We Study Billionaires - The Investor’s Podcast Network - TIP749: Unlocking Hidden Investing Secrets From Basic Science w/ Kyle Grieve

Episode Date: August 31, 2025

On today’s episode, Kyle Grieve discusses how mental models from physics, chemistry, and biology can give investors and business leaders sharper decision-making tools. He’ll explore how applying these frameworks helps to identify opportunities, avoid risks, and build lasting advantages. IN THIS EPISODE YOU’LL LEARN: 00:00 - Intro 02:06 - How relativity helps investors see opportunities from different perspectives. 07:33 - Why inertia reveals which businesses stay great or stuck over decades. 09:29 - How momentum creates powerful flywheels in business and investing. 23:22 - When leverage accelerates growth or dangerously magnifies risk. 29:13 - How catalysts can rapidly unlock an investing thesis. 35:50 - Why ecosystems multiply value from a single input change. 41:52 - How niche strategies create outsized business advantages. 52:50 - Why honest versus dishonest signals matter for investors. 01:00:19 - How misaligned incentives quietly increase investment risk. Disclaimer: Slight discrepancies in the timestamps may occur due to podcast platform differences. BOOKS AND RESOURCES Join Clay and a select group of passionate value investors for a retreat in Big Sky, Montana. Learn more ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Join the exclusive ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TIP Mastermind Community⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ to engage in meaningful stock investing discussions with Stig, Clay, Kyle, and the other community members. Buy a copy of The Great Mental Models Part II: Physics, Chemistry and Biology here. Follow Kyle on ⁠⁠Twitter⁠⁠ and ⁠⁠LinkedIn⁠⁠. Check out all the books mentioned and discussed in our podcast episodes ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Enjoy ad-free episodes when you subscribe to our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Premium Feed⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. NEW TO THE SHOW? Get smarter about valuing businesses in just a few minutes each week through our newsletter, ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠The Intrinsic Value Newsletter⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Check out our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠We Study Billionaires Starter Packs⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Follow our official social media accounts: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠X (Twitter)⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠LinkedIn⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Instagram⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Facebook⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ | ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TikTok⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Browse through all our episodes (complete with transcripts) ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠here⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Try our tool for picking stock winners and managing our portfolios: ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠TIP Finance Tool⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Enjoy exclusive perks from our ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠favorite Apps and Services⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Learn how to better start, manage, and grow your business with the ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠best business podcasts⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. SPONSORS Support our free podcast by supporting our ⁠⁠sponsors⁠⁠: SimpleMining HardBlock AnchorWatch Human Rights Foundation Linkedin Talent Solutions Vanta Unchained Onramp Netsuite Shopify HELP US OUT! Help us reach new listeners by leaving us a ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠rating and review⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ on ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Spotify⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠! It takes less than 30 seconds, and really helps our show grow, which allows us to bring on even better guests for you all! Thank you – we really appreciate it! Support our show by becoming a premium member! ⁠⁠⁠⁠⁠⁠https://theinvestorspodcastnetwork.supportingcast.fm⁠⁠ Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Learn more about your ad choices. Visit megaphone.fm/adchoices Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm

You're listening to TIP. Have you ever wondered if the secrets to smarter investing might be hidden in some overlooked scientific principles? Today I'll be sharing several of my favorite metal models from physics, chemistry, and my personal favorite biology. These have helped mightily in my understanding of specific businesses and business models. The best part, you don't need a PhD to use them. All you need is an understanding of what they are and how to apply them to solve problems.

We'll explore how relativity can reveal perspectives that other investors miss, how momentum applied to a business's fundamentals helps you spot whether a company is improving or deteriorating, and how distinguishing between honest and dishonest signals can help you cut through the noise of the markets. And that's just the beginning. This episode is for investors who want to make more rational decisions, business leaders who want to build stronger companies, and really anyone curious about applying timeless scientific principles to investing, business, and life. Now, let's get right into this week's episode on mental models from chemistry, physics, and biology.

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Greve. Welcome to the Investors' podcast. I'm your host, Kyle Greve, and today we'll discuss three broad scientific concepts, and there are underlying mental models. I'll be referencing many from the great mental models volume two by Shane Parrish, which focuses on three, like I said, areas of science, which are physics, chemistry, and biology. And I'll be adding a few personal favorites as well from these three areas of science throughout the episode. So we'll focus mainly on what these models are and how we can use them

in the context of investing. We'll start with physics, then move to chemistry, and then finish with biology. My personal favorite area of science from which to pick up mental models. Don't worry if you're not knowledgeable in any of these fields, I'm sure as heck not, but I'll be simplifying these concepts as much as possible throughout the episode to make it easy for you to understand. So we're going to start here with physics. Let's dive right into the concept of relativity, which basically means that there's more than one way to perceive something.

It's really that simple. So two people can observe an event and come to completely different conclusions. Not only because they're viewing the event from various angles, but also because of the internal biases that we all bring to the table as well as our previous experience. The theory of relativity can be understood very well through thought experiments, which I covered in detail on TIP 740, which I'll be sure to link. The book covers two thought experiments, though, both presented by noted physicists. I'm going to focus on the first one here by Galileo.

So Galileo concluded that two observers moving at constant speed and direction will obtain the same result for all mechanical experiments that they perform. Let's pretend that we're on an airplane, 35,000 feet in the air. A young child has a bouncy ball that he's chasing after in the aisle next to us. Anyone on the aircraft will see the ball bounce on the ground and then come right back up. The child drops it vertically. It will appear to bounce back up vertically. But if we were a bird at the same height and looked into the window, the ball would appear to be moving horizontally as the airplane passed by.

This is relativity. Two different observers perceive the same event in different ways. Relativity is prevalent in investing. Let's take an extreme hypothetical example to illustrate this. Let's say we have two investors. We'll call them value investor Vince and Speculator Steve. So a random microcap comes across their desk and they decide to spend a few minutes looking at the opportunity. Let's say it's a hot AI stock.

Call it Clara Technologies. This is a real business, by the way. So this business has a $133 million market cap and is appreciated by 24,000% here to date. So speculator Steve loves the name immediately just because it's head. has risen significantly and he buys into the story and thinks that it's just getting started. He looks at websites, he sees robots on the websites, AI, and AI coaching, it just falls in love with the name. He doesn't bother looking at their financials and buys a big chunk of shares. Next is Value Investor Vince. He's already kind of hesitant to look at it because he thinks

AI is in a pretty big bubble. But he decides to spend a few minutes looking at their financials in case this one is some sort of hidden gem. The first thing he sees on the balance sheet is that the business has $40,000 in tangible assets. Okay, well, it's asset light. He justifies it as he plays devil's advocate. He then examines the revenue and sees that over the last nine months, the business has generated only $26,000 in revenue. So if we annualize that over the year, he gets to about $35,000. The company is therefore trading at $3,800 times revenue. So he knows this is an easy pass, but he checks to see if the business might be profitable, just purely out of curiosity. Unsurprisingly, they've incurred a loss of $165,000 over the last nine months.

