Systems thinking and investing

Peter Senge, an MIT professor introduced 'Systems Thinking' in his book 'The Fifth discipline' in 1990. We discuss how it provides a helpful mental model in investing.

Systems thinking - the concept

A system is a collection of interconnected and interactive components. Systems are all-pervasive and affect our day-to-day life but we usually relate the word systems with only computers and software. In general, any group of components interacting with each other can form a system regardless of whether we perceive it as such or not. To extend the idea further, the components need not be electrical, mechanical, or a bunch of APIs. It can be a group of people as well. The complexity of a system keeps increasing with the number of components. For example, an economy is a complex system comprised of various sectors, businesses, consumers, and governments, all interdependent. More complex systems have sub-systems interacting with each other. The human body is a robust system with nine sub-systems including the nervous system, respiratory system, circulatory system, etc. interacting with each other.

The design of a system determines its functionality. Robust systems are dynamic and self-correcting. The human body can heal itself of diseases and wounds, etc. Major economies have survived the great depression, wars, tech boom, the US sub-prime crisis etc. However, the human body cannot fly or a major economy cannot suddenly grow in double digits. In other words, what a system can do depends a lot on its design. This is easier to recognize for the systems that are visible physically. However, it is difficult to understand abstract systems, and hence deeper study is required to understand its parts and functionalities. Nevertheless, the notion that the design ultimately determines the inherent capabilities and flaws of the system provides an important mental framework.

There are four fundamental aspects of any system behavior.

i) interconnectedness - how the parts of the system are interrelated. If interrelatedness is not understood properly, often interventions create more problems than solutions

ii) synthesis - the system is not merely sum of the parts but the product of interaction between the parts and hence it’s important to see the system as a whole and not just as collection of parts

iii) feedback loops - such interactions create reinforcing/positive or balancing/negative feedback loops

iv) causality - identifying positive or negative causal linkage between the parts

The below picture aptly summarizes systems thinking.

Systems thinking as a mental model for investing

Though ‘Systems thinking’ is primarily a tool for problem-solving, the underlying idea provides an important framework to see things from systems perspective. A business is part of a huge ‘ecosystem’ called industry and understanding linkages of supply chains helps figure out where the value is being created. Let’s consider two different industries to understand this concept better.

During 2007-2017, China’s share in the global chemical industry expanded from 6% to 37%. The chemical industry shifted from the West to Asia and China grabbed the opportunity to grow its chemical sales supported by domestic demand, government subsidies, and relaxed pollution norms. India’s share during the same period just moved from 2% to 3%. During FY15-17, the Chinese government tightened the pollution norms and which led to a significant capacities shutdown in China. Further, labor costs also increased in China reducing the competitiveness of its chemical industry vis-a-vis India. Hence, the Indian players got benefitted immensely during FY17-21 with India’s share in the global market increasing to 4%. The share is expected to further increase to 6% in the next 5 years as per CRISIL estimates and the Indian chemical players will continue to flourish. However, the value -addition by the companies will depend on the management’s understanding of the global ecosystem and thus it’s an important criterion while evaluating a chemical company.

Compare this with the current solar energy ecosystem in the world where China is at an advantage in solar panel manufacturing. China commands 80% of the share in the manufacturing of polysilicon which is a key raw material to manufacture solar modules. Further, China alone produces more than 60% of metallurgical grade silicon which is a raw material for polysilicon. In India, big players like Reliance, Adani, and Jindal have participated in the PLI scheme to establish a 4GW vertically integrated facility from polysilicon to solar wafers and modules. However, the raw material supply chain is dominated by China. In addition, Chinese players have built up significant capacities for solar modules. This is an example of difficult ecosystem wherein Indian solar module manufacturers are at disadvantage in terms of global competitiveness. This, however, does not mean that Indian players will always be at disadvantage compared to their Chinese counterparts but it can take a very long time for the ecosystem to turn favorable.

This framework is used by businesses to identify structural issues by looking deeper and understanding causal relationships between the functions. However, it's an important mental model while evaluating companies as revenue and profits only grow to the extent ecosystems allow regardless of management optimism or comprehensive strategies adopted by the companies.