Reasoning From First Principles
"The discovery of truth is prevented more effectively, not by the false appearance things present and which mislead into error, not directly by weakness of the reasoning powers, but by preconceived opinion, by prejudice." - Arthur Schopenhauer
"All of our reasoning ends in surrender to feeling." - Blaise Pascal
When I began thinking about starting my own investment firm, I thought back to starting my two previous companies. The first company was designed by committee and we thought it should have a core set of values and a mission. This was designing by analogy - meaning we designed a company as we assumed others have done over time. Hence, the classic values and mission statement. My second firm - Nintai Partners - was an entirely different creature. Rather than create it in the form of other consulting firms (or by analogy), we constructed it using "reasoning from first principles." For instance, consultant compensation was based on long-term value as calculated by the client, not our company. This was designed around our first principle that any value to a client must be both sustainable in nature and as defined by the client.
First principles thinking
The first principles approach allows you to cut away the rhetorical fat and get to the most basic truths. In this type of thinking, you can't simply rely on the traditional way of doing things (or by analogy). You need to break the process or problem down, and rethink it from the ground up. You must return to the most basic assumptions (the first principles) and understand the underlying facts of the model.
I'll use the design of Nintai Partners as an example and then move the discussion to the investment world. When building out Nintai Partners, we reverse engineered the startup process and focused on the basic building blocks that make a consulting firm work. When we looked at the basic model, it was based on billable hours. Breaking the model down to its main principles, we found a business that overcharges clients, faces a constant need for new clients and has no reward system for producing value as measured by the client. By utilizing a design by first principles, we found a business model that was hopelessly mired in overcharging, churn and poor work quality.
When we began Nintai Investments, it was clear we would need to apply the same first principal approach to designing the firm and understanding the core building blocks in an industry undergoing rapid change. After completing the process, we identified four principles that - interestingly enough - were both good for our company and good for our investment strategy. These overlapping qualities gave these principles even more value in our eyes.
Principle 1: The value we deliver to our investment partners must be long-term in nature to be of value at all
As a value investor, I strongly believe finding management teams that are great capital allocators along with companies that can produce high returns on capital are a powerful combination. The third component of that formula is time - letting the power of compounding work for the greatest duration possible. Accordingly, any value Nintai adds to our clients must - by its very nature - be long term in scope. The same goes for any investor or owner of Nintai Investments. There is reason why many wise investors will tell you to avoid the funds, but buy the fund managers.
Principle 2: Growth is finite. A company's growth will always end - whether by a lack of opportunity or a competitor creating a better mousetrap
In evaluating any possible investment, the ability to grow will be a key driver in the success or failure of that investment. No matter what valuation tool you use, a slowdown (or worse - total absence) will drive down valuations and lead to permanent impairment of capital. Therefore, understanding how the investment will grow, understanding the risks to that growth and successfully prognosticating when that growth will end is vital to the investment process. As a small startup, Nintai understands there are two risks to our growth - an absence of opportunity brought on by market and business model changes (such as the move to indexing) or simply being unable to find new capital to deploy. We believe the former is a much larger risk than the latter.
Principle 3: Scale is the gravity of business
In almost all businesses (but not all - think Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) or Google (NASDAQ:GOOG)(NASDAQ:GOOGL)), scale is a weight that will eventually change or dramatically slow down a business. That doesn't mean it will eliminate growth (though it might). Far from it. But it changes the nature of the growth by creating new organizational needs, capital returns and market dynamics. The Amazon of 2000 is a very different animal than the Amazon of 2019. The company has dramatically changed in product, organizational, capital structure and returns standpoint. The same is true for Nintai. As assets grow, the structure of the company will change, our investment opportunities will drop and history would lead us to predict it will bring with it lower returns.
Principle 4: What's good for the client is good for us
You would think this principle would serve as a guiding light for most companies, but surprisingly it isn't. How many times have you had a service company say they will visit between 8 a.m. and noon? Generally, for companies in asset management, what's good for the client is good for the firm. But there are still far too many examples of what's bad for the client (high fees) is good for the firm. As an asset manager ourselves (with what we perceive to be fair fees), long-term outperformance is good for our clients and good for Nintai.
Conclusions
Utilizing a first principal approach is a commodity shared by some the world's great thinkers. Whether it be Charlie Munger (Trades, Portfolio) or Richard Feynman, some of the smartest people in the world use first principals to focus on what really makes something tick. Hopefully this discussion has shown its use is remarkably widespread and can allow you to make connections or see core issues you might never have understood before. Being able to make a direct connection between Nintai as a business and its investment criteria was a remarkable eye-opener for all of us. I highly recommend you use it the next time you are looking at a potential investment.
As always, I look forward to your thoughts and comments.
Disclosure: None.
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