On first principles thinking in business and investing

Searching for the ocean currents that move the waves

Investing is an activity where success is measured by movements in third derivatives, that is, stock prices. If stock prices are third derivatives, then what are the second and first derivatives? From a fundamental perspective, the second derivative is the figures found in financial statements for a given period of time and their related metrics. Many investors stop here and treat financial statements and their related calculations as gospel: growth rates, margins, cash flow conversion, returns on capital, leverage, and on and on. However, financial statements by their nature are backwards looking and thus incomplete information for investment analysis. And as noted earlier, they’re second derivatives, implying that the financial results of companies are a function of some other, deeper activity. We thus arrive at the first derivative, which is the day-to-day activity of everyone involved in a business. It’s the sum result of all this activity over a period of time that financial statements represent. At this point, investors begin to discuss topics like competitive moats, strategy, capital allocation, management teams, and similar terms to explain what’s going on behind a company’s financial results. This is the heart of the qualitative approach to investment analysis that so many well-regarded investors have used to guide their decisions. But I believe that there’s something beyond the first derivatives that represent the bulk of the investment world’s process, and that is first principles. And if first principles are the foundation on which all the scaffolding of investment analysis is built on, then it stands to reason that understanding and recognizing the first principles that lead to exceptional businesses is fundamental to comprehending the first and second derivatives that ultimately lead to the third derivative that drives superior investment performance.

What then are first principles in this context? In short, they are the essence of a business; the single sentence or sentences that explains the ethos by which a company chooses to exist in the world. A first principle is the root problem and solution proposed by an enterprise and therefore is ultimately tied to the concept of customer centricity. Consequently, a competitive moat is a function of the first principles that guide how a business seeks to solve its customers’ problems, while strategy and execution are merely the means by which these first principles are brought to life. A first principle is thus the simplest conception of a company, but also its most all-encompassing trait, and therefore capable of explaining the signals that investors are looking for.

Now, let’s turn to a few examples to turn this abstract concept into a firmer reality.

Spotify is the world’s largest streaming platform for music, with almost three quarters of a billion users and almost three hundred million paid subscribers. As a fundamental investor, it’s easy to characterize the business as a network, where the user base provides economies of scale to acquire content at the most competitive price, consequently attracting more customers who can access a wide library of content at a low price, that in turn makes the platform the most attractive means for artists to reach their fans. But these observations are only a component of the first derivative.

The first principle that guides Spotify is delivering an engaging service. This organizational focus on user engagement drives both user retention and growth; an offering that people love to use and keep coming back to is one that users also want to share with the people they know, driving user growth. An engaged and growing user base in turn provides the opportunities for Spotify to monetize their user base through paid subscriptions and advertisements. An engaged user base also means that artists can consistently reach existing fans and attract new ones with their work. Crucially, no amount of effort or strategy to crystallize value from users will be successful if Spotify’s platform is not engaging. Monetization without engagement is a dead end, demonstrating the importance of the first principle and its relationship to the first derivative.

The second principle of Spotify is delivering more value to customers than what’s charged for. In other words, Spotify’s streaming service is designed so that customers feel they’re getting more than what they paid for. So long as the company continues to find ways to give its customers more than they received previously, they will find their subscribers willingly paying more for the service, justifying any price increases. In this context, pricing power, the threat of substitutes, and switching costs are the first derivatives, while revenue growth and gross margins are the second derivatives.

Importantly, these first and second derivatives are a function of Spotify’s first principle of delivering a service that results in surplus value for customers. This reality is why an excessive focus on revenue growth rates, subscriber penetration, ARPU, gross margins and other financial metrics is missing the forest for the trees. If Spotify’s management loses their devotion to the company’s first principles of user engagement and surplus value for customers, it’s only a matter of time until investors see disruption in the financial metrics that they typically track. However, it’s this transition period between a loss of first principles and the lagged effect on first and second derivatives where most fundamental investors will be flying blind, ignorant of the festering problem. And when this change ultimately manifests itself in the second derivative that the market fixates upon, the violent reaction in the share price of the company (third derivative) will finally reflect the reality that has been accumulating under the surface.

However, monitoring the discussion of first principles is information that analysts systematically underweight, especially so in earnings calls. Sellside analysts will ask questions about pricing, user growth, content costs, or operating leverage to tune their models while ignoring what is said when management opines on first principles. In fact, the amount of time that I’ve seen Spotify’s co-CEOs devote to discussing user engagement and surplus value is what gives me confidence that the company will remain on a similar trajectory even though the founder, Daniel Ek is stepping back from the day-to-day. Therefore, as an investor using this lens, what I’m on the lookout for from Spotify’s management team is their sustained devotion to operating the business in accordance with the first principles that have driven their success to-date. As soon as management loses sight of these fundamental factors that make Spotify what it is, decline becomes an inevitability that cannot be escaped, because there won’t be any capital to allocate, strategy to employ, or operations to execute on if users aren’t engaged and feeling like they’re getting a deal. Management’s success in strategy, execution, and capital allocation will simply delay the decline of the business while wringing a few extra pennies out of it for shareholders if their first principles are no longer practiced. But if the first principles remain intact, I can remain confident as an investor that the long-term success of the business is secure, irrespective of any inevitable short-term volatility seen in either financial results or the price of the company’s shares.