He quickly discards the business idea. Now, while most listeners of the show will probably resonate with value investor Vince, it's essential to understand the perspectives of both sides to see why anyone might bother being interested in a business like this in the first place. So a crucial point to remember about relativity is that a significant degree of subjectivity is inherent in it. That means people will have different opinions due to their inherent biases and experiences. If we look at, say, speculator Steve, let's say he's a software engineer who works in AI and has

had success investing in one of these pre-revenue startups that he's heard from a friend in the past. So he tends to overlook the fact that he has also lost, you know, maybe hundreds of thousands of dollars in similar startups, which have still left him in the red. However, since he understands AI better than the average person, he has decided to focus primarily on AI for potential investments. And Claire, technology got him very excited because it reminded him of his one big winner, but at a slightly earlier stage of its growth cycle. With this background, you can get a better understanding of where speculator Steve is coming from. When we examine value investor Vince, he's different. He went to Columbia and he took value investing courses there.

He has every version of Benjamin Graham's margin of safety as a collector's item. While he will invest in technology businesses, he prefers one that everyone hates and are trading at bargain bin basement prices, even if they have decent growth metrics. He's allergic to companies that trade for double double-digit PE multiples and has had massive success sticking to his low PE principles. So you can see how these two avatars are just night and day and would come to a completely different view on the business. While I resonate personally a lot more with value investor Vince, many investors are going to deeply resonate with Speculor Steve and that's completely fine. But as an investor, we can use this information to understand why a business might be priced

the way it is in the market. It may be purely for entertainment purposes such as the way I view Tesla, but it's still useful. If we believe, leave a business we own is drifting further and further away from reality, then it might be time to sell out of that company before reality comes for a pound of flesh. Another great example is Warren Buffett and Benjamin Graham. While Buffett idolized Graham because of his investing principles, they actually didn't always see eye-to-eye during Buffett's tenure at Graham Newman. So Graham had been burned badly by the Depression. This drove much of his investing strategy towards stocks that were trading below liquidation value. Graham always feared that another depression was just around the corner,

and this kept him away from a ton of opportunities. Buffett, on the other hand, was born during the tail end of the Depression and didn't necessarily fear that another one was just around the corner because he never experienced it first hand. So he was more likely to go out and find good opportunities that might not have the same margin of safety that Graham wanted, but were still great investments. The next mental model I want to cover from physics is inertia.

So inertia is a product of Isaac Newton's first law of motion stating that an object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction, unless acted upon by an unbalanced force. So René Descartes in his book Principles of Philosophy simplified it even more. Each thing, as far as it is in its power, always remains in the same state, and that consequently, when it is once moved, it always continues to move. So inertia means things tend to just stay the same.

If things are constantly changing, they will likely continue to do so, and the same applies to things that are still. Now, inertia is a great mental model to use in investing. When I think of inertia, one of my first thoughts goes right to Poulac Passaud's great book, what I learned about investing from Darwin. So Prasad examined a study of the Fortune 500 from 1955 to 2015. Interestingly, this study suggests that there's a plausible case for about 40 to 45% of businesses from 1955 to have sustained their excellence for a full 60 years.

This is not a number that you would expect. Where inertia plays a role here is the fact that great businesses tend to remain. great. An average or below average companies tend to stay average or below average. There is some ability for upward and downward mobility, but it's pretty tough. Pooleck also makes the point that a lot of information can be found from the businesses that did not survive, such as those that were not found on the Fortune 500 list. Pooleck asks us to imagine 10,000 potential companies, both private and public, that could have made the Fortune 500 in 1955. He estimates 10,000. But out of those, was only about 300 made it. That's low single digits. So 97 and 99% of businesses failed to stay

great over 60 years. Therefore, stasis tends to be the default. Another interesting way to view inertia is by considering momentum. Depending on the type of investor you are, you may view momentum differently than I do. A trader views momentum as the continuous movement in a stock price. When I think about momentum, I try to focus more on the momentum of the business's fundamentals. And more specifically, I'm looking at the pace at which a company is growing its intrinsic value. If a business has an EPS of, let's say, a dollar and a year later has an EPS of $1, to me, it lacks momentum. One of my primary goals in investing is to avoid these situations.

While my businesses won't grow EPS linearly, if I zoom out over a multi-year time period, it should approximate my forecast or, you know, be above my hurdle rates. Since my goal is to double my capital every five years, the average business in my portfolio, should grow EPS at approximately 15%. I'll definitely be wrong. I've been wrong in the past and I'll be wrong in the future, which means that I will have companies that fail to achieve this benchmark. But when I'm right,

I'll also have businesses that far exceed this benchmark by crushing my goal of 15%. For instance, one of my biggest winners, Topicus, has compounded EPS at about 30% per annum since it had normalized earnings around December of 2022. Since that time, my compounded annual returns have been 39% on the stock. You can also view inertia through the lens of your investing strategy. Since it's human nature to remain in stasis, you should audit what you are doing today and what is helping your strategy versus detracting from it. If you're honest with yourself, you may find that there are some

habits that maybe you have sticking around simply because they're the path of least resistance. One great example of an investor who escaped this inertia was Adam Cecil, the author of where the money is. So he observed that traditional value investing principles had evolved in line with the times. And since many value investors were just stuck, you know, focusing on gap accounting without making adjustments, they were actually missing out on some incredible opportunities in stocks that were actually punished for investing in themselves primarily through intangible assets. So rebalancing inertia is another strategic blunder in my books. Many funds are forced to take this route because they lack a steady stream of new capital. However, if you're a retail investor who

still works and consistently adds cash to your account, then you don't actually need to make the same move. Fund managers often have to make this move, as they need to find funds somewhere if they have a great idea. But if you are not in the same circumstances, then you don't need to be a victim of rebalancing inertia. You can hold your best positions and never sell a share. The final example of inertia I have for you concerns selling inertia. I was a victim of this one. So my reading and researching into investing has often allowed me to spotlight investors such as Warren Buffett and Charlie Munger. A large part of their success stemmed from making a few big bets that paid off very well.

and could be held for an extended period of time. My thought process was that I should be looking for businesses like these. And while I may have one or two of these in my portfolio today, I have lost a significant amount of money by attempting to hold on to losers, allowing inertia to keep me anchored to a thesis that just is no longer valid. I know I often criticize Alibaba and I don't plan on stopping anytime soon. I thought this was a business that I could keep as a long-term compounder. Unfortunately, I was probably about 10 years too late on that assumption.

