What I Learned About Investing from Darwin

by Pulak Prasad

Nalanda’s investment philosophy can be summarized in ten words: We want to be permanent owners of high-quality businesses.

On the other hand, in some cases, as with the elephant and rhinoceros, none are destroyed by beasts of prey; even the tiger in India most rarely attacks a young elephant protected by its dam. Charles Darwin, On the Origin of Species, chapter 3, “Struggle for Existence”

Almost everyone—and I say “almost” because this statement does not apply to my wife—makes mistakes. These errors fall into two broad categories: We do things we are not supposed to, and we don’t do things we are supposed to. For me, buying a hot fudge sundae at McDonald’s falls into the first category, and not keeping in regular touch with my school and college friends falls into the second.

The goal of all animals is to survive for as long as possible, at least until they reproduce. In the animal world, everyone is both prey and predator. Yes, even we, the Homo sapiens. How are we prey? Remember COVID-19?

Let’s now turn our attention to the predator. The predator, too, can make two types of error: It can commit itself to killing prey that turns out to be too dangerous or too large or too fast (type I error), or it can refrain from attacking prey that it could easily have killed (type II error). Which error do you think a predator makes more often? A cheetah is the fastest mammal on Earth and routinely achieves speeds of eighty to one hundred kilometers per hour while chasing prey.6 It sacrifices size and bulk for speed. A cheetah typically weighs 34 to 54 kilograms (75 to 120 pounds), which is significantly less than a lion, whose weight typically ranges from 170 to 230 kilograms (375 to 500 pounds). Hence, a cheetah usually preys on smaller animals like birds, rabbits, and small antelopes. A cheetah will never attempt to kill an adult water buffalo, a favorite prey of lions. The cheetah is simply trying to avoid getting hurt. Committing a type I error will lead either to death—water buffalos can turn on their hunters aggressively—or wasted energy—when a cheetah chases an antelope that was too far away to begin with. These mistakes, in turn, will lead to hunger and poorer hunting performance.

era about 490 million years ago, and there are about 400,000

Unlike animals, the dramas of whose lives play out on African safaris, on wildlife TV channels, and in children’s books, plants may seem uninteresting, sedate, peaceful, and “inactive.” Nothing could be further from the truth. Look closely, and you will notice that the life of a plant, in many ways, is more exciting and action-packed than that of almost any animal. Paradoxically, this is because plants can’t move. If they are malnourished, they can’t move to a different location to feed; when attacked by herbivores, they don’t have feet to run or claws to fight back; when infected by pathogens, they can’t be offered treatment and cuddles like we humans can.

Before we go any further, allow me a slight digression to get the definition of “risk” out of the way. The definition I use in this book is not the same as the one defined by corporate finance theorists. Finance theory claims that risk is the chance that the actual investment return will differ from the expected investment return.12 Thus, if an asset is highly volatile, it will be classified as riskier than an asset that is not as volatile. If you think about this for a moment, you will conclude that this is nonsensical. For any investor, risk should simply be the probability of incurring a capital loss.

Thus, whereas most investment books and college curricula focus on teaching how to make good investments, everyone would be better off by learning how not to make bad investments. An investment career is probably among the very few that rewards the skeptic more than the optimist. Buffett is the best investor in the world because he is the best rejector in the world.

Imagine a tennis match in which Roger Federer is playing John, who is ranked 500 in the world. I ask you to bet 5 percent of your wealth on John winning the match. You refuse (I hope). But John wants you to bet on him. And so, before the match starts, in a face-to-face meeting with you, John makes an impassioned plea to ignore his ranking and recognize his innate talent. He speaks eloquently and makes a slick PowerPoint presentation on his plan to defeat Federer. John says he has been watching Federer’s game very closely for the past two years, and his plan, he believes, is exemplary. To bolster his claim, John invites one of the leading tennis coaches in the world, who admits that John’s plan is laudable and that he has a real chance of beating Federer. It’s decision time for you. Would you bet 5 percent of your wealth on John?

After many years of investing, I realized that I needed to focus as much, if not more, on the company’s balance sheet. Receivables, inventory, payables, fixed assets. And most important of all, debt. Corporate finance theory has a thing for leverage. For those of you who are not familiar with it, finance academics claim that companies need to have an “optimal” level of leverage to improve returns.18 If a company can borrow money to purchase assets, its return on equity and earnings per share should improve. Mathematically, this is undoubtedly true. Realistically, this is undoubtedly dangerous.

