Why is it that businesspeople and investors see businesses differently? A friend mentioned a derivation of this analogy to me years ago and I brushed it off. But recently I started to think about it again, and the simplicity of it hit me as brilliant. As an analogy there are obvious flaws, but maybe, just maybe this will be good enough to become a framework, or a mental model, or latticework, or whatever other trendy thing analogies are now called.
I present to you The Box.
Think of every business as a box, a very simple box. The box takes inputs, these inputs are materials, labor, or really anything. The box outputs a something. Some boxes create things for other boxes and some boxes create things for people. These boxes all live together in their box world.
Every box can be described the exact same way with three statements, a balance sheet, an income statement and a cash flow statement. These three statements describe everything the box is doing. It describes the items the box is purchasing from other boxes as well as the output of the box itself. The statements describe what the boxes are doing inside the box.
Using the same three statements every box can be compared to any other box and measured against any other box. In the box world there is an industry of box watchers. The box watchers aren't allowed to look inside any of the boxes. Although from time to time a box watcher will take a peek inside a box, or talk to someone who works in a box.
To the box watchers all boxes are the same. They all have inputs, produce output and can be described the same way. Box watchers are hyper focused on the size of the box. Is the box growing or shrinking? Box watchers live for the four times a year that the boxes produce their description statements. Box watchers believe that boxes should combine with other boxes, or at times cut themselves in half. Small boxes should combine with other small boxes, but once a box is too big it should split itself apart. The combinations rarely alter anything inside the box, or change the box's inputs or outputs, but that doesn't matter. These combinations and reductions are important to the watchers.
For a box watcher differences in a box's input and outputs can be described with simple mathematical formulas. They believe that two boxes the exact same size should be described the exact same way with their financial description documents. After all, if both boxes have the same inputs, are the same size, and produce the same output how could their financials be different?
The reality inside of each box is much different than what box watchers see. On the outside a box is a box is a box. It's inside that box where the action happens.
Each box is completely different, no two boxes have the same workers, and the workers are what set each box apart. The managers who are in charge of the boxes are worried about securing their box's inputs and making sure production inside the box continues. Workers are fickle. They are constantly dealing with issues related to other workers and outside issues (with family, friends, and relatives). Sometimes workers have kids who get sick, and the sick kid preoccupies their mind for the day reducing output. Other times workers don't get along but are forced by a manager to work together. The output from feuding workers is drastically less than the output from workers who enjoy each others company, or workers who have complimentary skills. All of these preoccupations and personality conflicts multiply across the box. It is rarely one issue that impacts inefficiencies, but hundreds or thousands of issues, all different, all happening at once.
Box managers spend most of their time worrying about issues related to their workers. And when it's not their own workers it's workers from other boxes. Sometimes the workers of a supplying box are so distracted their quality suffers and downstream boxes are forced to implement processes and procedures to handle the poor quality inputs.
Inside the boxes everything can be reduced to a people problem. It's the people who work together that take the inputs and generate the outputs. It's the people at other boxes that consume the output, and people at other boxes that create the inputs. Inside the box world what's happening takes the backseat to people. People are everything inside the box world. A motivational manager is the difference between underperforming workers and performing workers.
Boxes themselves are interchangeable. A box with a specific input can find that input as the output from a number of different boxes. Likewise what a box produces can be consumed by people or other boxes, interchangeably. It's different inside a box. People are an ecosystem. They aren't interchangeable. People have specific skills and personalities, taking a person from one box and putting them in a different boxes doesn't mean the results generated in the first will follow to the second.
What frustrates box watchers is they don't understand what's happening inside the box. To them all boxes are the same. Boxes that are shaped the same and do the same things should have the same results given a set of inputs. To a box watcher fixing outputs is as simple as fixing the inputs and tweaking a few items on the financial statements.
Box management is frustrated by the box watchers. Everything is so simple to the box watchers, if only those watchers knew what happened inside the box! Box managers try to appease the watchers by using their terms and superficially managing inputs and outputs, but box managers know that changing the box's financials isn't as simple as rearranging the inputs and outputs. Box managers know that production is efficient because of their people, or that production is inefficient because of a few people. People that need to be nurtured and coddled and dealt with individually.
Box watchers can exert enough pressure that a box tries to change itself. It rarely works, the box is the way it is due to the people it has. The only way a box can reinvent itself is by gutting the inside of the box and starting over. A process that isn't much different than creating a box from scratch.
It should be apparent that the box watchers and box dwellers will never see eye to eye. They won't because they're looking at different things. Inside the box (business) employees are concerned about the day to day operational aspects. The box watchers (investment analysts/investment industry) is only concerned with the financial statements the businesses produce. Without the detailed operational knowledge about what happens in a business an investor can only make broad claims and judgements.
The danger to investors is when they adopt the box watcher mentality. Box watchers are paid to watch boxes, not produce investment returns. Investors are paid by understanding what happens inside the box. A curious quirk to this entire analogy is that one doesn't need to become an expert on what's in the boxes to take advantage of this knowledge that each box is different. Some investors recognize this situation and believe the key to earning outsize returns is to know who is in each box and what they're doing. My own view is that this is the wrong approach.
The right approach is to understand that what happens in each box is different, but why things happen isn't as important as understanding the differences reflected in the financial statements. Understanding the differences between the boxes is fundamental to making an investment decision. Inefficient boxes will rarely become efficient boxes. And efficient boxes will probably remain efficient . Don't invest in an inefficient box thinking it'll become efficient, instead incorporate a discount or premium for these differences. Just because a box is inefficient doesn't mean it doesn't have value either.
I talk more about how I evaluate management in my Investing System mini-course. Check it out here.