To combat the selling inertia, I now assume I'll have a shorter holding period. This gives me a cushion to be incorrect without beating myself up over it. And I take a pretty data-centered approach. So over 40% of the decisions that I've made have actually cost me money. There is no point in allowing that fact to deter me from holding onto businesses that are unlikely to succeed in the future. Another mental model in physics that I've found to be highly useful and think about very regularly is momentum.

It's not mentioned in the book, but I believe it's a mental model that, is highly useful investing in life. So momentum is mass times velocity. It's elementary. It's hard to get things moving. And once things get moving, it's hard to stop. It's very similar in some ways to inertia, but it's not the exact same. So one way I like to look at momentum is as a flywheel.

This is where there are self-reinforcing elements that keep the flywheel moving and provide it with momentum. You see flywheels in businesses all the time. One of my favorite flywheels in business is the model of being a security. successful serial acquirer. So here's how being a successful serial acquire works. First, the serial acquirer purchases a business. Second, they understand the business model well and have the right personnel in place to improve the business's margins. And this means additional cash flow is made after the purchase price. And third, the business that they purchase do not require much reinvestment.

This means the parent company can reinvest that cash flow into an additional business. Once they buy a second one, they now have cash flows from two businesses instead of one. That provides even more cash flow to deploy and the cycle continues. You can also view momentum in terms of a business's culture. Does a company's culture foster growth or stagnation? If you listen to my episode on Netflix's culture on TIP 748, you learn that part of Netflix's recipe for success has been their ability to cultivate high amounts of innovation because they have a culture that has a lot of momentum.

Their founder, Reed Hastings, was very intentional about how he built Netflix's culture, knowing that innovation would be one of the keys of Netflix's success. So where many businesses go wrong is when they decide that they can just rest on their laurels. If a company has grown to be a giant, that's often due to innovative products or services. But some businesses become monopolies, where their customers have just no other options, and the company can then cut costs, providing a poorer service while maintaining or even increasing prices. You see this all the time in utilities and other slow-moving monopolies. Buffett likes these businesses because he knows they don't need to reinvest in themselves

and they have them out, so it's very unlikely that competition is going to steal their customers away. However, someone like Adam Cecil would actually refer to these types of businesses as rent seekers, where the company sits on a product that generates cash and does as little work as possible to enhance the customer experience. I'm not saying who is right or wrong. Still, it's essential to view businesses through the lens of momentum to see if you can observe whether a company is gaining momentum or if it's slowly losing steam due to the forces of capitalism. One area of momentum that has been top of my mind in 2025 is just business momentum. Businesses like culture go through periods of high momentum, but this momentum can actually slow down. While I'd prefer

a business where momentum is actually speeding up, this is incredibly difficult to find. And if a company is picking up momentum, it also attracts a lot of attention. In businesses, attention can be really a a double-edged sword, especially when selling a commodity-type product or something that is easily imitated. The other challenging aspect of investing is distinguishing when a business is truly losing momentum versus merely experiencing temporary fluctuations. This may be one of the most challenging aspects of investing. Many investors will sell a name going through a poor quarter, only to realize years later what a mistake that was once the business has become a multi-bagger. In investing, stock prices are the primary source of noise.

that can confuse investors. My primary strategy for combating this is to remove the stock price from the equation and think of a business like a business owner would. I'll ask myself questions such as, you know, is the business getting better? Good. Then I'll keep it. And since the market does silly things like sell companies that will have a single bad quarter, you should try to avoid taking part in this herd-like behavior.

Instead, focus on the business's KPIs and whether it will generate higher profits or cash flows in the next few years. If you think it will, then selling's a mistake. even if the stock price is currently being punished. The size of a business also has significant impact on its momentum. Remember, momentum is mass times velocity. If a company has large scale, it becomes increasingly complex for competitors to slow down that highly scaled business.

Because their mass is so large, some of these major tech businesses are just incredibly difficult to compete with. The usual suspects, Microsoft, Amazon, Alphabet, and Meta, for example, have these massive operations that are very, very difficult to stop. And you can use this as a strategy to find great businesses. One thing I like to focus on is finding businesses that are building mass and velocity. That's why I tend to like smaller companies. Some of these larger companies reach a point where they can no longer add significant mass or velocity

simply because they're already at a substantial size and serve a substantial portion of the market. These businesses can still be decent because it's difficult for competitors to stop them completely, but they also won't move fast enough to really keep me interested. stock prices also contain a significant amount of momentum. Much of this is directly related to just market sentiment. If your business is attracting new investors, its stock price is going to increase. Investing is most dangerous when scores of novice investors are investing simply because they've seen their family and friends making easy money by investing in stocks. This causes a massive amount of momentum in stock prices.

So the reason this is so risky is when price momentum and business momentum become completely disconnected. Consider a company like Ava Technologies. They create specialized sensors for cars that enable them to see the road by measuring the distance objects, their speed, the composition of the object, primarily for self-driving and driver assist features. It's basically LIDAR. However, it's a story stock. So since December of 2023, the stock has compounded EBITDA at 4% while its share price is compounded at 131%. So these are incredibly risky to own because investors are betting on the stock's momentum to generate returns. As long as other investors are playing the role of the greater fool and bidding up the price,

then owners will have a willing buyer of their stock to sell to. But what happens is that businesses like this will see their momentum dry up eventually, and then owners start selling in droves to find other high momentum story stocks. And once they start trading, the selling pressure increases significantly and the price drops sharply. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo, at the height of the summer. You've got long days of daylight,

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Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So the following metal model from physics that I'll be covering is one that everyone's going to be very familiar with. And this is leverage.

So leverage is simply the ability to achieve results significantly greater than the force put in. When you're getting a loan from the bank to buy a home, you're using leverage to own a home that you would probably not otherwise be able to afford. When you have a long list of colleagues and acquaintances and you need help on a particular problem, you're using leverage to solve that problem by tapping in to that extensive network. And if you're a business that can create value by acquiring other companies, you may seek additional capital beyond your existing cash flows or what's on your balance sheet

to help continue creating value for your shareholders. So Parish writes that there are three things that we need to know about leverage. The first one is, how do I know when I have it? Second is when should I apply it? And third is, how do I keep it? These are all great questions to ask. And when I examine the businesses in my portfolio that utilize debt, it provides me with a really interesting perspective on how to view it. So let's examine a business that I own that isn't particularly well known, but I think illustrates leverage very effectively.

