They all use something called First Principles to simplify complex problems. We use them for analyzing private investment opportunities.
You might be surprised at how simple, yet effective, it can be.
Investment analysis can be highly challenging. Each Issuer of securities (the company seeking your investment) is likely rather unique and is different from the previous company you analyzed. This means it’s easy to miss “the forest” for a few particularly compelling “trees.” Therefore, we’ve found it essential to apply a consistent approach to our analysis that first identifies the fundamental rationale for an enterprise, before digging into the many other considerations which are also important when considering a potential investment.
Following the leads of Investor icons (e.g., Charles Munger, Carl Icahn), Carofin use a First Principles-based approach to each company we encounter. It guides us as we initially determine whether we want to represent the business as a Placement Agent (for offering private equity or debt securities), and then as we introduce private investment opportunities to our investors.
First Principles is a framework for getting to know the fundamental “Why’s” behind a given business. Once understood, an Investor has a clear lens through which they can analyze the other important factors (the “What’s”) which can affect an investment’s performance.
Defining First Principles
The fundamental concepts or assumptions on which a theory, system, or method is based. “I think we have to start again and go right back to first principles.” 1 While often used in scientific research, a First Principles approach to investment analysis is guided by the following questions:
- The Opportunity - What primary business opportunity is the Issuer addressing?
- The Challenge – What stands in the way of it (or any other company) capturing the value the business opportunity?
- The Solution - What is the company’s solution(s) to the challenge(s)?
This approach may seem overly simplistic, but, all too often, an investment opportunity presents the sizzle over the steak. If the meat is no good, it doesn’t matter how well you season it.
First Principles, Its Origins and Application to Investing.
The concept of First Principles is over 2,000 years old. Aristotle is first credited with the concept, and his approach has withstood the test of time.
“In every systematic inquiry (methodos) where there are first principles, or causes, or elements, knowledge and science result from acquiring knowledge of these; for we think we know something just in case we acquire knowledge of the primary causes, the primary first principles, all the way to the elements.” 2
He connected an idea to fundamental underlying knowledge, defining First Principles as “the first basis from which a thing is known.” 3
In other words, a First Principle is a basic assumption that cannot be reduced any further. Reasoning by First Principals removes the impurity of assumptions and conventions, allowing you to see where reasoning by analogy might lead you astray.
Financial markets consistently provide us with examples of what can happen when a First Principle analysis is not used. With the benefit of hindsight, we can see how the great “crashes” involved:
- Less discerning Investors following a hot market trend into unrealistic company valuations (remember Warren Buffet’s “irrational exuberance” market call in the late 1990’s);
- Business realities asserting themselves when investment returns could not be produced by the underlying business activity; and
- Grossly over-valued investments that ultimately result in major losses for the last Investors to “get in on the action.”
Of course, the opposite can occur after a market has over-corrected. More disciplined Investors, recognizing good buying opportunities, start to invest at overly depressed prices (such as public stock investment opportunities in early 2009).
Private Investment & First Principles
Investment in private companies, because each is so unique and represents a “buy and hold” investment, is particularly well-suited to a First Principles analytical discipline. Private investments, by their nature, are usually not correlated to public market valuations and volatility. They perform for the Investors when the Issuer simply achieves its business objectives and generates greater profits.
Please be on the lookout for related articles expanding upon each of the factors in our First Principles rubric, The Opportunity, The Challenge and The Solution.