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In the big picture, one store’s inventory problem may seem trivial and fixable. But imagine that the inventory is that of all the unsold automobiles in America. Orders for more or fewer cars affect production not only at assembly plants and parts factories, but also at steel mills, rubber and glass plants, textile producers, and energy producers. Everywhere in this system are perception delays, production delays, delivery delays, and construction delays. Now consider the link between car production and jobs—increased production increases the number of jobs allowing more people to buy cars. That’s a reinforcing loop, which also works in the opposite direction: less production, fewer jobs, fewer car sales, less production. Put in another reinforcing loop, as speculators buy and sell shares in the auto and auto-supply companies based on their recent performance, so that an upsurge in production produces an upsurge in stock price, and vice versa. That very large system, with interconnected industries responding to each other through delays, entraining each other in their oscillations, and being amplified by multipliers and speculators, is the primary cause of business cycles.

The difference between a systems thinker and a system builder lies in a single verb: design. To read Meadows is to learn how to see feedback loops in existing systems—to trace reinforcing spirals and identify balancing mechanisms. But the operator’s question is harder: how do you engineer feedback into a system that does not yet have it? How do you decide what signal to amplify, what delay to shorten, what correction to automate? The shift from observation to architecture is the shift from analysis to craft, and it is the foundational skill of anyone who builds organisations, products, or supply chains.

A well-designed feedback loop compounds because every major decision is evaluated against the loop’s logic, not against isolated metrics.

Zara’s customers shop at their stores 250% more than other fashion retailers—not because their clothes are inherently better than everybody else’s—but because they understood how to design effective feedback loops.

The flagship brand of Inditex, Zara’s feedback loop was built on speed and efficiency. Traditional fashion retailers typically take six to nine months to go from design to shops, with most of production done pre-season. Zara has compressed this down to fifteen days. Under a quarter is designed before the season begins, with over half designed, manufactured, and shipped mid-season in direct response to customer demand. Store managers across more than six thousand shops in over eighty countries transmit sales data and qualitative observations—”this colour shirt isn’t selling,” “we can’t ever have enough stock of this winter coat”—to a centralised data-processing centre that operates around the clock. Small initial batches, sometimes just a few items, are sent out to test demand and feed data back into the system.

The logic behind the loop runs as follows: fast response to demand generates higher sell-through rates (roughly 85 per cent of items sell at full price, against an industry average of around 60 per cent), which generates better margins, which funds the proximity manufacturing infrastructure. There was also a deliberate choice to house roughly 50 per cent of production hubs in Spain, Portugal, Morocco and Turkey in lieu of Asia to make this kind of speed possible in the first place. The average Zara customer visits seventeen times per year, compared with three or four for a typical retailer, because the product mix changes constantly.

The feedback loop is not merely observed; it is architecturally embedded in every operational choice—from the location of factories, to the design of the RFID-tagged supply chain, to the twice-weekly ordering cadence.

But not every feedback loop requires speed to be effective—and not every successful feedback loop has to be reinforcing.

Between 1948 and 1975, Taiichi Ohno and Eiji Toyoda created Toyota’s Andon system—one of the most elegant balancing feedback loops ever designed for a production environment. When a worker on the assembly line spots a fault, defect, shortage, or safety hazard, they pull a cord (or press a button in modern versions). A coloured light displays above the assembly line—green for normal, yellow for help requested, and red for line stopped. The word “Andon” means “paper lantern” in Japanese, hence the colours. Once initiated, a team leader goes over to thank the worker who pulled the cord. If the problem can be fixed within the cycle time, the line continues; if not, the affected station is stopped until the problem is resolved. The frequency and nature of every stop is logged and fed into Toyota’s continuous improvement process, Kaizen.

Problems on a Western production line are thought of as poor performance, whereas at Toyota—they are seen as the highest form of quality control. At one Toyota plant, when the average number of Andon pulls per shift dropped from a thousand to seven hundred, the CEO called an all-hands meeting—not to celebrate but to investigate. Either problems were being hidden or standards were too low. For Toyota, the absence of correction is itself a danger signal because it implies the balancing feedback loop has gone quiet.

The NUMMI joint venture between Toyota and GM in the 1980s proved the system was transferable: the Fremont, California workforce, previously considered GM’s worst, became its best within a year of adopting the Andon system and its cultural infrastructure.

Toyota embedded in their production lines a system that rewarded patience over speed, quality over output metrics. They demonstrated another clear understanding of feedback design when they also created a negative feedback loop—with the purpose of mitigating material waste.

Toyota’s pull-based system ensures materials are only moved down the production line as and when they are needed, resulting in maximum efficiency. This is the inverse of a push-based system that forecasts when certain materials are expected to be needed.

At Toyota, Kanban cards are physical tokens of demand, visible to all. The card-based production control system operates as a balancing feedback loop: downstream workstations signal to upstream workstations when they need more material. This pull-based system creates a negative feedback loop that regulates production by actual consumption rather than by forecast, preventing the overproduction that bedevils push-based systems.

The Zara and Toyota cases are instructive, but they're the easy half of this essay. The harder question is what happens when feedback loops go wrong — and more usefully, what you actually do about it. Below i've covered three failure modes (with the case studies to match), the single highest-leverage intervention for each, and a practical audit framework you can apply to your own business. If you've ever explained a bad quarter with "the market shifted" or "we didn't see it coming," that section is probably worth your time. There's also a downloadable worksheet for paid subscribers.

