The Power of Horizontal Thinking
Letter from Vail
Because men, groping in the Arctic darkness, had found a yellow metal, and because steamship and transportation companies were booming the find, thousands of men were rushing into the Northland.
The Call of the Wild, Jack London, 1903
THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.
Context Switching. The past 8 days I was in three states and two investment conferences. What stood out was the difference between vertical knowledge--the ability to go deep on a certain topic--and horizontal knowledge--the ability to think across domains. Each conference had excellent subject matter experts…who left enormous variables outside their analysis because including them required studying something adjacent. Our training is vertical. While I revere deep vertical analysis, I find horizontal thinking a more accurate way to understand reality and investing. It certainly reduces the risk of being blindsided. Below is a rubric to visualize different modes of thinking using a familiar example, our academic curriculum.
Travel forces horizontal thinking. I know my New England town well. I know the tides and the smell of the creosote-soaked wooden timbers on the town bridge. Setting out on a journey disrupts this familiarity, horizontal thinking incarnate. After the ValueX conference in Vail, Colorado, I drove six-plus hours west to see my daughter, the one I wrote about in Raising a Thief. The Utah-Colorado border was parched and hot and I thought of Mormon settlers moving West and the Native Americans they encountered. Nothing New England-y about it.
The asymmetric US boom. Over my career, I’ve traveled quite a bit to better understand, I now realize, this horizontal perspective. I’ve witnessed growth booms before but only one, in the US, driven voluntarily by private consumption. I’ve observed Moscow’s boom after the fall of the Soviet Union, Croatia after admission into the European Union, and China’s provinces on the receiving end of state-approved financing. But the US is different. Salt Lake City’s once modest airport now requires hiking for long stretches to get from one side to another; housing developments sprout like mushrooms far beyond the center. The contrast to Connecticut, whose dreary winters and high taxes have alienated digital nomads, is obvious.
Source: Axios
The Salt Lake City airport was packed. While the lower end of the income distribution in the US is now struggling, clearly there is plenty of money for discretionary travel. The point is—the US economy looks different from a horizontal perspective.
The value vertical. Both conferences were value-investing stomping grounds. Attendees walk in the footsteps of Warren Buffett and search for a company trading less than its “intrinsic value.” The faith is in free cash flow yield, return on invested capital, and share buybacks. There is much to be learned from this perspective and I am grateful they invited me. Value investing is vertical thinking. As Buffet’s success suggests, this approach works. Being more of a horizontal guy, at ValueX I shared my outlook on bonds. (If any paid subscribers want the deck, email me). A bond is in the stock, but most value investors don’t think about that. If bond yields rise, PE ratios fall and debt service rises. So if you are betting on stocks, you are also betting on bonds. One clear and present danger for the equity market is an inverted yield curve. The Fed may cut rates, but long rates could rise, not fall, which is counter-intuitive. An investor can hedge this risk by simultaneously being long stocks and short long-duration bonds.
Shipping, a vertical within a vertical. Shipping is a sub-specialty within value, the value of stocks that relate to moving items by sea. Items include coal, cars, manufactured goods, oil, natural gas, and propane. The sector is a prism into the global supply chain. Brazil, Australia, and the Middle East send raw materials to China, which then create goods the US and Europe consume. Most of this cargo travels by ship. The beauty of these stocks is that many variables are known. There is the order book—how many ships will be produced—and the forward-looking booked ship travel. Out of this you can discern cash flows (supply of ships and demand for them) and compare that to the value of the stock. It is a coherent world. I hold a number of these stocks in my portfolio. I shared the diagram below once before. It’s a way of visualizing the business cycle (bonds) against the industry cycle. To accurately understand the world, you need to visualize all these cycles at once and shipping is one of them.
The China and the Houthis horizontals. However, there are significant horizontals to shipping. Bonds are one of them, another is China. I spent several years studying China when I was at Bridgewater. China buys a lot of iron ore and energy and an entire industry exists of shipping it to them. But none of the shipping analysts knows much about China, so no one talks about it. If China is growing more weakly or has already produced too many electric cars, then the demand for shipping will shift. Ditto the Houthis, who are attacking ships, forcing them to travel longer distances, which is a boom for profits. If the Houthis shift tactics, cargo rates will fall. This risk can also be partially hedged by buying adjacent assets, like short-term bonds in the US and Europe.
Technology as a horizontal. A final horizontal is technology. The rate of change in technology cuts across industries. I heard a fascinating duel between a Tesla analyst and a VW analyst. VW is a gigantic, traditional car company believed by value investors to be trading at a significant discount to future cash flows. The only problem is the cars we are going to use are changing, fast. Not only from combustion to electric but also to self-driving. Will VW make the jump? The Tesla analyst made the argument that Tesla is not a car company, it is an AI company and he included projections five years forward about how many robots and driverless cars Tesla will churn out. Not surprisingly, the projections hockey stick upwards. That is horizontal thinking. It may not be accurate forecasting, but it is horizontal. The VW analyst was unmoved.