What is First Principles Thinking?
Imagine you're trying to build something new, like a complicated LEGO set. Most people would look at the instructions or try to copy what someone else has built. That's thinking by analogy.
First Principles Thinking is different. It means breaking things down to their absolute fundamental truths, the smallest, irreducible components. Instead of asking "What has been done before?" or "How do others do this?", you ask "What are the undeniable facts here?" and "What are the basic laws governing this?"
Think of it like being a scientist or a detective. You're not just accepting common wisdom or assumptions. You're digging deep to find the foundational elements from which everything else is derived.
Here's a graphic illustration to help visualize it:
The Core Idea:
Deconstruct: Break down a complex problem into its most basic, undeniable truths. What do you know to be true, without any assumptions?
Reason: Build up new solutions or understandings from these fundamental truths.
Innovate: This often leads to novel, more effective, and often disruptive solutions, because you're not constrained by existing frameworks.
First Principles Thinking in the Indian Stock Market
The Indian stock market is full of conventional wisdom, historical patterns, and analogies. While these can be useful, relying solely on them can lead to missed opportunities or costly mistakes. First Principles Thinking allows you to cut through the noise and make independent, data-driven decisions.
Here's how you can apply it:
1. Deconstruct a Company's Value:
Analogical Thinking: "This company's P/E ratio is lower than its competitors, so it's undervalued." or "This sector usually performs well in an election year."
First Principles Thinking: Instead of just comparing ratios, ask:
What exactly drives this company's earnings? Is it sales volume, pricing power, cost efficiency?
What are its fundamental competitive advantages (moat)? Is it a unique product, distribution network, brand loyalty, or switching costs for customers?
What is the intrinsic value of this business based on its future cash flows, discounted back to today? (This requires understanding revenue streams, cost structures, capital expenditure, and growth rates from first principles, not just analyst estimates.)
What are the non-negotiable facts about the industry it operates in? Regulatory environment, raw material availability, demographic trends?
2. Evaluate Investment Hypotheses:
Analogical Thinking: "Everyone is buying into the EV theme, so I should too." or "Pharma stocks always do well during health crises."
First Principles Thinking:
For EVs: What are the fundamental drivers of EV adoption in India? (Charging infrastructure, battery costs, government subsidies, consumer preferences, range anxiety). What is the actual market size today vs. projected? What are the fundamental constraints on scaling production for specific companies?
For Pharma: What are the basic needs for healthcare in India? What specific diseases or conditions are growing? What are the regulatory hurdles and opportunities? What are the true R&D capabilities and patent pipelines of specific companies, independent of past performance?
3. Understanding Market Crashes/Corrections:
Analogical Thinking: "The market fell X% in 2008, so it will recover similarly now."
First Principles Thinking: What are the fundamental causes of this particular correction? Is it interest rate hikes, inflation, geopolitical tensions, specific sector-related issues, or a combination? How do these fundamental factors impact corporate earnings, consumer spending, and the cost of capital? By understanding the root causes, you can better assess the duration and nature of the recovery, rather than just relying on historical precedents.
Example 1: Analyzing a Bank (e.g., HDFC Bank)
Analogical Thinking: "HDFC Bank has always been a strong performer; it's a safe bet."
First Principles Thinking:
What are the fundamental sources of a bank's profits? (Net Interest Margin, Fee Income).
What are the fundamental risks? (Credit risk, liquidity risk, operational risk).
What are the undeniable truths about HDFC Bank's operations? (Its low-cost deposit base, efficient branch network, robust risk management framework, diversified loan book, technological prowess).
How do these fundamental elements translate into sustainable earnings and growth, independent of its past stock price performance or sector trends? Are there any changes in regulatory environment or competition that could fundamentally alter these truths? This deep dive helps you understand why it's a strong bank, not just that it is one.
By consistently asking "What are the fundamental truths?" and challenging assumptions, investors can develop a deeper understanding of companies and markets, leading to more informed and potentially more profitable decisions in the dynamic Indian stock market.
The Analogy (Old Way): For decades, stockbrokers in India charged a percentage of the trade value as brokerage. The assumption was: bigger trade = more brokerage. This was how it had always been done.
First-Principle Thinking (Zerodha's Approach): Nithin Kamath, Zerodha's founder, broke the business down to its fundamentals.
Question: What is the actual cost for a brokerage to execute a trade for a client?
Fundamental Truth: With the rise of technology and online trading, the cost to the broker for executing a trade is almost zero and is completely independent of the trade's size. It costs the same to execute a trade for ₹10,000 as it does for ₹10,00,000.
Rebuilding the Model: If the cost is fixed and negligible, why should the price for the customer be a variable percentage? Based on this first principle, Zerodha introduced a flat-fee model (e.g., ₹20 per trade), completely disrupting the entire industry.
By ignoring the analogy ("how brokerages have always worked") and focusing on the fundamental truth of his operational costs, Kamath built a new, wildly successful model from the ground up.
As an investor, you can apply the same logic. Don't just accept that a company is great because everyone says so. Break it down. Understand its core components, question the assumptions, and you'll make far more informed and powerful investment decisions.