When feedback loops fail: too slow, too fast, or miscalibrated

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Charlie Munger said that to get ahead in life you need to understand the basic concepts of the hard sciences: physics, chemistry, engineering and maths. And while accountancy is more art than science, it should go without saying that every investor—whether you buy stocks, real estate or commodities—and every current or aspiring business owner, should be able to understand and interpret financial statements.

Why?… because your capital depends on it.

Regardless of how much money you do or don’t have—nobody likes to lose it. Especially not to ignorance.

Financial statements are broken down into three main documents: the income statement, balance sheet and cash flow statement. Today we’ll be going through the income statement and breaking down what each line means. This document lets you know if the company you own or stock you want to buy is profitable.

But don’t take my word for it. Here’s an excerpt from the brilliant book Financial Intelligence:

“Learn to decipher this document, and you will be able to understand and evaluate your company’s profitability. Learn to manage the lines on the income statement that you can affect, and you will know how to contribute to that profitability. Learn the art involved in determining profit, and you will definitely increase your financial intelligence. You might even get where you are going.”

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To help put the scary and confusing definitions into context, we’ll be using Amazon and Visa as example companies. One of them (Amazon) produces products and services and the other (Visa) is a service-based company that collects fees on transactions. Both are well known for what they do, and you should always start with companies you already know a lot about.

This is an in-depth one, so you might want to bookmark this in case you want to come back to it. If you’re reading this in email and the email is truncated click on "View entire message" and you’ll be able to view the entire post in your email app.

A Few Tips Before You Start

Where to Find Them

When you want to read a company’s financial report, you have some options on where you can find them:

1. Investor Relations Pages: Most large corporations will have dedicated “investors” or “investor relations” sections on their website where an archive of their reports will live in PDF for you to read/download.

2. Third-Party Aggregators (free & paid): AnnualReports.com: A free directory of annual reports for listed companies across the UK, US, Canada, and Australia. Financial News & Portals: Sites like Yahoo Finance and the Financial Times (FT) Markets Data often provide links to annual reports on their company “tearsheet” pages. Specialised Databases: For deep research, subscription services like FAME (for UK/Ireland), S&P Capital IQ, and LSEG Data & Analytics provide consolidated financial data and original filing images. I personally use a paid service called Fiscal.ai, who also offer a free version (no affiliation).

3. Official Government & Regulatory Portals (free): Companies House (UK), EDGAR / SEC (USA), SEDAR+ (Canada), for example.

Or, just type in “COMPANY NAME annual report” into your favourite search browser.

Nomenclature

When reading financial statements, you’d have thought that there would be concrete wording for each definition but alas, there isn’t—there are multiple names for the same thing. Sales, top line, turnover and revenue aren’t different things—they’re the same. Net profit is also known as bottom line, net income, net earnings and net income after taxes (NIAT). At first this can be confusing, especially when looking at income statements from different companies, but I’ve tried to make it as easy as possible to understand by breaking down the income statement into six key components which I list before reviewing Amazon and Visa’s income statements.

Standardised vs Reported

Probably a bit beyond this article, but you should know that companies have to follow certain rules when it comes to financial statements. Depending on where you live, these might be called GAAP, US GAAP, IFRS or something else. The basis for these complicated accounting rules is to “standardise” how companies report their numbers so that the average Joe (and investor) can understand them as there is continuity across reports and companies. Most companies also report non-GAAP figures in their reports, as they may believe it represents a better picture of the company’s actual financials.

What Currency Is It In?

This might sound obvious but shouldn’t be overlooked. Be sure to check whether the numbers are in pounds, American/Canadian dollars, euros or something else. If you want to convert that currency back to your own, remember that the currency conversion rates might be different today from the reported numbers. This is where online websites excel over print or static copies because many allow you to select the company’s local currency, USD, or the currency of your country and convert the numbers for you.

Thousands, Millions or Billions?

Are the numbers you’re reading in thousands, millions or billions? At the top of each statement, the company should state what the numbers are “rounded” to. Here’s a screenshot from Visa’s 2025 Annual Report that tells you the numbers are in “millions.”

Before we begin, have a quick look at Amazon and Visa’s “statements of operations” which is just their way of saying... income statement, and have a go at guessing what you think the definitions mean, how both companies differ slightly, and why.

Visa

Amazon

To better understand the income statement, you can break it down into six key sections: 1. revenue, 2. operating expenses, 3. operating profit, 4. non-operating income, 5. taxes, and 6. net profit. That’s it.

Beyond that, you can introduce ratios, margins and percentage changes to the numbers to help assist you with your analysis of a company. A word of warning though: up isn’t always good and down isn’t always bad. Remember when I said it’s more art than science?

Let’s get into it.

1. Revenue

Visa calls it net revenue and Amazon calls it net sales (broken down into products and services) but they’re the same thing. It’s the total amount of money the company has charged its customers from selling its products or services over a given period and before costs are deducted. Revenue can certainly make you gleeful when first looking at it but revenue certainly isn’t profit. At least not yet.

Visa

Amazon

* You’ve probably noticed that Visa’s latest year is on the left hand side and Amazon’s is on the right. Don’t ask me why but be aware—there are little traps everywhere trying to trip you up if you’re not paying attention.