So the company we're going to be looking at is called TerraVest Industries. TerraVest Industries is a Canadian-based consolidator of niche steel-focused manufacturing businesses with operating units across HVAC, compressed gas, processing equipment, and service segments. They specialize in storage vessels, boilers, wellhead processors, and fluid management systems. If I want to answer the first question from the framework, how do I know when I have leverage? I'll just simply look at Terabest's balance sheet. So as of Q2 2025, the business has $108 million for the current portion of long-term debt and $828 million of long-term debt. So total debt there is about $936 million. When I look at serial acquirers, I really like to look at cash from operations and owner's earnings.

Luckily, Terribes has a metric that they use called cash available for distribution, which is essentially the exact same calculation as Buffett's owners' earnings. The numbers for the last quarter are cash from operations about $34 million and cash available for distribution around $31 million. So Terabest does have some seasonality in the business, but they also have a massive acquisition that's going to contribute very meaningfully to forward cash flow. The next question regarding leverage is where and when should I apply it. So a business like Teribus clearly does not require debt.

their internal cash flows serve all of the company's needs. But as with many Sierra acquires, more opportunities exist than they have cash on their balance sheet and cash flowing in on a regular basis. As of Q2 2025, they only have $17 million on the balance sheet and cash. But just before the quarter's end, they announced a U.S. $546 million acquisition. So if you looked at TerraVest as a business and saw that the debt levels were this high compared to its cash flow, you might have zero interest in the business. But since Teribus management has shown the ability to deliver well over 20% returns on invested

capital on acquisitions over the last decade or so, it brings up an investor's confidence that they can probably continue doing it into the future. As a result, management believes that they should apply leverage when the right opportunity arises. If I were looking at a different business that maybe had just an average return on invested capital of, let's say, 5% over the last decade, I would be running to the exit door once I came across that idea. A business like this is likely to just destroy shareholder value by utilizing debt, as it can't generate high enough returns over its cost of capital, which is just value destructive.

It's just math. You don't want any of these in your portfolio. Now, the third question is, how do I keep it? So in the case of TerraVest, leverage will remain within the company as long as it sees potential to deploy capital at high rates of return. As I mentioned earlier, businesses with high leverage that cannot create shareholder value should be avoided at all costs. And even serial acquires that pile on debt for significant acquisitions can create additional risk. Where I find comfort is in the trust I have in Terravist's CEO and

CIO who are just masterful capital allocators. I have very little doubt this new acquisition's going to pay off in a big way in the long run. And even though Teribus added debt to their balance sheet to make the acquisition, my future projection of cash flow shows that they're going to be able to service that debt. Now, let's suppose they had an acquisition that just seriously failed. That might make me less likely to stay invested in the business, but in TerraVest's case, no event has yet occurred. Now, leverage is interesting because it has this kind of intoxicating allure to offer better returns than a business could achieve without its use. This is why individual investors use margin on their trades, or why corporations will look for loans to improve their

business at a faster rate than their internal cash flows would allow. But there's undoubtedly a dark side to leverage. If a company cannot service its debt and continues to pile up, on more, it is increasing the risk to its business. In that sense, leverage is very bad and can rapidly increase the risk of an investment. Another way to look at leverage is as a force multiplier. So as individuals, we all possess unique qualities that make us who we are, and leverage can amplify these strengths. If we look at someone like Warren Buffett, he used a lot of leverage in these qualities that he had to make himself who he is. Look at Buffett's reputation, for instance. It was not built overnight.

It was built over many decades, just brick by brick. And that reputation led them buy businesses simply with a phone call and an oral commitment. That's leverage. That's real power. And it came from acting ethically, consistently, and rationally. However, if you possess the opposite qualities of Buffett, such as vanity or foolishness or impulsiveness, then you're more likely to leverage those qualities into risky outcomes. So take a look at the qualities that define you and try to ensure that you're leveraging the right ones

and avoiding the ones that could lead to ruin. Now, let me pose a question. Have you ever owned a business that you think is just doing a superb job but won't budge in terms of price? But you own it, you courageously hold onto the name, knowing that the market can't stay irrational forever and will eventually close that price and value gap. Then boom, over the next few months, the stock price doubles. That moment of sudden movement often comes from the invisible hand of catalysts. So catalysts originate from the world of chemistry. A domain, I personally don't understand too well, but catalysts are something that I can easily wrap

my head around and I think you can too. So catalysts do the following things. They accelerate change and they increase the rate of reaction. To put these directly into investing, they might show up as not altering the underlying value of a stock, but unlocking the recognition of it. Or it might show up in time. You know, a catalyst can collapse time in investing, something that maybe would happen in five years can happen in one year. So META is an example of how a catalyst can unlock the recognition of value. So let's rewind back to 2022.

Meta experienced a 76% drawdown as a result of its CEO Mark Zuckerberg's announcement that they would invest about $10 billion into the Metaverse. An unvalidated part of the business that investors just didn't seem to be very excited about. However, at the same time, META's underlying advertising business would continue to improve. It increased its revenue by 17% in 2022, and there was just no signs of its slowing down. down. So while the Metaverse spending would have an effect on cash flows in the short term, it wasn't a case of will this investment bankrupt the company. Meta's free cash flow also plummeted in 2022, declining from $40 billion to $19 billion, which also spooked investors. As a result of all

this, meta stock price dropped to around $90, but just two years earlier, it was sitting at $380. Then in 2023, Meta announced it would be a year of efficiency. They cut costs and largely refocus on the core advertising business. that was their cash cow. And the results were absolutely spectacular. So here are some of their KPI since 2022. Advertising revenue has shudged along at a 19% kegger. Free cash flow has exploded to a 46% kegger. The PE multiple has doubled from 14 to 28. And the stock price has increased by an over 100% kegger going from 90 to 780, nearly a nine-bagger in only three years. Which is all the more impressive considering meta is now worth more than $2 trillion.

So some other examples of catalyst and investing include things such as management changes. You might look at a new CEO who has a really good track record. You know, someone like Sotje and Adela at Microsoft is a good example. You might look at a company going through spinoffs or breakups, which can unlock hidden business value. You might look at an example such as when PayPal span off from eBay. Another one to look at is just buybacks or dividends. These can be a really good signal of capital allocation discipline.

There's M&A activity. Acquisitions or the announcement of acquisition of a competitor can be a huge catalyst. Then there's regulatory or legal changes, you know, something like FDA approval, the removal of tariffs, or maybe the settlement of a court case. Then there's product launch or innovation. A good example would be Apple's iPhone moment. Then there's capital reallocation, you know, things like asset sales, de-leveraging, shifting to higher capital efficiency areas of the business and getting rid of lower capital efficiency areas. Then there's insider buying. This obviously is a strong signal of confidence in the business.

And lastly, is short squeeze triggers. These might be from businesses that have small float and sudden demand. And therefore, when a small catalyst happens, it can blow up the shore price in a good way, which an example would be something like GameStop. So there are catalysts just everywhere in investing. And if you look hard enough and arrive early enough, you can find some incredible multi-beggers. My favorites are announcements of buyback below the intrinsic value. When a company is just chronically cheap and they announce they're going to do buybacks,

I'm downright giddy because it means that I'm going to get an increased share of the business at great prices. I also like undervalued M&A activity. Since I have many serial acquires and some of them make larger acquisitions, the market will try to revalue companies when a new acquisition is announced. However, sometimes the market doesn't fully appreciate or understand an acquisition. and even if it re-rates upwards, sometimes it doesn't re-rate upwards enough, and that's a really good opportunity to pick up shares. So a good example of this is TerraVest once again. So when Terravist announced its latest acquisition, there was a short period when I felt it was much more

reasonably valued. So I added shares. However, that time was very short-lived, and the opportunity to add shares disappeared very quickly if you just weren't incredibly decisive. So regulatory changes are another good one. I don't really use this catalyst very often, but I appreciate how it can contribute to a market-wide sell-off during something like the tariff period we just went through. That was a great time to deploy capital into businesses that were unlikely to be significantly affected by tariffs or would only be affected for a very short period of time. Product or innovation launches are also a significant catalyst for growth that I like to watch. Many companies will release new products to an already very loyal customer base.

Apple and their iPhone is a great example. As a result of these new products, they rapidly increase their top and bottom lines already having a loyal customer base to sell to, which was very familiar with their legacy products. Another catalyst is related to capital efficiency. Imagine a business that has gross margins of 20% in its legacy business, and then it develops another line of products with gross margins north of 40%. The value proposition on the new products is actually much better than the legacy products, and their new inventory is just flying off the shelves. This means the business is now selling more high margin products instead of low margin products, which will significantly improve its margins.

I have a microcap in my portfolio that's doing just this. Another way investors can utilize capital efficiency to their advantages by observing the capital expenditure cycles in the industry. I prefer very well on businesses like Eritzia and Dino Polska simply by buying shares in these businesses when their capex cycles increased. So in the short term, the market dislikes the decreases in the cash flow, but in the long term, it appreciates the increased cash flow. Catalyst is simply waiting for the increased CAPEX to pay off in these two businesses that have high returns on invested capital, and therefore they benefit greatly from that increased CAPX spend, but you need to wait a little bit. So I must take a moment to note that some businesses don't require the catalyst above to deliver value to their shareholders. Some companies like, you know, Constellation Software, are their own catalyst.

And what I mean by that is the business has been expensive since it went public in 2006, and yet it is compounded its shares at 33%. So it's a rare case where the quality of the business is its catalyst for success. However, as long as that quality remains high, the company's probably going to continue to provide value to shareholders as long as they retain their shares. The following overarching theme we'll be covering is now in biology. So this is a scientific field from which I tend to use mental models from the most because it's a field that I just find very, very fascinating and I found very fascinating for a long time. So let's start here with ecosystems.

The book defines an ecosystem as a community. of interacting species within their non-living environment. The effects of ecosystems are vast and complex. The reason that ecosystems are so complex is that they're basically systems. This means that when one input is altered, it can affect multiple outputs. A notable example is the reintroduction of wolves into Yellowstone National Park. The one act of introducing a species that was native to the land resulted in numerous outputs. So the increased wolf population helped stabilize the growing elk population. Since elk

consumed things like young willow, aspen, and cottonwood trees, the decrease in the numbers allowed those plant species to repopulate. The vegetation surrounding the riverbanks also improved, helping to enhance the biodiversity of the surrounding areas. As a result, beavers, birds, and insects repopulated the area. Beaver, who now had trees to use for their dams, could build dams that increased water retention, further increasing biodiversity. Scavenger species such as ravens, eagles, and bears increased due to the increased level of carcasses that were left over from the wolves. And then the improved vegetation, reduced riverbank erosion, and waterway stability.

So Parrish has another part of ecosystems that is very important as part of the mental model. So he writes about something called keystone species. These are organisms within a system that are just foundational to the ecosystem survival. If these organisms were removed from the ecosystem, it could result in a complete change or collapse. This is an excellent lens in which to view a business. First, you can do something such as search out companies that make products that are just integral to an industry. A business like ASML is one such business. So ASML is a near monopoly in extreme ultraviolet lithography, which is essential for producing small cutting edge chips. Without ASML, the industry would be decades

behind where it is right now. Generally speaking, these businesses also make really good investments. So over the last decade, ASML has compounded its revenue at 19%, EPS at 22%, and share price at 23%. If you want to learn more about ASML, my co-host Clay Fink just released an excellent episode that discusses the business in a lot more detail on TIP 746, which I'll be sure to link in the show notes. The method I use above involves examining the supply chain of a given industry. See who makes what, and then identify which ones have certain interdependencies. If all businesses that manufacture a product will acquire apart from a single supplier, you've identified interdependencies, and that can be a highly valuable way to view companies.

If you find a business like this, ask what would happen if it were to fail. If the consequences are dire for customers, there's a good chance that you found a company with a pretty powerful moat. Charlie Munger was very well known for its obsession with Costco, and Costco had a magnificent ecosystem. So Costco is kind of this middleman between suppliers and customers. Suppliers love Costco because Costco can buy very high volumes of a product, since they're also very dependable and have vast amounts of experience. Then when you look at customers, since Costco will only mark up their products by about 15%, customers know they're always going to get the cheapest prices from pretty much anything that they buy from Costco.