Which brings me to the second reason I detest any debt. This answer is often underappreciated and even ignored by investors and management. It is this: Debt diminishes strategic flexibility and hence long-term value creation. For a day trader or even an investor whose holding period ranges from three to five years, a reasonable amount of leverage may not matter. But for a permanent owner like Nalanda, any constraint that prevents a business from taking calculated strategic bets is undesirable.

Here are the statements made by the CEOs of AOL and Time Warner when they announced their $350 billion (!) merger on January 10, 2000. Stephen Case, the cofounder of AOL, proudly proclaimed, “This is a historic moment when new media has truly come of age.” Not to be left behind, Gerald Levin, the CEO of Time Warner, gushed philosophically that the internet had begun to “create unprecedented and instantaneous access to every form of media and to unleash immense possibilities for economic growth, human understanding and creative expression.” The result of this bromance? The largest failed merger in the history of the corporate world.23 Within two years, AOL took a write-off of $99 billion on the deal. Yes, “billion” with a “b.” The market value of AOL went from $226 billion in 2000 to $20 billion in 2002. In June 2015, it was acquired for a mere $4.4 billion by Verizon.

The second major opportunity cost is a reduced focus on existing businesses because of the distraction of a bad acquisition. You can see this in Bayer’s annual reports of 2018, 2019, and 2020, in which a lot of ink was expended on justifying the acquisition and on steps being taken to mitigate the disaster. As usual, numbers tell a better story, as I will explain next.

When we started Nalanda in 2007, there was a lot of buzz around a company called Eicher Motors led by a young, dynamic guy called Siddhartha Lal. Lal had inherited a hodgepodge of poor-quality businesses from his father in 2004. They manufactured motorcycles, footwear, garments, tractors, trucks, auto components, and a few other products, and none was an industry leader. In a remarkably bold strategic move, Lal decided to divest thirteen of the fifteen businesses to focus on just two products: trucks and motorcycles.30 Almost every analyst was gung ho about the future of Eicher; they were all taken in by its dynamic leader who was aggressively culling businesses, something that Indian firms rarely did. However, in 2007, this was a turnaround story with no empirical evidence of success. The company’s biggest hit, the Enfield Classic motorcycle, was launched only in 2010. We decided not to invest in the business. By the 2010s, the company’s motorcycles had taken on cult status in the Indian consumer’s mind. Sales exploded from just 52,000 units in 2009 to 822,000 units in 2019: a sixteen-fold growth. If you had listened to what we had to say about the business, you would not have invested. Your opportunity loss? Seventy times your money from 2007 until 2021. Tesla and Eicher Motors are the kinds of type II error we will inevitably commit because we reject highly indebted businesses, rapidly evolving industry landscapes, and turnarounds.

The team found that the bumblebees soon started committing more type II errors: they started avoiding flowers even where there were no spiders, thereby reducing their foraging efficiency. In the wild, this instinct to avoid danger at the cost of going hungry must have played a significant role in the tremendous success of the species over millions of years. If the bumblebee can, why can’t we?

For every company, you see a gazillion pieces of information on tap: revenue growth, profit growth, debt level, margin profile, stock price movement, analysts’ views, bond ratings, Twitter commentary, shareholder information, top management résumés, conference call transcripts, annual reports, quarterly filings, media coverage, competitor profiles, shares bought or sold by senior management, receivable and inventory levels, CEO statements, Reddit threads, hedge fund ownership, and so much more. And all this is just at the company level.

Here is a stark example. If you have time, I suggest watching the YouTube video of the January 2000 presentation by the president of Enron, Jeffrey Skilling, and his senior management on the launch of Enron Broadband.2 I dare you not to be impressed. The guys are poised, confident, and, at least to my eyes, extremely competent. It is hard to find fault with their strategy or vision, and their execution plan for broadband services seems spot on. However, in less than two years after this impressive presentation, Enron went bankrupt, and in 2006 Skilling was sent to prison for perpetrating a massive fraud.3 Except for a few short sellers, no professional analysts or investors could have guessed what was going on at Enron even though the management was quite open to the media and regularly gave interviews. I know what you are thinking. Am I building my entire case on an outlier like Enron? Let’s look at it another way. I assume you have read the interviews of many CEOs or company presidents. Did any mention that they don’t care for the customer, that they have stopped innovating, or that they hire people who have been rejected by other companies? Have you ever heard a company leader disparage their products or services or admit that their competition is doing a better job or that they are sick and tired of company politics?

You will rarely—if ever—learn anything insightful from what the management says. They always say what they have been taught to say, which at best is useless and at worst is harmful, because, as with Enron, their words are persuasive. In my experience, when someone says, “This is a great management team,” what they are actually saying is, “These guys talk so well!” The “great management team” filter thus fails the first criterion of measurability (being easily measurable).

Many high-growth companies don’t burn equity for growth but rely on debt instead, which is even worse because debt holders need their money back with great regularity, unlike equity investors.

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. This was an audacious guess since most scientists then assumed that physical morphology was the unit of selection. How could Dmitri test his bold theory? Only by going back to the time when animals first started becoming domesticated. For dogs, this would have meant experimenting on wild wolves. But getting a supply of wolves would have been very hard in Siberia, so he chose the silver fox. He designed a selective breeding experiment that focused only on tameness as the selection factor.

In 1974, Lyudmila decided to raise the experiment’s stakes by living with the foxes in the same house. To start, she chose a friendly fox called Pushinka. One evening, Lyudmila was sitting on a bench outside her home with Pushinka relaxing next to her as usual. Suddenly, Pushinka got up as if she had heard something and started barking. It turned out to be the night guard, and Pushinka stopped her aggressive posturing and barking when she realized that the guard posed no imminent danger to Lyudmila. This guard-dog-like behavior—rushing to protect a human from a potential threat—had never been observed before by Lyudmila.

Do you now see why using operating margin to filter businesses may not be the best approach? Margins do not tell us what we had to invest to get those margins. The advantage of measuring ROCE is that it accounts for the quality of P&L (in the numerator) as well as the balance sheet (in the denominator). Let’s return to Costco and Tiffany.

High ROCE is a lot like tameness in the Siberian silver foxes. Just as tameness brings with it a curly tail, piebald fur, and floppy ears, a high-ROCE business ushers in many attributes relevant for an owner like us at Nalanda. Here are some examples. A Consistently High-ROCE Business Is Likely to Be Run by an Excellent Management Team What? “Excellent management team” again? If we can’t measure it directly, why am I sneaking it in indirectly? Just because we can’t measure management quality through interviews and discussions does not mean quality management teams do not exist. Of course they do. What we need is not some airy-fairy impression of an investor made over a coffee (or a Zoom call) but a quantitative measure.

We should expect the following from a quality management team. That they deliver products and services to their customers that are superior to those of their competitors, allocate capital prudently, attract and retain quality employees, manage their cost structure (which is commensurate with their size and revenue), maintain a quality balance sheet, and continuously innovate by taking calculated risks. All this should—and does—correlate with high ROCE.

But here is the thing. We would have looked at this lost opportunity and not regretted it one bit. I know we will lose Netflix-like businesses, and I am okay with it. Our strategy of selecting only high-ROCE companies for our initial list invariably excludes some potential winners, but it also excludes hundreds of low-quality businesses that we would never want to own. Thus, on average, I believe this approach works well for us. We will not change our approach just because others have made money with a strategy that we have chosen to avoid. C’est la vie.

Not only is the experiment still ongoing, but Lyudmila Trut, who is now almost 90 years old, is still active! And not only is she active in the institute, she is also publishing path-breaking scientific articles. Herbeck was kind enough to attach four research articles published by Lyudmila Trut (and others) in prestigious scientific journals in recent years. The latest one was published in the Journal of Neuroscience on July 14, 2021, and is titled “Neuromorphological Changes Following Selection for Tameness and Aggression in the Russian Farm-Fox Experiment.” I used to feel proud that we have been successfully investing for over fifteen years. No longer. After reading about Lyudmila Trut, who has maintained her passion, discipline, and excellence over more than sixty years, I am confronted with a stark and painful reality. We have a very long way to go.

Moreover when a modification of structure has primarily arisen from the above or unknown causes, it may at first have been of no advantage to the species, but may subsequently have been taken advantage of by the descendants of the species under new conditions of life and with newly acquired habits. Charles Darwin, On the Origin of Species, chapter 6, “Difficulties of the Theory”

We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. Warren Buffett, annual letter to shareholders, 1983

One of the greatest wonders of this world is this: Living things are highly resistant to internal and external changes while simultaneously possessing the ability to evolve.2 Let me call this ability to function well despite internal and external disturbances “robustness.”