Revenue should only be recognised when a product or service is delivered. Here are some differences between when Amazon and Visa recognise revenue:

1. Amazon (Direct Sale): When you buy a $100 Echo from Amazon’s own inventory, they record the full $100 as revenue. They are the “Principal” in this transaction.

2. Visa (The Fee): When you use a Visa card for that same $100 purchase, Visa doesn’t count the $100. They only record their small transaction fee (often just cents) as revenue. They are a “Service Provider.”

3. Amazon (Third Party): When third-party sellers make a sale on Amazon, Amazon does not recognise the full amount of the sale as revenue. Instead, they only record their net share plus commissions and fulfilment fees.

But when something’s delivered can mean different things for different people. In the book Financial Intelligence, the author asks what you would do in these situations:

- Your company does systems integration for large customers. A typical project requires six months to design and be approved by the customer, then another twelve months to implement. The customer gets no real value from the project until the whole thing is complete. When have you earned the revenue that the project generates?

- Your company sells to retailers. Using a practice known as bill-and-hold, you allow your customers to buy product (say, a popular Christmas item) well in advance of the time they will actually need it. You warehouse it for them and ship it out later. When have you earned the revenue?

- You work for an architectural firm. The firm provides clients with plans for buildings, deals with the local building authorities, and supervises the construction or reconstruction. All these services are included in the firm’s fee, which is generally figured as a percentage of construction costs. How do you determine when the firm has earned its revenue?

The first example I’m not too sure, the second I would say once the product is shipped, and the third I have direct experience in as I co-run a construction company and deal with architects all the time. They’ll take 90% of it up front and do f-ck all after that.

Relax, architects—i’m joking. I know you work in milestones.

2. Operating Expenses

Operating expenses are the costs the company incurs from making a product, delivering a service or running the company’s day-to-day operations. Some directly contribute to growing the business such as (COGS/COS), some keep it afloat (SG&A) and others look to bring work in or develop products (marketing, R&D). Take a look at some of the differences between the two companies.

Visa

Amazon

Both companies have different types of operating expenses because they’re two very different companies but, on most statements you’ll find the following:

Cost of Goods Sold / Cost of Services (COGS/COS)

Cost of Goods Sold or Cost of Services represent the direct costs to the company for producing a product or service—the materials, labour and delivery.

For companies that sell products like Amazon, it’s easier to attribute a cost to a physical product plus work out the inbound shipping costs. For companies like Visa, who offer a service, it’s harder to tie a specific cost to a specific unit of service.

Selling, General & Administrative (SG&A)

A catch-all for costs that fall outside of COGS/COS and don’t directly contribute to growing revenue but keep the lights on and the company ticking over. Think of things such as:

• Salaries

• Office rent

• Marketing

• Advertising

• Legal or HR fees

Depreciation & Amortisation (D&A)

This is a “non-cash” expense. Accountants spread tangible assets like equipment, vans and buildings, or intangible assets like software and patents out over their useful life for accounting purposes and record this on the income statement. If my company buys a van for £36,000, the accountant, if using a straight-line method of depreciation, might determine that the useful life of the van is 3 years and would allocate a £1,000 cost of the van per month to the income statement.

My company is not paying out £1,000 per month as the van was bought in a previous accounting period using cash, debt or a mix of both but, it’s still expensed and thus comes off the company’s gross profit.

Research & Development (R&D)

R&D is money a company is spending on researching and developing future products, services or processes. For Amazon, think Amazon Echo, Firestick, Prime, etc. Visa doesn’t explicitly have an R&D section, but does have a “Network and Processing” line which, if Visa is making improvements to their systems, you could argue this is R&D.

Total Operating Expenses

This represents the total costs of all operating expenses and is subtracted from revenue. You can see how Visa—a service provider, has significantly less operating costs than Amazon that has physical infrastructure and inventory.

If you have money left over after all costs are subtracted, well done—you’ve made an operating profit. But you still can’t get too excited yet. You’re closer to making a profit, but it’s no home run.

3. Operating Profit

Once all operating expenses are subtracted from revenue, you arrive at operating profit. Operating profit is a useful metric when assessing the health of a company because it gives you an indication of how profitable the company is before you start to add or deduct tax, interest, and other investment income. Things that don’t really have any bearing on how well the company is operating from the products or services it sells.

Visa

Amazon

4. Non-Operating Income

Companies can also make money from activities that do not directly contribute to their operations.

Visa

Amazon

Non-operating income can include:

Interest Income

• Interest earned from cash in a savings account

• Interest from government or corporate bonds the company holds

• Interest received from notes receivable or loans to third parties

Investment Income

• Dividends they receive from shares held in other companies

• Realised gains from selling physical assets such as property, plant, equipment

• Stock they sell (if they sold it for more than they bought it)

• Rental income from investment properties that may not be related to the primary business

They could also owe money.

Interest (Expense)

Interest expense is the cost of borrowing funds the company may have used to grow the business, make an acquisition or pay down bad debt (swapping high-interest debt for low).

Total Non-Operating Income

Total non-operating income is what the company earned from interest and investment income minus any interest paid (expensed). If it’s a plus, the number is added to operating profit, and if it’s negative, deducted.

5. Tax Provisions

When companies make profits, they have to pay taxes, and what the company’s liability for that tax will show up here before the bottom line—net profit.

Visa

Amazon

As these companies are global powerhouses you’ll have to do some digging as where they paid they tax if that’s you’re thing. Is it all in the states or is it spread over regions?