If you remove Costco from this equation, then both suppliers and customers are probably just worse off. The supplier then has to find multiple companies to sell their products to, to which can increase complexity. Or if a supplier produces too much, they may have to reduce prices to find buyers for their product which is going to reduce their margins. Customers would have to live with shopping for their items at increased prices elsewhere because there's just few businesses that can compete with Costco's ability to offer everyday low prices. One critical part of an ecosystem is something called feedback loops. So in any ecosystem, when an input changes, feedback can be observed in the system's outputs. Some ecosystems exhibit immediate feedback,

while others have delayed feedback loops. I had the opportunity to discuss the role of feedback loops in a lot of detail when I interviewed Annie Duke on TIP 623. So when investing in a stock, investors are constantly seeking feedback loops that can confirm their thesis is correct. Most investors use stock price as their feedback loop. Long-term investors might focus on other fundamental KPIs such as, you know, growth in cash flow or profits. In the short term, a stock price can rise even if a cash flow is going down. going down. This is why stock prices are not a good indicator for feedback loops, at least in the short term. Instead, you can find specific KPIs that are vital to long-term success

of a business and look at feedback loop through that light. For instance, I've owned several companies that heavily emphasize the importance of their backlog. Let's say a business converts 100% of its backlog. I know this is unrealistic in real life, but it just makes the numbers easier to work with, so bear with me. Let's also say that the conversion of backlog to revenue is kind of lumpy because revenue is only recognized once the product is shipped to its customer. A business like this would have feedback loops that we can use to determine if our thesis is intact, but it may not be the most obvious number. Many investors will look to metrics like revenue and profits.

In that case, they may be heavily disappointed during certain quarters because a company might develop a product, increase its backlog, and then not see revenue for, let's say, six to 12 months afterwards. But if the backlog is continuing to grow by, let's say, 25%, then it means that revenue should probably also grow around that number on a trailing 12-month basis 12 months into the future. And if the business has operating leverage, then profits will grow at an even higher rate, which is obviously something that we'd love to see. This means the KPI that maybe you should focus on, in this example, is the backlog rather than revenue or share price. These types of businesses

can offer great opportunities as they often have these rising backlogs. However, if they have a bad quarter, they're frequently penalized for these short-term reductions in revenue and profits but are rewarded in the long-term once those numbers run back up after they convert their backlog into revenue. So within every ecosystem, numerous species coexist in a variety of niches, our next mental model. Some of these species are generalists who cover a large amount of territory and face more competition for resources but are maybe more flexible in meeting their needs. Then you have specialists. They occupy smaller territories and tend to face less competition. competition, but they're also a lot more rigid in their requirements for survival.

So since I've already mentioned Yellowstone, let's just stay there. Coyotes are generalists. They can live in Rome in large areas of Yellowstone, but life can be pretty tough for them as they have a lot of competition for resources. They will eat anything from animals to berries to dead birds, but many other animals will also eat the exact same thing. Now we look inside of Yellowstone's hot springs. Now inside of the hot springs live these little microbes that are fully adapted to living in the

high temperature areas of the hot spring. There are practically no other living organism in there because the environment is obviously incredibly harsh and hot. But they also can't ever escape the hot springs. They're trapped there for the entirety of their lives. If they were to move to, say, normal temperatures, they instantly die. Ultimately, the key difference between generalists and specialists lies in their response to a changing environment.

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business inside of the mining industry, automatically assume the company is highly cyclical, but this business is actually quite different. The niche it occupies is not cyclical. So wastewater and effluent have a significant impact on their surrounding ecosystems. This can be anything from the fish that swim in the water to the water that humans drink. Therefore, when a mine is established today, they must employ engineers and water treatment specialists to ensure that the water is safe to release into the surrounding environment. As a result, water treatment, Treatment Co is a recurring revenue machine. All wastewater and effluent generated by a mine must be treated. It cannot just be treated one year and then allow to enter the surrounding environment the next.

So while it's not a recurring revenue machine like a Netflix since water volumes are highly volatile, they actually do have an incredibly long runway for treating wastewater. So a mine requires treatment before, during, and after it's in service. As a result, water needs to be treated from a mine for anywhere between 10 and 30 years. So the reason this business is doing so well is that it occupies just a tiny niche. There are larger engineering and water treatment businesses out there, but they rarely pursue the same contracts that Water Treatment Co does. The smaller size and scope of the projects that Water Treatment Co. Chase is

would just be a rounding error for many of these larger water treatment companies. So while Water Treatment Co will never have the ability to serve every mine out there, they don't actually need to do that in order to succeed. They can just focus on smaller deals, where they rarely face much competition on their projects and service the smaller projects that larger competitors often overlook. Another way to think of niches in investing is to exploit any trade-offs between generalists and specialists. Since generalists are more flexible, they can thrive in a variety of settings. However, there are specific environments in which they cannot thrive, as the environment may be just too specialized for them to succeed.

This brings to my one of my favorite moats that Hamilton-Helmer covers in his excellent book Seven Powers. The mode is called counter positioning. So this is when a business harms itself by attempting to make large scale change. Dollar Shave Club, which I'll refer to as DSC and Gillette, are just great examples of this. So Gillette was a generalist that could survive and thrive nearly everywhere and had its brand that helped save off competition. However, DSC emerged, offering razors through an online subscription at a fraction of the price at Gillette charged. DSC was capitalizing on the niche of a younger generation, of online savvy shoppers who just didn't want to be stuck in Gillette's razor razor-race model of buying expensive blades for the rest of their lives.

Now, if Gillette wanted to compete with DSC, it would have been very challenging. So their razors were looked at as kind of a premium product. And that meant that competing on price just would not have made sense and would have also angered the retail stores that were selling their products. Margins would have also had to compress. Not to mention if Gillette went direct to consumer like DSC did, it would have actually cannibalize their retailers business for their own benefit. Another way of thinking of niches is to find the rare business that can utilize multiple

niche benefits, providing owners with the Lollapalooza effect. If you ever been to a Berkshire Hathaway annual meeting, you may have trekked to Nebraska Furniture Mart to stand in awe of its sheer size and excellent prices. But Nebraska Furniture Mart or NFB is where it is today because it occupies several niches that make it very difficult to compete with. So first is geographical, dominance. NFM is just a destination. It's not at just a place that you go and stop. Customers will travel hours to shop at their locations because they know they're going to get the best price as possible, probably in the state. Next is vendor relationships. Since NFM is so large, you can place large orders from its suppliers. Suppliers also know that since NFM sells things

at razor-thin margins, there's a good chance they'll be able to move their inventory and continue buying from them. And lastly, is unmatched buying power. Since NFM can purchase such large volumes, it gains bargaining power over suppliers to secure fantastic prices that it can then pass to its customers. As NFM diversifies its business and grows, this advantage only strengthens. The last niche I'll discuss is one that I like to take advantage of, and that's investing in invisible or underappreciated niches. I like small businesses, and these small businesses tend to sell niche products and are businesses that 99.99% of people have never even heard of. As a result of their lack of discovery, these businesses are not closely followed by the market. This is why I love to

adapt Charlie Munger saying fish where the fish are. I actually prefer to say fish where there are no fishermen. This means you can find some incredibly successful businesses that are growing rapidly, generating profits, and are largely unknown to the general public. These are the businesses that I spend all of my time researching and thinking about. These businesses are also small enough to have certain constraints. They may have a market cap that is just too low for institutional investors. They may not have sufficient liquidity to allow institutions to build a position without significantly impacting the stock price. And since many of the businesses I invest in have no analyst coverage, brokers and other analysts are not incentivized to report the positive aspects of these businesses. It's a great niche to explore and has helped me generate some excellent ideas.

