Multiple Modes
We need both focus and imagination in investment analysis. We need to focus on understanding the details of businesses and markets, always checking our beliefs and assumptions against the data. But investing is about the future and as long-term investors, we have to use our imagination to "see what's not on the page" or imagine what hasn't happened yet but could or is likely to happen in the coming years.
It is difficult to explain this way of thinking because it sounds contradictory -- like we are anchored to the ground and have our heads in the clouds at the same time. But it isn’t contradictory — it just takes practice switching between and reconciling the two different modes of thinking. While we call these modes focus and imagination, but we could just as easily call them pragmatics and potential, or other things. They would logically be the same things. In one mode we are looking at the details, looking down at where we are placing our feet. In the other mode we are looking out at the horizon where the earth meets the sky, where the colors blend and blur.
In a business, focus is required to manage the working capital cycle. Payables and receivables are not amenable to re-imagining. But imagination, or an eye to long-term economic potential is required in planning capital expenditures, research and development and other long-term aspects of the business. These different modes of thinking as an analyst work because the same modes are required within a business.
In terms of the Hedgehog and the Fox analogy popularized by Jim Collins’ book Good to Great, as an analyst one needs to be both a Fox and a Hedgehog. Isaiah Berlin captured the tension in his famous essay on Tolstoy entitled, well, The Hedgehog and the Fox. Berlin offers the hypothesis that “Tolstoy was by nature a fox, but believed in being a hedgehog.” Tolstoy wrote so amazingly because he couldn’t help but see all the details and sharp edges like the focused fox, but he wanted with all his heart and faith to fit all that into an empowering vision of mankind, employing a hedgehog’s imagination. In our framework, the CFO should be a fox and focused, managing the woirkign capital cycle - while the CEO should be a hedgehog and imaginative directing the long-term investments of the company. It’s not an either or - but a which when sort of thing.
While there are many ways to understand shifting between focus and imagination — my favorite will alway be Feyman’s brief story on the beauty of a flower.
Richard Feynman
In Feynman's framing -- the data or the scientific knowledge is expansive or enables a structured imagination which the artist doesn't have. You need to focus and see details so that you can know what questions to ask to unlock your imagination. Focus anchors imagination in reality. It’s not an either or. In Feynman’s construction, he agrees with Berlin — seeing that one can’t be a successful hedgehog without being a fox. You can’t construct an imagination which is based on reality without being an expert oberver of reality first.
As business analysts we are really trying to develop something similar, where we can look at a business and we know enough about the people who work there and the nuts and bolts of the business that we can imagine we see inside it (when as outsiders we don’t ever actually get inside information - so we have to imagine being insiders) and we can imagine what the business could become over time. Then we can check that imagination with company management to calibrate things, because the future one imagines for a business will only happen if the business is imagining something similar and planning and investing accordingly.
Feynman - Excerpts
What does this mean we do?
Because we are investors, our ideas need to be defined in the language of business: accounting. We quantify imagined futures in terms of how they would play out in the financial statements of companies. Our task is not to understand scientists or literature or philosophers — I am using them to introduce why and how, but that’s all useless if we don’t continue on to what.
What are the tasks we need to complete in researching a company?
Our task is to imagine what “progress” may look like for a company out 5 to 10 years and then walk it back analytically based on the constraints imposed by financial statements and management objectives. We start with a broad imagination and keep working at it until the pieces of the puzzle come into focus in terms of financial statement impacts.
Seeing what's not on the page is the process of seeing where the future has already arrived and then estimating how it will be "distributed" to the rest of the world. Imagination is iterative.
If one combines the advantage of seeing the future arriving before it scales or is fully distributed, with valuation discipline and analytical skill -- one should be able to create significant wealth over time.
This shifts our focus from short-term economic cycles or product cycles or political cycles which anchor many market paricipants, to long-term progress. In investing, can’t afford get stuck thinking only of the world as it is. We are investing in the world as it will be, and we are attempting to study how it gets from "here" to "there."
The process of assembling sets of long-term expectations and studying how they might play out in the next 5-10 years and then walking them back to today is generally referred to as “scenario building". Part of the projected financials model for a company will be a set of expected events which are reflected in the models.
And once we have a model and a set of expected events, the next step is to stay focused on the gaps between what we expected and what actually happens. Focusing is iterative too.
Closing
Quality investment analysis isn’t about finding answers. Answers apply to a point in time generally and if you are investing you hold an investment through time.
Investing isn’t about finding the answers. Investing is process, balancing focus and imagination to find the relevant questions to ask at different points in time.