6. Net Profit/Income

Net Profit is the bottom line of the income statement. If you’ve made a profit it’s what’s distributable to shareholders of publicly listed companies, or the owners of private companies, after all costs, interest and investments, taxes, and any one-time charges are removed from revenue.

Visa

Amazon

Considering Amazon’s revenue was almost 16x Visa’s they’re not too far apart when it gets to the bottom line. Being the beast they are, Amazon needs to keep spending money on new warehouses, fleet and product development to keep growing. On the other hand, people are increasingly paying less with cash and more with their cards. Visa, and Mastercard own a duopoly in this space and have done for decades.

If you only understand those six sections, you’ll already be ahead of buckets of people when it comes to understanding the income statement. For those that want to analyse the statement in a little more depth, you can look at the following.

This article is from “The Nuts & Bolts” section where I provide business operators and investors the mechanisms and manuals to make better decisions. To continue viewing articles like this please consider upgrading to The School of Knowledge+.

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Margins, Percentages and Ratios

Gross Profit Margin

Gross profit is what’s left after Cost of Goods Sold (COGS) and Cost of Service (COS) is subtracted from Revenue. Gross Profit can also be expressed as a percentage to monitor profitability of a company’s products and services at a rudimentary level.

Visa’s revenue for September 2025 was $40 billion and its cost of sales was $7.9 billion. Therefore, its gross profit was $32.1 billion.

To see that as a percentage (or margin), just do the following calculation:

$32.1 / $40 = 0.8025

0.8025 x 100% = 80.25%

*I’ve rounded the numbers.

Operating Margin

Like gross profit margin, investors and business owners want to keep an eye on the operating margin of a business and understand why it’s moving in one direction or another. Is the corporate office bloated and dragging down margins? Is the company embroiled in a legal dispute with fees adding up? What about the other way—why has your operating margin jumped 10% this year? Maybe you’ve cut back on marketing or used internal employees instead of consultants who’ll likely charge higher fees.

Either way you need to ask: Is what you’re seeing sustainable or is it smoke and mirrors?

To get to this figure, the calculation is as follows:

$68.6 / $638 = 0.108

0.108 x 100% = 10.75%

Net Profit Margin

Net profit margin is expressed as a percentage once all operating costs, non-operating costs and tax provisions are subtracted from revenue. It tells you what the company earned as a percentage in relation to revenues. Low margins are vulnerable to sudden price changes or one-off charges. Think Trump and his tariff war the last 6 months.

$20 billion (net profit) / $40 billion (revenue) x 100%

$20 / $40 = 0.5

0.5 x 100% = 50%

Percentage Change of a Metric

If you want to track a metric change of a company, such as revenue to see if it’s improving or declining, use the following calculation:

Current year - prior year

/

prior year =

x 100%

Example:

If this year’s revenue is £550,000 and last year’s revenue was £500,000, the calculation would be as follows:

£550,000−£500,000 = £50,000

/

£500,000

= 0.1

0.1 x 100 = 10%

Earnings Per Share

Earnings per share (EPS) is a company’s net profit divided by the number of shares outstanding. EPS is a number that investors, particularly Wall Street keep an eye on. An EPS miss will almost certainly drag the stock price down but weirdly enough it rising can sometimes do the same. Who’d be an investor.

Final Thoughts

The income statement answers one question: Is this company profitable? A company showing a loss this year might have been profitable eight of the last ten years. Is it a good company or a bad company then? When analysing a company—you’re own included, you want to look for trends overtime. Has revenue grown at a healthy rate over the last 5-10 years? Has D&A rocketed suddenly (think AI/tech stocks)? If so, why? Why is this companies gross profit 15% higher/lower than it’s industry peers?

If you like solving puzzles or murder mystery games you might do well at investing. If you can smell bullshit a mile away, even better.

You should now, at least on a basic level, be able to answer that primary question, understand what each definition means, and how to get to net profit. Understanding the nuances though is just a little more difficult and will require reading many income statements form different companies and industries.

Here’s a quick checklist of everything we’ve gone through:

Before diving in, tick off these basics:

• Check the currency: pounds, dollars, euros?

• Check the scale: thousands, millions, or billions?

• Identify the reporting period: quarterly or annual?

• Note the accounting standard: GAAP, US GAAP, or IFRS?

Then work through the six key sections:

1. Revenue: the top line; what the company charged customers

2. Operating Expenses: COGS, SG&A, D&A, R&D

3. Operating Profit: revenue minus operating expenses

4. Non-Operating Income: interest, investments, and other gains/losses

5. Tax Provisions: what’s owed to the taxman

6. Net Profit: the bottom line; what’s left for shareholders

Key calculations:

Gross Profit Margin = (Revenue − COGS) ÷ Revenue × 100

Operating Margin = Operating Profit ÷ Revenue × 100

Net Profit Margin = Net Profit ÷ Revenue × 100

Percentage Change = (Current Year − Prior Year) ÷ Prior Year × 100

And, remember:

• Revenue isn’t profit

• Up isn’t always good; down isn’t always bad. Understand why it’s so.

• The same thing has multiple names (revenue = sales = top line = turnover)

• It’s more art than science.

Until next time, Karl (The School of Knowledge).

