Evolution And Investing
Last weekend, I finished reading - What I learned about investing from Darwin. It is a fascinating book that shows how evolution theory can be used to create an investment strategy. I might be biased towards liking the book because I used evolution theory to explain how Silicon Valley works.
I found the following two concepts particularly interesting:
1. One selected behavioral trait of animals can trigger many physical changes in animals over generations.
Following edited excerpt clarifies the idea:
A sixty-year-long study focused on selecting silver foxes for only one trait: their willingness to be tamed. The researchers were not interested in body size, coat color, skull shape, ear stiffness, or any other physical characteristics. They took great care to ensure that selection was based solely on tameness. However, this single behavioral characteristic triggered many physical changes in the animals.
This principle is applied at Nalanda Capital (NC), the investment firm run by the author, to filter a shortlist of businesses to invest in. The idea is that one trait of a business can cause all the other characteristics of a good business, such as sustainable competitive advantage, earnings growth, free cash flow (FCF), and a good management team, to emerge. For NC, that trait is historical return on capital employed (ROCE).
ROCE is the operating profit of the business as a percentage of total capital employed. Operating profit is defined as earnings before interest and taxes (EBIT). Capital employed is defined as net working capital (excluding excess cash, i.e., cash minus debt) plus net fixed assets. After all, extra cash is not an operating asset.
So, generally speaking, a company with high historical ROCE will have good management, sustainable competitive advantage, earnings growth, FCF, etc.
Pulak Prasad, the author of the book, provides many examples and has the results from NC to prove his point.
2. Proximate causes and ultimate causes
Proximate causes answer the "how" question, and ultimate causes answer the "why" question. Proximate mechanisms explore immediate physical influences on a trait. The history of the organism determines ultimate causes, specifically the role played by natural selection in favoring one trait over another. The following edited excerpt clarifies the idea:
Using the example of bird migration, Ernst Mayr posed the question: "Why did the warbler at my summer place in New Hampshire start its southward migration on the night of August 25th?" He proposed four causes for this migration. First, an ecological cause: "The bird would starve if it stayed in New Hampshire for the winter." Second, a genetic cause honed over millions of years that induced the warbler to respond to external stimuli and gain a selective advantage over warblers that did not migrate. Third, an internal physiological cause that propelled the bird to leave once the number of daylight hours dropped below a certain level. And last, an external physiological cause reflected in a sudden drop in temperature on August 25th. The warbler was already physiologically ready for migration, and this sudden cold wave made it leave that day. Mayr called the first two explanations ultimate causes and the latter two proximate causes.
In business, proximate causes of share price movements include macroeconomic news, stock market fluctuations, hot categories (i.e., if EVs are favored by investors, then prices of all EV businesses go up), and company-specific changes like management changes.
Investors should ignore all proximate causes when analyzing a business and focus on ultimate causes, i.e., business fundamentals.
What I Learned About Investing from Darwin is a fun read for long-term investors.
