Entropy reduction is a model of reality that could help spot great businesses. Businesses that reduce entropy / increase order the most in the system promote evolution. Thus, they are the most attuned to the natural flow of human race.
James Lovelock is a 102 year old British scientist who is best known to the general public for the publication of the 1979 book Gaia: A new look at life on Earth. He graduated in 1941 with a degree in chemistry from the University of Manchester. Thereafter, in the 60s he worked as a consultant at NASA. Among many fields of work, NASA’s scientists and engineers of the time were trying to find the most suitable instruments and techniques that could be used on Moon and Mars landers to detect traces of life. Lovelock noticed that all the solutions being debated stemmed from the basic assumption that life on another planet would be similar to life on Earth. If life on another planet were something completely different, none of the proposed solutions would be able to detect it. He suggested taking a few steps back and looking at the most general attribute of life: local entropy reduction.
In any non-living and non-stationary system (which has not reached its equilibrium), entropy flows invariably in only one direction: it increases. If entropy is not increasing, it must be stationary, which indicates the system has reached a steady state. Think of a mountain with a rock on its top. If the rock falls off the mountain top and shatters as it reaches the bottom, the entropy of the system mountain + rock increases. As everybody can see, the system is more disordered now that the rock is broken in thousands of pieces at the bottom of the mountain. This is how the world evolves through time.
Living systems, however, are different: life reduces entropy or, to put it in a more familiar term, life brings order to the system. Thus, the presence of a life on another planet should bring the entropy of the system to a lower level, incompatible with a stationary non-living system. In the case of Mars, Lovelock proposed to look at traces of certain chemicals in the atmosphere that indicated lack of thermodynamic equilibrium. Thus, if Mars’ atmosphere were not in a state of thermodynamic equilibrium, it would indicate a lower level of entropy, which could be the consequence of life.
When I look at the human civilisation, I see an evolution that goes in the direction of consistently reducing entropy/increasing order; not the maintenance of a system in low-entropy/high-order state. The evolution of human civilisation seems promoted by ideas and discoveries that further reduce the entropy of the system. One important clarification should be made: order does not mean simple. A system with a higher degree of order is not necessarily a simpler one.
Populations were first scattered in hunter gatherers small tribes, then they collected in larger groups, which then became societies with increasing levels of organisation and coordination of activities.
We learnt specialisation and division of labour.
We learnt to coordinate the work of many individuals to make more complex products. We went from artisans that made one chair per day in their shop to large businesses that could make thousands of chairs per day by coordinating labour.
We learnt how to communicate simultaneously with vast crowds at the same time (e.g., Television and Facebook).
We evolved the way we exchange value from barter, to coins, to credit card, Apple pay.
Great businesses for the long term are undoubtedly a subset of those that create the greatest value for people’s lives: improve life, solve problems and allow people to do things better, faster and cheaper (quote from Kevin Martelli). This added value manifests itself at the highest level by reducing the entropy of the system; i.e., by creating greater order.
The entropy reduction model could be another tool in the investor’s toolbox to look at the world at the highest possible altitude and help spotting great businesses. The entropy reduction model could help avoid one of the biggest risks in investment analysis: to not see the wood for the trees.
As a final note, I would like to clarify that from an investor’s point of view, the greatest businesses are those that can increase their intrinsic value per share the fastest over the long term. Creating value for people’s lives is not a sufficient condition for having a great business, as many examples from history have shown: the aeronautic industry is a case in point.
May 2021