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This article is from “The Nuts & Bolts” Section where I provide business operators and investors the mechanisms and manuals to make better decisions. To continue viewing articles like this please consider upgrading to The School of Knowledge+.

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References:

1. Financial Intelligence by Karen Berman & Joe Knight

2. Amazon 10-K - Feb 2025

3. Visa 10-K - June 2025

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You can predict with near-certainty that an industry with 25% returns on capital today will earn far less in five years. You can also predict with near-certainty that an industry earning 5% returns today will improve. You cannot predict which specific companies will succeed or fail, when exactly the turn will come, or how management will respond. This distinction—between what’s predictable and what isn’t—is the essence of the Capital Cycle Framework, and it changes everything about how you should invest and run a business.

The Ebb and Flow of Capital

Companies that generate high returns tend to attract capital (think AI at the minute), whereas companies that generate low returns repel it. This simple statement is the core idea behind the Capital Cycle Framework, coined by Marathon Asset Management.1 Not only is this sequence of events predictable—it can also be capitalised on by the contrarian investor and business owner.

When companies start to make above-average returns, capital floods in. Banks, VCs and hedge funds want this train to continue past its designated stop and offer to fund the companies through debt or equity. The companies use this injection of capital to invest in growing their market dominance.

But what goes up must come down, and growing profits don’t just attract greedy investors—they attract competition. More players want to join the game and get their sliver of pie. When a company, industry or sector has had excess capital pumped into it and competition is fierce, it begins to develop overcapacity, margins start to get squeezed and profits start to decline.

When the cost of capital exceeds returns, worried investors start to panic and begin selling off their shares. Once this starts, and nothing interrupts it, it snowballs. They take their money and begin to look (and promote) the next best thing.2

But what happens when excess capital has left? The industry should start to consolidate as the debt-laden companies merge or get bought out. Once this has happened, and excess capital has moved over to the next best shiny thing, profits should start to climb up again and the cycle starts afresh.

The framework is laid out in Capital Returns, and the book’s editor, Edward Chancellor, argues that this ebb and flow of profits, capital and competition helps contribute to market bubbles and busts. Once you realise this, you can’t unsee it.

But if this is so obvious and so predictable, why does it continue to happen? The answer lies in how we think—or fail to think—when money is involved.

Let me introduce you to the behavioural traps.

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Understanding Mean Reversion’s Role in the Capital Cycle

Capital cycle analysis is fundamentally about mean reversion—the idea that extreme things tend to move back towards average over time.

Understanding this should help investors not overreact when companies make above-average returns. Except it often doesn’t. People buy stocks they’ve never heard of based on a viral tweet. Businesses invest in building up their capacity at exactly the worst time—when everybody else has the same information and idea.

The Capital Cycle Framework shows that people spend too much time focusing on the supply side of the equation, and not the more predictable side—demand. Often in business, there are winner-take-all, or winners-take-most scenarios at play, so when something comes along that brings higher than normal profitability, the rest of the companies in the industry adopt what brought them the returns, or else they get left behind.

Demand for construction projects doesn’t triple overnight just because three new firms opened. But supply—the number of firms bidding—can double in 18 months when returns look attractive. You can’t predict which firms will win, but you can predict the overcapacity will crater margins.

So what do you do if you find yourself in an industry that’s either overhyped or bottomed out? Well, correct capital allocation principles still apply. And that starts with working out what return you expect to get from your investment (your internal rate of return, or IRR). If the investment falls below your desired rate of return, you should pass. If you remember back to my post on the Outsiders, Bill Anders did this. He sold the companies where General Dynamics wasn’t the number 1 or 2 player.

Divesting made financial sense.

So why don’t more people make decisions that are best for their situation? How do they consistently get burned by bad investments and poor capital allocation decisions for their business?

The answer has something to do with how you view your circumstances.

The Inside vs Outside View

The Inside vs. Outside View is about how you make predictions and judgements. The inside view focuses on the unique details of your specific situation—your plan, resources and circumstances. The outside view looks at what typically happens in similar situations by using statistical data and historical patterns from comparable cases.

Reading case studies is the easiest and cheapest way to learn about the Capital Cycle Framework.

Wall Street investors and the banks don’t care about the long-term prospects of a company, sector or industry, because they understand one simple fact: a dollar today is worth more to them than a dollar in the future, and Wall Street continues to play a blinder. We think that they’re the idiots with their short-sightedness, but they’re the ones who know that there’ll always be start-ups, IPOs and new fads that need funding. Even better, when the bubbles burst they offer their helping hand through debt.

Much like the prostitute who doesn’t care if the man who wants to pay her for sex has had a bath this week—Wall Street will continue to get into bed with anybody willing to pay them fees.

How to Avoid the Inside View

The inside view makes you overly optimistic because you focus on what makes your situation special whilst ignoring base rates. Most people naturally default to the inside view (”our project is different”), which is why projects run over budget and start-ups fail at predictable rates (90%). Using the outside view helps you make more accurate predictions by grounding your estimates in reality rather than hope. And no, prayers don’t help.

So how do you become somebody that takes the outside view? You study. You study because you don’t have the luxury of making the mistakes that the companies and investors make in real booms and busts. Not many companies survive being blown up. When you take the outside view, you’re opting to be a rational, contrarian, and independent thinker. They say: “it’s different this time,” but you ask: “why is it?”

It’s great if you can ride the 30ft wave and safely stay on board all the way back down to the applause of others, but if you can’t surf, or worse, swim—don’t bother getting in the water.

