Book Talk on the day Darwin began writing his monumental work
"What I Learned About Investing From Darwin"
Hello everyone, today I'm going to talk about a book that excites me immensely. I really wish I could have read this book a few years earlier, but unfortunately, it has only been published recently. This book is called "What I Learned About Investing from Darwin."
If you have heard me talk about the book "Scale," you would know that a company is a living entity and can be analogized to a biological organism. Therefore, if we want to understand the laws of corporate development, effective academic experience is most likely to come from evolutionary theory.
The author of this book is an Indian investor who founded an investment company called Nalanda. To date, Nalanda manages assets of over 5 billion US dollars, with very generous returns. If you had invested 1 Rupee in Nalanda in 2007, by 2022, you would have received 13.8 Rupees, a 13.8-fold increase in 15 years.
What convinces me most about this book is that all its investment philosophies are based on mathematics. Only if you have a deep understanding of mathematics can you believe this. Because the most reliable things in this world are likely related to mathematics. The author spent 20 years reading various books related to evolutionary theory, so all his investment principles come from the evolutionary principles of biological competition. He summarizes a few very simple principles in the book.
First, their goal is to become permanent shareholders of high-quality enterprises. The book states: "We want to be permanent owners of high-quality businesses." Then, Nalanda's three investment principles, which sound very simple. The first principle is called avoiding major risks. Buffett said that the first rule of investment is never to lose money, and the second rule is to remember the first rule. This might sound like a joke to everyone, as we all definitely don't want to lose money. Why say such an obvious thing? This is not an obvious thing. Many people, when investing, only think about making more money and forget about not losing money.
The second principle is called buying high-quality stocks at a reasonable price. The third principle is called not buying easily, and even more so, not selling easily. These are Nalanda's three basic investment principles, all derived from evolutionary theory. So the interesting thing about this book is that half of its content is very interesting biological knowledge, and then it tells you the relationship between this biological knowledge and investment.
Section I: Avoid Big Risks
First, Chapter 1 talks about avoiding major risks. There are two types of errors in investing. The first type of error is making an investment mistake, for example, you buy a company's stock, and the company eventually gets delisted. The second type of error is missing out, meaning a company's stock rises significantly, but you didn't buy it, so you missed the boat. Which of these two types of errors is more serious? If you don't understand evolutionary theory, you might think these two types of errors are the same. But the difference between these two types of errors is significant.
The author believes that we must reduce the probability of making the first type of error but allow ourselves to make the second type of error. Because it's impossible for you to pick every stock that skyrockets. If you give up pursuing stocks like Tesla, you will find that your investment risk is significantly reduced. How is this principle derived?
First, from a biological perspective, all organisms that have survived to this day are extremely sensitive to the first type of error. That is to say, organisms must first learn to preserve their lives; this is very important. As we know, after an adult male deer grows large antlers, it must "fight" with other males to compete for mating rights with female deer. But if you observe carefully, you will find that the frequency with which they use their antlers to fight is not as high as we imagine. Before the mating season, what is their first move? Roaring at each other. It's like two stags "singing a high-pitched song," and whoever's song is not as high-pitched as the other's withdraws. This way, they don't have to fight, their lives are not in danger, and the winner is decided just by "singing."
If "singing" cannot determine the winner, the stag's second move is even more amusing: walking side by side. Two stags walk competitively side by side, and the one whose gait appears less imposing, less powerful, or less charismatic will feel inferior and eventually withdraw. This is their way of competing. If the second move still cannot determine the winner, and neither side is willing to withdraw, only then will the stags symbolically lock antlers and fight. But very few stags will lose their lives to compete for mating rights. Their goal is to determine the winner as much as possible without losing their lives.
So, animals in the biological world have various ways to protect themselves from injury. If a certain type of animal doesn't know how to protect itself, it will quickly become extinct. For example, after humans arrived on the Australian continent, because many animals on the Australian continent had never encountered humans, they were not afraid of humans at all. Eventually, you find that a large number of species disappeared.
Cheetahs live on the African savanna and run very fast, but if you observe them, you will find that cheetahs never eat water buffalo. Why? Because if a water buffalo gores it just once, it's finished. Only lions dare to risk eating water buffalo, while cheetahs will never attack water buffalo because the risk is too great. So, we learn from animals not to do high-risk things.
Plants are the same. Everyone knows that if a plant wants to secrete toxins, it requires a huge amount of energy. It needs to mobilize most of its energy to secrete toxins. Why? To save its life. It would rather spend a high cost to save its life. This is a principle of biology.
So how to avoid the first type of investment error? First, stay away from criminals, fraudsters, and big talkers. If you find that the company you want to invest in has financial fraud, then don't consider it anymore; directly remove it from your investment plan because it is dishonest. Don't even touch dishonest companies or those run by big talkers.
