3. First principles, not a formula

Part 7 of 19 in The Patient Owner: Charlie Munger’s Ideas, as Rakesh Jhunjhunwala Might Have Taught Them to an Indian Investor← Part 6Part 8 →

This chapter explores the concept of first principles thinking in business and investing, as explained by Rakesh Jhunjhunwala. It emphasizes understanding the fundamental mechanisms behind financial decisions rather than relying on superficial conclusions or formulas.

Aniruddha. You did not hand me a method. You handed me a habit of taking a claim apart until only the load-bearing sentence was left. Munger called it worldly wisdom. The physicists call it first principles. I am going to use the second phrase, because it is the one I can take back to a clinic and to a pitch. What did you think you were teaching, on the evenings when you refused the ratio and asked for the mechanism?

Rakesh. I was teaching you not to rent a conclusion. A ratio is a conclusion that has forgotten its childhood. Price to earnings is a child of profit, and profit is a child of cash, and cash is a child of a customer who had a reason. If you cannot walk back to the customer, you are decorating. First principles is just the walk. Charlie walked it across disciplines. I walked it across a business until the person across the table either knew or did not.

Aniruddha. In medicine the rented conclusion is the protocol nobody has re-derived. Junior doctors follow it because the senior followed it. Sometimes the senior followed it because the company that made the device paid for the conference. The first-principles question is rude and short. What is actually happening in the tissue? What would I do if the guideline had not been written? Investing has the same rudeness available. What is actually happening to a rupee that enters this company?

Rakesh. Stay with that rupee. It is the only first principle I trust on Dalal Street. A rupee enters from a customer. Some of it is kept by the taxman, the landlord, the employee, the lender, the wastage, the promoter’s cousin. Some of it stays. Of the part that stays, some can be put back into a machine, a store, a lab, a brand, at a rate that justifies the stay. If you cannot narrate that path without adjectives, you do not have a thesis. You have a sector.

Three dissections he made me do

The first was a brand. Not ‘does it have a brand?’ — that is a rented word. Who pays more, or walks less far, because of the name, and what would they do on the day the advertising stopped? Titan and Asian Paints survive that question. A new direct-to-consumer label often does not, which is why its first principle is the advertisement, not the product. Advertisements can be bought. Habits have to be earned.

The second was a lender. Not the growth rate. The question under the question: on what evidence does this institution say no, and what happens to the person who says no in a good year? If the answer is ‘he is called negative’, you have found the mechanism. The mechanism will produce a beautiful book, and then a bad one. You do not need a cycle view. You need an org chart.

The third was a technology story, which is where angels go to hide from first principles. ‘Platform’ is not a mechanism. A mechanism is: who is on both sides, why the second side arrives, what is charged, what is the cost of serving the next unit, and which regulator can turn the charge into a ceiling? Payments in India are a real shift in habit. The rupee path inside any one app is a separate sentence. Mixing the two sentences is how 2021 priced hope as if it were tollbooth.

Aniruddha. I have started using the same dissection on decks we see for Indian Angels. Strip the adjectives. Leave the rupee. If the founder cannot walk the rupee, the model in the appendix cannot either. Models inherit the confusion of the person who typed them. A large language model inherits it faster.

Rakesh. Good. And do not let first principles become a personality. Some men use the phrase to mean ‘I ignore history, because I am original.’ That is not first principles. That is vanity. The base rate is a first principle. Physics does not ignore the previous experiment. A doctor who re-derives appendicitis from the atom is not rigorous. He is late. Use the simplest true layer, not the most flattering one. Charlie’s razor was practical. If a lower layer does not change the decision, stop descending and go and see the customer.

Aniruddha. Patience is a first principle too, though nobody files it under physics. A business that compounds does so on a clock the market does not run. If your process requires the clock to match your mood, you have substituted a feeling for a mechanism. That was the other thing you taught me, and it took longer than the ratios, because the ratios can be memorised in a week.

Rakesh. Memorise less. Narrate the rupee. Then wait until the narration is either confirmed by the cash or killed by it. Everything else is a seminar, and seminars do not compound.

Evening question. Take one holding and write the path of a rupee from the customer to the retained cash, in plain sentences, with no ratios. Circle the sentence you are least sure of. That sentence is your research plan. The others are already done.