Source: In the Vastness of Transmitting Enlightenment
Author: Yao Bin
Regarding the first principles, Mr. Zhang Lei stated in his book 'Value' that the best methods may not necessarily involve valuation theories, asset pricing models, or investment portfolio strategies. Instead, adhering to the first principles—tracing back to the origin—is key. This 'origin' encompasses basic axioms, philosophies of life, human nature, and the laws governing all things. This articulates the essence of the first principles.
Whether it is Isaac Newton or Albert Einstein, in their physical worlds, they both described the essence of the world with a concise formula.
Similarly, when we invest, we must also adhere to the first principles, seeking a concise formula within the business world. However, simplifying to a formula is not the ultimate goal of business research; the true endpoint should be exploring the context from which this formula arises. By focusing on the development history of micro-businesses, we can identify truly valuable industries and business models. From this perspective, adhering to the first principles essentially builds upon in-depth research into industries and companies.
The concept of the first principles originated with Aristotle, who said:
In every system exploration, there exist first principles. First principles are fundamental propositions and assumptions that cannot be omitted, deleted, or violated.
Notably, each principle can give rise to other subordinate principles and propositions, forming a theoretical system.
Euclid's 'Elements' exemplifies this, deriving all definitions and propositions from a few axioms, thereby constructing the entire geometric system. This represents an axiomatic way of thinking, which has had a profound influence on future generations.
Within the business realm, a renewed understanding of the first principles emerged through Elon Musk, who is a practitioner of 'first principles.'
As a result, the first principles have been reinterpreted as follows:
It is very important that we apply first principles rather than comparative thinking when addressing problems. In life, we tend to compare; we follow what others have done or are currently doing, which can only lead to incremental progress. The thought process of first principles involves viewing the world through the lens of physics—stripping away the surface layers of phenomena to uncover their essence, then building upward from that essence.
Clearly, in Elon Musk's view, 'first principles' involve tracing the core essence of things and rethinking how to approach entrepreneurship, rather than merely applying comparative thinking to make improvements on existing foundations.
However, such an explanation still leaves me in a state of ambiguity. I generally disregard concepts or definitions that remain unclear to me. Yet, the concept of first principles seems too significant to ignore. This leads me to ponder whether, despite my previous ignorance of the so-called first principles, I may have unconsciously applied them.
If we consider Aristotle’s definition—'In every systematic inquiry, there exist first principles. First principles are fundamental propositions and assumptions that cannot be omitted, deleted, or violated'—we may gain some insights upon deeper reflection.
First principles exist in every system, which is not difficult to understand. For example, Isaac Newton's three laws, Albert Einstein's theory of relativity, and Charles Darwin's theory of biological evolution all express the essence of the world through concise formulas, forming first principles. Within these systems, first principles are indeed basic propositions and assumptions that cannot be omitted, deleted, or violated.
This brings to mind Mr. Charlie Munger’s 'latticework of mental models.'
The latticework of mental models serves as a metaphor for a multidisciplinary knowledge system where the fundamental principles of various disciplines are logically connected and integrated, resembling a grid that analyzes the same problem from multiple perspectives and dimensions. Pay attention to the 'fundamental principles' of each discipline.
These 'fundamental principles' are essentially what are referred to as first principles.
Every discipline contains profound wisdom: Newton's three laws in physics, the theory of evolution in biology, and the 'invisible hand' in economics—all are excellent examples of first principles. Mr. Charlie Munger advocates learning the fundamental principles of each discipline, then forming a mental model to analyze problems using as many applicable models as possible. This is the 'latticework of mental models,' which also reflects the application of first principles.
If first principles are introduced into value investing, the three cornerstones proposed by Benjamin Graham become the first principles.
The three cornerstones of value investing are: buying stocks is equivalent to buying companies, always pursuing a margin of safety, and correctly addressing market fluctuations. Similarly, these three cornerstones form the basic propositions and assumptions of value investing, which cannot be omitted, deleted, or violated. If they could be omitted, deleted, or violated, it would no longer qualify as value investing because it would contravene its fundamental principles.
All value investments must ultimately be applied to specific investment targets. Behind every investment target lies a tangible company, not merely a so-called "stock."
Therefore, in my view, only value investors refer to "buying companies," as they typically do not describe themselves as simply "buying stocks." The distinction between "buying stocks" and "buying companies" can determine whether one truly engages in value investing. When value investors "buy companies," they repeatedly evaluate core factors such as management, prospects, competitiveness, and moats, then make investment decisions. During this selection process, they naturally employ first-principles thinking, reflecting the application of model-based reasoning.
For instance, when considering investment risks, the "extreme survival assumption" mental model can be applied, representing a forward-looking approach beyond immediate visibility.
This model treats events that may never occur as probable occurrences. Its purpose is to help businesses or investors anticipate and prepare earlier than others during the onset of sudden events or systemic black swan incidents. Survival ensures everything else can be addressed; this represents a strategy for responding to worst-case scenarios.
You can also apply the "local predictability" mental model, which suggests that order may exist within chaos for a company. What appears entirely disordered in the short term may exhibit greater predictability than initially perceived. Certain regions within complex phenomena can be precisely forecasted, with unpredictability unevenly distributed across the entire system. Both mental models serve as first principles in investment.
If we further delve into micro-level analysis, such as when the investment target is a high-tech company, you can introduce the theory of "increasing returns." Increasing returns represent the mutual enhancement of value between investment and technology. If a company’s production costs decrease as its market share grows, a company that gains a substantial market share early on due to good fortune will outperform competitors, and any company with a strong initial start will likely monopolize the market.
You can also incorporate the "economic moat" theory.
An economic moat refers to a structural competitive advantage that helps a company withstand external competition over an extended period, enabling excess returns and making it difficult for competitors to replicate. In the United States, if an individual or institution invests the majority of their wealth in three excellent domestic enterprises for the long term, they are almost certain to accumulate significant wealth.
Finally, incorporate the "leading technology portfolio advantage" theory.
In the context of a knowledge-based economy and globalization, competition between enterprises is not about price but rather non-price factors such as product quality, technological advantages, innovation, and after-sales service. Among these, competition in technological advantages occupies a central position.
Through long-term repeated practice, it is possible to construct a first-principles framework for one’s own investment system. In my own case, after years of learning, I have preliminarily built my own first principles, among which the Power Law is the most frequently applied.
The Power Law originates from economic principles and is also known as the '80/20 Rule,' first proposed by economist Vilfredo Pareto in 1906. He posited that in any group of things, the most important elements comprise only a small portion—approximately 20%—while the remaining 80%, though larger in number, are secondary.
The Power Law suggests that the scale of development of phenomena is inversely proportional to their frequency; the larger the scale, the fewer the occurrences. The concept closely related to the Power Law is power-law distribution.
In the 1930s, linguist George Zipf analyzed the frequency of English words and found that only a small number of words are truly common, while many others are rarely used. The frequency of word usage and its priority rank follow an inverse power-law relationship. Two important theories emerged from this power-law: the Long Tail Theory, which states that there are few excellent companies and many mediocre ones with a long tail; and the Matthew Effect, where the poor get poorer and the rich get richer, the strong grow stronger and the weak weaker.
Physicists also study earthquakes using power laws.
Seismological research shows that small earthquakes are common, but large earthquakes are rare. Earthquakes vary in magnitude, but the higher the magnitude, the rarer the occurrence. For every doubling of earthquake energy, the probability of an earthquake of the corresponding magnitude decreases by three-fourths, resulting in a landslide curve distribution ranging from small-scale to large-scale earthquakes. Physicists refer to this relationship as a 'power law' because it is described by exponential equations or powers.
Once the Power Law is introduced, many previously ambiguous phenomena gradually become clearer.
For example, why are there always more losers than winners in the securities market? Why are there always more bad and mediocre companies than good ones? These are all effects of the Power Law at work. Considering these questions is no different from pondering why only a few students in a class can enter prestigious universities or why Olympic champions tend to be the same individuals. Understanding the Power Law makes it possible to solve many seemingly difficult problems.
If you want to stand out among the majority of losers, you must think and act differently from most of them.
If your actions are the same as those of most losers, the results will inevitably be the same. Only by doing something different might you achieve a different outcome. If you want to achieve excess returns in investment, you cannot afford to have too many choices among mostly bad or mediocre companies, because choosing such companies likely yields only a small probability of success and a high probability of mediocre returns.
The powerful effect of the power law forces us to think carefully when investing, forming the first principle, because we cannot ignore, delete, or violate it. Peter Thiel astutely distilled the 'power law' within investment contexts.
Peter Thiel pointed out:
Every great company is unique, but no one knows in advance exactly which companies will succeed.
Monopolistic enterprises capture more value than millions of similar competitive firms combined. However, only a small fraction of companies achieve exponential growth in value.
The task of venture capitalists is to identify promising startups, invest in them, and profit from their success. If they make the right judgment, they stand to gain returns, typically around 20%. Investment returns do not follow a normal distribution but adhere to the power law: a small number of companies significantly outperform all others.
Geoffrey West discovered in his research on 'scale' that companies, like living organisms, scale according to simple power laws. The growth and decline curves of companies resemble those of biological organisms, both exhibiting characteristics of systematic sublinear scaling, economies of scale, constrained growth, and finite lifespans.
The mortality rate of organisms and companies is the same, regardless of their age or years in existence, how strong they are, or what they have done. Publicly listed companies die at the same rate through mergers, acquisitions, bankruptcies, etc. Companies grow rapidly during their early stages but gradually stop growing after reaching maturity. If they survive, they will eventually cease growing compared to GDP.
During the startup phase, many companies are driven by a series of innovative ideas as they strive to optimize their position in the market. As they grow and become increasingly stable, however, the scope for product innovation narrows.
At the same time, they need to establish complex administrative and management structures. Soon, under the significant challenges of efficiently managing such large and complex organizations, economies of scale and sublinear scaling of innovative thinking ultimately lead to stagnation and decline. Half of U.S. publicly traded companies disappear within 10 years; very few survive to 50 years, let alone 100 years.
These are merely some case studies of power-law research, but they are sufficient to illustrate the powerful effects of the power law or exponential rule.
Everyone may have a different understanding of first principles, which can lead to varying interpretations of their essence. However, if one truly wishes to construct their own set of first principles, it is necessary to dismantle the existing system in order to build a larger system and ultimately discover the first principles within this broader framework. Disruptive innovation is equally applicable here. This presents an incredibly difficult challenge for me. Nevertheless, introducing first principles as a mode of thinking in investment can gradually improve one’s investment acumen, leading to a broader perspective on investing.
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Editor/Rice
