What I Learned About Investing From Darwin - Book Summary

What does Evolutionary Biology and Private Equity Investments have in common?

Charles Darwin revolutionized biology with his theories of evolution. He observed how species competed for natural resources and reproductive opportunities. Certain physical and behavioral traits allowed beneficial characteristics to continue in the species and others to die off.?

In this book, Pulak Prasad pulls from elements of evolutionary biology to inform how he invests in companies at Nalanda Capital.

My Top Points:

#1 Use the single selection criteria when choosing companies to invest in.

Dmitri hypothesized that the key factor selected when our ancestors domesticated wild animals was tameness. Thus, the unit of selection was not related to an animal’s physical attributes but to its behavior.?- Pulak Prasad

An evolutionary biologist named Dmitri Belyaev performed a revolutionary experiment in the 1960s. He began with a hypothesis that trait selection in evolutionary biology extended beyond genetically passed down physical attributes. He believed nature could also select for behavioral attributes. This is a bit counterintuitive because Darwin’s theory of evolution largely rests on the premise that nature selects beneficial physical traits which enable organisms to survive and compete against others. In this experiment, Dmitri captured wild foxes and proceeded to breed them based on their perceived tameness and domestic tendencies. With each generation of new foxes, as Dmitri continued to breed those showing domestic behaviors, he observed them beginning to show behaviors and physical traits similar to domesticated dogs. This included tail-wagging, floppy ears, and snarling at intruders (protective behaviors) when entering his home. All these behaviors and traits came about after selecting for a single trait, tameness.?

How does this relate to finance??

When investors are deciding what company to invest in, they should also start with a single trait, Return on Capital Employed (ROCE). ROCE = Net Operating Profit / (Shareholder’s Equity + Long-term Liabilities). Put plainly, ROCE is the return from a business’s operating activities which exclude financing or investing incomes. This metric is a measure for how profitable a business’s core operations are. It indicates how well the company’s equity and liabilities are being put to work.?

Prasad explains, companies with consistently high ROCE are doing many other unrelated things right. He believes a consistently high-ROCE business is likely to:

• Be run by an excellent management team
• Have a strong competitive advantage
• Allocate capital well

By choosing to invest in companies with consistently high-ROCE, compared to others in their respective industry, you become a beneficiary of several other positive effects.

#2 Be skeptical of future estimates and the use of Discounted Cash Flows. The past is a better predictor of success.

We prefer demonstrated consistent earning power (future projections are of little interest to us, nor are “turn-around” situations). - Warren Buffett, annual letter to shareholders, 1982

Charles Darwin, the father of evolutionary biology embarked upon a voyage to the Galapagos Islands to study many species. On this voyage, through his many studies and observations, he developed a theory that all living organisms descended from a small number of sources. He came to this conclusion by studying the minor differences between species and how many can be grouped. He studied the fossils and history of many species and came to the conclusion that an organism's ability to pass its genes to the future was dependent on its success in the past to navigate the complexity of sexual selection. Darwin made the case that the success of an organism’s species is based on its history, not potential to survive in the future.

How does this relate to investing??

Prasad makes the case that investors should look only at historical performance of a company when choosing to invest. More specifically, he warns against using complex formulas like Net Present Value which utilizes a discounted cash flow method to calculate the cost of using capital today. This formula uses estimated future cash flows as a predictor for success. This simply does not align with Prasad’s investment philosophy. He believes that most estimated future cash flows are educated guesses at best. Our world is becoming increasingly complex making estimates more difficult.?

Like Darwin, he believes one should look at the historical performance of a company as a predictor for future success.?

#3 Pay attention to honest signals, ignore the dishonest.?

The sexes of many animals incessantly call for each other during the breeding season; and not in a few cases, the male endeavors thus to charm or excite the female. This, indeed, seems to have been the primeval use and means of development of the voice, as I have attempted to show in my “Descent of Man”. - Charles Darwin, The Expression of Emotion in Man and Animals

Fechheimer is exactly the sort of business we like to buy. You may be amused to know that neither Charlie nor I have been to Cincinnati, headquarters for Fechheimer, to see their operation… if our success were to depend upon insights we developed through plant inspections, Berkshire would be in big trouble. Rather, in considering an acquisition, we attempt to evaluate the economic characteristics of the business - its competitive strengths and weaknesses - and the quality of the people we will be joining. - Warren Buffett, annual letter to shareholders, 1985

Sexual selection is competitive. In nature, male animals use signaling to communicate and persuade potential female partners to select them for sexual reproduction. Prasad explains how male green frogs croak to attract mates. When female frogs hear very deep and loud croaks, they naturally believe it is coming from a large healthy male. A frog’s reproductive success is dependent on the quality of his croak. Knowing this, over time smaller frogs developed the ability to decrease the frequency of their croak, thus increasing their chances of reproductive success. Many female frogs are tricked into believing the croak heard from a distance came from a large male only to find it is small. This is considered a dishonest signal but it worked to the advantage of the sender.?

How does this relate to investing??

Like small frogs, companies send both honest and dishonest signals about the health and quality of their business operations. Prasad argues there are very few honest signals sent by companies. Dishonest signals are cheap and easy while honest signals are expensive and hard.?

Dishonest Signals:

• Press Releases - These events are highly curated and carefully constructed by large marketing teams. Management generally tells you what they want you to know, not the truth.
• Management Interviews in the Media - Business leaders have been highly trained on what to say and what not to say in interviews. You will likely never hear much bad news from management that would help you make better investment decisions.
• Investor Conferences and Road Shows?
• Earnings Guidance - Estimations of future performance provided by a company are generally overly optimistic.
• Face-to-Face Meetings with Management - Business leaders are notoriously charismatic. Investors are often fooled by highly charismatic leaders.

Honest Signals:

• Past Operating and Financial Performance - Past balance sheets, income statements, and cash flow statements are the most honest signals produced by companies. They are audited by way of federal regulations.
• Voice of the Company’s Customers - Customers are generally very honest. Dissatisfied customers look for the opportunity to complain. Pay attention to the feedback of customers from the company’s you plan to invest in. They will provide an honest signal on the operations of a company.

Thanks for reading this edition of Waller’s Reading Room! If you enjoyed it or have thoughts, you can reply directly to this email and let me know. Don’t forget, I’m always taking recommendations, let me know what I should read next.

Yours Truly,

Omar Waller