What I Learned About Investing from Darwin

by Pulak Prasad

In 2017, Warren Buffett admitted on CNBC’s Squawk Box that he should have invested in Amazon. I have no such qualms. I know that I would have missed Amazon in the past, and I will miss an Amazon-like business in the future. So be it. The only saving grace of this failure? I doubt I will see another Bezos in my lifetime.

In our profession, getting the correct answer is easy. But, unfortunately, asking the right question is not.

6. However, applying the principle of convergence is tricky because we humans can see patterns where none exist. We can also miss out on one-off opportunities like Amazon that seem to defy the convergent notion that focus is the key to success.

Fechheimer is exactly the sort of business we like to buy. Its economic record is superb. . . . 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 people we will be joining. Warren Buffett, annual letter to shareholders, 1985

If you are as ardent a fan of the National Geographic channel as I am, some of or all the following scenes should be familiar to you. A male lion roaring to assert his dominance over a pride; female baboons with their bright sexual swelling indicating their readiness to mate; bees performing their waggle dance to show the direction and distance of flowers; a female elephant caressing her calf to soothe him; a deep-sea squid emitting light to attract prey; and a meerkat squealing to warn her family of a predatory eagle. All these are examples of signals, and no textbook on evolutionary theory is complete without a lengthy discussion on them.1 Signals emitted by a “sender” have explicitly evolved to alter the behavior of the “receiver” and are used to communicate with and influence the behavior of prey, predators, mates, competitors, friends, and family.

Plants are masters of deception. Since they can’t run or hide, many of their survival strategies involve deceiving other plants or animals. Some of the best examples—or worst, if you happen to be a wasp—are certain species of Australian orchids.4 Australia has about 1,400 species of orchids, and around 250 of these have adopted the same strategy of deceiving male wasps to enable pollination.

While I call myself an investor, an evolutionary biologist would not be remiss in branding me a “signal decoder.” The only things investors can rely on to assess a company are the signals emitted by it—some direct and others indirect, some comprehensible and others bizarre, some ongoing and others delayed, and some quantitative and others qualitative.

Have you ever read management interviews that claim they aren’t innovative, don’t have the best business leaders, aren’t “leveraging” technology, aren’t customer focused, don’t treat their employees well, don’t listen to shareholders, make bad capital allocations, and ignore the value of making “sustainable” investments? I haven’t.

Excellence is rare in this world, including the business world. You just won’t know it if you are relying on management interviews. I am not saying I don’t read (or listen to or watch) interviews of business leaders. I do. But I read them for the same reason I read articles on Brexit, running, films, and the latest Trump tantrum: to gossip with friends, to pass the time on a Sunday afternoon, and for general interest in our fascinating world. Not for investing.

Road shows are a scaled-down version of these conferences during which the company management typically visits investors at their offices. Since most investors have offices in large cities like New York, San Francisco, London, and Tokyo, a company can usually meet six to eight investors in a single day. What do you think most company managers want when they meet investors? They want the investors to buy their stock so that the share price moves up. Are they likely to present a balanced view of their business? It would be easier to believe in Santa Claus.

I am not suggesting that all of GE’s problems resulted from its guidance culture, but I think it played a significant role. When business managers are hyper-focused on meeting quarterly numbers, their long-term orientation takes a back seat; when a company is desperate to make an acquisition just to meet its earnings, it can overpay for a bad asset; when a manager is unable to speak the truth about accounting obfuscations, they pile up over time.

Why were so many experienced investors blind to the problems that Munger had highlighted publicly? Why could Munger correctly predict Valeant’s demise without meeting Mike Pearson when many of Valeant’s board members and investors continued to be passionate supporters? My hypothesis is this: Mike Pearson was a fantastic salesperson. Correction. He was probably one of the best salespeople to have enamored Wall Street. The smartest people lost their sense of judgment when faced with Mike Pearson’s persuasive skills. Valeant’s honest signals of its myriad problems remained undetected or ignored in the light of the dishonest signals emitted by Mike Pearson in face-to-face meetings, which by definition were cheap to produce.

Jamie Dimon of JPMorgan, Mark Zuckerberg of Facebook, Jack Dorsey formerly of Twitter, Tim Cook of Apple, Elon Musk of Tesla—all these business leaders regularly attend their companies’ quarterly calls. Let’s take a concrete example. Chevron, one of the world’s largest oil companies, had revenues of about $140 billion and a market value of about $190 billion in 2019. The management held a conference call for investors and analysts on January 31, 2020, to highlight its performance.20 The analysts and investors asked twenty-nine questions. What percentage of these do you think were about the future? More than 70 percent.

An honest signal is not “our margin will be 15 percent next year” but “our average margin was 12 percent over the last ten years”; an honest signal is not “we will have robust free cash flows starting two years from now” but “we generated free cash flow only one year in the last decade”; an honest signal is not “we will launch six new products next year” but “in our recent history, we have launched an average of one product every two years.” No stories, no projections, just facts about the past.

