Pattern Recognition and Forging Your Own Path 

Pattern recognition plays a critical role in investing—it helps investors narrow down opportunities and influences the prices they are willing to pay. By applying lessons from history, patterns reduce uncertainty and increase the likelihood of successful outcomes. 

However, while “mental models” offer significant benefits, they also have drawbacks: easily recognizable patterns often carry higher valuations due to their perceived reliability. Patterns can also be manipulated. For instance, when a startup describes itself as "the Uber for X," it invokes a well-known success story to trigger favorable associations. This familiarity creates comfort and confidence, leading investors to accept higher valuations where it may not be merited. 

As a mental model becomes widely accepted, investors increasingly pull forward anticipated future success into today’s valuation. Unfortunately, higher prices today reduce the value of cash flows generated tomorrow. As the last in line, public equity investors must remain mindful of how widely adopted the mental models they rely on have become, recognizing that as these models mature, their potential to deliver outsized returns typically diminishes. 

Studying “Hundred Baggers” 

I spent years studying a database of the best-performing stocks of all time, expecting to uncover patterns to help me identify future winners. Instead, it was mainly an exercise in frustration. 

As I returned to the data multiple times with vigorous excitement–each time with new methods to apply–I was convinced that I'd finally cracked the code that would uncover deep insights. Instead, despite numerous attempts and approaches, I could not identify the common threads that tied exceptional performers together. 

Then, one day, like many epiphanies do, it just clicked. I even laughed at its simplicity: I realized the pattern these outlier companies shared was the absence of a pattern! 

By definition, a publicly traded stock can only deliver legendary returns if it is not appreciated as great in advance. Once a company unexpectedly achieves an enviable track record, investors rush to identify the underlying causes and distill the “ingredients of success” into a repeatable formula. This new mental model is then applied to similar-looking companies, increasing the valuation of these analog businesses. 

This “succeed-distill-copy” cycle demonstrates how mental models mature, and it's why the next legendary stock is unlikely to look like one that succeeded before it. Whenever a company enjoys a well-understood advantage, consensus gives it credit in advance, reducing how much return can accrue to later-stage investors. Ironically, if your goal is to identify truly outlier opportunities, what you're looking for isn't a pattern but the absence of a pattern! 

This thought exercise highlights the importance of maintaining independence and thinking for oneself as a public market investor. Our sweet spot, therefore, lies in identifying valuable patterns that others haven't recognized yet but are likely to appreciate later. 

To be clear, I am not saying that ideas that rely on conventional wisdom cannot yield outsized returns. Instead, many no-brainer ideas can deliver good results, and we, too, own such investments. Instead, the key idea is that the truly outlier opportunities require uniqueness. If we are fortunate enough to find them, such ideas will only represent a limited portion of our capital but hopefully will represent an outsized proportion of the returns we generate. While we will own our fair share of “conventional” ideas, I expect the most significant rewards will come from recognizing and investing in opportunities before they become obvious. 

Conventional wisdom suggests studying past successes is the best way to identify the next big idea. Ironically, though, while this approach increases the odds of identifying something good, it also reduces the odds of finding something great. If you imagine the distribution of potential returns of an investment resembles a bell curve, situations that rely on widely accepted patterns have a thinner and truncated right tail of outlier outcomes and increased height around “the bell” of above-average outcomes. Although it feels safer to stick with tried-and-true methods, outlier opportunities come from forging your own path instead of following in someone else’s footsteps. 

The late Professor Joseph Campbell frequently discussed going your own way through the "hero's journey" often present in stories and myths. There are some parallels between this idea and investing. Expanding on this idea, Campbell once said: 

“In the story of Sir Galahad, the knights agree to go on a quest, but thinking it would be a disgrace to go forth in a group, each “entered into the forest, at one point or another, there where they saw it to be thickest, all in those places where they found no way or path.” 

Where there is a way or path, it’s someone else’s way. Each knight enters the forest at the most mysterious point and follows his own intuition. 

...In that wonderful story, when any knight sees the trail of another, thinks he’s getting there, and starts to follow the other’s track, he goes astray entirely.” 

A core belief within Bonsai Partners is to seek great companies that are overlooked due to “barriers to investment.” These barriers keep prices sensible and allow us to earn an outlier result if we are right about our thesis, allowing us to forge our own path. 

While “barriers to investment” present themselves in many ways, we consider the absence of a widely understood mental model as one of its most valuable forms. If we can identify hidden insights before they become apparent, we ensure that exceptional business results also translate into investment results. When we are fortunate enough to spot a powerful mental model before others, we intend to exploit it. Some of our investment cases shared in previous letters illustrate this process.