Finance is a good source for metaphors, and many ideas that are most cleanly expressed in markets can be applied more widely than that. Why? Markets are a deliberately over-simplified version of the real world, and they exist to convert vague approximations into precise statements—the present value of all future profits that Walmart will produce is an open question, but Walmart’s stock is a liquid and easily-tracked measure of the world’s collective judgment on that question. And the list of what things could go wrong with a company can be endless, while the way bonds and options react to news roughly quantifies them. Physical commodities are not perfectly fungible; a barrel of West Texas Intermediate is not identical to a barrel of Arabian Heavy. But futures markets use somewhat standardized definitions so we can all generally agree on statements like “Oil went up yesterday.”
Because these definitions are powerful and tricky—and sometimes powerful in proportion to how counterintuitive they are—The Diff sometimes produces a detailed writeup on how a specific financial concept works and how you can apply it in other areas—and we call it Capital Gains.
Agency Paper
The collapse of Silicon Valley Bank (SVB) brought mortgage-backed securities back into the public consciousness for the first time since the financial crisis. But the financial crisis was all about one variant of the product: subprime mortgages packaged into other securities. The other kind of mortgage-backed security, agency paper, is what's behind SVB's downfall. This post why agency mortgage-backed securities exist, how they work, and how a low-risk choice can still be costly.
Book Value and Mark-to-Market
The most simplified form of valuation is also fairly obvious: add up the assets, subtract the liabilities, and you get an accountant's-eye-view of what a company is worth: the book value. Since a company's price-to-book value can be a useful measure of a business, understanding that the book value is subject to variable accounting methods is critical. This post explains how those methods vary and what implications they have for valuations.
Unit Economics
While free cash flow, EBITDA, and revenue can be telling, they don't tell us much about the long run; the long run is best understood at a more granular level. This mode of thinking is typically referred to as unit economics, but how do we decide what units to use? And what can we do when we think this way? This post explains how to think in terms of unit economics, and how doing so helps to explain explosive valuations, burnt capital, and mini-bubbles.
CEOs as Capital Allocators
Most senior roles are well defined: CFOs keep track of money, CMOs make products famous, heads of engineering make sure the products work, and heads of R&D figure out the next products—so what do CEOs do? Warren Buffet argues that a core responsibility is capital allocation, and this has some interesting implications that goes beyond dividend and share buybacks. This post explains how capital allocation becomes a daunting task, and how CEOs end up investing most of a company's capital rather quickly.
Just-in-Time Inventory Management
If you want to make a sale, you need to have something to sell; but if overestimate how much you'll be able to sell, you end up with a hurt to your balance sheet. Companies try to optimize their working inventory because it affects cash flow and return on equity. This post explains the mechanics and how the numbers shake out.
Soros' Theory of Reflexivity
Whether it's a change to earnings, expectations, or perceived risk—the standard theory says that fundamentals are what move stock prices. It turns out the the opposing theory, where stock prices are what move the fundamentals, is what made George Soros very rich. This post explains the mechanics behind reflexivity, how it applies to the tech sector, countries, stadium sponsorships, and AI.
Multi-Manager/Pod/Hedge Funds
The taxonomy used to describe different types of funds is notoriously convoluted—but normally when people talk about funds, there's a good chance they are referring to a multi-manager pod shop, which happens to have some very old antecedents. This post breaks down how these hedge funds work, and how they are bigger and more profitable than ever.
The Alchian-Allen Effect
One of the most delight paradoxes of microeconomics was first observed by Aermen Alchian and Willian Allen in the early 1980s. With it, you can explain why Michelin star restaurants agglomerate in NYC and SF, why cybersecurity companies have pricing power, and why it can be used as a guiding light in career navigation. This post breaks down those examples by fitting them to the same model.
Money Manager Fees
Management fees, performance fees, and pass-through fees—from mutual funds to crypto prop trading firms, all funds charge different fees and to different degrees. To understand why that's the case, it's helpful to think about funds on a spectrum of skill. This post breaks down money manager fees using that model.
The Supply Chain Economy
Since one company's expenditures is another company's revenue, it's helpful to think about the global economy as a set of interlocked supply chains. This model helps investors think about booms and busts, time industry cycles, and spot second- and third-order outcomes of news. This post breaks down how to think about it with some examples.
Interest Rates
Interest rates matter the most to two diametrically opposed kinds of businesses: (1) highly-levered, capital-intensive old economy firms, and (2) high-growth, asset-light, and future-focused companies. But why? This post breaks it down by explaining where interest rates come from and why they exist.
Duration & Convexity
Bond Math is mostly the province of Bond People, but it gives us some powerful tools for understanding why assets are sensitive to interest rates, how that sensitivity changes over time, and how to think about other kinds of sensitivity as well. This post goes into much more detail. Convexity in particular is a powerful tool. Think of personal networking: if you know a handful of people, you have a limited set of useful introductions you can make. But once you know just about everyone, you can help any of them find a specific person they really need to meet.
Discounted Cash Flow
The value of a financial asset is the total value of all future cash flows, discounted back to the present at some rate. Somehow, by introducing two unknowns (what will cash flows be, and at what rate should they be discounted) we have not dramatically simplified the problem. Not to worry: it's a surprisingly complex topic.