“The business ‘grapevine’ is a remarkable thing. It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company.” Truer words have rarely been uttered.

There is almost never a clear winner in the arms race between the senders and receivers of signals in the natural world. You may have heard of cuckoos leaving their eggs in the nests of other bird species so that someone else can rear their chicks. The signals here are the size, shape, and color of the cuckoo egg, which match those of the eggs of some other bird species. However, scientists have found that some of the parasitized bird species have not allowed themselves to be exploited—they have evolved to produce eggs that are distinctly different, even compared to eggs of their own species.24 As a result, they recognize cuckoo eggs as interlopers. They have evolved a way to detect the dishonest signal from cuckoos. This race has no winner, and there will probably never be one. In sharp contrast, in the business world, the senders of signals—the companies—are clearly winning over the receivers—us, the gullible investors. No wonder our community performs poorly compared to the broader market. What should we long-term investors do?

A green frog mimicking the low-pitched croak of its larger rival is a dishonest signal, whereas the conspicuous coloration of a male guppy is an honest indicator of its health and virility.

We rely exclusively on honest signals from businesses that, as in the natural world, are costly to produce. These include past operating and financial performance and scuttlebutt signals from suppliers, customers, competitors, ex-employees, and industry experts.

They cooked their meals in a small cave protected from the harsh sun by a sheet of cloth. Once settled, they would spend the next six months measuring the body size, beak size, and beak shape of every finch on the island. They would also extract blood to do a genetic analysis. Why would anyone in their right mind spend time on such an island? Because it offered many advantages that few other places could.

The Grants published the results of their long-term study of the evolution of the two species of finches—fortis and scandens—in Science in April 2002 under the title “Unpredictable Evolution in a 30-Year Study of Darwin’s Finches.”8 Before starting their research, they had hypothesized that the body traits of the finches would vary within a narrow band over the period of the study. But as they say at the beginning of the article, “The data do not support the expectation of no change.”

There is a lovely fractal-like property to this phenomenon. It does not seem to matter if the measurement period is thousands of years (bears) or just a few decades (finches). The pace of evolution speeds up over shorter periods and slows down over more extended periods.

My observations are nowhere as scientific as the Grants’ or Kurtén’s. However, I know that the daily, weekly, monthly, and quarterly rate of change in exceptional businesses appears much greater than the rate of change measured over years and decades. This realization has helped me formulate an investing principle that I call the Grant–Kurtén principle of investing (GKPI). It goes as follows: When we find high-quality businesses that do not fundamentally alter their character over the long term, we should exploit the inevitable short-term fluctuations in their businesses for buying and not selling.

We are highly demanding. We want a company to be run by an honest management team, and show solid operating and financial track records over many years. It needs to stay ahead of the competition and be debt free, and we also want it to keep taking calculated risks while not unduly burdening the business. And, as if all these demands were not enough, we dare to insist on a fair price for these rare gems! How is this even possible? The market should almost never offer us an attractive price for such a business, and it doesn’t.

However, on rare occasions, investors who don’t subscribe to GKPI succumb to the pressure of temporary macro, industry, or company issues, and we can then swoop in to buy a piece of an exceptional company. It doesn’t—and shouldn’t—happen often, but when it does, we go all in.

GKPI is our religion. And it reflects in all kinds of big and small ways in the way we work. Our office doesn’t have a TV screen playing CNBC or any other news; our lone TV screen is used only for video conferencing. The only Bloomberg terminal we have is in the corner of our office pantry; it remains unused and unwatched probably 99 percent of the time. We never discuss recent company news or share prices in our team meetings. I mainly read physical newspapers, in which the information is always one day late. We have never bought or sold a single business based on news flow and never will.

We sell under the following three conditions (the numbers in parentheses indicate the number of businesses sold): 1. A decline in governance standards (0) 2. Egregiously wrong capital allocation (3) 3. Irreparable damage to the business (6) We have sold ten businesses since 2007 (the nine listed here plus the mistake). I am excluding three businesses that strategic buyers acquired. This translates to one exit every one and a half years. How’s that for laziness? As you can see, six of our nine exits occurred because we believed the business had been damaged beyond repair. And how did we come to that conclusion? An example can clarify.

We have capitalized on the inevitable short-term fluctuations in high-quality businesses to invest at attractive valuations. However, since these opportunities arise infrequently, we rarely ever buy. We are lazy. 5. After investing, we ignore near-term fluctuations because the fundamental characteristics of stellar businesses remain stable over the long term. We never sell on valuation—we are very lazy.

Why should not Nature have taken a leap from structure to structure? On the theory of natural selection, we can clearly understand why she should not; for natural selection can act only by taking advantage of slight successive variations; she can never take a leap, but must advance by the shortest slowest steps. Charles Darwin, On the Origin of Species, chapter 6, “Difficulties of the Theory”