We need to make a brief foray into one aspect of the history of molecular biology to unravel the paradox. In 1968, the Japanese geneticist Motoo Kimura proposed the “neutral theory” of molecular evolution.8 Kimura contended that most changes at the level of DNA and amino acids do not impact the function of a molecule and hence the organism’s ability to survive and reproduce. He contended that a small number of mutations are favorable, and natural selection preserves them. Some mutations are rejected because they are harmful, but most mutations don’t really affect the organism. According to Kimura, most mutations are neutral, which causes robustness in the organism. So how does neutral mutation lead to evolution? While a neutral change does not alter the primary function, it can alter a secondary function, thereby becoming the source of a future innovation.

It has changed without changing. This is what we seek as owners in our businesses: the ability to keep evolving while staying robust.

Robustness Takes Many Forms How does an investor measure robustness in a business? I wish I had a simple quantitative answer. I don’t. Like almost everything in investing, the solution is somewhat subjective, somewhat vague, and somewhat controversial. But it works for us.

After graduating from college, Walton started in sales at J. C. Penney in 1940, then enlisted for the war in 1942. In 1945, he started managing a franchise Ben Franklin store in Newport, Arkansas (where the population was then seven thousand). By 1950 he was running two stores in Newport and had achieved reasonable success by experimenting and innovating. One of his innovative ideas that had been a massive hit with his customers was an ice cream machine. As he writes in his autobiography, “Every crazy thing we tried hadn’t turned out as well as the ice cream machine, of course, but we hadn’t made any mistakes we couldn’t correct quickly, none so big that they threatened the business.”

In 2000, Walmart joined hands with a leading Silicon Valley investment firm, Accel Partners, to launch Walmart.com. Accel, by the way, gained much fame (and a gargantuan fortune) as a result of its $12.7 million investment in an early-stage company called Facebook in 2005.16 In about eighteen months, in mid-2001, Walmart acquired the minority stake of Accel to own Walmart.com fully. By 2020, Walmart’s e-commerce sales had climbed to $24 billion and Walmart.com was approaching 10 percent of Walmart’s overall U.S. sales. What had started as a “neutral” strategy in 2000 is now fast becoming the centerpiece of Walmart’s approach to gaining market share.

success is solely the result of its slow-and-steady approach to growth and expansion. Walmart has undoubtedly flourished for many reasons. Apart from Sam Walton being the founder, though, I don’t know what other factors have led to its success. I can rattle off a list of things from various business books and articles written on Walmart, but I don’t know if they were the cause or the effect of its success. But I do know that taking calculated risks and staying robustly healthy have had a strong correlation with its accomplishments over sixty years.

Dinosaurs, a diverse group of more than a thousand reptilian species, dominated our planet for 180 million years.17 As a matter of comparison, we Homo sapiens have been around for less than 0.2 million years. Dinosaurs couldn’t have survived and thrived for so long unless they were highly robust and adaptable. Molecular evidence has shown that many modern mammalian orders—Carnivora, Primata, Proboscidea—coexisted with dinosaurs for at least 30 million years during the Cretaceous period (145 to 66 million years ago), and maybe even earlier. The mammals during the era of dinosaurs were small, squirrel sized, and probably insectivores. If aliens had landed on our planet 65 million years ago, they never could have predicted that a small offshoot of the insignificant mammalians would reign supreme one day.

The chapter is titled “ ‘Margin of Safety’ as the Central Concept of Investment.” Graham knew that the corporate world is highly uncertain and that the best protection offered to an investor is the price they pay for a business.

We do the best we can to choose businesses based on their current and potential degree of robustness. But bad things will happen—we just don’t know what, when, or how. And so we turn to the one aspect of investing that is entirely within our control: the price we pay.

We want our businesses to mimic the robustness of the living world: to survive and prosper in a dynamic external environment, withstand internal strategic and organizational upheavals, and evolve by taking calculated risks. 5. Hence, we choose to invest only in businesses that are robust at multiple levels. A robust business has high ROCE, minimal or zero debt, a strong competitive advantage, fragmented customer and supplier bases, a stable management team, and is in a slow-changing industry. 6. Just because a business is robust today does not mean it will continue to be so. Our only protection against the loss of robustness of a business is to be price sensitive. We do not invest unless the market offers us an attractive valuation, which happens rarely.

