Drilling Down to the Bottom of the Bottom

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Jul 04, 2015
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Almost all genuine value investors use bottom-up approach, which neglects the broad macroeconomic analysis and focuses merely on selecting a specific security of a company based on the fundamentals of the business. This is in sharp contrast to the top-down approach, which places more emphasis on broader economy and predicting the trend in factors such as GDP, interest rates, inflation, commodity prices and exchange rates.

I’m confident that the vast majority of the readers on this forum utilizes the bottom-up approach by focusing on the fundamentals of the business. I don’t have much to add on the concept of the bottom up approach itself but I’d like to discuss layers in the bottom-up approach, or bottom-up from bottom-up if you will. In a nutshell, this involves drilling down one layer after another layer until you get to the fundamental drivers of the business. You start by identifying the very bottom layer of the fundamentals of the business, then you work all the way up to segment key metrics, then segment revenues and profits, then you roll the segments up to get to the consolidated results of the whole company. However, in order for you to identify the very bottom layer of the drivers of the business, you will have to start top-down and keep asking what drives that and why?

We also have to remember Occam’s Razor, which states that “among competing hypotheses that predict equally well, the one with the fewest assumptions should be selected. Other, more complicated solutions may ultimately prove to provide better predictions, but—in the absence of differences in predictive ability—the fewer assumptions that are made, the better.”

I’ll write another article to walk through an example in details but for the purpose of simple illustration. Let me again use Coca Cola (KO, Financial) as an example. Where do Coke’s revenue come from? Selling syrups to bottlers and selling finished products to the consumers. In a simple format, it is price per unit x unit volume. So the fundamental drivers for the business are basically the price per bottle and how many bottles can Coca Cola sell around the world. But that’s not enough, you then drill down further to identify the factors affecting the price per bottle and the worldwide volume. You’ll see per capita consumption and the affordability and availability of Coke’s products are key. What then drivers the per capita consumption, affordability and availability then? It’s the GDP per capita growth, appealing of Coke’s products, and the distribution network. Then you put everything above together for each of Coca Cola (KO)’s geographically and in the end, you roll them up.

I have to admit that I was deeply inspired by the following interview of one of my heroes – Richard Feynman:

Interviewer: If you get hold of two magnets, and you push them, you can feel this pushing between them. Turn them around the other way, and they slam together. Now, what is it, the feeling between those two magnets?

Feynman: What do you mean, "What's the feeling between the two magnets?"

Interviewer: There's something there, isn't there? The sensation is that there's something there when you push these two magnets together.

Feynman: Listen to my question. What is the meaning when you say that there's a feeling? Of course you feel it. Now what do you want to know?

Interviewer: What I want to know is what's going on between these two bits of metal?

Feynman: They repel each other.

Interviewer: What does that mean, or why are they doing that, or how are they doing that? I think that's a perfectly reasonable question.

Feynman: Of course, it's an excellent question. But the problem, you see, when you ask why something happens, how does a person answer why something happens? For example, Aunt Minnie is in the hospital. Why? Because she went out, slipped on the ice, and broke her hip. That satisfies people. It satisfies, but it wouldn't satisfy someone who came from another planet and who knew nothing about why when you break your hip do you go to the hospital. How do you get to the hospital when the hip is broken? Well, because her husband, seeing that her hip was broken, called the hospital up and sent somebody to get her. All that is understood by people. And when you explain a why, you have to be in some framework that you allow something to be true. Otherwise, you're perpetually asking why. Why did the husband call up the hospital? Because the husband is interested in his wife's welfare. Not always, some husbands aren't interested in their wives' welfare when they're drunk, and they're angry.

And you begin to get a very interesting understanding of the world and all its complications. If you try to follow anything up, you go deeper and deeper in various directions. For example, if you go, "Why did she slip on the ice?" Well, ice is slippery. Everybody knows that, no problem. But you ask why is ice slippery? That's kinda curious. Ice is extremely slippery. It's very interesting. You say, how does it work? You could either say, "I'm satisfied that you've answered me. Ice is slippery; that explains it," or you could go on and say, "Why is ice slippery?" and then you're involved with something, because there aren't many things as slippery as ice. It's very hard to get greasy stuff, but that's sort of wet and slimy. But a solid that's so slippery? Because it is, in the case of ice, when you stand on it (they say) momentarily the pressure melts the ice a little bit so you get a sort of instantaneous water surface on which you're slipping. Why on ice and not on other things? Because water expands when it freezes, so the pressure tries to undo the expansion and melts it. It's capable of melting, but other substances get cracked when they're freezing, and when you push them they're satisfied to be solid.

Why does water expand when it freezes and other substances don't? I'm not answering your question, but I'm telling you how difficult the why question is. You have to know what it is that you're permitted to understand and allow to be understood and known, and what it is you're not. You'll notice, in this example, that the more I ask why, the deeper a thing is, the more interesting it gets. We could even go further and say, "Why did she fall down when she slipped?" It has to do with gravity, involves all the planets and everything else. Nevermind! It goes on and on. And when you're asked, for example, why two magnets repel, there are many different levels. It depends on whether you're a student of physics, or an ordinary person who doesn't know anything. If you're somebody who doesn't know anything at all about it, all I can say is the magnetic force makes them repel, and that you're feeling that force.

You say, "That's very strange, because I don't feel kind of force like that in other circumstances." When you turn them the other way, they attract. There's a very analogous force, electrical force, which is the same kind of a question, that's also very weird. But you're not at all disturbed by the fact that when you put your hand on a chair, it pushes you back. But we found out by looking at it that that's the same force, as a matter of fact (an electrical force, not magnetic exactly, in that case). But it's the same electric repulsions that are involved in keeping your finger away from the chair because it's electrical forces in minor and microscopic details. There's other forces involved, connected to electrical forces. It turns out that the magnetic and electrical force with which I wish to explain this repulsion in the first place is what ultimately is the deeper thing that we have to start with to explain many other things that everybody would just accept. You know you can't put your hand through the chair; that's taken for granted. But that you can't put your hand through the chair, when looked at more closely, why, involves the same repulsive forces that appear in magnets. The situation you then have to explain is why, in magnets, it goes over a bigger distance than ordinarily. There it has to do with the fact that in iron all the electrons are spinning in the same direction, they all get lined up, and they magnify the effect of the force 'til it's large enough, at a distance, that you can feel it. But it's a force which is present all the time and very common and is a basic force of almost - I mean, I could go a little further back if I went more technical - but on an early level I've just got to tell you that's going to be one of the things you'll just have to take as an element of the world: the existence of magnetic repulsion, or electrical attraction, magnetic attraction.

I can't explain that attraction in terms of anything else that's familiar to you. For example, if we said the magnets attract like if rubber bands, I would be cheating you. Because they're not connected by rubber bands. I'd soon be in trouble. And secondly, if you were curious enough, you'd ask me why rubber bands tend to pull back together again, and I would end up explaining that in terms of electrical forces, which are the very things that I'm trying to use the rubber bands to explain. So I have cheated very badly, you see. So I am not going to be able to give you an answer to why magnets attract each other except to tell you that they do. And to tell you that that's one of the elements in the world - there are electrical forces, magnetic forces, gravitational forces, and others, and those are some of the parts. If you were a student, I could go further. I could tell you that the magnetic forces are related to the electrical forces very intimately, that the relationship between the gravity forces and electrical forces remains unknown, and so on. But I really can't do a good job, any job, of explaining magnetic force in terms of something else you're more familiar with, because I don't understand it in terms of anything else that you're more familiar with.

In my next article, I’ll walk through a detailed example.