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Circle of Competence Issue #49

Quote of the week: "The ultimate purpose of life, mind, and human striving: to deploy energy and information to fight back the tide of entropy and carve out refuges of beneficial order." —Steven Pinker


A Foolish Conversation

This week I had the opportunity to speak with David Gardner on The Motley Fool's Rule Breaker Investing Podcast. Thank you David for a fun day at Fool HQ and for the invitation to share some of my back story and experiences! Check out the podcast episode here.

Late Cycle Investing

I listened to Brookfield Asset Management's (BAM) earnings call this week and wanted to share a great tidbit that I think applies to both the individual as well as corporate investor. There are some principles in this question and response that are timeless for both parties (sorry for the analyst speak here):

Dean Wilkinson (Analyst)

"Thanks. Good morning, everyone. Bruce, in your comment on the market environment, looking out you made the observation which we generally agree with it. We're likely to see a recession at some point in next few years and certainly that's what the bond yields are indicating to us. So against that and given $34 billion of liquidity and what could be another banner year of fundraising, are you happy to sort of take the foot off the accelerator a bit on acquisitions and let the puck come to you or how are you thinking about that in the context of what could be a slowing environment?"

Bruce Flatt (CEO of Brookfield Asset Management)

"Yeah. So I would just say our business is about investing capital but there are times when you should - I guess we try to take macro - look at the macro environment. There are times when you should go heavy on investment because anything that you can buy probably will be successful. And I would suggest 2009 was one of those periods. If you had $1 to invest and in hindsight, this is certainly true, almost anything you bought, it would have been a successful investment, didn't really matter what happened.

There are times when you should be - you should be doing some things and not doing others. And there are times when you shouldn't be doing anything. I would say given our scale of our business, given the global nature of our business and given most of our returns come out of operating excellence as opposed to financial returns, we always find things to do within the market. You wouldn't imagine we could have bought three companies out of bankruptcy last year and one of the best markets that you would have found for business performance. And so I would just say, we're very focused on making sure we find these bulk opportunities, but we feel no, we're not compelled to invest the cash we have, we have long investment periods should that be available.

And on a corporate level, I would say we're ensuring that our balance sheets are as strong as we possibly can make them to ensure we have cash around to do all the things that we will want to do and may have to do with respect to our investments in that we go through a recession at some point in time. So it's not - it's the time to be wary but also we're opportunistic."

In a nutshell:

- Always be searching for opportunities, because though they may be scarce, they are present. You just may have to dig harder.

- Operate with excellence, don't just expect returns to materialize from financial engineering.

- Don't compromise your standards for what is the best use of cash at the present (sometimes just holding onto it tight!).

- Keep a strong balance sheet with the ability to be opportunistic when periods of economic turmoil inevitably occur.


Since reading Steven Pinker's book, Enlightenment Now, I've been thinking about this quote deeply:

“The ultimate purpose of life, mind, and human striving: to deploy energy and information to fight back the tide of entropy and carve out refuges of beneficial order.” —Steven Pinker

For those not as familiar with the concept of entropy, I suggest reading James Clear's post on entropy first to get a solid grasp on the idea that entropy is constantly increasing.

Before going further, I want to define entropy as "lack of predictability or order, gradual decline into disorder." So why am I writing about a physics and chemistry concept on a business blog? Well, I firmly believe, as Charlie Munger has pointed out many times, that the great ideas of humanity can be applied across fields. And so it is with the concept of entropy.

The idea of increasing disorder, wear and tear, breakdown, rot, decomposition can apply not just in physics and chemistry, but also in neighborhoods, company cultures, political institutions, and industries. The struggle of humanity is a struggle against entropy in our bodies, our homes, our communities, our companies, our ethics, our cultures, and our nations... a struggle to form order out of chaos in each of these areas.

So how would one apply the mental model of entropy in investing? This is what I have really been thinking long and hard about lately. There have been entire libraries of books dedicated to fighting decay in company cultures, political institutions, and our bodies. How can this idea be applied to investing and business?

I suggest to my readers that they read Shane Parrish's article on Compounding Knowledge. Based on the mental model of entropy and Parrish's piece, I have two main ideas to put forward. The first is that to make good business or investing decisions, we need knowledge that is not particularly susceptible to rapid decay (for example, news), but that will hold true for a relatively long period of time to allow us to build on that body of knowledge. The second idea is that entropy is constantly increasing in a capitalistic system. The companies that will ultimately succeed will be either the businesses that resist economic decay to their moat (monopolies in steady industries resistant to change) or the businesses who are able to control and drive the pace of entropy and change in an industry (the innovators). The process of identifying these businesses begins with acquiring knowledge that has a long half life (per Shane Parrish) and ends when we identify a company with an advantage in its business model, product, or service that is entropy resistant.

The struggle of humanity is forming order from chaos in our personal ethics, families, communities, and our nations. The struggle of a company can be thought of in the same manner - carving out a place of refuge in the chaotic jungles of capitalism. The spoils will go to the ones who are able to resist corporate culture decay as they scale and moat decay from the constant competitive pressures of industry peers. The winners will be the ones who will be able to resist or control the economic entropy in their product and service spaces, and the longer they are able to do this, the longer they will compound returns for their owners.

Two questions I'll leave you with:

- What areas are you neglecting in your life that are showing signs of breakdown? (Personal question - no need to reply!)

- What company are you most confident has a moat that is entropy resistant?

Have a great week!

- Benton


- TOP READ: - China's housing glut casts shadow over the economy (Asian Review)

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- Askeladden Capital Q4 update

- Satellites gather big data on businesses below (New York Times)

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- Eddie Lampert's plans for Sears: smaller stores, less apparel (WSJ)

- Safal Niveshek's wall of ideas for investing, decision-making, and living

- Institutional investors are preparing for a downturn but still leveraging up (Institutional Investor)

- Jamie Dimon bashed cryptos, but now J.P. Morgan has it's own cryptocurrency (CNBC)

- Amazon cancels its HQ2 in New York (New York Times)

- Paul Tudor Jones says we are in a buyback glut (CNBC)


- TOP LISTEN: Building a $300M multifamily real estate business from scratch with Chad Doty (BiggerPockets)

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- TOMS: Blake Mycoskie (How I built this)

- Joe Rogan interviews Twitter's Jack Dorsey

- Bill Bellicheck on leadership, winning, and more

- Warren Buffett offers thoughts on business school

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