Second, refuse to invest in companies in transitional difficulties. If a company is changing its CEO, or the industry the company is in is currently undergoing a major reshuffle and faces the possibility of being disrupted, or the company is trying new profit models, these are all companies in transition. Companies in transition may have huge risks that are difficult for you to predict.
Third, learn to "avoid debt." What does avoiding debt mean? Don't invest in highly leveraged, highly indebted companies. Because high leverage and high debt mean their room for choice is very small, with basically no room to maneuver. So don't invest in companies that are heavily in debt; it's best to choose companies with no leverage and a lot of cash on their books. Because enough cash represents strong strategic flexibility.
Fourth, stay away from acquiring companies. Why? Mergers and acquisitions (M&As) can cause large fluctuations in stock prices, but the success rate of M&As is extremely low. Research data shows that 70% to 90% of corporate M&As end in failure. So, for companies that are like M&A maniacs, although their stock prices may seem to be rising well, you need to be careful. If their M&A fails, big problems will arise.
What is the most important characteristic of an excellent company, do you know? It's called "uneventful." The operating process of an excellent company is very boring, just like an elephant that hasn't evolved for a long time; it's always been this way. If you invest in an elephant-like company, you can rest assured investing for many years because it is uneventful year after year. Although it looks boring, this is a typical feature of an excellent company.
The book cites the case of Bayer's acquisition of Monsanto. Monsanto is a company that produces crop seeds (and is also a US agrochemical giant), and Bayer is a pharmaceutical company. After Bayer acquired Monsanto, what was the most serious loss it caused? It's called opportunity cost. Because after acquiring Monsanto, a lot of integration work was needed, and a large amount of capital was needed for internal management. As a result, the COVID-19 pandemic occurred at this time. During the COVID-19 pandemic, other large pharmaceutical companies like Bayer launched vaccines in a short period and made profits of tens of billions or even hundreds of billions. But Bayer made no move because it had acquired an "indigestible" Monsanto company and was working hard on internal integration. So, being too fond of M&As is not a good thing.
There is one more thing to remind everyone: don't predict ways to make money. What does "don't predict ways to make money" mean? For example, someone says they recently invested in a project, and this project will have such-and-such potential in the future, and the market will be this big. Everyone, these are all uncertain things; these may all be imagined. So the author says there are so many good companies in the market that are like money printing machines and have been making a lot of money for many years, yet you don't buy them. Instead, you try to predict that this company will be the next Tesla. What if it isn't? If it isn't, it's very likely that the money you invested will be completely gone. So, ways to make money are not predicted.
Moreover, people's excessive prediction of ways to make money will lead to a large number of bubbles in the capital market. Everyone still remembers the IT bubble crisis in 2000, the real estate crisis, and various derivative crises. These are all because people are desperately trying to predict ways to make money. And stability is truly predictable. You see a company that has made so much money continuously for 30 years, then it's highly probable that it will still make that much money next year. This is the most reliable thing. But what is its biggest problem? It's boring.
You see, in our daily lives, we often encounter someone excitedly saying, "I invested in NVIDIA last year," or "I invested in NVIDIA five years ago." They feel very excited and happy because this is the current mainstream topic. But few people will boast to you that they made so much money by investing in Walmart. Because investing in Walmart provides relatively stable returns. People are more easily influenced by stimulating topics and news and are willing to predict those possible ways to make money. This is a very dangerous thing. Because there are more companies that fail, more companies that do not succeed, and more companies that have not figured out how to survive.
The last point is not to cooperate with companies that "fail to treat everyone equally." What does this sentence mean? For example, this company's profits are very good, but the company's profits are obtained by long-term exploitation of employees, and it has many labor disputes. Don't invest in such a company, because you will have to pay off the debts it owes. This is the main content of the first part of this book: avoid major risks and learn to protect yourself.
Section II: Buy High Quality at a Fair Price
Next, the entire second part talks about how to buy high-quality companies at a reasonable price. The first experiment in this section is about geneticists training foxes in Siberia. What were they studying? How to domesticate foxes and observe how many generations it takes for foxes to be domesticated and exhibit dog-like characteristics. The results showed that it doesn't take too long. As long as you find a certain indicator in foxes and continuously select for it, after several generations of selection, they will exhibit dog-like characteristics, such as wagging their tails at people. Wild foxes never wag their tails at people, but after several generations of training and selection, foxes began to wag their tails at people.
