10 lessons from Darwin for 20% yearly returns
From evolution to investing
Nature is brutal.
So is trying to beat an index fund! But there might be ways to go about this.
Pulak Prasad has linked his love for evolution with his investing approach and even wrote an entire book about it (“What I learned about investing from Darwin”).
But before diving into his lessons, who is Pulak Prasad?
Pulak runs Nalanda Capital. Since 2007, Nalanda has achieved a yearly return of 20% after fees. I think their website description says it best:
We consider ourselves to be permanent (part) owners of high-quality publicly listed businesses run by exceptional people. We invest exclusively in small to mid-cap companies in India where we aim to be a large (typically the largest after the founding family), friendly (active, without being activist) and long term (ideally, permanent) shareholder.
Nalanda was launched in May 2007 and its LPs are primarily US Endowments and Foundations, and US and European Family Offices. Nalanda is currently closed to new investors.
His shareholder letters often contained stories derived from evolution and biology. This is where the book found its origin.
In this article, you’ll discover:
The Nalanda investing strategy
10 lessons from Darwin
Conclusion
The Nalanda investing strategy
Pulak’s strategy is simple but hard to execute:
Avoid big risks
Buy high-quality companies at a fair price
Be lazy, very lazy
This also means, they rarely trade. Nalanda was a net buyer in:
2008
2011
2020
You probably guessed what these years have in common, a (significant) downturn in the market. Suddenly, high-quality companies were also available at a great price.
To emphasize this, the average trailing P/E at which they bought their holdings was 14.9. Their portfolio currently trades at a P/E of 49.
When we look at a couple of quality companies in the market right now:
He wouldn’t buy Dino Polska at a P/E of 22 (Dino has never traded this low)
He wouldn’t buy a Visa at a P/E of 31 (it had a PE of 16 at the end of 2010)
And he certainly wouldn’t buy Costco at a PE of 54 (it reached a PE of 15 in 2009)
This strategy works, but you need loads of patience to execute well. Or as Pulak says, be very lazy.
Let’s dig deeper into his investment philosophy and the link to evolutionary theory.
10 investing lessons from Biology
Lesson 1: The Bumblebee
Learnings from evolution
The following experiment was done on Bumblebees. In 2008, scientists created a garden of artificial flowers. Some of these flowers contained robotic spider crabs. When a bumblebee landed on a flower with a spider crab, it was temporarily captured.
What happened?
The bumblebee started avoiding more and more flowers. In other words, their foraging efficiency decreased, to increase their survival rate.
Has it worked? Well, they have been around for 30 million years.
Application to investing
Avoid big risks
Follow Buffett’s 2 simple rules:
Rule 1: Never lose money
Rule 2: Don’t forget rule n°1
The behavior of the bumblebee can be seen time and time again in different species. From the statistical hypothesis, there are 2 types of errors:
Type 1 error: Error of commission, making a bet and losing
Type 2 error: Error of omission, not making a bet and losing as in “Why didn’t I put all my money into Nvidia all those years ago”
In nature, a type 1 error can lead to death. The investing world is less harsh.
It is better to make many type 2 errors instead of type 1. Or again as the master so eloquently writes:
You don't have to swing at everything – you can wait for your pitch."
- Warren Buffett
This means to only trade on a fat pitch. It is now the end of August. In the last 8 months, how many trades did you make?
Lesson 2: The Silverfox
Learnings from evolution
In Siberia under the reign of Stalin, genetics was deemed a pseudoscience. After being fired (and luckily not executed as others had Dmitri Belayev continued his research into genetics in secret. He wanted to understand how animals had become domesticated by man. Secondly, he wanted to know why domesticated animals share similar traits (like spotted skin and flappy ears). Silver foxes were bred by selecting only one single trait: tameness, a behavioral trait!
After only 6 generations, signs of other traits were becoming visible. By selecting a behavioral trait and breeding with the foxes that displayed this trait, others were expressing themselves.
Incredibly, this experiment started in 1959, and is still ongoing!
Application to investing
Start your selection of a high-quality business using 1 metric only. Use a metric that conveys multiple layers of high quality and results in other traits that could signal a quality business. Nalanda uses Return On Capital Employed (ROCE > 20%) as its single metric.
It’s an easy way to filter out a lot of businesses.
What are the traits you get for free by breeding using this single metric?
A company with a consistently high ROCE:
is likely to be run by a great management team
is likely to have a strong competitive advantage
allocates capital well
Sounds good to me!
Lesson 3: Sea Urchins
Learnings from evolution
Sea Urchins have evolved over millions of years. They have weathered much by staying robust at multiple levels. Each time, adapting to their niche environment.
Application to investing
Invest in businesses with multiple levels of robustness. High ROCE, low debt, wide MOAT, etc. Not only are they better armed at withering a storm, but they usually have more opportunities to evolve, create a new business line, or expand.
The only way to protect against a loss of robustness is a margin of safety.
Lesson 4: Dung Beetle
Learnings from evolution
The evolution of dung beetle horns can be explained by asking proximate questions (which gene was expressed, the HOW questions) and ultimate questions (WHY is that type of horn more valuable than another one?)
