Three Useful Mental Models For Investing

This week I’ve started researching an exciting new investment idea that I’ll share with you this coming weekend. The concept combines three of our favorite investing mental models: Marshmallow-Test, Cult-like Communities, and Paradox of Choice. 

As such, I thought I’d scribble a quick note outlining what these models are, why we love them, and how we’re expressing them in our portfolio today. 

Marshmallow Test: Building Tomorrow’s Business Model, Today

Everyone knows the Marshmallow Test, a psychological experiment where you defer one marshmallow now to get more later. The premise is simple: You are rewarded for taking the long-term view despite current emotional cravings. 

Parents use marshmallows to get their kids to eat vegetables, mow the lawn, or empty the dishwasher. Employers use them to retain their most talented employees. The goal is to train the employees (or children’s) minds that it’s often in their best interest to defer gratification a little longer. 

This model not only works for parental discipline and employee retention but for businesses trying to innovate and change an industry. 

Here’s a straightforward way to think about the marshmallow test for businesses. Any company deferring today’s profits for tomorrow’s success is building a Marshmallow-Test Business Model. 

Clayton Christensen, the renowned business innovation thinker, explained this phenomenon in his book Seeing What’s Next (emphasis mine): 

“Solving the hard problems allows firms to capture value. Forward-thinking firms move to solve tomorrow’s hard problems, because solving tomorrow’s hard problems creates tomorrow’s profits.”

Solving tomorrow’s complex problems has its issues. There is never a guarantee that deferring for tomorrow’s profits will reap rewards. The timeframe may change, new entrants may destroy your chances, or management simply makes poor decisions. 

Yet for the winners, solving tomorrow’s challenging problems lead to mega-riches for the company, its employees, and its shareholders. And that’s why we love investing in these businesses. 

Take Redfin (RDFN), for example. RDFN is building a business based on a completely different set of industry-wide assumptions — this is that real estate commissions will eventually go to zero. 

RDFN made its real-estate agents full-time salaried employees with health/401K benefits to capture tomorrow’s profits. They’re buying homes from customers via iBuying. Most importantly, they’re returning all of those savings back to the customer: the home buyer/seller. 

RDFN’s business model is perfect for tomorrow’s industry if/when it gets there. In the meantime, the model represents a significant risk. Why would a deeply cyclical company add full-time employees to their expense stack? 

How To Think About/Find These Businesses

Investing in Marshmallow Test businesses requires a strong stomach. After all, these companies will forgo profits today in the hopes of making more tomorrow. Investors should expect lower revenue and earnings growth during recent quarters. 

Ask yourself questions like, “Do I know on a per-unit basis what the company could make in five years?” or “If the company stopped investing in expansion tomorrow, what would its margin profile look like?” 

Also, scan earnings transcripts for phrases like “long-term mindset” or “deferring profits.” Ensure that management’s actions and words are consistent with its Marshmallow Test model. 

Finding these businesses is hard, too. A good “Marshmallow Test” screener might look something like this: 

  • 3YR Revenue Growth CAGR > 15%
  • Gross Profit Margin CAGR > 0%

Yes, it’s wide, but that’s on purpose. Marshmallow Test businesses should experience high revenue growth rates and GM % expansion. Whatever you do, don’t filter on operating income. Remember, these businesses are optimized for long-term value creation, not short-term operating profits. 

Cult-like Communities: Exploiting Our Evolutionary Desire To Find “Our People” 

Businesses that harness our desire to assemble and affiliate with like-minded individuals can generate serious wealth for shareholders. We’ve covered cult-like stocks extensively throughout our research, most recently with Figs Inc (read here). 

The Cult-like Community model is simple: Find things that people use to signal social status, then create a brand that brings those people together. 

This idea, a cult-like community, stretches far back into the web of evolutionary time. Scientists have documented culture and cult-like behavior in bonobos monkeys, the great tit (it’s a bird!), and yes, humans. But here’s the catch. Culture and cult-like behavior increase in proportion to the size of an animal’s brain. 

Andrew Whiten and his team explain this phenomenon in the journal article The reach of gene-culture, coevolution in animals (emphasis mine): 

“Culture relies not only on social learning but also on intermittent behavioural innovation, and similar comparative analyses have identified relationships between records of innovation and brain size in both primates and birds. Reinforcing these correlational analyses, a recent mechanistic model of brain evolution concluded that ‘our results are consistent with aspects of various cultural hypotheses for brain evolution.

