Borrowing from Physics to Improve your Investing Thinking

Another way to think outside the box

This might be a misleading topic and you’ll think I’m referencing how being a physicist can make you a great Quant, or you may be thinking how I’m going to explain how the concept Brownian motion leads to the Black Scholes model. I’m going to answer neither concepts because they are too complex. What I am going to do is use basic ideas in physics to make analogies in investing, not for the sake of unlocking investing secrets, but rather see how one can invest more rationally.

1. Acceleration, Velocity and Momentum

Acceleration means to the rate at which velocity, distance over time at a certain direction, changes over time. Momentum refers to the motion of a moving body measured by mass multiplied by velocity. All of this is a mouthful, but below is an easy to understand analogy in investing.

In value investing, look for companies that are like trucks. They accelerate slowly but once on the move, their momentum keeps them moving forward. In other words, look for companies that can grow big, but are moving steadily at the start so they appear undervalued.

If you were to model this, you would measure the slope of the company operating earnings over time. Simply, just see how the company earnings have changed from time A vs time B. For example, (x2-x1)/(y2-y1) where x = operating earnings and y= the year. You can use this formula for any of your metrics eg. share price or revenue. The pitfall of this method is that it can hide poorly performing years. However, if you plot each value by year on a graph, you can more clearly see if profits are coming in cyclically or growing linearly.

What else acceleration tells us is that if you push something hard enough, you can make it move faster. This is usually true the lighter something is. In a way, this explains to us why usually the overpriced companies are fairly light on equity. (The worth of a company after taking the value assets from the value of liabilities) For example, Tesla. Yes, it is a large company, but if you its annual reports, you will see that it was ‘light’ on equity while it was considered as ‘hot’ stock. Also, to point out, light is a relative term and related to other competitors in the industry.

2. Leverage

In physics, leverage refers to the mechanical advantage that one gets when applying pressure further from a hinge. In other words, if you have a seesaw, you require less energy to push the other side up the further you are away from the hinge versus the closer you are to it.

In finance, leverage is the concept of using borrowed money to buy assets to increase the potential return on investment. The amount you can borrow usually depends on how much equity you have. The more equity you have, the more you can borrow.

However, I don’t feel that financial leverage quite exactly hits the same tone as physical leverage. The way I see leverage is return on equity. Companies that can return a lot of profit with little equity are definitely worth looking at. I’m also assuming little borrowings are being used as well. On the other end, companies with a lot of equity with poor earnings tend to have reduced return on equity and may not be great investments.

Another way to look at leverage is that we want to be on the look out for companies that are punching above their weight. Ultimately, you want to see companies that bring in a lot of profit with the little they have such minimal equity, assets and borrowings. They would also be considered as high profit margin businesses. For example, if you don’t consider your time writing stories on Medium as an expense, writing on Medium is high profit business because you get cash without needing to expense anything.

3. Viscosity

Viscosity measures the resistance of a liquid to change. For example, if you put your hand on a layer of oil, you can feel your hand almost floating; whereas, if you put your hand on top of water, it will want to sink immediately. Basically, water is more acceptable to change while oil is not.

In investing, you want to see how liquid your investments are. In other words, how quickly can you turn your investments back into cash. Beware of the companies you invest in! You may find a vague, small cap company, which you think has great prospects and is selling at a discount now, but if you purchase this small cap now and it performs poorly, what is the likelihood that another soul will buy the stock from you? Mid to larger cap companies are easier to sell because what you consider as overpriced another may consider as mispriced.

In other words, you can view viscosity as the inversion of liquidity. Investors are always looking for assets that they can purchase and turn into cash when needed. But, in terms of viscosity, you would be avoiding assets that would take too long to turn into cash, such as real estate.

On another note, viscosity can be reduced by a surfactant, which is something that reduces viscosity or in our case increases liquidity. Basically for us, a surfactant would be an event that makes people want to buy and sell more often. For instance, this could be good news that drives market changes.

Conclusions

Ultimately, I don’t think physics and investing are that intrinsically linked. However, by creating distant analogies you can more likely reflect upon the the effectiveness of your decision making and decide when opportunities arise.