Now, are there any other examples of a first principles approach to business that are worth discussing? Absolutely.

Anyone who has read my prior writing will know that I have long been a fan of Les Schwab Tires. However, conceptualizing the importance of first principles is what gave me the perspective to explain why this example has been so successful for so long in a brutally competitive industry. Les Schwab’s first principles were threefold: 1) sell tires at the lowest price in the industry, 2) provide customers with exceptionally good service, and 3) share profits with employees to incentivize them to prioritize the needs of customers. These mutually-reinforcing principles have led to a highly loyal customer base, supporting over 70 years of success while weathering competition from big box retailers and tire brand corporate stores. But if any of these principles had been discarded, Les Schwab would not have the position it has today. For instance, these principles directly contributed to developing the sources of Les Schwab’s competitive moat. In the early days of the company, Les Schwab only had a few locations, and therefore lacked the bargaining power with suppliers it now has. Consequently, it was the adherence to the first principle of offering the lowest prices to customers that resulted in the company’s ability to leverage the purchasing power of over 500 locations to negotiate the lowest tire cost from suppliers - an ability that is now a competitive advantage. Similarly, the practice of exceptional customer service at an individual store level was what preceded the creation of a brand that signals to customers that they’ll be treated better than at any other tire shop.

Another business following a similar approach to Les Schwab is Costco, a company I’ve also written about in the past. In many ways, Costco is the Les Schwab of groceries (or maybe it’s the other way around). The overarching principle of Costco is providing its members with the lowest priced goods anywhere. Regardless of the category, Costco sells everything in its stores with a fixed mark-up of 15%, and all benefits arising from Costco’s buying power are passed on to customers in the form of lower prices. This maniacal focus leads to a customer base so loyal that they’re willing to pay a fixed annual fee for the privilege of shopping at Costco. Yet, you can be sure that if management ever stopped talking about their commitment to providing the lowest prices or relaxed their fixed mark-up policy, it would signal the beginning of the end of the company, no matter what the benefit to short term margins or revenue growth would be. Because if Costco lost its reputation for having the lowest prices, a drop in member count would be inevitable, leading to a reduction in the buying power that makes the overall business so successful and a loss of the structural low price advantage the business had enjoyed.

Amazon has followed a similar pathway to Les Schwab and Costco with a first principle based on selling items at the lowest price online. However, Amazon has added another first principle to reflect its web-centric approach, and that is providing the fastest and most convenient shipping options for its customers. As a result of Amazon’s first principle of prioritizing customer convenience, the company has built a logistics operation that ships more packages than UPS or FedEx while also reducing shipping costs, further extending the company’s price advantage and thereby benefitting its other principle of providing the lowest prices. Important to note when discussing Amazon is that while the logistics operation is a component of the company’s competitive moat, it’s derivative of the first principles of providing the lowest prices in the most convenient way. The company would not have developed logistics capabilities unless they improved customer convenience or reduced prices. Amazon’s first principle of providing the lowest price also extends to its AWS business that offers cloud compute services. Here, the aggregation of many users increases the utilization of hardware assets to reduce the price of compute for everyone, and Amazon’s internal development of networking and compute hardware components further extends its cost of compute advantage, enabling even lower prices for its services and subsequently increasing its competitive advantage.

My final example is ASML, the sole provider of lithography equipment for the semiconductor manufacturing industry. With this company, it’s easy to get caught up in the impressive number of technical domains that need to be mastered in order to offer an effective solution: the generation of EUV light and the plasma physics behind it, ultra-precise optics that are free from imperfections at an atomic-scale, vacuum engineering to keep environments free from contamination, mechatronics and motion control to ensure nanometer precision during patterning, computer algorithms to operate and optimize wafer patterning, developing multi-layer structures and resist chemistry for EUV masks, high precision metrology to measure defects, and the integration of all these various systems into a turn-key package for customers. But the principle behind all this technical innovation is simple; ASML’s core aim is to raise the rate of chip production per period, while increasing the yield of good chips produced from each wafer die. Or put simply, ASML’s lithography equipment enables its customers to produce more chips at a lower cost. As a result, the company’s technical innovation and resulting pricing power (first derivatives) are ultimately a function of the improved economics that ASML’s equipment produces for its customers (first principle). In other words, so long as ASML remains focused on leveraging its technical capabilities to improve the outcomes of its customers, the company will continue to justify its monopoly position that allows it to charge hundreds of millions of dollars for each lithography machine. But if the firm begins to prioritize innovation that doesn’t lead to better production efficiency, or prices machines without consideration of customer economics, the company will set itself on the path to irrelevance.

As I have hopefully shown by now, first principles are the animating concepts behind the major factors that investors focus on but are also qualitative datapoints that are systemically ignored or misunderstood by investors. Screening for management teams that evidence first principles thinking is therefore a durable source of alpha-generating insights, as businesses operating in accordance with first principles will advance or retain their competitive positions, consistently grow over longer periods of time, and generate superior economic outcomes. Deviation from first principles is also a leading indicator of business deterioration, while the adoption and rigorous adherence of first principles in environments where they previously were not practiced can assist in predicting corporate turnarounds. Consequently, the identification of first principles and observation of their persistence will form a core part of my investment process going forward. I look forward to updating readers on the businesses I find that are aligned with this perspective as well as their contribution to future investment performance.