[#23] On "What I learned about investing from Darwin"

Simplicity is the ultimate sophistication

Hey! Welcome to Marginal Futility. Here, I share interesting things I come across, especially related to business, finance and tech. You can find my previous posts here.

You can subscribe below to join 1,000+ readers who receive updates directly in their mailbox. No spam, ever! :) You can also follow me on Twitter here.

---

I, like many others, have tremendous respect for Nalanda Capital - one of the best performing public markets fund in India for more than a decade.

I had the good fortune of learning a course called "‘Applied Value Investing” from Mr. A.N. Seshadri of Nalanda during my MBA and was thoroughly inspired and impressed by his (and the fund’s) thought process. I am also an avid reader of Mr. Anand Sridharan’s always educational and often fun blog. So when Mr. Pulak Prasad, founder of Nalanda Capital, published a book earlier this month, I didn’t want to waste any time in picking it up.

In this book, Pulak marries his two interests - investing and evolutionary biology, and talks about principles which hold true not only in investing, but life. They say history is the best teacher; and evolutionary biology is in a way, the broadest history possible of life on Earth.

…

I found the book a very instructive read, largely because of how each idea sticks better when you see it sticking around for centuries and millennia from an evolutionary lens. Below, I share a few lessons I learnt from this book.

…

Lesson 1: Minimize Type 1 errors

…All investors make two (kinds of) mistakes. The first kind—dubbed a type 1 error…occurs when I make a bad investment because I erroneously think it is a good one. It 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 one type of error leads to a higher risk of the other error. Minimizing Type 1 error means keeping a very high bar for investments and being overly cautious, which would mean you would miss out on some good investments. Minimizing Type 2 error means being highly optimistic, which would mean committing to some bad investments. So which error to minimize?

Pulak offers a good framework to think about this.

• There are around 4000 companies listed in US. Let’s say 25% of these companies, i.e. 1000, are of good quality and hence, investable (This is important, the number of good investable companies has always been, and will always be, lower than the number of bad companies)

• Let’s say you are a savvy investor who is right 80% of the time. If you come across a bad investment, you will reject it 80% of the times (20% Type 1 error). And if you come across a good investment, you will invest in it 80% of the times (20% Type 2 error)

• Now, when you make an investment decision, what is the probability of it being correct? As we saw, there are 1000 good investments. You will reject 20% of them, and hence you will have 800 good investments in consideration set. You will also have 600 bad investments (20% of 3000) in consideration set. Probabilty of making good investments is 800/1400 i.e. 57%

• Hence, despite being right 80% of the times, the probability of you making a good investment is 57%

• Now for the crucial part - focusing on Reducing type 1 error has the highest positive impact on your success rate. For all those thinking, why not reduce type 1 and type 2 error both - not only is it quite difficult to practice, it also offers very marginal benefits

(Note: The earlier version of this article had an error in the above table, which I have now corrected. The irony of making an error in a table depicting impact of reducing errors!!)

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.

…

Lesson 2: Don’t ignore base rates

“People who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.”

- Daniel Kahneman

When you are making forecasts, let’s say for investing, there are two things you can do.

The first one, and the more common one, is focusing on an issue, gather necessary information, search for evidence based on your experience and specific knowledge etc. This is called the “inside view”. You ask the question - “What will happen in this situation?”

The second way is to consider the outcomes of a relevant reference class. This is called the “outside view” or looking at “Base rates”. You leave aside your own personal experience and specific knowledge, and instead ask the question - “What happened to others when they were in a similar situation?”

There are some patterns which keep on repeating.

Pulak gives the example of the airline industry. The base rate of airlines earning above their cost of capital has been low, across time periods and geographies. So if you come across an airline stock, you could either use the first approach of developing an “inside view” and seeing why this stock will be different for most other airlines. Or you could simply reject evaluating the idea basis the “outside view”. You may probably end up missing on some good investments, but remember, the idea is to minimize Type 1 errors.

