Adella at Microsoft is a good example. You  might look at company going through spin-offs or   breakups which can unlock hidden business value. (27:00) You might look at an example such as when   PayPal span off from eBay. Another one to look  at is just buybacks or dividends. These can be   a really good signal of capital allocation  discipline. Then there's M&A activity.   Acquisitions or the announcement of acquisition  of a competitor can be a huge catalyst.   Then there's regulatory or legal changes. (27:19) Something like FDA approval, the removal   of tariffs, or maybe the settlement of a court  case. Then there's product launch or innovation.   A good example would be Apple's iPhone moment.  Then there's capital reallocation. You know,   things like asset sales, deleveraging, shifting  to higher capital efficiency areas of the business   and getting rid of lower capital efficiency areas. (27:39) Then there's insider buying. This   obviously is a strong signal of confidence  in the business. And lastly is short squeeze   triggers. Businesses that might have a sudden  float and sudden demand. And therefore,   when uh a small catalyst happens, it can  blow up the share price in a good way.   An example would be something like GameStop. (27:59) So, there are catalysts just everywhere   in investing. And if you look hard enough and  arrive early enough, you can find some incredible   multi-baggers. My favorites are announcements of  buybacks below the intrinsic value. When a company   is just chronically cheap and they announce  they're going to do buybacks, I'm downright   giddy because it means that I'm going to get an  increased share of the business at great prices.  (28:18) I also like undervalued M&A activity.  Since I have many serial acquirers and some   of them make larger acquisitions, the market will  try to revalue companies when a new acquisition is   announced. However, sometimes the market doesn't  fully appreciate or understand an acquisition and   even if it rerates upwards, sometimes it  doesn't rerate upwards enough and that's   a really good opportunity to pick up shares. (28:39) So, a good example of this is Terravest   once again. So, when Teravest announced its latest  acquisition, there was a short period when I felt   it was much more reasonably valued. So, I added  shares. However, that time was very short-lived   and the opportunity to add shares disappeared very  quickly if you just weren't incredibly decisive.  (28:56) So, regulatory changes are another good  one. I don't really use this catalyst very often,   but I appreciate how it can contribute to a  marketwide sell-off during something like the   tariff period we just went through. That was  a great time to deploy capital into businesses   that were unlikely to be significantly  affected by tariffs or would only be   affected for a very short period of time. (29:16) Product or innovation launches are   also a significant catalyst for growth that  I like to watch. Many companies will release   new products to an already very loyal  customer base. Apple and their iPhone   were a great example. As a result of these  new products, they rapidly increase their   top and bottom lines already having a  loyal customer base to sell to, which   was very familiar with their legacy products. (29:37) Another catalyst is related to capital   efficiency. Imagine a business that has gross  margins of 20% in its legacy business and then   it develops another line of products with gross  margins north of 40%. The value proposition on   the new products is actually much better  than the legacy products and their new   inventory is just flying off the shelves. (29:56) This means the business is now   selling more high margin products instead of  low margin products which will significantly   improve its margins. I have a micro cap in my  portfolio that's doing just this. Another way   investors can utilize capital efficiency  to their advantage is by observing the   capital expenditure cycles in the industry. (30:13) I performed very well on businesses   like Aritzia and Dino Pulska simply by buying  shares in these businesses when their capex   cycles increased. So in the short term the  market dislikes the decreases in the cash   flow but in the long term it appreciates  the increased cash flow. So the catalyst   is simply waiting for the increased capex to  pay off in these two businesses that have high   returns on invested capital and therefore they  benefit greatly from that increased capex spend.  (30:37) But you need to wait a little bit. So I  must take a moment to note that some businesses   don't require the catalyst above to deliver  value to their shareholders. Some companies like   constellation software are their own catalyst.  And what I mean by that is the business has   been expensive since it went public in 2006  and yet it has compounded it shares at 33%.  (30:55) So, it's a rare case where the quality of  the business is its catalyst for success. However,   as long as that quality remains high, the  company's probably going to continue to   provide value to shareholders as long as they  retain their shares. The following overarching   theme I'll be covering is now in biology. (31:12) So, this is a scientific field from   which I tend to use mental models from the most  because it's a field that I just find very very   fascinating and I found very fascinating for a  long time. So, let's start here with ecosystems.   The book defines an ecosystem as  a community of interacting species   within their non-living environment. The  effects of ecosystems are vast and complex.  (31:32) The reason that ecosystems are so complex  is that they're basically systems. This means that   when one input is altered, it can affect multiple  outputs. A notable example is the reintroduction   of wolves into Yellowstone National Park. The  one act of introducing a species that was native   to the land resulted in numerous outputs. (31:52) So the increased wolf population   helped stabilize the growing elk population.  Since elk consume things like young willow,   aspen, and cottonwood trees. The decrease  in the numbers allowed those plant species   to repopulate. The vegetation surrounding  the river banks also improved, helping to   enhance the biodiversity of the surrounding areas. (32:11) As a result, beavers, birds, and insects   repopulated the area. Beavers who now had trees to  use for their dams could build dams that increased   water retention, further increasing biodiversity.  Scavenger species such as ravens, eagles,   and bears increased due to the increased level  of carcasses that were left over from the wolves.  (32:30) And then the improved vegetation reduce  riverbank erosion and waterway stability. So   parish has another part of ecosystems that is  very important as part of the mental model. So he   writes about something called keystone species.  These are organisms within a system that are   just foundational to the ecosystem survival. (32:48) If these organisms were removed from   the ecosystem, it could result in a complete  change or collapse. This is an excellent lens   in which to view a business. First, you can do  something such as search out companies that make   products that are just integral to an industry.  A business like ASML is one such business. So,   ASML is a near monopoly in extreme ultraviolet  lithography, which is essential for producing   small cuttingedge chips. (33:10) Without ASML,   the industry would be decades behind  where it is right now. Generally speaking,   these businesses also make really good  investments. So, over the last decade,   ASML has compound its revenue at 19%, EPS at 22%,  and share price at 23%. The method I use above   involves examining the supply chain of a given  industry, see who makes what, and then identify   which ones have certain interdependencies. (33:34) If all businesses that manufacture   a product require a part from a single supplier,  you have identified interdependencies. And that   can be a highly valuable way to view companies.  If you find a business like this, ask what would   happen if it were to fail. If the consequences are  dire for its customers, there's a good chance that   you found a company with a pretty powerful moat. (33:54) Charlie Munger was very well known for   his obsession with Costco, and Costco had a  magnificent ecosystem. So Costco is kind of   this middleman between suppliers and customers.  Suppliers love Costco because Costco can buy   very high volumes of a product. They're also very  dependable and have vast amounts of experience.   Then when you look at customers, since Costco  will only mark up their products by about 15%,   customers know they're always going to get the  cheapest prices from pretty much anything that   they buy from Costco. If you remove Costco from (34:22) this equation, then both suppliers and   customers are probably just worse off. The  supplier then has to find multiple companies   to sell their products to, which can increase  complexity. or if a supplier produces too much,   they may have to reduce prices  to find buyers for their product,   which is going to reduce their margins. (34:38) Customers would have to live with   shopping for their items at increased prices  elsewhere because there's just few businesses that   can compete with Costco's ability to offer, you  know, everyday low prices. One critical part of   an ecosystem is something called feedback loops.  So, in any ecosystem, when an input changes,   feedback can be observed in the systems outputs. (34:58) Some ecosystems exhibit immediate feedback   loops while others have delayed feedback  loops. I had the opportunity to discuss the   role of feedback loops in a lot of detail when  I interviewed Annie Duke on tip 623. So when   investing in a stock, investors are constantly  seeking feedback loops that can confirm their   thesis is correct. Most investors use  stock price as their feedback loop.  (35:19) Long-term investors might focus on  other fundamental KPIs such as, you know,   growth in cash flow or profits. In the short term,  a stock's price can rise even if a cash flow is   going down. This is why stock prices are not a  good indicator for feedback loops, at least in the   short term. Instead, you can find specific KPIs  that are vital to long-term success of a business   and look at the feedback loop through that light. (35:43) For instance, I've owned several companies   that heavily emphasize the importance of their  backlog. Let's say a business converts 100% of   its backlog. I know this is unrealistic in real  life, but it just makes the numbers easier to   work with. So bear with me. Let's also say that  the conversion of backlog to revenue is kind   of lumpy because revenue is only recognized  once the product is shipped to its customer.  (36:03) A business like this would have feedback  loops that we can use to determine if our thesis   is intact, but it may not be the most obvious  number. Many investors will look to metrics   like revenue and profits. In that case, they may  be heavily disappointed during certain quarters   because a company might develop a product,  increase its backlog, and then not see revenue   for, let's say, 6 to 12 months afterwards. (36:24) But if the backlog is continuing to   grow by, let's say, 25%, then it means  that revenue should probably also grow   around that number on a trailing 12-month  basis, 12 months into the future. And if   the business has operating leverage, then  profits will grow at an even higher rate,   which is obviously something that we love to see. (36:41) So this means the KPI that maybe you   should focus on in this example is the backlog  rather than revenue or share price. These types   of businesses can offer great opportunities as  they often have these rising backlogs. However,   if they have a bad quarter, they're frequently  penalized for these short-term reductions in   revenue and profits, but are rewarded in  the long term once those numbers run back   up after they convert their backlog into revenue. (37:05) Jim Ran once said that you're the average   of the five people you spend the most time  with. and I really could not agree with him   more. And one of my favorite things about being  a host of this show is having the opportunity   to connect with high quality like-minded people  in the value investing community. Each year we   host live in-person events in Omaha and New  York City for our tip mastermind community,   giving our members that exact opportunity. (37:33) Back in May during the Bergkshire weekend,   we gathered for a couple of dinners and social  hours and also hosted a bus tour to give our   members the full Omaha experience. And  in the second weekend of October 2025,   we'll be getting together in New York City for two  dinners and socials, as well as exploring the city   and gathering at the Vanderbilt 1 Observatory. (37:56) Our mastermind community has around 120   members and we're capping the group at 150.  And many of these members are entrepreneurs,   private investors, or investment professionals.  And like myself, they're eager to connect with   kindered spirits. It's an excellent opportunity  to connect with like-minded people on a deeper   level. So, if you'd like to check out what the  community has to offer and meet with around 30   or 40 of us in New York City in October,  be sure to head to the investorspodcast.  (38:26) com/mastermind to apply  to join the community. That's the   investorspodcast.com/mastermind or simply  click the link in the description below.   If you enjoy excellent breakdowns on  individual stocks, then you need to   check out the intrinsic value podcast hosted by  Shaun Ali and Daniel Mona. Each week, Shaun and   Daniel do in-depth analysis on a company's  business model and competitive advantages.  (38:52) And in real time, they build out the  intrinsic value portfolio for you to follow   along as they search for value in the market. So  far, they've done analysis on great businesses   like John Deere, Ulta Beauty, AutoZone, and  Airbnb. And I recommend starting with the episode   on Nintendo, the global powerhouse in gaming. (39:12) It's rare to find a show that consistently   publishes highquality, comprehensive deep dives  that cover all the aspects of a business from   an investment perspective. Go follow the  intrinsic value podcast on your favorite   podcasting app and discover the next stock to  add to your portfolio or watch list. So within   every ecosystem, numerous species coexist in  a variety of niches, our next mental model.  (39:38) Some of these species are generalists who  cover a large amount of territory and face more   competition for resources, but are maybe more  flexible in meeting their needs. Then you have   specialists. They occupy smaller territories and  tend to face less competition, but they're also a   lot more rigid in their requirements for survival. (39:56) So, since I've already mentioned   Yellowstone, let's just stay there. Coyotes  are generalists. They can live and roam in   large areas of Yellowstone, but life can be  pretty tough for them as they have a lot of   competition for resources. They will eat anything  from animals to berries to dead birds, but many   other animals will also eat the exact same thing. (40:14) Now we look inside of Yellowstone's hot   springs. Now inside of the hot springs live  these little microbes that are fully adapted   to living in the high temperature areas of the  hotring. There are practically no other living   organism in there because the environment is  obviously incredibly harsh and hot. But they   also can't ever escape the hot springs. (40:33) They're trapped there for the   entirety of their lives. If they were to move  to, say, normal temperatures, they instantly die.   