Mental Model:

Feedback Loops - When The Output Influences The Input

by Alex Mason | Nov 25, 2020 | Episodes, Mental Model | 0 comments

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Mental Details

Description

  • Facing conflict is always difficult. Facing conflicts on multiple sides is even harder. When companies face multiple headwinds and their attention and capital is diverted, we know as investors to take a close look at the risks. We can also apply this principle to looking at a company’s stock price through the lens of technical momentum (buyers and sellers are always fighting to change the current stock price).
  • In today's episode we cover the mental model of the Two Front War.

Transcript

  • Alex Mason: Today on stock stories. We're going to be talking about a mental model, specifically the two front war I'm Alex Mason, host of stock stories. This is the podcast where we decode investing principles by analyzing the business behind the stock, as well as learning about mental models in order to help you become a better investor.
  • [00:00:24] You ready? Let's go.
  • [00:00:53] Welcome. Welcome to the show. Thank you so much listening to stock stories. Yes. My name is Alex Mason. I am your host and stock storyteller. Thanks so much for joining me on the podcast today. This is the show dedicated to helping you become an individual investor and a better one by decoding the business behind the stock.
  • [00:01:20] And we're going through the entire S&P 500. We are well on our way with dozens and dozens and dozens of companies that we studied so far. And then in addition to that, in order to help our learning some more, we talk about mental models. These are more of the academic ideas behind not just investing, but better thinking processes in general.
  • [00:01:42] So that's what we're going to be talking about today on the show. Now I hope you enjoyed last week's episode. That was the wrapping up of the Keurig Dr. Pepper series. I hope you enjoyed it. It was the first time I've done a three part series on any particular company and man, like, wow. I just learned so much researching.
  • [00:02:06] That company and its history and its business model and everything behind it. So I hope you enjoyed it and learned just as much as I did now, today, we are going to go into a mental model and let's just get right into it today. We're going to be talking about the mental model of a two front war.
  • [00:02:39] All right today, we're going to be talking about the mental model of a two front war first. We'll talk about the basic definition of the mental model. Then we'll go into a general explanation and then we'll spend the last part of the episode talking about how do we actually apply this to our practice as investors?
  • [00:03:00] All right. Let's start with the basic definition. A two front war is a conflict. That's fought on two sides, putting the fighter at a disadvantage. So it's very simple, right? When you're fighting a war, any type of battle or conflict, if you're fighting on two sides, then your efforts are divided. You're focused your attention, your money, your time.
  • [00:03:24] All of that is being split to fight two different enemies. And that's not a good thing when you're trying to win the war. So let's talk about an explanation of what this concept means. This is a concept that comes from military strategy. Essentially it States that if you're fighting two enemies in two different arenas, it's really easy to lose a battle.
  • [00:03:46] Now Shane Parrish, who I've mentioned before on the show, he mentions this mental model on his website Farnam street, which has a great list of mental models. And the example that he gives for this particular concept is of world war II. When Nazi Germany was fighting the allied forces. So just a little bit of background on how this came about.
  • [00:04:09] Initially Hitler had a pact with Joseph Stalin of the Soviet union. And it was a non-aggression treaty. So Hitler said, you know what? We won't fight on Russian soil. We want to attack you. And Russia agreed to do the same. So he fought the allied powers mainly on the Western side of Germany, and then gradually expanded that direction throughout Europe.
  • [00:04:35] So naturally if you're familiar a little bit with world history, you know, that Adolf Hitler, he Rose to power in Germany during world war two, back in the early to mid 20th century. And he went all out to try to conquer as much as he could. And so you had this pact with the Soviet union, but he was fighting on the Western side of his country and he gradually expanded.
  • [00:05:00] Now eventually what happened is that Hitler decided to go against Stalin and he decided to invade. The Soviet union anyway, and he actually was quite successful in doing this. He started taking over city after city village, after village and pressing further and further into Soviet territory. His progress was stymied though.
  • [00:05:22] Eventually when he got to Moscow, the capital city. He was stuck fighting the United Kingdom and the United States in the West, as well as being unprepared for the bitter cold in the East. And Hitler failed to take Moscow down and he was eventually caught, fighting on two fronts. So what this did was exactly what the mental model says.
  • [00:05:46] It's divides your resources, your time, your money, your attention between fighting multiple enemies on multiple sides. And that's just not a good place to be in. So if you're fighting a war on two sides it's just, it's, it's difficult to win. And the tides eventually turned against Germany and the Axis powers, they were allied with Japan and Italy and they eventually lost.
  • [00:06:12] They lost world war two. There's a whole lot more that happened, but just, just a quick snapshot of that point in history, world war II ended and the allied countries won and they were victorious. So even if you are very powerful, you can lose. It is possible. Hitler had a lot going for him. He had significant control over a large part of Europe, as well as some of the most advanced military technology in the world at the time.
  • [00:06:46] But it was still difficult to deal with fighting battles on both sides. So that's a real world historical example of how this mental model can be looked at. Now let's talk about the mental model in the context of investing. So let's take this principle and apply it now to investing when we invest, we're not in a literal battle per se, per se, but we are in a battle in a way against opposing market forces all the time.
