Developing an Investment Thesis

I have been editing our investment thesis for years now. One thing I can say for sure is that it is subject to further revision. Nonetheless, I find the reflection and editing helpful. Have you written your thesis? How often is it updated? In this post I provide definitions, examples from Little Engine Ventures, and process to craft your own.

A thesis –investment or otherwise– is a premise. A good premise is a fact able to be proven true. This is important because atop good premises a person may apply sound reasoning to reach a conclusion that should therefor also be true.

An investment thesis, as defined by Investopedia, helps an investor evaluate ideas and the idea’s ability to meet their objectives.

So, an investment thesis is a premise regarding investing. That seems plain enough. Let me try to use the above statement and restate our investment thesis yet again for Little Engine Ventures at large:

At Little Engine Ventures, our objective is to get paid for the risks we bear without sacrificing our character. Our ability to achieve this objective depends upon acting in accord with our ideas. Our ideas combine truths in unusual ways but logical ways. This makes us calculating contrarians. We act boldly because our reasoning is sound. The results will come in time.

Underneath the broad thesis at Little Engine Ventures there are several premises we hold true and timeless. Here are a handful:

  1. Price and Value are not equal.
  2. Value is what an asset is worth to us as the sole private owner.
  3. Value is best expressed in a range, estimated from both facts and sound reasoning. We call the median of this range, the “Intrinsic Value.”
  4. Actions of people, ourselves included, can affect the intrinsic value and the price.
  5. A price below the median value increases the probability of returns above cost of capital.
  6. Returns above cost of capital equal investment profit.
  7. Revenue above expense equal operating profit.
  8. We can control our actions.

Based on the premises above, an investment profit can be systematically realized by paying prices less than our intrinsic values. These investment profits will return to us via operating dividends or the sale of our equity at or above our intrinsic value.

Since we believe our actions affect both the intrinsic value and the price, we aim to apply our actions into the marketplace. The objective is to move situations into our favor. We know this is not guaranteed but we are not forced buyers either. Strategically implementing the above thesis, we are aggressively pursuing a very dense geography to tip the market in our favor. The result of this should be greater future deal flow.

What is your investment thesis? How does that premise logically bear out an inevitably true conclusion? Have you written it down? Are you acting in accord with those beliefs?

Let’s now try to describe a process to develop your own thesis. First, identify one or more core truths. Here is a more specific example: Automobiles have glass windows. Objects crack, chip and break glass windows. Automobiles with glass windows and objects will exist in the future. Therefore, there will be broken auto glass in the future. This is pretty straight forward, right? What mistake(s) did I make?

Here are a couple aspects of the above that may be difficult to be proven absolutely true: automobiles will exist in the future, and glass will be breakable. There is some chance that automobiles will no longer exist. How can this be deduced? Easily… they did not always exist, therefore they are not permanent. This weakens the reasoning. Is the logic broken? Not necessarily if you account for the possibility of automobiles vanishing. What is true? Automobiles with breakable glass do presently exist. What is the point of this paragraph? Look closely at the aspects of your thesis that are in fact provable to be true. Sometimes entrepreneurs and investors get swept away in the concept of a thing that could exist and confuse that which does in fact actually exist. Be careful.

Second, let us then assign probabilities. In the case of automobiles or breakable glass vanishing, we can estimate each chance at some .00001% chance. Multipled together in a Bayesian method we can determine that both simultaneously vanishing is even more unlikely. Perhaps autonomous cars without windows might exist. But, no cars with no windows is less likely to occur. It is probably more likely to have unbreakable glass. How likely is that? Cost-wise, we estimate it to be very low. Point of this paragraph? Assign some probabilistic thinking to your “future truths.” When we think about beer consumption we know with significant confidence that beer will be consumed. What we don’t know accurately is the precise fluctuations in the near term future of our niche. This is much more difficult, if not impossible.

Third, order your premises in a reasonable manner. If automobiles vanish then the glass associated with them probably disappeared, too. (what would the breakable glass be attached to?) But, since the automobile is foundational to the glass, the breakable glass could change without dependency on the underlying structure holding the glass being substantially different. Example: an autonomous car is different but it is still a form of automobile that likely has breakable glass. An example challenge I see often is a low probability requirement occurring before your desired situation develops. Staying on the automobile example, let’s say you require complete autonomous automobile traffic before you can launch your autonomous, street-crossing, hover-board. This might be a fun thing to imagine but the order of requirements is unlikely. However, it is not illogical. An example of poor logic would be the unbreakable glass occurring in autonomous automobiles. That is an illogical assumption. It is logical to remove windows from the autonomous automobile, but not unbreakable glass. What is the purpose of the windows anyways? Is it not to facilitate people’s desire to see their surroundings? Do people strive toward their desires? Yes. I think it is more likely that autonomous vehicles will have rotating seats before they do not have windows. Anyways… I digress…

Finally, I’m not going to go through all possible human error in a single blog post. The point of this article was to encourage and help you drive toward a solid foundation, a logical ordering of your investment logic, and arrive at a conclusion in which you have confidence. How much you should invest is a subject for another post.