The present moment is a unique combination of a health crisis and a sudden-stop economic shock. This mix has not been seen before in modern financial history, and so is confounding a lot of investors’ attempts to search for a historical precedent.
There is an awkward truth at the root of most cognitive biases: humans are lazy. Our big brains take a lot of energy to get fired up, so wherever possible we like to use the quickest shortcut that we can find. This is the efficient path, so it makes sense most of the time. But in moments of great change – like this one – efficiency can lead us deeply astray.
We have seen this with world leaders that applied the wrong analogy to the virus itself: “it’s just a flu”. Or to investors in February that applied the wrong analogy to the economic impact: “this is just going to be a blip like SARS in 2003”. During the depths of despair in March we also saw the wrong economic analogy: “this is the Great Depression all over again”.
Reasoning by Analogy
The problem with all these takes is that they are reasoning by analogy. We take one thing that looks kind of like another thing, and treat them as being the same. This is one of our brain’s favourite shortcuts. We humans absolutely love reasoning by analogy. Reasoning by analogy is simple, quick, and efficient.
Once we have truly grasped the fundamentals of a situation, we can use analogies to explain our understanding to others. They also help to solidify the understanding in our own minds. At its best, analogy allows us to learn things from each other incredibly quickly. At its worst we arrive at Godwin’s law: the longer an online argument continues, the probability of one side making an analogy comparing the other to Nazis or Hitler approaches 100%.
Analogies are so powerful that we should be careful when they are the only tool being used to convince us. You can find an analogy to fit any argument. If there is a public debate about gun control, the pro-gun lobby will argue that guns are a tool, like knives, and so like knives, should not be banned. The anti-gun lobby will argue that guns kill people, like poisons, and so, like poisons, should be banned. Both of these analogies are tools of explanation, but not tools of fundamental understanding.
The mental shortcut of using an analogy can be incredibly valuable. It saves our precious brainpower. But efficiency is a problem when we quickly travel to the wrong destination. When we are facing something new or different, we should be careful to make sure that the analogy truly fits.
If you are trying to explain a particular view to someone, use an analogy. If you want to improve your understanding of the world, there is a better tool to use.
Reasoning from first principles dates back to Aristotle. It is a cornerstone of mathematical and scientific progress. First-principles thinking requires us to question everything until we have reduced the problem down to its most fundamental truths. Once we have those, we can then build back up to a solution.
Elon Musk is a famous proponent of first-principles thinking. When Elon created Space-X, he had a problem: spaceflight was too expensive. There was no way we could become a space-faring civilization with the cost of spaceflight being so high. If Space-X had reasoned by analogy it would have looked at all the rockets that had been launched before and concluded that low-cost launches were impossible. That was not an acceptable answer. It was time to question everything.
Elon broke the problem down to its most fundamental parts: and asked his engineers to calculate the weight of different materials that make up a rocket: steel, copper, hydrogen etc. and then compute the total cost based on spot prices for those commodities. He could see that radical cost savings were possible. The Space-X team of engineers got to work designing a low-cost launch system from the ground up.
One of the most famous examples of this approach was the development of reusable rockets. Before Space-X, rockets were extremely expensive to produce, and only ever used once. When a rocket blasted off for space it jettisoned huge chunks of itself in stages and sent them crashing back to Earth. Elon asked, why? If Space-X could land and re-use the rocket it would cut up to 75% of the cost of manufacture. In December 2015 Space-X achieved what was previously thought impossible – landing a rocket back on the landing pad. Today, a rocket returning smoothly to earth has become so commonplace that it barely makes the news.
How do we apply first principles thinking to the current investment landscape?
We first need to determine what the fundamental truths are of this crisis, and then reason our way up from there. In late February that primarily meant considering the nature of the virus itself. Now we need to combine this with an understanding of the sudden-stop economic shock. What has been directly locked down? Which activities are no longer happening? Which activities are customers most eager to restart? What psychological impacts will lock down have? Are they temporary or permanent? Once we have some understanding of that, we can then reason our way up from there.
