Letter# 07 June’2007
Key learnings:
1.How to have creative thinking?
1)Start thinking about something, gather data to the point of saturation, recognize
anomalies and recognize that you are now stuck.
2)Retreat and simmer, mull it over and a period of incubation ensues with the unconscious mind deployed.
3) Whilst doing something else a solution to the problem surfaces.
4)Go and verify the new solution.
2.Co-relation of scaling laws to investing.
Let us first understand what are scaling laws?
Scaling laws describe the functional relationship between two physical quantities that scale with each other over a significant interval. An example of this is power law behavior, where one quantity varies as a power of the other.
Example:
Why do small animals live for less time than bigger animals, and why do humans live for around one hundred years rather than say, one thousand years, or one year? The simplest of scaling laws concerns body-mass and skeletal strength. As an organism increases in size its body-mass grows with volume (to the cubed) whilst the shear strength of the skeleton only increases with the width of the bones (to the squared, or a power law of 3/2). Without a bigger bone structure,
mass soon overwhelms strength, and the organism collapses under its own weight!
What can investors learn from the scaling laws?
The question that needs to be answered is: why is it predictable that a business will grow from a mouse to an elephant?
Several tenets are important.
1) A business ought to be able to self-fund its own growth, and if the opportunity set is large, then the return on capital needs to be suitably high.
2) Second, barriers to entry should increase with size; that way a company’s moat is widened as the firm grows. To do this, the basic building block of the business, its skeletal structure, is probably best kept very simple.
In short, we want a skeletal structure that can support growth from mouse to elephant without too much skeletal re-engineering.
This is law used by Nomad investment lab in identifying Amazon.( I have attached a full note of the same from the letter)
3.Short term result volatility and stock weighting:
There are 2 ways of portfolio construction:
1)Start with 2 -3% allocation and then reach the desired double-digit allocation.
2)Start with double digit allocation and then slowly reach 2-3%.
The adoption of the second approach will give more volatile results in the short term as there is high % of investment in one stock.
4.Investors are often guilty of chasing the new-new thing far from home sometimes in the name of diversification, or higher returns, or both. Such activity often has more to do with marketing than it does with underlying investment reality.
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