In other words, larger brains predispose humans to favor tribes and groups over the individual. As a result, companies that exploit this innate desire to form groups should win more business than those that don’t. We see evidence of this when we view the 5YR returns of some of the market’s favorite cult-like brands like Yeti, Inc (YETI), Peloton (PTON), Apple (AAPL), and Lululemon (LULU) below. 

Creating a cultish brand is simple in theory, incredibly difficult in practice. It’s a mix of catching lightning in a bottle and creating a product that signals virtue or status. I explained this in the FIGS write-up (emphasis mine): 

“Take a commoditized item (cars, workout clothes, stationary bikes, and coolers) and make it a social status symbol. Now, you don’t just drive any vehicle; you drive a Tesla. You’re not working out in sweats, but Lulu gear. That stationary bike? It’s not a clothes-hangar; it’s a Peloton — a portal into a community of bike-fitness freaks.

Remove the brand, and you kill the cult.

But here’s the kicker: not every commodity product can (or should) be a cult. Cults form around sociable products. Items you can bring to a friend’s house or post on Instagram. Nobody’s hash-tagging their latest toilet paper purchase, and for a good reason. We only share things that give us “points” in life’s never-ending social status game.”

Nintendo (NTDOY) is an excellent example of a cult-like company in our current portfolio. NTDOY has one of the strongest brands and IPs globally. Millions of diehard fans will flock to the new Nintendo World amusement parks annually once it opens its doors. 

There are global tournaments solely dedicated to Nintendo video games (like Super Smash). The company’s branded clothing/toys fly off the shelves. Moreover, NTDOY is a rare cult-like company that crosses generational borders. 

My parents played Nintendo games growing up, just as I did. The simple, easy-to-learn nature of each game created a thread that connects gamers of all demographics. 

We love investing in cult-like communities because they’re foundational to our evolution as a species. Humans form groups, tribes, and identities around things seemingly bigger than themselves. Betting on those first principle desires is one of the most profitable games out there. 

How To Think About/Find These Businesses

A consumer’s mindset is the best tool to find cult-like companies. Look around your everyday life. What are people wearing? What are they discussing at parties? Have you noticed any new products that your friends use as social status symbols? 

The answer to these questions can yield the latest cult-like growth stock. For example, one of my buddies can’t stop talking about his Traeger grill. He’s in a Facebook Group with other guys that own Traegers. They post recipes and share grilling techniques. I don’t get it, but he (and thousands of other grill-masters) are hooked.

My friend has entered an entirely new social community (i.e., cult) because he owns a Traeger grill. 

Unfortunately, you can’t screen for cult-like stocks. That said, there are a few factors to look for, including: 

  • Dedicated Facebook/Discord groups revolving around the product
  • Strong social media presence/following 
  • High NPS Rating 
  • Niche product/market
  • High Revenue Growth Rates

Finding these factors requires some Googling and scouring social media, but it’s work that others won’t do. Also, I use two websites to find NPS ratings outside a company’s investor presentation or S-1: Comparably and CustomerGauge

The Paradox of Choice: Addition By Subtraction

The third type of model we invest in helps customers solve the Paradox of Choice problem. Popularized by psychologist Bary Schwartz, the paradox of choice is simply the idea that having many options can cause consumers stress and problematize decision-making.

If you haven’t already, I highly recommend listening to Schwartz’s Ted Talk (here) and reading his book, Paradox of Choice (e-book link here). 

We experience Paradox of Choice problems every day as consumers. It is deciding which condiments to get at Chipotle or a new pair of socks. Having endless options seems freeing, but it forces us to use precious brain reserves for even the most trivial purchases. 

For example, Mark Zuckerberg wears the same outfit to escape the Paradox of Choice.

Helping customers solve the Paradox of Choice is a valuable and highly profitable endeavor. Companies do this through a few mechanisms like brand name trust, curated algorithms, and scarcity

Let’s break each of these down. 

Brand name trust is a simple concept. Customers find a brand they’ve bought before and enjoyed, so, by default, they tend to trust similar products from the same brand. Mercedez-Benz is a great example. The Mercedes- Benz brand is associated with luxury and quality. Customers know what they’re buying when they see the brand name. 