This process is not easy. We don’t just need to consider the fundamental truths of how physical particles behave. Since we are dealing with business and financial markets, we also need to consider some fundamental truths of human psychology. It’s not rocket science, it’s much harder. Thankfully there are some tools we can use to address that.
But first, let’s look at two examples where simple assumptions could have led us astray: funeral services, and cruise ships.
Invocare has around 25% share of the Australian funeral services industry. While most of the market was falling in March, Invocare shares rallied 15% as traders speculated that COVID19 would bring a spike in Australian deaths. It was a pretty morbid and short-term trade idea. It was also poorly thought out.
Traders were reasoning that COVID19 would be analogous to previous increases in the death rate that typically benefit Invocare. The logic hinged not just on more deaths, but on more funerals. Did that make sense? Funerals are the type of gatherings where COVID19 are likely to spread, and therefore one of the most likely to be restricted. Indeed that is exactly what happened. The Australian government limited funeral attendance to just 10 people, and Invocare’s share price fell sharply.
Meanwhile, the Diamond Princess was the subject of huge media attention as it was one of the first recorded major outbreaks outside of the borders of China. The close quarters of a cruise ship made containment very difficult. Despite the crew’s efforts, over 700 of its passengers ultimately caught the virus, and at least thirteen of those passengers tragically passed away. In total over 25 other cruise ships have reported cases of COVID19.
A lot of people concluded that the cruise ship industry was over, and compared it to other 20th Century industries that disappeared as the world progressed. But so far it seems they would be very wrong, as the Los Angeles Times reported:
“In the last 45 days, CruiseCompete.com, an online cruise marketplace, has seen a 40% increase in bookings for 2021 compared with 2019, said Heidi M. Allison, president of the company. Only 11% of the bookings are from people whose 2020 trips were canceled, she said.”
What did folks predicting the end of the cruise ship industry get wrong? For starters they ignored that cruise ships have been dealing with health questions for years. Between 2008 and 2014 over 120,000 cruise ship passengers were infected with the gastrointestinal illness known as norovirus. The worst outbreaks made headlines around the world. Yet tens of millions of people still embarked on a cruise, reasoning that those outbreaks were infrequent and unlikely to cause them any harm. Should it have been a surprise that people that love cruise ships would want to return quickly once a one-in-a-hundred-year pandemic had subsided?
Not understanding how cruise ship passengers think is also a symptom of a larger problem that afflicts forecasting. It seems that most (all?) of the people saying that nobody will ever cruise again, were also people that just didn’t like cruises and might have never actually been on a cruise themselves. It is easy to think that an activity will stop after a disaster if you never thought it was attractive to do anyway. Who would want to cruise anyway, especially after a pandemic? Tens of millions of people, it turns out.
Which brings us to one of the most important tools in our investing arsenal: the power of observation.
Escaping our filter bubbles
These examples highlight the importance of not just arriving at a first-principles hypothesis, but also testing it. Once we have an idea we must then ruthlessly search for disconfirming evidence. Is there any information that we can find that will prove our hypothesis is wrong? Space-X doesn’t just run with the first rocket design it comes up with, it tests hundreds or thousands of designs to arrive at what works.
This is particularly important in the present day due to how easy it is for us to avoid interacting with people that have different viewpoints. The more that our activity moves online, the more time we spend in warm little bubbles of our own creation.
Whenever we search for new information on the web, or social media, we are almost always viewing the world through the bias of our own filter bubble. The algorithms of search engines, and social media sites, have been trained by hundreds of thousands of our responses to only show us results that we engage with. These algorithms become our Magic Mirror in Snow White and the Seven Dwarves: “Facebook, Facebook, on the wall, whose opinions are the fairest of them all?” They become a filter on our reality, only showing us what we want to see and reinforcing our chosen tribal identities.