  • [00:07:20] And here's what I mean by that. Stock prices are determined at any given point in time by the equilibrium achieved between buyers and sellers. It's just like any other marketplace or auction where value in the moment is constantly being reframed and recalculated really based upon what people believe to be true about the nature of assets.
  • [00:07:42] So in this way, then we can look at the price movement of any individual stock as subject to this quote, unquote two front war of its own, right? Each and every day that the stock market is open. So sometimes the momentum for a stock is really negative. People are really sour on it. Oh no. This company is going to fail all these bad things happen and prices get depressed.
  • [00:08:06] And then sometimes it's the opposite. It's very positive and prices rise quickly. That's happening a lot right now, as I record this in the first quarter of 2021, the markets they're still up, people are really excited about. A lot of different companies. There is a lot of excitement, very recently about GameStop, which that's a topic on, on his own, which we won't get into today, but everyone was really excited about GameStop and the stock price shot up.
  • [00:08:39] So there's different levels of momentum depending on the stock and depending on the particular point in time. But we always have this push and pull of market forces that eventually. Result in a price at a given point in time that represents that equilibrium. So as an individual investor, I think it's useful to think about how this war, so to speak is playing out for any stock that you're considering.
  • [00:09:08] So let's look at an example. It always helps me to look at examples. So. Let's look at a company called general mills. Now we haven't done an episode on this company yet, but we will eventually get to it as it's part of the S&P 500. So just a little bit of a sneak preview here. I guess, if we look at.
  • [00:09:28] The five-year stock chart of this stock. Now, if you want to follow along, if you're on your phone and you're able to look at your phone, go ahead and pull up your stock app. Maybe it's CNBC or seeking alpha or Yahoo, finance, whatever it is. Pull up that stock chart of the ticker symbol. G I S. G I S so that stands for GIS general mills.
  • [00:09:52] And what you'll see if you can look at five years worth of data for this stock. So between 2016 and 2021, you'll see that the total price appreciation of that stock is only 1.5, 5%. And the thing is that's not even an annual return figure. That's the total return of how much the stock price went up. So, yeah, that pretty much sucks right now.
  • [00:10:20] Keep in mind though, for a company like this general mills is a really mature company. They make cereal and they've been doing it for a long time and they make other wheat and grain based products. So they're really old mature company. They're large, they're slow growing. They've been paying dividends as well for many years.
  • [00:10:40] So a company like this, the dividends. Are going to be an important part of total return. So if you've held general mills over the past five years, you would have done better than that 1.5, 5%, but you probably wouldn't have performed much better than inflation. So what's my point, the tug and pull of stock prices over this period has fluctuated a lot, but it hasn't fluctuated too much.
  • [00:11:04] Now the price has gone as high as $71 per share has gone as low as $38 per share. But at the end of the day, you started the period in the fifties somewhere, and you ended in the fifties, that's around where the stock price is at right now. So, if you're going to invest in a stock like general mills, you should know that at least historically, you can't really count on that much price appreciation of your stock.
  • [00:11:31] That's the tug and pull of the stock price momentum doesn't really win out in one way or the other. So let me explain a little bit what I mean by this, because usually I'm speaking. On the podcast in terms of earnings, in terms of sales, growth, market share competitive advantages, things like that. s you've heard me throw terms like that around in the past many times, but what I'm talking about now is actually a different field of investing.
  • [00:11:59] I'm referring to a field of investing called technical analysis. It's a study of how prices on a stock chart move over time. And essentially based on certain patterns in the charts, you can make reasonable assumptions about how the stock is going to move in the future. Pretty interesting right now, no, I'm not talking about market timing and I'm definitely not saying that you or I can predict the future.
  • [00:12:27] What I am saying though, is that you and I can learn how to read charts in order to make probabilistic predictions about the future price movement of a stock. So based on what I'm seeing, if you look at ticker symbol, G I S they're caught in this two front war, so to speak between the price zone in the low forties and the price zone in the mid sixties.
  • [00:12:52] So it's going to be really hard to gain momentum with a stock like this. And that's not even considering the fundamentals of the business, which. Are certainly important. And trust me when I cover this company in this stock in a full episode, dedicated to it, that's what I'll be considering. But just looking from the technical side for a moment, we can look at this as this push and pull of prices and.
  • [00:13:16] The buyers general mills stock. Aren't really winning out that much. And the sellers aren't really winning out that much either. It's kind of just Teeter tottering in the middle. So kind of what I think is an interesting application of this principle to look at a particular stock through the lens of technical analysis.
  • [00:13:37] But let's talk about fundamental analysis to specifically in the context of looking through the company's lens. So like countries that are going to war companies are always going to war in the marketplace in some respect, right? Even in win-win situations within industries, companies are always fighting against at least the status quo to gain customers and to gain their profits.
  • [00:14:04] Now, sometimes they're fighting against other companies that occupy the same niche as them. And those are their competitors. So sometimes companies fight a two front war of their own by trying to take on too much or overextending themselves with multiple priorities. So I want to give an example to you from history, consider a company called Eastman Kodak.
