First Principles in the hedge fund business

A case study with Tesla

Mike McCue’s blog on the first principles approach in entrepreneurial management is great. He walks us through a tough decision and how asking first principle questions helps unambiguous decision making.

I often struggle in the hedge fund world about how to make the “right” decision. The key is to see through the fog and grasp the complexity without being torn apart by it. For example. I am looking at theTesla investment thesis. What are the key questions to ask in order to make the right decision. There are so many variables.

1. Tesla is not making money
2. Tesla is making a great car
3. Tesla is using advanced software to make the experience better
4. Tesla is run by an accomplished entrepreneur
5. The competition is slow and lacks entrepreneurial force
6. The cost to produce electric cars are coming down
7. Competition is heating up
8. Other battery makers are making progress in bringing down cost and improving performance
9. Consumers want a fast, low cost car
10. Consumers want to get away from gasoline but not from convenience
11. Tesla is the first semi autonomous driving car commercially available

The list goes on and illustrates the complexity of the Tesla investment case. Pretty much any of these factors can be viewed from a different angle. The company is not making money but it will once the volumes grow. The Tesla software is advanced but it might not be in the future. The self drive feature might be overtaken by others. etc.

McCue offers a clue of how to deal with this complexity. Ask first principal questions. “What do we know to be true?”

Let’s try this with Tesla. What do we know to be true?

1. They make great cars
2. They are heavily using software to improve the experience
3. They built the car as an electric car from the ground up so if electric cars gain share they will have an advantage
4. Electric cars have performance advantages vs. IC cars
5. Working for Tesla is considered a good thing
6. Consumers love the Tesla Model S
7. Gasoline is not cool, electricity is
8. The self drive feature in the Tesla is ahead of others
9. The self drive feature in the Tesla is useful and potentially a magnet for buyers

10. Tesla has better service than most competitors because they are new and fresh

11. Tesla has a technology lead in electric cars because the company attracts outstanding engineers focused on the problem

12. Tesla has an advantage in developing a self drive feature because they can test their models and learn on live driven miles. That also attracts the best engineers to work on the problem

What does the first principles approach yield?

Tesla is good at developing software intensive electric cars. Tesla has an edge in building great EV cars with artificial intelligence. Tesla has an advantage because engineers want to go work there to solve EV and AI problems. Consumers like both features. EV because it has better torque, drives better, makes less noise and costs less than IC. AI because it makes the driving experience better.

What we don’t know.

1. Competition could underprice to drive Tesla out of the market. For example, Mercedes could price it’s S-Class at 60,000$ instead of 100,000$ to hurt Tesla.
2. Tesla could run into manufacturing problems because the company doesn’t have an edge in manufacturing.
3. Elon Musk could screw up

Conclusion

If EV’s gain share and AI becomes a consumer loved feature Tesla will do well sell more cars and be profitable. The market is huge and Tesla’s valuation will be fine. The risk lies in execution.