Another biological mental model that I find fascinating and highly useful is the concept of signals and specifically honest first dishonest signals. So I already mentioned Poulac Prasad's excellent book why I learned about investing from Darwin, and I learned this metal model also from that book. An honest signal occurs when a signal reliably transmits truthful information about an organism's qualities, intentions, or conditions, usually because it's costly or difficult to fake. A dishonest signal happens when a signal conveys false or misleading information, often to gain an advantage without possessing the quality that's being signaled. So you'll see these signals just all over the place in the natural world.

So a simple honest signal would be a gazelle in the wild. So when a gazelle spots a predator, such as a cheetah, it will often do this type of jumping gate called stotting instead of immediately fleeing. This is an honest signal to the cheetah that the gazelle is an excellent shape and it's energetically costly to do the stodding in the first place. So only the most fit gazelles do it. And this signals to the cheetah that they're not worth pursuing as they're going to be. incredibly challenging to catch. An interesting example of a dis-on-a-signal can be found in a plant called the mirror orchid. The orchid produces flowers that actually mimic the look and pheromones of female insects.

This means the orchid is essentially tricking male insects into attempting to mate with it. As a result, the male insect picks up or deposits pollen. The male wastes his time thinking that he is mating, but is just a pawn being used by the mirror orchid to proliferate. Signals are found in literally every corner of the stalker. market. Let's go over a few examples. So the first one is insider buying. Executives purchasing shares of their own businesses on the open market can signal confidence. Second is share buybacks. Reducing share accounts can signal undervaluation and intelligent capital allocation from a business.

And third is mergers and acquisitions. These can quickly improve a business's top and bottom lines and offer value when they allow a company to expand their margins on an acquired business at a pretty rapid pace. Now, insider buying on the open market is a reliable signal based on my own experience. If an executive is buying shares on the open market, that means they're using their own money to buy shares in a business that they know more about than nearly anybody else. If investors knew what an executive knew about a company, they would be charged with insider trading. So while investors can't directly ask a CEO why they buy a stock, the signal of them using their cash on a stock is a powerful and honest signal. One interesting way to analyze insider purchases is to examine the

insider's history of stock purchases. If they consistently buy the top, well, that's a dishonest signal as it likely means they're just bad investors falling into the typical traps of euphoria. However, if you have noticed in the past that they're buying during quarters when the stock is dipped, and then maybe look forward to see where the stock is today and find that it's multi-bagged since when they bought it, that's another great signal. Another dishonest signal related to insider buying is when when an executive holds a significant stake in their company shares, but hasn't spent a dime of their own money accumulating it. This means they're simply acquiring through stock options.

Options generally are very interesting to me. Still, if you have a good manager who is exercising options, holding onto their stock and also buying on the open market, that's a pretty good signal. If they're exercising their options immediately selling and never purchasing anything on the open market, then their signal is very muddled. Next are buybacks.

This is an area where I'm sad to say there's a large amount of dishonest signaling in the market. Most investors like buybacks because they mean the company is increasing investors' stake in the business without requiring any additional capital. And while that's true to some degree, what truly matters in buybacks is whether the stock was repurchased below intrinsic value or not. Let's look at a hypothetical situation in a business that we'll call storage pros. As the name suggests, they own several storage facilities in North America and they collect rents from their customers.

The company is easy to value because storage tends to be a pretty stable industry. I consider future cash flows and I assume that they're just not going to grow and then I discount it back to their present value. I then determine that the business is worth $10. Storage pros is sitting on a decent amount of cash and since they aren't growing much, that cash pile just continues to grow. The CEO determines that a buyback program is the most effective use of capital. Now here are two hypothetical scenarios.

So the first scenario is where the company buys back. shares at $20. So the rationale that it's giving the market is that the market's hot, investors love the company, and the buyback program will likely increase its share price because it'll be perceived well by investors. The second scenario is that the company buys back shares are $5. The company is in the dumps because of a market-wide sell-off. The rationale is that since the business will continue to generate substantial profits, and since shares are worth more than $5, it will be highly value-accretive to repurchase shares. The first situation I think probably happens more than the second, which is just a shame.

You want businesses that are taking advantage of an undervalued share price. That is how value is added via buybacks. The first buyback scenario was a dishonest signal. The business is buying back shares just to capitalize on the temporary euphoria of the market. And while it may work in the short term to cause a slight surge in the share price, it ultimately destroys value in the long run. The second situation is an honest signal because buying undervalued shares truly adds value. If you can find a business that has a history of buying back shares at depressed levels,

watch them very, very closely. If you observe them long enough and see that they're buying back shares, you can just clone them. That can give you some very, very exciting and profitable ideas. Then we get to M&A. So M&A is similar to share purchases in that it can be super value-creating when the deal makes sense. Sadly, many deals also just don't make sense. And M&A can destroy value. Interestingly, Peter Lynch preferred companies that paid a dividend specifically because he

believed it reduced the likelihood that management would pursue a potentially harmful deal. Acquisitions typically result in a short-term increase in share price. They can also offer significant revenue increases for a business. Therefore, if a CEO is incentivized based on increasing revenue, M&A is a very straightforward way to achieve that goal without relying on any organic growth. But if a company acquires another business that has zero profits and no real path to becoming profitable in the future, then how does buying that company exactly benefit shareholders. When analyzing an acquisition, you need to ask if the business can get a return on the acquisition above its cost of capital. It's just that simple. A simple way to think about this

is whether a company can achieve double-digit returns on the acquisition. If they can, there's a very good chance they're earning above their cost of capital and the acquisition will create value for shareholders. I like serial acquires because they have a history of making numerous value accretive acquisitions. They know what they need to pay for a good deal and what to avoid to make a bad one. They also have the discipline required not to make a bad deal just for the sake of action. So if you're considering a business that engages in M&A or is interested in pursuing M&A, consider the management's track record of successfully completing deals. If they have succeeded before, there's a decent chance that they will succeed again. That's an honest signal. But if they've

never done a deal, I tend to default to being very skeptical. In that case, a potential deal might be a dishonest signal. Another honest signal I like inside of Cere Acquires, is when they have an incentive that are aligned with shareholders. Incentives based on returns on invested capital are one of my favorites, because I think it's one of the best ways to keep shareholders and management very well aligned. It also helps prevent managers from wasting shareholders' capital, provided they can succeed at deploying capital above the cost of capital. This transitions well into the final mental model from today and from biology that I'd like to discuss with you,

which is incentives. So Parrish mentions two considerable factors when it comes to incentives. The first is that humans, when we are thoughtful about incentives, will change our behavior to attain a perceived benefit. Second, since incentives are such a powerful influence, they can cause us to behave irrationally to achieve a given incentive. Let's start by looking at an example of incentives found in nature. A great example is the clean or rass fish.