Ultimately, the key difference between generalists  and specialists lies in their response to   a changing environment. Generalists can survive  in changing environments because they can easily   gather a variety of resources to sustain life. (40:52) Specialists require as little change   as possible in the environment because subtle  changes can have catastrophic effects on them. I   love niches and I love investing in companies that  service these specific niches. A business I own,   which I won't name, is in the mining  industry. I'll call it water treatment   co. It specializes in treating water. (41:11) It seems like a highly cyclical   business because most of the people who look  at the business inside of the mining industry   automatically assume the company is highly  cyclical. But this business is actually quite   different. The niche it occupies is not cyclical.  So waste water and effluent have a significant   impact on their surrounding ecosystems. (41:29) This can be anything from the   fish that swim in the water to the  water that humans drink. Therefore,   when a mine is established today, it must employ  engineers and water treatment specialists to   ensure that the water is safe to release into  the surrounding environment. As a result,   water treatment co is a recurring revenue machine. (41:48) All waste water and effluent generated by   a mine must be treated. It cannot just be  treated one year and then allowed to enter   the surrounding environment the next. So  while it's not a recurring revenue machine   like a Netflix since, you know, water volumes  are highly volatile, they actually do have an   incredibly long runway for treating wastewater. (42:06) So a mine requires treatment before,   during, and after it's in service. As a  result, water needs to be treated from   a mine for anywhere between 10 and 30 years.  So the reason this business is doing so well   is that it occupies just a tiny niche. There  are larger engineering and water treatment   businesses out there, but they rarely pursue the  same contracts that Water Treatment Co. does.  (42:25) The smaller size and scope of the  projects that Water Treatment Co. chases   would just be a rounding error for many of these  larger water treatment companies. So while Water   Treatment Co. will never have the ability  to serve every mine out there such as WSP,   they don't actually need to do that in order  to succeed. They can stay in these smaller   niches where they rarely face much competition on  their projects and service the smaller projects   that larger competitors often overlook. (42:49) Another way to think of niches   in investing is to exploit any trade-offs  between generalists and specialists. Since   generalists are more flexible, they can  thrive in a variety of settings. However,   there are specific environments in which they  cannot thrive as the environment may be just   too specialized for them to succeed. This brings  to mind one of my favorite modes that Hamilton   Helmer covers in his excellent book, Seven Powers. (43:10) The mode is called counterpositioning. So,   this is when a business harms itself  by attempting to make largecale change.   Dollar Shave Club, which I'll refer to as DSC,  and Gillette are just great examples of this.   So Gillette was a generalist that could survive  and thrive nearly everywhere and had its brand   that helped stave off competition. (43:30) However, DSC emerged,   offering razors through an online subscription  at a fraction of the price at Gillette charged.   DSC was capitalizing on the niche of  a younger generation of online savvy   shoppers who just didn't want to be stuck in  Gillette's razor razor blade model of buying   expensive blades for the rest of their lives. (43:48) Now, if Gillette wanted to compete with   DSC, it would have been very challenging. So,  their razors were looked at as kind of a premium   product and that meant that competing on price  just would not have made sense and would have also   angered the retail stores that were selling their  products. Margins would have also had to compress.  (44:04) Not to mention, if Gillette went  direct to consumer like DSC did, it would   actually cannibalize their retails business for  their own benefit. Another way of thinking of   niches is to find the rare business that can  utilize multiple niche benefits, providing   owners with La Palooa effect. If you ever been  to a Bergkshire Hathway annual meeting, you may   have tked to Nebraska Furniture Mart to stand  in awe of its sheer size and excellent prices.  (44:28) But Nebraska Furniture Mart or NFB is  where it is today because it occupies several   niches that make it very difficult to compete  with. So, first is geographical dominance. NFM   is just a destination. It's not at just  a place that you go and stop. Customers   will travel hours to shop at their locations  because they know they're going to get the   best ideas possible probably in the state. (44:49) Next is vendor relationships. Since   NFM is so large, it can place large orders from  its suppliers. Suppliers also know that since NFM   sells things at razor thin margins, there's a good  chance they'll be able to move their inventory   and continue buying from them. And lastly is  unmatched buying power. Since NFM can purchase   such large volumes, it gains bargaining  power over suppliers to secure fantastic   prices that it can then pass to its customers. (45:13) As NFM diversifies its business and grows,   this advantage only strengthens. The last  niche I'll discuss is one that I like to take   advantage of, and that's investing in invisible or  underappreciated niches. I like small businesses,   and these small businesses tend to sell  niche products and are businesses that 99.  (45:31) 99% of people have never even heard of.  As a result of their lack of discovery, these   businesses are not closely followed by the market.  This is why I love to adapt Charlie Mer saying   fish where the fish are. I actually prefer to say  fish where there are no fishermen. This means you   can find some incredibly successful businesses  that are growing rapidly, generating profits,   and are largely unknown to the general public. (45:52) These are the businesses that I spend   all of my time researching and thinking about.  These businesses are also small enough to have   certain constraints. They may have a market  cap that is just too low for institutional   investors. They may not have sufficient liquidity  to allow institutions to build a position without   significantly impacting the stock price. (46:10) And since many of the businesses I   invest in have no analyst coverage, brokers and  other analysts are not incentivized to promote   the positive aspects of these businesses. It's a  great niche to explore and has helped me generate   some excellent ideas. Another biological  mental model that I find fascinating and   highly useful is the concept of signals and  specifically honest versus dishonest signals.  (46:32) So I already mentioned Pulak Prasad's  excellent book why I learned about investing from   Darwin and I learned this mental model also from  that book. An honest signal occurs when a signal   reliably transmits truthful information about an  organism's qualities, intentions, or conditions,   usually because it's costly or difficult to fake. (46:52) A dishonest signal happens when a signal   conveys false or misleading information, often  to gain an advantage without possessing the   quality that's being signaled. So, you'll see  these signals just all over the place in the   natural world. So, a simple honest signal  would be a gazelle in the wild. So when a   gazelle spots a predator such as a cheetah, it  will often do this type of jumping gate called   starting instead of immediately fleeing. (47:16) This is an honest signal to the   cheetah that the gazelle is in excellent  shape and it's energetically costly to   do the starting in the first place. So  only the most fit gazels do it. And this   signals to the cheetah that they're not worth  pursuing as they're going to be incredibly   challenging to catch. An interesting  example of a dishonest signal can be   found in a plant called the mirror orchid. (47:37) The orchid produces flowers that   actually mimic the look and pherommones of female  insects. This means the orchid is essentially   tricking male insects into attempting to mate  with it. As a result, the male insect picks up   or deposits pollen. The male wastes his time  thinking that he is mating, but is just upon   being used by the mirror orchid to proliferate. (47:56) Signals are found in literally every   corner of the stock market. Let's go over a few  examples. So, the first one is insider buying.   Executives purchasing shares of their own  businesses on the open market can signal   confidence. Second is share buybacks. Reducing  share counts can signal undervaluation and   intelligent capital allocation from a business. (48:16) And third is mergers and acquisitions.   These can quickly improve a business's top  and bottom lines and offer value when they   allow a company to expand their margins on an  acquired business at a pretty rapid pace. Now,   insider buying on the open market is a  reliable signal based on my own experience.   If an executive is buying shares on the open  market, that means they're using their own   money to buy shares in a business that they  know more about than nearly anybody else.  (48:40) If investors knew what an executive  knew about a company, they would be charged   with insider trading. So, while investors can't  directly ask a CEO why they bought a stock,   the signal of them using their cash on the  stock is a powerful and honest signal. One   interesting way to analyze insider purchases is to  examine the insider's history of stock purchases.  (49:01) if they consistently buy the top, well,  that's a dishonest signal as it likely means   they're just bad investors falling into  the typical traps of euphoria. However,   if you have noticed in the past that they're  buying during quarters when the stock has dipped   and then maybe look forward to see where the stock  is today and find that it's multibagged since when   they bought it, that's another great signal. (49:20) Another dishonest signal related to   insider buying is when an executive holds a  significant stake in their company shares,   but hasn't spent a dime of their own money  accumulating it. This means they're simply   acquiring through stock options. Options generally  aren't very interesting to me. Still, if you   have a good manager who is exercising options,  holding on to their stock, and also buying on   the open market, that's a pretty good signal. (49:41) If they're exercising their options,   immediately selling, and never purchasing  anything on the open market, then their   signal is very muddled. Next are buybacks. This  is an area where I'm sad to say there's a large   amount of dishonest signaling in the market.  Most investors like buybacks because they   mean the company is increasing its stake in the  business without requiring any additional capital.  (50:02) And while that's true to some degree,  what truly matters in buybacks is whether the   stock was repurchased below intrinsic value or  not. Let's look at a hypothetical situation in   a business that we'll call storage pros.  As the name suggests, they own several   storage facilities in North America and  they collect rents from their customers.  (50:20) The company is easy to value because  storage tends to be a pretty stable industry.   I consider future cash flows and I assume  that they're just not going to grow and then   I discount it back to their present value.  I then determine that the business is worth   $10. Storage Pros is sitting on a decent  amount of cash and since they aren't growing   much that cash pile just continues to grow. (50:39) The CEO determines that a buyback   program is the most effective use of capital.  Now here are two hypothetical scenarios. So   the first scenario is where the company buys  back shares at $20. So the rationale that it's   giving the market is that the market's hot,  investors love the company, and the buyback   program will likely increase its share price  because it'll be perceived well by investors.  (51:00) The second scenario is that the company  buys back shares of $5. The company's in the   dumps because of a marketwide sell-off. The  rationale is that since the business will   continue to generate substantial profits, and  since shares are worth more than $5, it will be   highly value accreative to repurchase shares. (51:15) The first situation, I think,   probably happens more than the second, which  is just a shame. You want businesses that are   taking advantage of an undervalued share price.  That is how value is added via buybacks. The   first buyback scenario is a dishonest signal. The  business is buying back shares just to capitalize   on the temporary euphoria of the market. (51:33) And while it may work in the short   term to cause a slight surge in the share price,  it ultimately destroys value in the long run. The   second situation is an honest signal because  buying undervalued shares truly adds value.   If you can find a business that has a history  of buying back shares at depressed levels,   watch them very, very closely. (51:51) If you observe them long enough   and see that they're buying back shares, you can  just clone them. That can give you some very,   very exciting and profitable ideas. Then we  get to M&A. M&A, similar to share purchases,   can be super value creating when the deal  makes sense. Sadly, many deals also just   don't make sense, and M&A can destroy value. (52:10) Interestingly, Peter Lynch preferred   companies that paid a dividend specifically  because he believed it reduced the likelihood   that management would pursue a potentially  harmful deal. Acquisitions typically result   in a short-term increase in share price.  They can also offer significant revenue   increases for a business. Therefore, if a CEO  is incentivized based on increasing revenue,   M&A is a very straightforward way to achieve  that goal without relying on any organic growth.  (52:36) But if a company acquires another business  that has zero profits and no real path to becoming   profitable in the future, then how does buying  that company exactly benefit shareholders? When   analyzing an acquisition, you need to ask if the  business can get a return on the acquisition above   its cost of capital. It's just that simple. (52:52) A simple way to think about this is   whether a company can achieve double-digit  returns on the acquisition. If they can,   there's a very good chance that they're earning  above their cost of capital and the acquisition   will create value for shareholders. I like serial  acquirers because they have a history of making   numerous value accreative acquisitions. (53:08) They know what they need to pay   for a good deal and what to avoid to make  a bad one. They also have the discipline   required not to make a bad deal just for the  sake of action. So, if you're considering a   business that engages in M&A or is interested  in pursuing M&A, consider the management's track   record of successfully completing deals. (53:26) If they have succeeded before,   there's a decent chance that they will succeed  again. That's an honest signal. But if they've   never done a deal, I tend to default to being  very skeptical. In that case, a potential deal   might be a dishonest signal. Another honest signal  I like inside of serial acquires is when they have   an incentive that are aligned with shareholders. (53:46) Incentives based on returns on invested   capital are one of my favorites because  I think it's one of the best ways to keep   shareholders and management very well aligned.  