Spectrography & Investing: Finding Hidden Patterns in Light and Business

During their recent episode, Taylor, Carlisle, and Ardal Loh-Gronager discussed Spectrography & Investing: Finding Hidden Patterns in Light and Business. Here’s an excerpt from the episode:

Tobias: That’s very interesting. JT, are you– We’re going to see if we can get JT to do his vegetables. He’s lying in his deathbed. He’s resurrected himself- [Ardal laughs]

Jake: Lazarus.

Tobias: -just to come on the show.

Jake: [chuckles]

Ardal: Welcome JT.

Jake: All right. Let’s see what we can do here. We are going to be talking about this concept of spectrography, which if you haven’t heard of it before is actually completely blows my mind. But it sounds intimidating, the word. But don’t worry, we’ll explain it how it works, maybe almost to a five-year-old, which is good, because that’s the level I need it at.

It’s this tool that lets scientists study light and break it down into its elements. From simply analyzing light, we can tell what something is made of, how hot it burns, how fast it’s moving. It’s a technique that’s unlocked the secrets of the universe from distant galaxies to crime scenes more locally.

So, the science of spectrography goes back to this guy, Joseph Ritter von Fraunhofer, I believe his name is. He’s an 1800s German optician who turned a failed glassmaking apprenticeship into one of the greatest scientific careers of all time.

So, his life was really wasn’t supposed to amount to much. He was orphaned at 11, and he was sent to work in a glass-making factory, which was a grueling, low-class job. But fate had other plans for him. One day, the factory collapsed on him and he was buried under the rubble. And a nobleman, Prince Maximilian, saw the rescue and took an interest in the boy. With the Prince’s support, Fraunhofer got an education, and then he just ran with it and he became obsessed with perfecting glass lenses. He spent his nights grinding and polishing and testing how light bent and split through these lenses.

His attention to detail allowed him to discover, that even in sunlight, which you would think is this very continuous spectrum of colors and light, there are these weird dark lines in the sunlight, these patterns. What was he seeing? Like, did he see this correctly? Wasn’t light completely continuous? No, actually, there were these dark lines that if you could measure close enough, you could see them. Sadly, he never lived to see how important this discovery would become. Probably, the exposure toxic chemicals at that job, he died when he was 39. But his name lives on in these Fraunhofer lines. These dark lines are called Fraunhofer lines now.

So, the way that this works is basically these– Think of like the light from the sun is not completely smooth. It has tiny gaps, like missing teeth in a comb. These Fraunhofer lines are really fingerprints of elements. So, when an atom absorbs energy, its electrons jump up to a higher level. And then, as the electrons fall back down to their original state, they release energy in the form of light at specific wavelengths. So, this is how scientists can analyze the light that’s emitted and absorbed by substances to decode the chemical makeup.

So, for light from our sun, the gaps are made up of elements like sodium, hydrogen and iron. They’re all imprinted on the spectrum that shows up here, the light that hits the earth. So, without ever touching a star, we can tell what it’s made of. Without stepping onto Mars, we know that there’s iron and it’s dust based on these lines that show up, all from reading patterns in light.

So, this idea of finding hidden patterns even when you can’t see inside makes spectrography, I think, a fun analogy for investing and hopefully, maybe ties in a lot with what Ardal’s saying and going and being boots on the ground. You don’t get to walk the factory floor of every business, interview every employee, sit in every C-suite meeting, but there’s often patterns there. Just like light tells a story about the stars, I think businesses emit signals as well. Some glow very bright, some are dim, some flicker before they fade to black.

And so, now, I’m getting like way over my skis, but I’m going to do six spectral lines of business here. So, the first one is high returns on invested capital. This is the elemental signature of quality, perhaps. If a business can reinvest profits at a high rate. It’s like a bright spectral line of hydrogen and a star. It tells you that there’s real fuel there. And weaker inconsistent returns, perhaps, it’s a dim star that’s burning out.

Number two, management incentives, the Doppler shift of integrity. Just like light shifts towards red or blue when objects are moving relative to each other, further moving away or towards, incentives reveal which way management is really heading. Are they aligned with shareholders or are they just juicing short-term numbers?

Number three, net promoter score, the absorption of spectrum of customers. So, a high NPS score might mean that customers aren’t just buying, but they’re coming back and they’re bringing their friends. Maybe a low NPS would be that’s an absorption of the spectrum where energy is getting drained away.

Number four, capital allocation, the emission spectrum of intelligent decision making. Some businesses generate a lot of cash and you reinvest it wisely. Others hoard it and waste it, burn it on maybe buybacks at the wrong time. The way capital moves through a company creates some of the clearest spectral patterns of all. Employee turnover– This is running a little long in the two, so I’m just going to keep going.

And then, last one, crisis response. So, this is like the supernova test. Some companies explode under the pressure, others absorb the shock and adapt and perhaps come out stronger. Watching how a business reacts in tough times tells you a lot about its internal makeup.

So, wrapping this all up, Fraunhofer, he turned light into knowledge. We don’t get to see inside every single company, but we really don’t have to, necessarily. The patterns are often there, whether it’s in starlight or financial statements. And so, as we learn to read them in the universe of businesses, everything starts to make a lot more sense.

Tobias: Amazing. Have you said spectrography?

Jake: Spectrography.

Tobias: Spectrography.

Jake: Yeah. I had to say it like a hundred times before–

[laughter]

Jake: -over the last few days, because I was choking on the word so much.

Tobias: From the deathbed, you’re still alive. Good job, JT. The nation of Value: After Hours appreciates it.

[laughter]

Jake: Ardal, inspire any thoughts about your process and things that you’re looking for?

Ardal: I think definitely, because I think I would sum all that up very similarly and I would say that that’s perception. It’s looking for patterns where other from something that’s obvious to everybody, which in this case is light. This is what we’re trying to do in investing. We’re all looking at the same sets of information and we’re trying to project forward different outcomes, different conclusions and what they’re made up of.

I think answering those questions, those black lines you alluded to, is really what the essence of successful investing. I liked the tangential there between something very quantitative, which is spectrography of light and how you parallel that then into the quantitative aspects of successful investing. So, thank you, JT.

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