So these are small, almost tube-shaped, beautifully colored fish that survive off parasites that feed on the bodies of other fish. They live in coral reefs. Here's how it works. So the cleaner wrasse swims around a fish's body, feeding on parasites found on the fish's scales, and even around its mouth. You could think of a cleaner rass as running a type of business. Its business is just to clean fish. Other fish will swim into areas where the cleaner rasses are located and provide the rass with food in exchange for reducing the parasites that are feeding on them.

But the rass can actually cheat. They can also feed on the mucus of a fish, which doesn't serve the fish that's providing the mucous but provides the cleaner rass with nutrition. The rass has the option of taking either option, but if it chooses to cheat and eat mucus, the fish will often flee, and the cleaner rass won't have a food source. So here you can see that the cleaner rass is incentivized to eat parasites rather than the mucus if it wants to maximize its potential return. This function is also the exact same in humans. We're offered a variety of incentives to do things on a daily basis.

And much of the time, incentives are great because they cause people to do good things. You know, when you think about traffic lights, we're incentivized to follow traffic lights so that we can reach our destination faster by using a vehicle while also keeping ourselves and others safe on the road. However, let's focus on the most interesting aspects of incentives, which is how investors can utilize them to enhance their decision-making. As Charlie Munger said, Inversion is one of the most powerful mental models out there. Therefore, to understand how incentives can benefit us, we must first recognize how they can

harm us. As Charlie probably would have said, show me the wrong incentive and I'll show you a disaster. There are two ways that incentives can harm us. perverse incentives and incentive-caused bias. So perverse incentives are rewards or penalties that unintentionally encourage harmful, wasteful, or unethical behavior. This perverse incentive is prevalent throughout corporations, where management is incentivized to do certain things to achieve their bonus. Things can be perverse including revenue-based KPIs, customer growth KPIs, and essentially any KPI that can be achieved by just simply spending an ever-increasing amount of money. If a company wants to grow revenue or the customer account, management can do so by spending money on marketing just to attract more business.

They can also spend a considerable amount of money on things like discounting. Many factors can keep a business unprofitable for very, very extended periods of time. This is a perverse incentive due to the embedded asymmetry. The person receiving the bonus from the incentive profits at the expense of shareholders. As a shareholder, I don't want management that is only concerned with increased. increasing revenue with no regard for profits. One of my favorite stories of perverse incentives I found while researching this episode was the story of the Russian nail factory.

So during the Cold War, Moscow wanted nails to be produced at a given quota. They initially wanted their quota to be met based on the total number of nails produced. So the nail factories ramped up production by making small flimsy nails that were nearly useless for actually holding two things together. So to address this issue, the central planners decided to modify the incentives and shift the quota's focus to the total weight of the nails. If a light nail wouldn't do the trick, then simply making a little heavier would make them useful.

The problem was that there wasn't a limit place on how heavy the nails could be. So the factories decided to make just giant nails that were so large in fact that some of them couldn't even be picked up by a single person. But they met their quota as these giant nails were very heavy. So the lesson here is that when you reward output without tying it to a desired outcome, you don't get better performance, you get gaming of the system. The workers in this study, I don't think, were lazy or evil. They were just rational actors responding to very poorly designed incentives.

So the next up here is incentive-caused bias, which occurs when a person's judgment is subconsciously distorted because they are rewarded for seeing reality in a very specific way. One example of this can be found in analyst reports. So these are the reports that Warren Buffett and Charlie Munger just chose to disregard, and I think for good reason. So the analyst writing reports have their own incentives. The analysts may work for a brokerage firm, and if the report causes additional trading, the broker profits. Suppose an analyst makes an overly aggressive price target for the future. In that case, it may lead the market to renew interest in buying the stock, thereby increasing volume and the commission fees that are paid for the analyst's firm. If the analyst is incentivized to increase the volume of shares being traded for the firm, then they do not need to bother with creating accurate analysis.

because they're not incentivized to be correct or to provide valuable research reports. They're incentivized to create additional trades. As a result, much of the analysis is essentially pointless to read. You receive things like price targets that are rarely met and often don't provide much benefit to anyone reading the report. However, the analysts, of course, don't admit this. They'll rationalize to themselves and others that they're trying to provide an honest analysis of a business based strictly on the business's fundamentals and that they have no ulterior motives.

So to take advantage of incentives when we are analyzing a potential investment, we have to ask ourselves a few questions. One, what are the incentives that are driving management's behavior in the company in question? And two, are incentives creating long-term value creation or short-term cosmetic results? It's essential to recognize that incentive structures all have their own unique nuance. I mention that I tend not to like revenue-based incentives, but this isn't black and white. For instance, Microsoft, an excellent company, has a revenue incentive. However, to balance things out and put the brakes on revenue growth, they're also incentivized

based on operating income. So this prevents Microsoft executives from just growing revenue at a rapid pace, potentially at the expense of profits. I think this is a solid incentive structure. As an investor, one thing to look out for is just short-term incentives. Are short-term incentives aligned with creating shareholder value or aligned with long-term incentives? You don't want to invest in a business that can have a short-term incentives.

term windfall for management at the expense of shareholders. So look closely at incentive programs to try to suss out the answers to the two questions that I posed above. Now, the power of all of these scientific mental models lies in their ability to give us a fresh lens through which to view the investing landscape. These models enable us to recognize things like patterns, anticipate risks, and identify opportunities that many would otherwise overlook. By boring ideas from scientific areas such as physics, chemistry, and biology, we're reminded that markets just like the natural world are complex adaptive systems. And just as in nature, survival, and success often belong to those who understand the forces

at play and can adapt the quickest. The key is to keep learning, keep questioning, and keep refining your mental models, because in both life and investing, the best edge is a well-trained mind. That's all I have for you today. Want to keep the conversation going? Follow me on Twitter at Irrational MRKTS or connect with me on LinkedIn. Just search for Kyle Grieve. I'm always open to feedback, so feel free to share how I can make the podcast even better for you.

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