What I Learned About Investing from Darwin

by Pulak Prasad

“Rule number 1: Never lose money. Rule number 2: Don’t forget rule number 1.”

Would you bet your life on your next investment?

“betting your life” is a remarkably sound strategy for investing and how adopting this approach has led to the spectacular success of all living organisms over millions of years.

Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.

a type I error1 by statisticians who can never be blamed for being creative—occurs when I make a bad investment because I erroneously think it is a good one. It is the error of committing self-harm and is also called a false positive or error of commission.

A type II error occurs when I reject a good investment because I erroneously think it is bad. This is the error of rejecting a potential benefit and can be termed a false negative or error of omission.

Minimizing the risk of a type I error typically increases the risk of a type II error, and minimizing the risk of a type II error increases the risk of a type I error.

Investors can’t have their cake and eat it, too! They need to choose to be more sensitive to making one type of error while living with the consequences of making more errors of the other kind.

The goal of all animals is to survive for as long as possible, at least until they reproduce.

Let’s start with the prey. What would be a type I error for a prey animal? It would equate to inflicting sufficient harm on itself to compromise its fitness.

From the fossil record, we know that the deer that we see today evolved from ungulates about fifteen to thirty million years ago.3 They have survived millions of years amid ferocious predators by being very sensitive to making type I errors—errors of not being too careful. If they weren’t so, the species would have become extinct.

A type I error of underestimating a threat could be the last error one of these animals makes.

Stags have found great evolutionary success because at each stage of the contest, they minimize the error of committing self-harm:

In some cases, a type II error may turn out to be a fatal mistake. A thirsty deer may not be able to run quickly enough to escape a predator, and an overcautious stag may not get to pass his genes on to the next generation. But on average, making this trade-off in favor of reducing the number of errors of self-harm while tolerating a higher number of errors of rejecting potential benefit has worked quite well for the species.

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).

Deer and cheetahs do not manufacture complex decision-tree diagrams with associated probabilities to make decisions in their lives. These animals do what they do because natural selection has honed their instincts over countless generations. Natural selection among animals is incessant and merciless and has produced millions of species, all of whom adhere to this simple principle: Minimize the risk of committing type I errors to curtail the risk of injury or death, and learn to live with type II errors or foregone benefits.

Plants can choose to commit resources broadly to two areas: defending against attacks or growing.

Since the lack of a proper defense may prove fatal to a plant, a type I error, or an error of commission, occurs when the plant does not devote resources to protecting itself. A type II error occurs when a plant directs energy toward preservation when it should have invested in growth.

when there are few or no insects, we should expect trichomes to be tiny or nonexistent. But when there is an insect attack, to reduce the risk of a type I error (erroneously investing in growth instead of preparing defenses), we should expect the plant to start making trichomes.

Within a few days or weeks following an insect attack, trichome density can increase from 25 to 1,000 percent!

An indirect defense works on the simple principle that “my enemy’s enemy is my friend.”9 It works simply—and beautifully—like this. When a plant senses an insect attack, it releases some chemical compounds from its leaves, flowers, and fruits into the atmosphere. These chemical compounds attract predators of the insects attacking the plants.

Plants, like animals, have found a way to their spectacular evolutionary success by focusing on reducing their errors of commission. In other words, like their animal counterparts, they avoid taking risks to their life and well-being at the cost of giving up some potentially juicy opportunities.

Avoid big risks. Don’t make type I errors. Don’t commit to an investment in which the probability of losing money is higher than the probability of making money. Think about risk first, not return.

As Buffett’s diktat shows, he is focused on minimizing risk and, in doing so, has become the envy of the entire investment world, which seems obsessed with running after every half-baked business idea.

The relative impact of reducing each type of error is quite stark,

A dramatic improvement in performance comes only when the rate of type I errors—errors of making bad investments—is reduced.

Our philosophy of permanent ownership requires—demands—that we partner only with promoters of the highest integrity.

The new CEO usually comes with an impressive resume, and many are highly qualified. But we don’t bet on these turnarounds either. An exceptional CEO was impressive in a certain context with a certain business—this context and this business are different. How are we to know that the new CEO, faced with a set of challenges they have almost certainly never met before, will do what they are promising to do? We don’t.

If we could not predict the fate of turnaround efforts at what appeared to be slam-dunk cases (IBM and JCPenney), what hope do we have in situations that don’t seem so clear cut? The corporate world is brutally competitive. Even the best companies have to run hard just to stay in the same place. How could the probability of success at a troubled company be anything but minuscule? And if so, why would we indulge in the fantasy?

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.

Bad things happen to businesses at remarkably regular intervals. The harsh reality of companies in any capitalist society—and the reason to always have cash—is not that things can go wrong, but that they do go wrong.

In my experience, only when the financial risk is low can management focus on mitigating business risks.

A strong balance sheet is not the one that maximizes debt to minimize the cost of capital but the one that minimizes debt to maximize the safety of capital.

“I skate to where the puck is going to be, not where it has been.”27 I am not one of them. I am just not that smart. In fast-changing industries, I have no idea who will win, when, or how.

We at Nalanda love stable, predictable, boring industries. Give us electric fans over electric vehicles, boilers over biotech, sanitaryware over semiconductors, and enzymes over e-commerce. We like industries in which the winners and losers have been largely sorted out and the rules of the game are apparent to everyone.