In the broad scheme of things, I think we financial investors are irrelevant to this world. Darwin wasn’t.

Charlie and I have many reasons to be thankful for our association with Chuck and See’s. The obvious ones are that we’ve earned exceptional returns and had a good time in the process. Equally important, ownership of See’s has taught us much about the evaluation of franchises. We’ve made significant money in certain common stocks because of the lessons we learned at See’s. Warren Buffett, annual letter to shareholders, 1991

Convergence is ubiquitous and not limited just to the external appearance or morphology of animals. It is also widely observed and documented in animal behavior and in plants, fungi, and even bacteria. Let’s start with behavior. What do you think these four species—a cobra, a stickleback fish, an octopus, and a spider—share? There is no convergence in body form here, unlike the Caribbean anoles. But a behavior has converged among them that has led to the success of each of their species: the females of the species guard their eggs. One of the best examples of convergent behavior is observed in humans and—hold your breath—ants! And I have witnessed this convergence with my own eyes. When I was on a family vacation in the stunningly beautiful Peruvian Amazon, I stumbled upon the tiny creatures that had beaten our human ancestors to the discovery of agriculture by many millions of years: the leafcutter ants. I had waited years to witness the miracle, and there it was in its full linear glory. A long single column of thousands of large green leaves appeared to be miraculously moving in perfect synchrony of their own volition on the forest floor. Each large leaf was being carried by a single tiny ant, who purposefully disappeared underground to pass on the booty to her specialist sisters. These ants chew the leaves to grow a fungus garden used for food for the entire colony. Not unlike human farmers, these ants produce fertilizers (amino acids and enzymes) to aid the fungal gro...

And just as agriculture helped us become the dominant species on this planet, leafcutter ants have become the dominant herbivores of the New World: They consume close to one-sixth of all leaves produced in tropical forests. Humans and leafcutter ants have solved their food problems by converging toward a similar solution, crossing time and species boundaries.

Let’s move on to plants. Most of us have had coffee, tea, and chocolate (derived from cacao). The Brazilians among us will be familiar with the drink Guaraná Antarctica, made from the guaraná plant in the Amazon rainforest. All four plants produce the same chemical desired by humans: a purine alkaloid called 1,3,7-trimethylpurine-2,6-dione—in short, caffeine.9 These four plants may seem to be closely related, but they aren’t. The common ancestor of tea and coffee dates back a hundred million years. Cacao is more closely related to maple and eucalyptus trees than to tea and coffee. Bizarrely, the ancestor of coffee gave rise to potatoes and tomatoes but not tea! Plants have many defense mechanisms against predators, and it appears that some have converged toward the same solution: producing caffeine. Many plants rely on birds to pollinate their flowers. So if a plan...

Convergence in nature symbolizes a profound fact: There is a pattern to success and failure. What can the Caribbean anole, the crest-tailed marsupial mouse, and caffeine teach us about investing? Convergence in business symbolizes a profound fact: There is a pattern to success and failure.

The questions I should have asked but did not were as follows: “Sure, credit card penetration is low in India, but so is penetration for every consumer product. What other consumer products in India have seen these growth rates over the long term? Do you have examples of other countries where we have seen such rapid credit card growth? If so, was their stage of development similar to India’s today?” I should have demanded a convergent template, but I didn’t.

Daniel Kahneman is one such individual. His masterpiece Thinking, Fast and Slow should be compulsory reading for all investing 101 classes. If you are already an investor, there is no more valuable chapter to read (and re-read) than chapter 23, “The Outside View.”

Given a choice between applying their intellectual horsepower to a single business by making a ten-year projection of profits or stepping back and asking if any of it even makes sense, brilliant folks often choose the former. As I was transitioning from consulting in my early investing days, I was the biggest believer in the myth that more work produces better answers for investors. It doesn’t.

I don’t know about the rest of the world, but in India, a married person inherits their spouse’s family. Whether they like it or not. The likelihood of getting along with your spouse over the long term is relatively low if you don’t like your spouse’s first, second, and occasionally, even third cousins. For the record, my in-laws are the best. Investing in companies is no different. Buying into a business means also buying into the industry of that business. For example, while I may think I am investing in a company that makes and sells sanitaryware, I am inheriting all the good and the bad of the sanitaryware industry. No company is an island. We can never ignore the kinds of businesses that surround it.