…

Lesson 3: Be a permanent owner aka do nothing

The most counter-intuitive fact about things that compound is that nothing seemingly happens for a very long time. This seemingly hidden impact for a long time pushes investors into action; which often becomes detrimental to performance.

An underappreciation of compounding…makes fund managers value IRR more than the multiple (of capital invested), instead of the other way around.

If a stock doubles in four years, its IRR is 19 percent and if it doubles in three, its IRR is 26 percent. For the same multiple (of capital invested), the shorter the period, the higher the IRR. Ignoring the beauty of compounding, investors like to boast about the IRR of their investment while undervaluing the benefits of the multiple.

If we own a high quality business, the share price will most probably (but not assuredly) react positively over the long run. Second, the share price will rarely make big moves, and if I am not invested in the stock on those particular days, I can bid farewell to substantial potential gains.

Pulak says that if valuation is the only reason to sell, don’t sell at all. But what about shares trading at very high valuations? Does it make sense to keep on holding them? Isn’t it contradictory to maintaining a margin of safety?

While the book answers this question, I will reference the blog post by Anand “Favourite holding period is forever” to describe Nalanda’s thought process.

There are three pre-conditions that need to be met for this method to even stand a chance of working.

Pre-condition 1: Long term horizon

No matter how outstanding a business, valuation correction will be an inevitable headwind to returns. Quantum of headwind, in annualized terms, is inversely proportional to duration. A material correction is an insurmountable headwind even over medium-term, but a modest one over decadal timeframes

Pre-condition 2: Selectivity, bordering on absurdity

What can offset a (modest) valuation headwind? Certain compounding. Both words matter. I am more concerned with certainty, than magnitude, of compounding. This requires real inputs to be in place: trustworthy focused prudent people, analysable attractive industry, well placed company gaining within its domain, wide moat, high return on capital, no distractions or big M&A, disciplined capital allocation.

Pre-condition 3: Paranoid, no bluffing reassessment

The only way to not take ‘outstanding’ for granted is to integrate paranoia into process. Obsessively track not just absolute performance, but relative performance at granular level, including against unlisted peers. Done well, we should catch any material slip-ups well before they become more broadly apparent. A corollary to my earlier statement is: if irredeemable business problems arise, sell without fussing about valuation. No unconditional love, ownership or ‘outstanding’ tag.

Everything so far sounds extreme, starting with ‘hold forever’. Interpret forever as indefinite, not infinite. Conditionally indefinite.

---

At the beginning of the book, Pulak says:

What you will discover in the following pages is a description, not a prescription. Instead of saying, “This is what you should do,” the book says, “This is what we have done.”

As I read the book, I was reminded of the quote by Rory Sutherland - “The opposite of a good idea can also be a good idea.”

• Nalanda looks at historical performance as a way to assess attractiveness and robustness of a business. Someone else might focus on turnarounds and still do well

• Nalanda loves stable, predictable businesses and stay largely away from fast changing industries like technology. Someone else might be better at picking on new trends and still do well

• Nalanda believes in being a permanent owner and hence doesn’t sell unless business fundamentals deteriorate. Someone else might be better at gauging momentum plays and still do well

Perhaps, the key is to find what works well - for you, consistently - while being respectful to base rates.

---

---

Interesting things I read this week

1. The Real Competition is the Water by Ravi Gupta

   Every morning in Africa, a gazelle wakes up. It knows it must run faster than the fastest lion or it will be killed. Every morning in Africa, a lion wakes up. It knows it must outrun the slowest gazelle or it will starve to death. It doesn’t matter whether you’re a lion or a gazelle. When the sun comes up, you’d better be running.

2. Fighting Entropy by Jack Raines

   Entropy isn’t some singular moment separating life and death. Entropy is a process, and entropy wears many masks. Entropy is procrastination, envy, apathy, and malaise. Entropy is the antithesis of excitement, and it’s the opposite of opportunity, optimism, and effort.

---

Thank you for reading! Please share this post with people who you think would find it interesting :)

You can also follow me on Twitter here.

(Disclaimer: The views expressed in this blog are mine; and do not represent the views of my employer.)