Warren Buffett’s right-hand man is Charlie Munger. I’ve read transcripts from several of Munger’s speeches, and I really love the multidisciplinary way he approaches investment decisions.
When he cites the idea of market niches as a way to build a durable competitive advantage, he borrows that concept from the field of ecology. In nature, it’s not the species with the greatest population that survives. It’s the species that performs a niche function in the ecological system that isn’t being served by another species.
When Munger talks about consumer brands reaching a critical mass of consumer awareness, he borrows the concept of critical mass from the field of physics.
One of my favorite Munger-isms is the concept of the mental model. This is something I’ve used for my entire career, and it was encouraging to realize that Munger uses something similar.
Here’s my version of a mental model.
A mental model is an idea you have in your head about a particular situation.
For example, the mental model you have about your business is your mental picture of how your business operates.
Your mental model is what enables you to have expectations about how the business will perform.
If you bring in 1,000 leads, you know through experience that you should produce 100 clients, and you know the corresponding expected revenue of each.
Now, here is the key insight when it comes to mental models.
Your mental model is going to eventually be wrong.
This occurs when there’s a deviation in what happens in your business and what you expected to happen.
When this happens, it means your mental model is out of date.
This can occur if sales drop drastically, and you didn’t see it coming.
It can also occur when sales accelerate suddenly, and you didn’t see that coming either.
My direct reports all know that anytime anything deviates from what I expect, I will be asking a series of questions that begin with “why?”
Direct Report: “Sales went up 20%, unexpectedly…”
Direct Report: “Sales went down 20%, unexpectedly…”
Back in the 1990s, General Electric was considered an incredibly well-run company. Its CEO at the time was the legendary Jack Welch. Welch was famous for absolutely grilling his executives anytime actual financial performance deviated from expected performance.
Here’s the kicker.
He was equally harsh if the business overperformed versus internal expectations.
In his view, when business performance was wildly different than what was expected, it meant the person running the business didn’t really know his or her business as well as they thought.
In other words, the business unit leader’s mental model of the business was not accurate.
The lesson from all of this is to pay attention to deviations from your expectations. If your customer satisfaction ratings come back quite different than what you expected, that means you don’t really know your customers as well as you think. If your end of month cash in the bank differs from what you thought it would be, that means the mental model of your operating cash flow isn’t accurate.
When you realize your mental model isn’t accurate (or isn’t accurate anymore), the single most important thing to do is to figure out… why.