What I Learned About Investing from Darwin

by Pulak Prasad

Stags have found great evolutionary success because at each stage of the contest, they minimize the error of committing self-harm: They do not even attempt to duel until they have big enough antlers, and even after acquiring their deadly weapons, they refuse to engage until they believe they have more than a fair chance of winning.

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.

So here is the unfortunate conclusion. Even if an investor is endowed with the divine power of being right 80 percent of the time, the probability that he will select a good investment is only 57 percent. Even though he is “right” 80 percent of the time, 43 percent of his investments will turn out to be bad! The reason is simple, especially when we incorporate our prior knowledge of the business world: There are very few good investments in the market. Let me repeat this statement, which is the bedrock of our philosophy and that of the rest of this book: There are very few good investments in the market.

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.

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. For everything else, thanks, but no thanks.

We eschew a very long list of risks. This is the core element of our investment strategy. We don’t invest in businesses run by crooks, we detest turnarounds, we stay as far away from leverage as possible, we refuse to engage with M&A addicts, we can’t figure out fast-changing industries, and we don’t align ourselves with unaligned owners.

What about total capital employed? This typically comprises two factors: net working capital and net fixed assets. In the net working capital number, we like to exclude excess cash (i.e., cash minus debt if cash happens to be much greater than debt) because extra cash is not an operating asset.

Thus, ROCE for nonfinancial companies can be defined as follows: EBIT ÷ (net working capital + net fixed assets)

We don’t vote for the best cricket bowler, best running back, or best marathoner based on their interviews or their ability to articulate their excellence, so why should we do it for management teams? The best bowling statistics and the best finish times determine the best bowler and the best marathoner. Similarly, in my view, an excellent—but not the only—indicator of the quality of the management team is their historical track record on the quantity of ROCE.

When it comes to gauging competitive position, barring some exceptions, there is almost nothing better than measuring market share of volume, revenue, and profit over a long period.

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.

“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.

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.

We use the principle of convergence across many other areas of business apart from assessing industry attractiveness. We use it much more often to figure out what not to do.

avoid at all costs: 1. Those owned and run by crooks 2. Turnaround situations 3. Those with high levels of debt 4. M&A junkies 5. Those in fast-changing industries 6. Those with unaligned owners

And herein lies Zahavi’s lesson for us investors: Lend credence only to those signals from companies that are costly to produce.

4. As investors, we, too, are bombarded with signals, many of which are dishonest. Examples include press releases, management meetings and interviews, investor conferences, and earnings guidance. All these signals attempt to favorably impress investors and are generally quite easy to produce. We ignore all of them. 5. 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.

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. GKPI demands that we be lazy when buying and very lazy when selling. And so we are. It has led to some decent outcomes for

Contrary to the expectations of Darwinism, evolution can be faster when measured over shorter periods and slower over longer periods. Björn Kurtén demonstrated this phenomenon in the evolution of the teeth of European brown bears. 2. High-quality businesses, too, seem to undergo many changes when measured over days or weeks or months but are much more stable when the period of measurement is years or decades.

I have divided this section into four parts, each of which separately asserts that great businesses remain outstanding and that inadequate businesses continue to underperform. Of course, none of these sections makes an infallible argument (hey, this is investing, not linear algebra).

The summary of all this research on industry and market concentration is as follows: 1. There are a few large and successful firms in most industries. 2. These successful companies are becoming even more successful. 3. Weak companies are getting weaker.

We presume guilt until innocence is proven; our starting hypothesis with every business is that we don’t want to own it. As you have seen throughout this book, a business needs to jump through several hoops before we choose to be permanent owners in it.

A world intent on swiping left and right at breakneck speed probably finds it very hard to notice a marriageable candidate even when that candidate has been staring at them for decades. That gives us a competitive advantage we never asked for and probably didn’t deserve.

During this period of hyperactivity from March to May 2020 we were often asked, “Why aren’t you waiting for things to get worse before buying?” My answer was, “We can’t.” We have a straightforward rule that is also easy to implement: Buy when the price is right. Unfortunately, not everyone follows this rule. As implied by the question, a widely practiced rule is to buy when the time is right. That is also a straightforward rule, but is it easy to implement? We follow the former because we know the price we want to pay for the business we want to own. It may or may not be the “right” price, but we know it for sure. We have no way of figuring out the right time.

Now that everyone could understand. Intellectually, this was a much simpler assertion to understand than Darwinism because it could be “visualized”—Darwin’s gradualism couldn’t be. The world of investing is eerily similar. Everyone seems to know that the stock price of AMC, a movie theater chain, tripled in May 2021, but how many know that Home Depot’s multiplied 140 times over thirty years from 1990 to 2020?

As I said, the bigger mystery of compounding is not that it leads to large numbers but that it doesn’t do so for a long time.

90 percent of the gain of 1,270 percent came in just thirty-five days. Those thirty-five days account for only 1.3 percent of the total number of trading days during which we held Havells. What if we had sold Havells during one (or more) of those very few days? Those thirty-five days are distributed across all years.

One of the most famous questions posed by Yaksha is, “What is the greatest wonder in this world?” Yudhishthir’s reply is, “Everyone sees countless people dying every day, but they act and think as if they will live forever.” Yudhishthir’s insight was that we are strangely blind to a fact that is blindingly obvious. For us, the Yaksha Prashna would be, “What is the greatest wonder in the world of investing?” With due apologies to Yudhishthir, my answer is, “Everyone sees immeasurable wealth being created by people who never sell, but they think and act as if it is selling that creates wealth.”

A consistent pattern was present throughout all ten chapters of this book. Did you detect it? Our entire investment approach at Nalanda admits to, and hence compensates for, our profound ignorance: • We avoid many categories of risks because of the wide range of possible outcomes in these situations. • We invest only in exceptional businesses because most businesses fail, and we want to reduce uncertainty. • We buy at an attractive valuation because, while we don’t know what will go wrong, we assume that something will. • We rarely buy, and sell even more rarely, because every activity may have unintended consequences we can’t foresee.