The Prisoner’s Dilemma

The prisoner’s dilemma is a situation where two people can either cooperate with each other or betray each other, and the best outcome for both happens when they cooperate—but each person is also tempted to betray because it could give them an even better individual result.

The classic example: two prisoners are questioned separately. If both stay silent (cooperate), they each get 1 year in jail. If both betray each other, they each get 3 years. But if one betrays whilst the other stays silent, the betrayer goes free whilst the silent one gets 5 years.

Here’s how it plays out: Industry returns hit 25%. Company A invests in expansion. Company B sees this and thinks if I don’t match them, I’ll lose market share. Company C sees both expanding and thinks I can’t be the only one sitting still. Within 18 months, the industry has overcapacity, margins compress, and everyone’s worse off than if they’d all shown restraint.

How to Know if You’re in a Prisoner’s Dilemma

You’re in it when your main justification for investing is “everyone else is doing it” rather than your specific competitive advantage. If industry returns are above historical average and you feel pressure to invest or be left behind, the trap is already sprung.

You have four options:

Don’t play (if you’re strong). If you have a healthy balance sheet, sit out the expansion phase. Let competitors overcapitalise, wait for consolidation, then acquire the weak players.

Play defensively (if you’re medium). Match investments but use operating leverage, not debt. Maintain flexibility so you’re not locked into high fixed costs when margins compress.

Change the game (if you’re smart). Compete on specialisation, relationships, or quality instead of capacity and price. Find a niche where you’re not playing the same game.

Exit (if you’re realistic). Weakly positioned? Sell while returns are high and buyers are optimistic. Ego prevents most people from taking this option, but it’s often the right one.

Capital allocation rules:

• Never take on significant debt to fund expansion when the entire industry is expanding

• Build cash reserves when returns are high, not when they’re low

• Question any investment justified primarily by “competitive defence”

• Prioritise balance sheet strength over market share during booms—underperforming temporarily is fine if you survive to consolidate later

The brutal truth is most companies can’t escape because they’re not strong enough to sit it out and not smart enough to change the game. If that’s you, recognise it early and exit before the defection phase destroys your equity value.

Competition Neglect

Competition neglect is when people, or businesses, underestimate just how many others are thinking the same way they are, leading them to ignore how much competition they might face. This is exacerbated when the barrier to entry is low.

Social media companies don’t care if the viral piece of content was from an account with 40 or 400,000 followers, and neither do advertisers care about who’s willing to pay them the highest bid. Amazon has even made this an essential part of their business model with their Pay Per Click (PPC) advertising. A haunting example of competition neglect I’ve fallen victim to.

How to Avoid Competition Neglect

Remembering this mental model helps explain why people enter overly crowded markets, apply for long-shot opportunities without backup plans, and overestimate their chances in competitive situations. Recognising this helps you make more realistic plans by remembering: if something looks like a great opportunity to you, it probably looks that way to many others too.

Before entering a market or making a major investment, ask: What can we do that competitors can’t easily replicate? If your advantages are all things others could copy in 12 months—better marketing, more capital, harder work—you’re underestimating competition. Real advantages are structural: proprietary relationships, regulatory moats, network effects, or genuine technical superiority. If you don’t have one, reconsider the investment or business model.

Creative Destruction

The great reset.

Creative destruction is when new innovations destroy old industries and jobs whilst creating new, better ones to replace them. Netflix destroyed Blockbuster, but created new jobs in streaming technology and content production. Cars destroyed the horse-and-buggy industry, but created the massive automobile industry. EVs are now creating more change, not just in the cars we drive, but in the infrastructure we build around them.

Too much of a good thing doesn’t last forever, and disruptive technology arrives when you least expect it. You can’t avoid it, but you can learn to live with it.

How to Survive Creative Destruction

Step inside the mind of your competitors or a new, hungry and ambitious founder. How would they take your market share? Play devil’s advocate and ask yourself questions such as:

• What emerging technology could make our core offering obsolete in 5 years?

• Which competitor is operating on a completely different cost structure?

• If I was building the business today, would I build it the same way?

When the landscape changes, you want to be on the necessary, not painful, side. Old jobs disappear, which hurts people in those industries, but new opportunities emerge that often make society better off overall. Understanding this helps you adapt to change rather than resist inevitable progress.

Now What? A Diagnostic Framework for Your Business

Understanding the behavioural traps of the capital cycle is one thing. Knowing where you are in it and what to do about it is another entirely.

Most business owners and investors can recognise a boom when they’re in one—but only in hindsight, and if you’re like me you fucking HATE hindsight. The challenge is identifying your position in real-time and making decisions that protect capital when everyone around you is expanding.

Below is a comprehensive diagnostic framework designed to answer three questions:

1. Where is your industry in the capital cycle?

2. How strong is your competitive position?

3. What should you do about it?

The framework consists of five interconnected tools for both business owners and investors:

1. Industry Position Assessment: A 12-question diagnostic that scores where your industry sits in the cycle (Trough, Downturn, Growth, or Peak). Uses observable market signals rather than guesswork.

2. Competitive Strength Assessment: A 5-question scorecard that evaluates whether you’re strong, medium, or weak relative to competitors. Your cycle position matters less if you’re positioned to survive.

3. Red Flag Checklist: 23 behavioural warning signs that you’re making capital cycle mistakes in real-time. The circuit-breaker when you’re caught up in momentum.