It also helps prevent managers from wasting   shareholders capital, provide they can succeed  at deploying capital above the cost of capital.  (54:00) This transitions well into the final  mental model from today and from biology that I'd   like to discuss with you which is incentives.  So Parish mentions two considerable factors   when it comes to incentives. The first is  that humans when we are thoughtful about   incentives will change our behavior to attain a  perceived benefit. Second, since incentives are   such a powerful influence, they can cause us to  behave irrationally to achieve a given incentive.  (54:25) Let's start by looking at an example of  incentives found in nature. A great example is   the cleaner rasse fish. So these are small almost  tube-shaped beautifully colored fish that survive   off parasites that feed on the bodies of other  fish. They live in coral reefs. Here's how it   works. So the cleaner rass swims around a  fish's body, feeding on parasites found on   the fish's scales and even around its mouth. (54:46) You could think of a cleaner rass as   running a type of business. Its  business is just to clean fish.   Other fish will swim into areas where the cleaner  rasses are located and provide the rass with food   in exchange for reducing the parasites that are  feeding on them. But the rass can actually cheat.   They can also feed on the mucus of a fish, which  doesn't serve the fish that's providing the mucus,   but provides the cleaner ras with nutrition. (55:07) The rass has the option of taking   either option, but if it chooses to cheat and  eat mucus, the fish will often flee, and the   cleaner ras won't have a food source. So here  you can see that the cleaner ras is incentivized   to eat parasites rather than the mucus if  it wants to maximize its potential return.   This function is also the exact same in humans. (55:25) We're offered a variety of incentives to   do things on a daily basis. And much of the time  incentives are great because they cause people   to do good things. You know, when you think  about traffic lights, we're incentivized to   follow traffic lights so that we can reach our  destination faster by using a vehicle while also   keeping ourselves and others safe on the road. (55:41) However, let's focus on the most   interesting aspects of incentives, which is  how investors can utilize them to enhance   their decision-m. As Charlie Munger  said, inversion is one of the most   powerful mental models out there. Therefore,  to understand how incentives can benefit us,   we must first recognize how they can harm us. (55:58) As Charlie probably would have said,   "Show me the wrong incentive and I'll show you  a disaster." There are two ways that incentives   can harm us. Perverse incentives and incentive  caused bias. So perverse incentives are rewards   or penalties that unintentionally encourage  harmful, wasteful or unethical behavior.   This perverse incentive is prevalent throughout  corporations where management is incentivized to   do certain things to achieve their bonus. (56:21) Things can be perverse including   revenue-based KPIs, customer growth  KPIs, and essentially any KPI that can   be achieved by just simply spending  an everinccreasing amount of money.   If a company wants to grow revenue or the customer  count, management can do so by spending money on   marketing just to attract more business. (56:39) They can also spend a considerable   amount of money on things like discounting.  Many factors can keep a business unprofitable   for very very extended periods of time. This  is a perverse incentive due to the embedded   asymmetry. The person receiving the bonus from the  incentive profits at the expense of shareholders.   As a shareholder, I don't want management  that is only concerned with increasing   revenue with no regard for profits. (57:01) One of my favorite stories of   perverse incentives I found while researching  this episode was a story of the Russian nail   factory. So during the cold war, Moscow wanted  nails to be produced at a given quota. They   initially wanted their quota to be met based  on the total number of nails produced. So the   nail factories ramped up production by making  small flimsy nails that were nearly useless   for actually holding two things together. (57:24) So to address this issue, the central   planners decided to modify the incentives and  shift the quota's focus to the total weight of   the nails. If a light nail wouldn't do the trick,  then simply making a little heavier would make   them useful. The problem was was that there wasn't  a limit placed on how heavy the nails could be. So   the factories decided to make just giant nails  that were so large in fact that some of them   couldn't even be picked up by a single person. (57:46) But they met their quota as these giant   nails were very heavy. So the lesson here is  that when you reward output without tying it   to a desired outcome, you don't get better  performance. You get gaming of the system.   