As investors it is critical that we can step outside of our own cozy little bubble, and test whether our view of the world is accurate. We should seek to understand the most fundamental truths about a business’ operations and then build our investment thesis up from there. This allows us to gain a firm grasp of how each business is affected by the sudden-stop economic shock, and it will allow us to value the fundamental cash flow impacts.
Crucial to this research is canvassing widely. Speaking with people from different domains, and with different areas of expertise. Each tile of information may not seem too useful on its own but by piecing together thousands of them we are able to create a mosaic of understanding that better represents reality.
To navigate this new world, avoid the analogy trap, reason from first principles, get out of your filter bubble, and if you think you might have stumbled upon some part of the world that is tipping past a fundamental inflection point – get in touch!
Great article Matt. Thanks. It is a concern that search engines are self-appointed censors now on information, and society censors any views that are not "woke" or politically correct or against the party lines. That in itself may be an inflection point (societal) which the Wuhan Flu has highlighted. ?? Bitcoin was a recent example perhaps - I was checking out the maths behind it when it was $60 and thought nice... Wasn't thinking inflection ! Your approach and comments here are gold.
Thanks Matt, glad you enjoyed it! There are some very legitimate concerns around censoring. To me the most pernicious part of the filter bubble though is that it is mostly voluntary. People click the links that they agree with, and those get reinforced. This pushes people to both political extremes on both ends. I am not sure what the solution is, but it's a big challenge. Great to hear you enjoyed the inflection point article too!
Thanks for the article Matt. Hard to argue against reasoning away from analogy and the pack in regards to picking winners! :) I do want to address the cruise industry though. It's one thing for them to eventually say "we're back" and it's now"business as usual World!". For the cruise industry, the romance and the travel bug people have to participate has not gone, and justifies hope on ticket sales. People will want to cruise, certainly. But when can the rest of the world actually safely join in? While Australia sails through the crisis relatively well, many parts of the rest of the world are only starting the cycle now (Africa/Russia et al.). Can we really see cruises that go from port to port, country to country across Europe, Asia and the States, starting again within 6 months? What about 12? When those businesses do eventually reboot, how much accumulated COVID debt are they going to be carrying? What sort of PE's do we realistically think these companies can achieve anymore? Are they a good business at all based on the regular checks and balances we normally apply? I would think the dour (and I think rather accurate) forecast for the cruise industry was built on those lousy fundamentals (no cash flow, huge refunds), rather than the belief that people won't find the idea attractive any longer?
Hi Jon, Thanks for the great questions. To be clear, cruise ships are not good businesses in the best of times. They are asset-intensive, cyclical, with low returns on invested capital. I have never invested in a cruise ship business and it's likely I never will. I am specifically talking about people that were speculating that the cruise ship industry was over permanently. There were a few people calling this on twitter, and it was a different sentiment than say the airline industry. Airlines are a similarly terribly industry, however nobody speculated that airlines would disappear. Part of the reason for that might be because we all fly on airlines, so we have first hand experience and know that we will personally travel again once this is over. It's worthwhile figuring out if an industry will exist even if we will never invest in it directly. First, it helps calibrate our view of the world for forecasting other industries. Second, there are always some parts of an industry value chain that are attractive - hypothetically if we were reviewing a travel reservation software business, it would be useful to understand. I'd expect that much like the airlines there will be waves of bankruptcies among cruise ships, and (unfortunately in my view) some bailouts, then due to the strong underlying demand, the industry will return again on the other side. I would change my view if there were signs that demand was disappearing permanently for some reason (which we haven't seen any signs of thus far). This is where gathering a wide range of independent data comes in :)
