“While markets and businesses are social constructions, they exhibit features that have strong parallels in nature. The similarity between brain development and industry innovation is but one example.” -Michael Mauboussin
New industries can be terrific hunting spots for stock market profits—if you don’t jump in too soon.
In chapter 19 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," author Michael Mauboussin explained a new form of the industry life cycle—and its parallel with human brain development.
He pointed out that three-year-old children learn at an extremely rapid rate; for example, they learn a new word roughly every two hours that they are awake. By the time they graduate from high school, they will have learned some 45,000 words.
But as they move beyond the toddler years, that rate of learning drops off. At some point after age three, children begin losing synaptic connections in the brain, some 20 billion a day by one estimate. Mauboussin does not use the word “evolution” at this point, but it appears to be an evolutionary process, as useful synaptic connections are strengthened and those that are no longer being used are pruned. The author wrote, “This process fine-tunes the brain to survive in its particular environment. By the time we are adults, synaptic selection has shaped our brains to succeed.”
He added that the process of synaptic overproduction and subsequent pruning seems quite wasteful, but can be explained: “Starting with lots of alternatives and winnowing down to the most useful ones proves to be a robust process, even though it appears quite inefficient.”
The same process is at work in new industries. Mauboussin argued that knowledge of the brain analogy provides investors with three benefits:
- It is a model of innovation that is theoretically sound and has been tested empirically by researchers.
- It provides a way for investors to understand manias and bubbles.
- It shows the innovation process can lead to investment opportunities (in early maturity).
The author has more on the subject later in the chapter, but at this point turned to James Utterback’s book, “Mastering the Dynamics of Innovation,” and its three-phase model of industry innovation.
- The fluid phase: This resembles the brain development of a very young child, with extensive experimentation.
- The transitional phase: A dominant product design becomes established through an evolutionary process.
- The specific phase: The adult phase, with only modest changes to products and processes. As the survivors emerge, investors should take notice.
In the early years of an industry, many companies enter it, each with some variation of the central idea. Most of those companies or divisions will go under or be absorbed by another company in subsequent years, as the pruning process sets in. Mauboussin wrote:
“These phases suggest a consistent pattern of a sharp upswing in the number of companies in an industry when it is in the early stages followed by a sharp downswing as the pruning process takes hold. The process appears very wasteful when we see how many alternatives it dismisses. But ultimately the interplay between technical capabilities and market choices selects a product design that best suits the environment.”
As examples, he cited the auto and television industries, in which a lot of capital was sprayed around in their early days. As time went by, there was a dramatic decline in the number of competing companies, as the survivors clustered around a dominant design.
More recently, the disk drive and personal computer industries went through the same process, but, as Mauboussin noted, the process took far fewer years. It took some 30 years for the auto industry, a century ago, but only about 10 years for personal computers in the late 20th century.
While the internet was not an industry, it too went through the same cycle of massive experimentation, pruning and stability. As most of us will recall, publicly traded internet companies proliferated in the late 1990s, only to be mercilessly pruned after the dot-com bust of 2000.
According to the author:
“Pundits often deride the boom-and-bust phenomenon as wasteful and speculative even though it provides the necessary platform for future growth. Further, over the 3 billion years of life on earth, nature has repeatedly settled on this process. In fact, paleontologist David Raup draws a direct analogy between the stock market and the fossil record.”
As noted, Mauboussin listed three benefits to understanding the process behind brain development and industry innovation.
First, it helps us understand the proliferation of booms and busts. Specifically, in an uncertain environment, it is logical to have a lot of alternative solutions and then prune those alternatives by selecting the few that are best suited to the market or situation.
Second, we can see at the outset of a new industry that there is tremendous potential for capital gains, if only we could pick the right stocks (which is unlikely). As Mauboussin put it, “the market is buzzing because the brain is creating a lot of synapses and some will be wildly successful. Enthusiasm reigns. Introduce prices, and you have a foundation for a mania.”
Third, one of the key signals for investors is a stock’s price, and if that price is bid upward, then a lot of investors want to buy it. In his words, “A positive-feedback loop kicks in, which bootstraps a mania.” Of course, manias are not a good long-term solution since many of the stocks bid up will come tumbling back down. He wrote, “The path to innovation is paved with failure and waste.”
Conclusion
In chapter 19 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Mauboussin has provided insight into the way new industries evolve and how investors react to that innovation.
As new companies spring up to take advantage of new technologies, processes or ideas, investors jump in, thus enabling many more companies to get to market and, in the process, may set off a mania or boom. But in the second phase, that enthusiasm is reined in as the many companies are whittled down to a few, the few that are considered the best match for the environment of the time. In the final phase, the remaining few companies make only minor changes as they become established entities.
Investors who recognize this cycle should be better prepared to withstand the temptations of the first phase and to commit their capital as the final phase begins.
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