>
Grahamites

# Path Dependence

## The path taken in the past influences the path in the future

The idea of path dependence is one popularized by the renowned Nobel Laureate Douglas North. The basic idea can be summarized as the following: “Actions in the present are constrained by actions in the past.”

One of the most interesting examples of the path dependence theory is the “standard gauge” of railway track — i.e., the width between the rails, which in North America and much of Europe is four feet and 8.5 inches. It has been the most common gauge throughout the history of modern railways.

One may think the reason this standard gauge is set at four feet and 8.5 inches is because it’s technically and economically optimal. But counterintuitively, that’s not true.

Let’s trace the roots of the standard gauge. Why is standard gauge of railway track set at four feet and 8.5 inches instead of, say, three feet and seven inches? Because it was the standard gauge of the British railway tracks.

Why is the standard gauge of the British railway tracks set at this distance? Because the “father of railways,” a British engineer named George Stephenson, used this gauge on an older system of coal tramways in Britain. Rather than coming up with an optimal new gauge, he simply continued his prior practice.

What prior practice? It turns out four feet and 8.5 inches is the distance between the wheels of horse carriages.

Why is the wheel distance of the horse carriage also these measurements? Well, the Roman chariot was pulled by two horses, and the distance between the rumps of the two horses is also four feet and 8.5 inches.

So, the standard gauge of the modern railway track was determined by the width of ancient horse’s rumps. Fascinating, isn’t it?

Incidentally, there’s a law in physics called Newton’s First Law of Motion, which basically says that an object will keep remain moving at the same speed and direction unless acted upon by another force.

Funny how sometimes economics and physics are joined at the hip.

Why does it matter in investing?

Investing is all about predicting the future, and future actions are influenced by present as well as past actions. As mentioned earlier, actions in the present are constrained by actions in the past. So past actions are enormously important when we try to assess the future direction a business may take. In other words, the future path of the business is most likely determined by the prievious path it has taken. As investors, we better understand what the original path is and why it was taken.

For instance, we are all familiar with Dell’s (NYSE:DELL) direct-selling model. It sure has worked well for Dell, but how did Michael Dell (Trades, Portfolio) come up with this model? Well, at age 12, he had already experienced the benefits of direct selling. He made \$2,000 selling stamps by abandoning the intermediary – the auction house- and selling them himself. In middle school, Dell discovered he could cut off the intermediaries (computer assemblers) by buying the computer parts and assembling them himself. This way he can sell his computers at a much lower price and offer better and more customizable services. This became the “Dell Way.”

Similarly, by studying the history of the founders of businesses, we can better understand why Alphabet Inc. (NASDAQ:GOOGL) has a “engineer-first” culture and the reason why Elon Musk of Tesla (NASDAQ:TSLA) reacted to Securities and Exchange Commission the way he did.

The important thing is, once a path is taken, it’s very hard to change because very often it requires a new path, which takes a lot of time and effort. With businesses, as long as the path that led to the success is still a good one, investors can expect similar results in the future. But more frequently, the old path stands in the way of adapting to new circumstances and a new path has to be taken. This is where management needs to make extremely difficult decisions and the most common result is total failure.

Value investors are also path dependent

The successes of many renowned value investors have a lot to do with the original paths they took when they first started. There are some “golden eras” of traditional deep-value investing such as the mid-1970s and right after the burst of the tech bubble. During these periods, the common path - a low price-earnings, low price-book strategy worked spectacularly. But is it because of the inherent superiority of the path or is it because of the confluence of era-specific factors that make the path especially effective during those eras? Similarly, we can argue that today, many growth investors are having a better time than traditional value investors. Again, is growth a better path? What specific conditions of the current environment makes it particularly more effective? What happens if these conditions change?

Conclusion

In the end, it’s worth pointing out again that the important thing is, once a path is taken, it’s very hard to change because very often it requires a new path, which takes a lot of time and effort. Such is human nature. That’s why I admire management teams and companies who can change paths when circumstances change. The most remarkable example is the management team at Daily Journal (NASDAQ:DJCO), led by Charlie Munger (Trades, Portfolio). How did they do it? In Munger’s own words: “If it seems slow and painful to you, we kind of like it that way.”

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

 Currently 5.00/512345 Rating: 5.0/5 (1 vote) Voters: