In this post, we will talk about a mental model from physics and how it relates to business.
Newton's first law of motion
In 1686, Sir Isaac Newton laid out three laws of motion in the book ‘Principia Mathematica Philosophiae Naturalis’. Out of these three laws, we will talk about the first law which is called 'Inertia'. It reads as follows
“An object at rest remains at rest, and an object in motion remains in motion at constant speed and in a straight line unless acted on by an unbalanced force”.
In simple terms, the object which is moving will keep on moving. This is the same fundamental principle behind momentum investing. The stocks which have performed well over the last one, three, or six months, will keep on performing well for a similar period in the future as well. This happens until some external force breaks the momentum such as negative news on the company, change in the macro environment or better alternative opportunity, etc. And when this happens, the stock loses its momentum and gets out of the momentum portfolio in the next monthly or quarterly rebalancing.
The same principle applies to people and businesses as well. Once the business has gained momentum, it maintains the same for time being. The management which has delivered value to shareholders in past is likely to deliver value in the future as well. This law provides an important mental framework to evaluate if a business is in the ‘momentum’.
In light of this, it’s important to ask if the business is constantly adding capabilities, launching new products/services, improving internal processes, fostering innovation, and moving up the value chain. Because these activities gain momentum in the business, it is natural to see momentum in revenue growth, margins, and ultimately ROE/ROCE. And this momentum will sustain for a while until an external force from the macro or regulatory environment hampers the motion. It could be increasing competition, new product/technology disrupting the sector, changes in government regulations, etc. When this momentum breaks, it is not uncommon for the business to remain laggard for a long time. During this period nothing noteworthy happens in the business, growth remains flattish, and ultimately returns suffer.
The second law of thermodynamics
This brings us to the second law of thermodynamics laid out by Rudolf Clausius and William Thomson in 1860. It reads as follows.
“In a natural thermodynamic process, the sum of entropies of interacting thermodynamic systems never decreases”
The law introduces the force called ‘entropy’ which simply means disorder. The law expresses a fundamental phenomenon of the universe that the disorder is natural in absence of efforts. If left to chance, things decay unless there exists a force that places things in order. The human body decomposes in absence of the heart constantly pumping blood and supplying energy to cells. Weeds grow in the garden unless mowed. Fundamentally, everything becomes disorderly in absence of intervention.
Similar to this fundamental law of the universe, businesses also decay in absence of proactive efforts for growth. If the activities discussed above are not in motion, the business will remain status quo for some time and eventually it will start stumbling. This is the stage where growth languishes for a long time, debt piles up, high profile employees leave and the firm eventually goes bankrupt or becomes vulnerable to frauds.
To conclude, momentum compounds and progress breeds progress. If this is not the case with the business, it’s prudent to be cautious and re-evaluate the case.