Foxes also gradually developed droopy ears, like puppies, their ears would hang down; these are all signs of being friendly. And surprisingly, foxes even developed black and white patches on their bodies, just like the Border Collies we see, with black and white patterns on their bodies. Generally, mammals with black and white patterned fur are relatively close to humans. Why? Because when their relationship with humans improves, it affects the secretion of melanin in their bodies, so they develop black and white patterned fur. Being able to train black and white patterned foxes is too interesting.
From this experiment, we learned one thing: there is a "select one, get many free" principle in biology. What does "select one, get many free" mean? As long as you grasp and control one core indicator, it will bring about a large number of derived changes. That is to say, when they were selecting foxes, they were not selecting for curly tails, not for droopy ears, nor based on the body's melanin secretion, because these are all derivative indicators and uncontrollable. There was only one trait they selected for, which was the degree of closeness between the fox and humans (willingness to approach humans). As long as you make selections based on this single trait of willingness to approach humans, over a long period, you will find that all sorts of traits are expressed. This is called "select one, get many free."
So when we select stocks, we also need to find a single indicator that can bring about changes in derivative indicators. At this time, your workload will be greatly reduced. I know many fund managers who, before selecting a company, often have to do market research, chat with the CEO and senior executives, and understand the channels. This author says Nalanda never does such things. Why? Do you think you can get signals by chatting with the CEO? You are very likely to be deceived because CEOs are always very optimistic about their own companies. Do you think you can get signals by chatting with channels? You are very likely to hear noise because what you see is only partial information. After doing a lot of research on derivative indicators, you may still not grasp the essence of this company.
For Nalanda, this company has a single-stage filter, which means they mainly look at one indicator: Return on Capital Employed (ROCE). Students who have studied finance can go back and study carefully what Return on Capital Employed means. You can also find it online; the English abbreviation is ROCE. Of course, the author also says that there is no sure-win business in the world. A high Return on Capital Employed only means that this company is more likely to be a good company, but it does not mean it is 100% a good company.
The Return on Capital Employed of the companies Nalanda invests in are all higher than 42%. What does higher than 42% mean? It means this company is like a money-making machine, like a printing press constantly printing money. The minimum standard for Return on Capital Employed they set is 20%. And there is another very important term, "historical." You cannot just look at one year; you must look at the Return on Capital Employed for at least five years, which is the company's operating profit as a percentage of the total capital employed. This profit refers to profit before tax. The total capital employed usually includes two parts: one is net working capital, and the other is net fixed assets. So this formula is very simple: you use the pre-tax profit divided by net working capital plus net fixed assets. If the calculation result is greater than 20%, it is a company worth investing in.
Why choose this indicator as the core indicator? Because this indicator takes into account both the income statement and the balance sheet. Its numerator represents the income statement, which is the company's ability to make money, and the denominator represents the company's safety and capital situation. For example, Costco, this company, has a profit margin of only 3%, while Tiffany's profit margin is 19%. If you compare them solely based on profit, Tiffany is clearly higher than Costco. But if you use Return on Capital Employed to calculate, Costco's Return on Capital Employed is 22%, while Tiffany's is only 16%. So Costco's capital availability is better than Tiffany's.
The inventory turnover period for goods in Costco warehouses and retail stores is usually 31 days. Now, please guess, what is Tiffany's approximate inventory turnover period? The answer is 521 days. When you can grasp such a core indicator, just like the person domesticating foxes grasped the indicator of the fox's friendliness to humans, you will find that other indicators change accordingly. If you want to improve the Return on Capital Employed, your company needs to be good in all aspects, especially to maintain it for many years, which is very difficult to fake. This is the first principle we talked about, called continuously maintaining a high Return on Capital Employed.
Next is the robustness principle. When this author first started working, it was at McKinsey. At that time, McKinsey paid extremely high salaries to recruit people in India, twice as high as the highest-paying companies in the Indian market at that time. So those outstanding young people joined McKinsey without hesitation. Twenty to thirty years have passed since then, and the market environment has changed dramatically. For consulting firms that sell case studies and experience, what they need most is consistency and stability. The market environment has changed so much that everyone thought McKinsey could no longer survive, but McKinsey is still doing very well. Why is it doing well? Because it is constantly evolving and changing. Many small consulting firms have already closed down, but such a large firm as McKinsey is still alive. Why? The reason is that organisms naturally have strong vitality. As long as a living organism is alive, it has vitality itself.
Vitality is reflected in the balance of two indicators: one is called "too robust," and the other is called "not robust enough." You see, all living things, including plants and animals, evolved from macromolecules in a primordial soup back then. If this macromolecule were too robust, what would happen? It would remain unchanged to this day; it would still be a macromolecule, and such a rich world would not have appeared. If this macromolecule were extremely unstable? Then it might have died, and this world would not have appeared either. The reason this world can appear is that our living organisms can maintain sufficient robustness while also being able to fine-tune and continuously evolve. This is a very important secret of living organisms.