4. Balance Sheet Strength Scorecard: A detailed financial health assessment. Tells you whether you can survive a downturn, acquire competitors, or need to exit.

5. Quarterly Tracking Template: Track your scores over time to spot inflection points early. The cycle doesn’t announce itself—you have to watch for the signals.

These aren’t theoretical frameworks. They’re operational tools tested against real historical bubbles. When we scored the 2006 US housing bubble using the Red Flag Checklist, 22 out of 23 warning signs were present at the peak—validating that the thresholds work.

For each of the tools there is also a business owner and investor version.

Not ready to upgrade yet? Fair enough. But here’s what separates this from other business newsletters: it’s written by an operator for operators—people who need to make actual decisions on Monday morning.

The models, concepts and frameworks are free. The tools that let you use them aren’t.

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This focus has allowed me to spend my time researching and writing about just one topic, but more importantly—practicing it.

Doing is the foundation of knowledge. Simply reading excess material and writing about it (although writing brings clarity) can often lead to biases such as the Dunning-Kruger effect or overconfidence. Simply knowing what something is and knowing how to do it is not the same thing. I wouldn't dare dream of getting in an F1 car!

The Journey So Far

The mini-series has taken readers through a progressive understanding of AI capabilities:

1. How to Use AI Effectively: We dug into the three systems models and assigned them best-case roles.

2. ChatCPT Agent Mode: A semi-autonomous virtual assistant that can execute complex, multi-step workflows or online tasks for you.

3. AI Isn’t Making You Stupid—You’re Just Learning Wrong: We through the latest research in the science of learning, and compared how AI was utilising the knowledge of world-class cognitive scientists, educators and pedagogy experts to help make you smart.

4. My Secret Productivity System: Practical workflows that helped me grow this newsletter to nearly 10,000 subscribers. Including how I use AI.

   ---

Quality Over Quantity

There have been two inflection points since I started The School of Knowledge: after reading Robert Pirsig's Zen and The Art of Motorcycle Maintenance and Lila, and upon writing my 100th piece here on Substack. At both times I was reminded that this isn't a race, quality matters and that the original thesis behind starting a Substack was to help me cope with my ADHD symptoms through writing. I didn't fare great in school, and it was only as an adult in my mid-twenties that the curiosity bug finally worked its way into my body and helped me realise that there's lots I wanted to learn about.

Different strokes for different folks.

Quality is an important subject to me. It always has been—I just didn't realise it before reading Zen. It was important, necessary even, when I was a 19-year-old Royal Marine, important when I returned to college at 29, when other people around me were stuck in careers they hated, important as a business co-owner leading projects and very much important as a writer now. The words I put to paper (digital) are a direct reflection of the many small decisions I have made prior to typing them.

In keeping with that theme I've created:

The AI Advantage: A Comprehensive Guide to ChatGPT, Claude and Gemini.

What You’re Getting

The AI Advantage is:

• 38 pages of consolidated learning

• 13,000 words of practical insights

• 23 core concepts organised into Foundational, Intermediate, and Advanced sections

• A reference guide that transforms you from novice user to operator

The Value Proposition

For paid subscribers, this comprehensive guide is included as part of your membership benefits. For others, it's available as a standalone purchase—an investment in understanding tools that are rapidly becoming essential for knowledge work.

If you’re somebody who wants to start seeing the benefit from using AI and are asking yourself “How do I go from someone who uses AI occasionally, to someone who wields it as a natural extension of their thinking?” This guide answers the critical question.

Looking Forward

The next series will be on Capital Allocation. For those that don't know what capital allocation is, it's how CEOs of publicly listed companies invest their companies' cash, and looking into if they're doing a good job for both the company and its shareholders. Now, you might say "Going from AI to capital allocation is a bit flip-floppy, isn't it?" but I don't think it is, and here's why.

You can replace capital with words such as people, resources, time, energy, commitment etc., and the principles are mostly the same. To allocate something is to distribute it—and the good thing about publicly listed businesses is the treasure chest of information we have available to us as well as books upon books on the people who created them.

They are of course all integrating AI in interesting and novel ways too.

Final Thoughts

In a world where AI capabilities are expanding monthly, having a solid foundation isn't optional—it's essential. This guide provides that foundation, built not on speculation but on seven weeks of dedicated practice and experimentation.

For those ready to move beyond basic prompting and discover what these platforms can really do, The AI Advantage offers a practical roadmap from someone who's already walked the path. If you don’t believe me, maybe take Charlie Munger’s Advice instead:

For paying members of The School of Knowledge, the guide is below the paywall.

For those interested in a one-time payment click here.

Until next time, Karl (The School of Knowledge).

Whenever you’re ready

The School of Knowledge helps you understand the world through practitioners. Those who try, fail and do (skin in the game). 📚💡

If you’re not ready for commitment just yet, join our growing community of like-minded lifelong learners here:

Subscribe now

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Here's what nobody tells you about productivity tools: most people use them wrong. They collect apps like trading cards—Notion for this, Obsidian for that, seventeen different AI assistants for everything else. Then they wonder why they feel more scattered than before.

The last 4 weeks, I've been exploring how to integrate AI more productively, but the lightning pace at which things can change has left me numb in the brain and feeling, well, unproductive.

I have had a lot of fun exploring the basic functionalities of Claude, ChatGPT and Gemini. I understand them better as tools now, but that's what they'll remain—tools. Not total solutions.

Through learning about AI, I've come to see the value in the tools I was using before. Slower, yes, but steady!

I can't deny AI has opened up ways of working that wouldn't have been possible just a few years ago. The key I've come to learn, though, is in understanding when to use the right tool for the right job—and that includes AI.

My system, if that's what you can call it, isn't perfect, but when I deter from using it, I can feel the ship taking on water. The tools I use can help bale water out, or drag the ship down further.

I've been writing The School of Knowledge part-time for a little over two years now. That's as well as co-running a construction business, which I greatly enjoy. The pair have formed this symbiotic relationship where I can use writing to help me at work, and work to help me write. If I'm calling a spade a spade, I'm not an expert in writing, content creation or pretty much anything, but I have built this Substack to nearly 12,000 people, and I want to share with anyone willing to listen my favourite tips, tricks and tools that got me there.

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Readwise

I've been using Readwise for a few years as a way of capturing highlights from my physical books. It does this by opening up my camera within the app and taking a picture of my highlight. Readwise then converts that passage into text where I can edit, tag and add notes. All of my highlights are in one place, so I can quickly read the highlights of one book or digital file if I wanted to. On top of this, I also have a "Highlights Feed" which can be thought of as a better social media, where instead of reading politically charged rhetoric all day, I can instead read Munger, Pirsig and Seneca—or whoever your favourite writers are.

The app is clean, easy to use, and even has some features that aid actual learning, such as spaced repetition. Readwise has also introduced an AI agent that can scan through my highlights and pull conceptually similar highlights for us to chat about. Great for resource gathering.

Reader

Reader is Readwise's sibling. What makes Reader brilliant is its unified reading experience. Instead of jumping between browser tabs, newsletters in Gmail, and PDFs scattered across my desktop, everything lives in one clean interface. I've set it up to automatically import my Substack subscriptions, so when I sit down for my reading session, I'm not hunting through emails or bookmarks. I just open Reader, and there's my curated queue of quality content. The highlighting syncs instantly to Readwise, meaning I never lose a good quote or insight again.

Kindle

Readwise's ability to capture highlights from a physical book is a game changer, but it's laborious. I had 199 highlights from Poor Charlie's Almanack and it took me hours to upload them all from that book alone. I've tried to upload them immediately after highlighting, but that ruins the flow of reading, and I've tried uploading the previous day's highlights before beginning to read, but whichever way I did it, it was a chore.

So, I decided to buy a book from the Kindle store and give it a go. It worked so much better than my old way. I highlight a passage, take notes and within a few minutes it's uploaded to Readwise and synced to my Obsidian vault upon opening. I still prefer reading a physical book, but having the ability to sync my Kindle, Readwise and Reader highlights directly to my note-taking app Obsidian saves me hours a week, days a month and weeks a year.

For those who are familiar with the book "How to Take Smart Notes," I take notes underneath my highlights, which are called literature notes. These are rough, and most of the time won't make sense to other people; however, these are important as they form the basis of my permanent notes.

Google Keep

The newest addition to my system, I've been using Google Keep to record on-the-move notes. Something Obsidian isn't great at. I can create lists, upload images, audio, set reminders and scribble over anything. Visually appealing and with easy exporting and integration capabilities, it's a great little note-taking app for when i’m on the move.

Capturing information is only half the battle. The other half is organising it before it buries you.

Eisenhower Matrix

I've tried many task management systems, including Thiago Forte's "Second Brain," but I've found most to be too complex—and when things are too complex—they rely a lot on motivation to keep going. I've found that the Eisenhower Matrix is simple, but works for me. Remember what Charlie Munger said:

Every week, I write out what needs doing and then organise it according to its importance and urgency, and just like dark clouds pass after a thunderstorm, so does my brain fog after completing this simple but effective exercise.

Notes Scheduler

Short-form content is hard to keep up with, even if you want to post just once a day. Substack Notes is great for discoverability, but it doesn't let you schedule posting which sucks. It sucks because you can sense when people haven't thought things through and gained the clarity that only writing, editing and time can provide.

How often do the words that come out of your mouth make sense? How often do you wish you would have said things differently?

To combat this, I created a "Substack Notes Scheduler" in Notion. Because Substack has limited API capabilities, I still have to copy and paste the text into Substack when I want to publish. Slightly annoying but it works great. No more opening Substack, clicking the + button and staring at a blank page.

Something I haven't been doing much of recently but need to get back into is sitting down every Sunday and making 7 days' worth of short-form content. Again, this simple system that takes an hour each week helps keep my Substack consistent and is often used as a guide to what long-form content I should write.

Here's where the real magic happens though: turning all that captured information into actual knowledge.

Obsidian

Obsidian is my note-taking app where all of my captured highlights live. From there, I elaborate on them and turn them into short notes. This forms the basis of my permanent collection and from which I write most of my long-form content. One of the key features of Obsidian is the graph view. Because Obsidian uses back links, the graph view represents a brain-like image showing the connections between all of my notes. It's like having somebody else's eyes to see a different world.

Obsidian offers community plug-ins, and this is where it goes from a really good note-taking app to a great one. Even the best knowledge system needs enhancement, and in the next section I show you how AI transforms my workflow from a 7/10 into a 9.5.

Smart Connections

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