The workers in this study I don't think were  lazy or evil. They were just rational actors   responding to very poorly designed incentives. (58:04) So the next up here is incentive cause   bias which occurs when a person's judgment is  subconsciously distorted because they are rewarded   for seeing reality in a very specific way. One  example of this can be found in analyst reports.   So these are the reports that Warren  Buffett and Charlie Munger just chose   to disregard and I think for good reason. (58:23) So the analyst writing reports have   their own incentives. The analyst may  work for a brokerage firm and if the   report causes additional trading, the broker  profits. Suppose an analyst makes an overly   aggressive price target for the future. In  that case, it may lead the market to renew   interest in buying the stock, thereby  increasing volume and the commission   fees that are paid for the analyst's firm. (58:44) If the analyst is incentivized to   increase the volume of shares being traded for  the firm, then they do not need to bother with   creating accurate analysis. They're not  incentivized to be correct or to provide   valuable research reports. They're incentivized  to create additional trades. As a result, much of   the analysis is essentially pointless to read. (59:02) You receive things like price targets   that are rarely met and often don't provide much  benefit to anyone reading the report. However,   the analysts of course don't admit this. They'll  rationalize to themselves and others that they're   trying to provide an honest analysis of a business  based strictly on the business's fundamentals   and that they have no ulterior motives. (59:18) So to take advantage of incentives   when we are analyzing a potential investment, we  have to ask ourselves a few questions. One, what   are the incentives that are driving management's  behavior in the company in question? And two,   are incentives creating long-term value  creation or short-term cosmetic results?   It's essential to recognize that incentive  structures all have their own unique nuance.  (59:41) I mentioned that I tend not to like  revenue based incentives, but this isn't black   and white. For instance, Microsoft, an excellent  company, has a revenue incentive. However,   to balance things out and put the brakes on  revenue growth, they're also incentivized based   on operating income. So, this prevents Microsoft  executives from just growing revenue at a rapid   pace, potentially at the expense of profits. (1:00:01) I think this is a solid incentive   structure. As an investor, one thing to look out  for is just short-term incentives. Are short-term   incentives aligned with creating shareholder  value or aligned with long-term incentives?   You don't want to invest in a business  that can have a short-term windfall for   management at the expense of shareholders. (1:00:18) So, look closely at incentive   programs to try to sus out the answers to  the two questions that I posed above. Now,   the power of all of these scientific mental models  lies in their ability to give us a fresh lens   through which to view the investing landscape.  These models enable us to recognize things   like patterns, anticipate risks, and identify  opportunities that many would otherwise overlook.  (1:00:38) By borrowing ideas from scientific  areas such as physics, chemistry, and biology,   we're reminded that markets, just  like the natural world, are complex,   adaptive systems. And just as in nature, survival  and success often belong to those who understand   the forces at play and can adapt the quickest.  The key is to keep learning, keep questioning,   and keep refining your mental models. (1:00:57) Because in both life and investing,   the best edge is a well-trained mind.  That's all I have for you today. Want   to keep the conversation going? Follow me on  Twitter at irrational mr kts or connect with   me on LinkedIn. Just search for Kyle Griev. I'm  always open to feedback, so feel free to share   how I can make the podcast even better for you. (1:01:16) Thanks for listening and see you next   time. Much of the success in everything, not  just investing, is just about avoiding failure.   And inversion is one of the best ways  I've come across to think specifically   about how to avoid it. If you can live  a life with minimal failures, you'll end   up with a very fulfilling and successful life. (1:01:32) and investing. If you can do the same,   you'll have a lot more money in the  future if you can avoid failures along the