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