  • [00:14:30] Now you may or may not have heard of Eastman Kodak before, but they used to be a really big, important company in the landscape of corporate America. Unfortunately, after over 130 years in business, as this blue chip American company, they ended up going bankrupt in 2012. Now, interestingly, they have since emerged from bankruptcy and now they're trading publicly as part of the Russell 2000 index.
  • [00:14:56] But what was Kodak known for? Well, Kodak used to have the leading position. In photography and they even invented the Kodak moment. Tagline. You remember that if you, if you're in your thirties or older, you'll probably remember that like Kodak moment. If you're a gen Z, sorry, you probably have no idea what I'm talking about.
  • [00:15:17] But they used to have this leading position in photography. They made film, they made cameras and they were one of the best at it. Unfortunately though by the 1990s sales of the camera and the film and all the photography equipment, they were slowing down. And this happened, even though Kodak itself invented the digital camera back in the 1970s, but they were really slow to develop and commercialize that technology.
  • [00:15:46] Unlike their Japanese competitor, Fujifilm, who really started taking off by embracing digital photography technology. So here's an example of how a two front war that a company faces. Based on the fundamentals works. So they struggle overall with industry's trends of customer tastes changing and a photography.
  • [00:16:09] And I'm talking about like analog, physical photography going out of style in favor of digital photography. And then also not only that, not only did the whole industry have to deal with this, but Kodak had to deal with more nimble competitors like foods you film. So sometimes companies face broad industry trends that hurt the business, but sometimes the competition might not be that fierce with other players because of things like regulatory constraints.
  • [00:16:40] For example, think about the tobacco industry. That whole industry has been going down by many measures for a long time. But then again, nobody wants to compete with them because no one wants to be in the business. So the existing players, they get all the market share. Right. So in this case, you might have a successful investment, even though the broader market is contracting in size instead of growing.
  • [00:17:04] And just want to make this side comment that, you know, a lot of novice investors think that you have to invest in a growing industry to achieve great investment returns, but that's just not true. You can invest actually in declining industries and succeed, but I think that it's kind of a, maybe a special situation, more of a special situation.
  • [00:17:25] That you have to consider, but you can certainly invest in growing industries and also achieve great investment returns. Now contrast this whole situation with something else where other times as a business, you might have a lot of great general trends that are going for you. But you might face a lot of competition for exactly that reason, which makes investing in the business more risky.
  • [00:17:49] Now I think of technology stocks as a great example of this, everybody knows, for example, that cable television it's, it's pretty much dead at this point. And the general public over the past decade has moved from the cable packages. Of yesteryear to streaming services that use the internet, which are way more affordable, offer way more content at a way faster speed.
  • [00:18:15] Now, Netflix is the clear leader in this space. And then you also have other companies like Disney with Disney plus Amazon. HBO. Max is also a big competitor. These are all serious competitors in the space. So when the market is growing fast and everything is new, it tends to invite a lot of competition that the new entrance and the incumbents alike have to deal with.
  • [00:18:38] So the best companies though will ultimately overcome those headwinds. But you see what I'm saying? Sometimes you have lots of competition, but a growing market. Sometimes you have a shrinking market, but not a lot of competition, but what's really, really bad. It's when you have a shrinking market and lots of competition.
  • [00:18:59] So what we really don't want as investors is multiple headwinds that are big risks to our returns. If an industry is generally contracting. And a company in that industry is having trouble keeping up with its peers for whatever reason. Then to me, that's a really bad sign and it's a red flag. This is all about risk.
  • [00:19:19] What risks are the businesses that you're studying facing? Are they major headwinds? Are they minor headwinds? Are they risks that are somehow related or correlated to each other? These are all important questions to ask. So seeking the answers to these questions can help you and I, as investors. By shining a light on which businesses, it might be difficult to get good returns from.
  • [00:19:42] Yeah. Things might work out. Of course there are always outliers, but how do we tilt the odds in our favor as investors and not investing in businesses that are so to speak facing these two front Wars could really help. If a business is really struggling to expand its market share and is struggling to raise its prices and is struggling with their suppliers and distribution system, you might just want to stay away unless it's trading at like a super dirt cheap valuation where you know that the company is absolutely worth more than it's trading for, but that's more of more of like a hardcore deep value type of investment operation.
  • [00:20:26] Which you probably don't want to do, especially if you're a beginner. So that is something that I think is important to recognize as investors, sometimes companies are facing Wars on multiple fronts and sometimes they succeed. But companies that don't have to face as many headwinds have a better chance at performing better.
  • [00:20:49] And that means increased earnings and increased earnings over the longterm mean increased stock prices, dividends share buybacks, all the good stuff that you and I as investors and part owners and companies love. So I'll leave you with those ideas. Think about risk. Think about. The context of facing multiple risks in a business with this concept of the two front war.
  • [00:21:16] Thank you so much for listening to the stock stories podcast. Thanks for tuning in and next week we'll be jumping right back into the companies. So be sure to download or stream next week's episode. We'll be going right back into the S&P 500 with yet another company. So thank you so much for listening.

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