Scarcity is different yet equally powerful. Scarcity-based companies provide only a few products, and that’s it. Examples of Scarcity companies include Direct-To-Consumer brands like Harry’s or All Birds. Both companies basically offer one product, yet both have experienced tremendous revenue and customer growth. 

Curation Algorithms are the final category and one that sits in our current portfolio. Curated Algorithms use machine learning (ML), artificial intelligence (AI), or human teams to make product recommendations. The best part is that the curation constantly improves to show the customer what they want when they want it, thanks to the self-reinforcing data feedback loop. 

Westwing AG (WEW) is a perfect example of this model. WEW helps customers discover unique and fashionable home/decor furniture items through a personalized online shopping experience. Think of it like a digital shopping magazine personally curated for every individual.

In other words, the more a customer shops with WEW, the more personalized the shopping experience. It’s this increased personalization that reduces the Paradox of Choice problem. Instead of choosing between 50-100 lamp variations, WEW customers choose between their personally curated 3-5 items. 

Westwing’s model works. 85% of its customers use the app over 100 times per year. All thanks to reducing that Paradox problem. 

Another example of Curation Algorithms is Adore Beauty Group (ABY.ASX). Like WEW, ABY personally curates make-up and beauty products to its 700K+ active customers. ABY offers over 11,000 products on its online store and a dedicated beauty service team to help customers find what’s best for them. 

As Australia’s leading pureplay beauty e-commerce company, ABY can leverage its customer data to provide more targeted (i.e., curated) items to its customers. The company can then create its own-brand items to replace third-party goods at incrementally higher margins. 

Be on the lookout for a deep dive on ABY in the coming weeks. 

How To Think About/Find These Businesses

Suppose there’s a central thesis underlying the myriad examples of Paradox of Choice businesses. In that case, it’s this: Paradox of Choice businesses help customers make better and quicker decisions on things they don’t really want to think about. 

Customers, in one way or another, like being told what to wear or what to buy. It’s the reason companies like HelloFresh (HFG), and Stitch Fix are highly successful. HelloFresh eliminates the question “what will we have for dinner?” while Stitch Fix solves for “What outfit should I buy next?” 

Now the last part of our central thesis is critical — “on things they don’t really want to think about.” Consumers want to think about big purchase decisions like a new home, car, or spouse. Curation algorithms, scarcity, and brand name trust still play a role in these types of decisions. But they take the backseat to the individual’s final deliberation. 

This is important because it refines our potential investable universe. The best place to find Paradox of Choice businesses is in small purchase consumer-facing products or areas where consumers can easily reverse a poor decision. Things like clothes, food, music, makeup, furniture/decor, etc. 

Concluding Thoughts: Three Potent Mental Models

Investing is simple. You find the 1-3 things that truly matter for a company’s long-term success, and you bet on the probability of those things happening. Most of what truly matters aren’t found in financial literacy but in social sciences, psychology, and evolutionary biology. 

At Macro Ops, we leverage these simple yet profoundly durable mental models to our advantage. We invest in companies that fulfill our desire for belonging (Cult-like Communities), help eliminate the Paradox of Choice (Curated Algorithms), and forgo profits today to solve tomorrow’s complex problems (Marshmallow Test). 

The investing universe is ripe with these types of businesses. It’s our job to find them.

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Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.


Investing & Personal Finance

AK is the founder of Macro Ops and the host of Fallible.

He started out in corporate economics for a Fortune 50 company before moving to a long/short equity investment firm.

With Macro Ops focused primarily on institutional clients, AK moved to servicing new investors just starting their journey. He takes the professional research and education produced at Macro Ops and breaks it down for beginners. The goal is to help clients find the best solution for their investing needs through effective education.

Tyler Kling

Volatility & Options Trader

Former trade desk manager at $100+ million family office where he oversaw multiple traders and helped develop cutting edge quantitative strategies in the derivatives market.

He worked as a consultant to the family office’s in-house fund of funds in the areas of portfolio manager evaluation and capital allocation.

Certified in Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

Alex Barrow

Macro Trader

Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Macro Ops’ research has been featured in Forbes, Marketwatch, Business Insider, and Real Vision as well as a number of other leading publications.

You can find out more about Alex on his LinkedIn account here and also find him on Twitter where he frequently shares his market research.