Hi Matt. As you likely know IVC' annual results on 26 Feb were well received versus consensus expectations. Thus its share price bucked the trend to peak on 27 Feb 2020, rather than 21 Feb with the wider market. From 27 Feb peak for IVC, it was only south for its price and market thereafter to 23-25 March 2020 on a closing basis. At 27 February, few if any COVID specific themes/factors were being priced in anywhere. Flightcentre was $31 by way of example. Qantas was $5.65. Both being two of the most COVID sensitive stocks. They had yet to make any large moves, as the market had yet to appreciate or focus specifically on the COVID issues. Twitter / other platforms you use to digest news-flow may have been alluding to "buy IVC for a rise in funerals" (your analogy), but the pricing tape and chronology for IVC does not reflect this. IVC did not rise 15% in March. IVC fell through March. Both before and after its capital-raising. Notably Propel Funerals Group had exact same peak on 27th Feb being the day of its HY results. It also had exact same fall throughout March with the market and IVC (no rallies for any false rise in funerals theme). Although no broker coverage for Propel Funerals, it delivered HY growth of 21-22% on Revenue&EPS, and conveyed positive outlook statements unrelated to COVID (because COVID thematic moves/commentary were yet to occur at 27 Feb). PFP, like IVC, supporting the 27th Feb share price peak being legitimate and due to stock-specific results. RE: Cruiseline Industry, think US Corporate Debt Markets retaining an Investment Grade rating on Carnival and Royal Caribbean speaks to the confidence they have for repayment, despite the PITCH Black near-term sales-outlook. In this instance trust your call that Cruiseline Industry will survive, supported by Bondholders steadfastness in the most trying conditions. (Given, if no one finances it, and it blows up, and I agree margins are slim, the industry may disappear in spite of demand. Thankfully no Chapter-11's imminent).
Hi Matt, Thanks for your feedback. "At 27 February, few if any COVID specific themes/factors were being priced in anywhere." I respectfully disagree with this. Disagreement is what makes a market of course :) The first signs of the sell-off started Friday afternoon on the 21st of Feb, and really got underway on the 24th of Feb onwards. Flight Centre was trading at ~$30 by the 26th of Feb before results, but that was down ~15% from $35 on the morning of Feb 21st. Flight Centre then continued to fall, and that is what we would expect from an information cascade. The weekend of the 22nd and 23rd was when it became clear that the virus was not contained to China. Not everyone becomes aware of that conversation at the same time however, so you see pricing reflect this as the information moves from being a variant perspective held by a few of us, to common knowledge held by everyone. Webjet shares fell 27% from the morning of the 21st to the 27th of Feb. Although it was certainly true that *most* of the market hadn't fully processed the information cascade yet, I would disagree that it wasn't being priced in anywhere at 27 Feb. Here's an update from the 26th of Feb in the AFR https://www.afr.com/markets/equity-markets/pandemic-fears... Invocare shares rallied 16% from the 24th of Feb to the 27th of Feb, after the Covid slide started. Then held on to most of the gains, such that through to the 10th of March were only ~4% below this high, depsite the broader market falling precipitously over the same period. It is a fair point that results were part of this rally. The market is forward looking and so I expect that most investors were thinking about the future outlook, and from the 24th that included COVID. I can also say that from the morning of the 24th onwards I was hearing that funeral services was a defensive play for the reason I outlined. We never know for sure what was in people's minds when they bought. I think the sharp fall when the government announced the restrictions on funerals does indicate that a reasonable chunk of shareholders were not fully appreciating the likelihood of this happening. Thanks again for the feedback Matt.
Matt C - I'd suggest you take a look at what rate Carnival has just had to issue debt to ensure its survival, for the moment. The ratings agencies are behind the ball, as usual, and the Fed's intervention has been its saviour.
Great article and thought provoking. I have learned though, that it also pays to be mindful even when hearing, reading or possibly even seeing something. Sometimes it just isn't so. I have high doubts about the positive view of the Cruise Industry going forward and not sure that a few select pieces of data tells the story. You have to question the basis and integrity of the data.
Thanks Brett! You are spot on - it is crucial to constantly verify your assumptions with multiple different data sets.