Application to investing
Focus on ultimate causes (historical fundamentals) instead of proximate causes (the macro, interest rates, …) to understand the value and price attributed to a business.
Ignore the rates, the macro, and the headlines in the news.
Lesson 5: The Peacock
Learnings from evolution
Why would a male peacock endanger itself with such an ornamental tail? This was once again one of the great insights by Darwin. Natural selection through sexual selection. By being chosen more often to mate, its species multiplied. Darwin discovered this by carefully examining the facts of the past.
Evolutionary biology does not make predictions. It aims to understand history.
Application to investing
Only use historical data. Understand the present based on this. Do not try to predict the future. It’s difficult to forecast the next 2 years, let alone develop a DCF model that spans a decade.
He claims DCFs are truly useless. We wrote about this in the past
He looks at the past to inform him about the present. If the analysis shows that the business is of high quality, he will buy at a PE lower than the relative market. The current trailing PE of the S&P500 is 27. So you could imagine buying a company at a PE of 20 but of higher quality than the overall market. He will rarely spend PE’s of high teens or low twenties on price. Remember, the average PE of the Nalanda portfolio was 14.9.
Lesson 6: Bacteria
Learnings from evolution
Unrelated organisms develop the same solutions to similar problems/environments.
If life evolved on another planet in the solar system with similar conditions to Earth, would it look similar?
There are only so many ways one can fly. To swim in the water, certain characteristics need to be uniformly developed.
This is called convergence. It has been observed across different species in different regions on our planet.
But there are exceptions. Experiments have been run on bacteria like E. Coli. Convergence has been observed until suddenly, a mutation. The bacteria had changed!
Application to investing
Convergence also exists in the business world. Look for patterns of success and failure instead of single businesses.
There are 2 main questions one needs to ask.
What is the outside view?
How is the business prospered elsewhere?
The outside view comes from Kahneman and is related to base rates. Humans are notoriously bad at predicting anything.
But remember the mutation
Convergence is the dominant pattern in the business world
On rare occasions, it isn’t
One such rare occasion in business?
Lesson 7: The Guppy
Learnings from evolution
The sender of a signal attempts to influence the behavior of the receiver. In nature, there are honest and dishonest signals. A green frog mimicking the croak of a large rival is dishonest. The bright red coloration of a healthy guppy is honest.
Application to investing
If a signal costs nothing (press release, interviews) it can be dishonest. If a signal costs a lot to produce it is probably honest (high ROCE). Only take into account honest signals in your analysis.
Lesson 8: The Brown Bear
Learnings from evolution
A Finnish scientist, Bjorn Kurten, plotted the evolution of the length of the second lower molar of the brown bear in Europe during the Pleistocene epoch (2.6M to 11,000 years ago). The rate of change of these molars was quick when measured over a shorter period, and longer over a long period.
Evolution can be fast over shorter periods and slow over longer ones.
Application to investing
Businesses seem to change a lot or not, depending on your time frame. 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. So Prulak devised the Grant Kurten principle of investing (GKPI)
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 business for buying and NOT selling.
During short timeframes, there can be opportunities to buy high-quality businesses at a great price. These are rare, so buying is rare. Selling is even more rare. Be lazy.
Only sell when there are:
A decline in governance standards
Egregiously wrong capital allocation
Irreparable damage to the business
Lesson 9: The Whale
Learnings from evolution
The picture shows different whales over different timeframes. What is observed is that evolution sometimes skips a beat. It is not always gradual.
Evolution occurs in a punctuated equilibrium. A whole lot of stasis with short bursts of change. Stasis is the default state
Application to investing
Great businesses stay great. Weak businesses stay weak. There is stasis. Profit from price fluctuations. Do not confuse them with business quality fluctuations.
Lesson 10: The Rabbits
Learnings from evolution
In Australia, 24 rabbits became 10 billion in 66 years. After 55 years, it didn't look like a problem. We’re talking about 40 rabbits per square kilometer. Once the population reached 10 billion, the fauna and flora in Australia suffered.
Application to investing
Understand compounding. For a long period, it will seem nothing is happening. Then, it all happens in an instant. Doing nothing while seemingly nothing is happening is hard.
Summary
What Pulak did is remarkable. We can call this “focused quality investing”.
Here’s the summary. You can also download it through the button.
I may have made the “mistake” myself of buying a great company at a PE above 20. A quality investor need only worry about business performance and multiple compression if he bought it at a higher price.
So I was wondering, let’s take some of the best companies in the world. When did they last trade at a PE of 15?
Indeed, as Pulak says, one must be very lazy!
Further reading
There’s a great article written by a fellow Substacker who visualizes the Nalanda portfolio. Check it out!
Go to the Nalanda website to see all their holdings. (all of them in India of course)
https://www.nalandacapital.com/category/portfolio/
And one last article on how to avoid losing money. A topic I would like to explore more:
I hope you liked traveling back in time through evolution.
As always, may the markets be with you!
Kevin
Interesting article, interesting and fun.
Wonderful read, I am definitely going to contemplate on this one