There are so many types of corporate changes and so many directions of evolution, but the type of company that ultimately makes money is stable, and its underlying principles are stable. Once a company succeeds and forms a stable state of life, it must change incrementally. If a company tells you: "This year I'm all in on this, next year I'm all in on that, I'll bet on success once." Then it is very likely that the next time it bets and fails, this company will cease to exist. It is not yet a robust living organism. So, one must choose companies that are more robust because robustness itself represents evolution, and evolution is built on the foundation of robustness. The main function of a company remains unchanged, while it constantly evolves some secondary functions. After these secondary functions have been screened by time and retained, they gradually become primary functions. This is the evolutionary process of a good company.
How do we measure a company's future adaptability to a changing market? It is achieved indirectly by measuring its robustness. That is to say, you know that this company can live for a long time (high robustness), then the possibility of this company changing (evolvability) will be greater. If a company cannot live long enough, then it does not have the space and ability to evolve. Organisms have robustness at various levels, and companies, like organisms, also have robustness at various levels, including return on invested capital, customer base concentration, debt ratio, competitive advantage, etc. We require the company to maintain robustness in all these aspects.
Everyone will ask: Isn't this requirement too high? Where can we find such a good company? The author reminds everyone that we are to become their permanent shareholders, so it's better to be a bit demanding and find companies that meet the requirements in all aspects.
Moreover, the speed of company evolution far exceeds our imagination. Everyone knows that Walmart is a very large company. Its founder, Uncle Sam (correction: Sam Walton himself was once the richest man in America), was once the world's richest man. Well, do you know how old Sam Walton was when he started his business and opened the first Walmart? We might think it must have been many years ago, when he was very young. Everyone, it was in 1962, when he was 44 years old, that he started his business and opened the first Walmart supermarket. After establishing a firm footing, he opened a branch. His method was to constantly try new things, increase product supply, and expand the customer base. To outsiders, it would seem that Walmart hasn't changed much over so many years, hasn't evolved; it has always been a supermarket. But if you study the entire development process of Walmart, you will find that it changes every day; it strives to try some new functions every day, but all new functions do not harm its main functions. This is the process of continuous evolution within stability. Therefore, the robustness of a company is a very important matter.
And it is essential to pay attention to calculable risks. If you say a company never takes risks, it means this company will not make progress. But if a company takes huge risks every day, it is very likely to disappear suddenly. Like Sam Walton, he always takes calculable risks. For example, adding a chocolate production line. If this chocolate production line loses money, it won't be a fatal blow, but if it makes money, it might make ten times, a hundred times the profit. This is called calculable risk.
Here, I also want to remind everyone of one thing: "'Robustness' is a sign of corporate development and success, not a guarantee." What does this mean? Robustness is the result of an organism's evolution, not a guarantee. As organisms that ruled the earth for 180 million years, dinosaurs were sufficiently robust, but eventually, due to an asteroid hitting the earth, dinosaurs completely disappeared. So robustness does not mean it can live forever, but robustness is a very important sign. You also don't have to worry about things like the extinction of dinosaurs happening, because such things will always happen, but the probability is definitely extremely low; it only happened once in hundreds of millions of years.
So, to make our investments robust, the most effective way is to master the margin of safety. The margin of safety is your investment amount, your investment value. If you look at the A-shares, I've been studying this recently. I often look at the companies I like, and I find that their price-to-earnings ratios are basically not lower than 20, they are all at 30, 40, and when things get crazy, some companies can reach 100. Everyone, what does this mean? Do you know what the price-to-earnings ratio means? For example, if your company's annual profit is 100 million, and if your company's price-to-earnings ratio is 20, then your company's valuation is 2 billion. That is to say, it is assumed that you can earn 100 million every year and continue to earn it for 20 years; this is the value of your company. So, a 20x price-to-earnings ratio is a very long commitment.
How can this author invest in so many companies with a price-to-earnings ratio of 14.9 times? He says, patience. That is to say, after you have selected a good company, the next thing you need to do is to wait until the price-to-earnings ratio drops to his psychological price before he buys. Because you don't need to invest all your money now in your lifetime; holding cash is also a good investment method. You have to wait, wait for opportunities, wait for the company's stock price to come down. This is the second principle, called maintaining robustness.
The third piece of advice from biology is called proximate and ultimate causes. For example, if I ask everyone why dung beetles (also called scarab beetles) and rhinoceros beetles have horns on their heads, do you know? One explanation says, "The horns of dung beetles are developed from the genes that control insect wings." What does this answer explain? It explains how the horn grows; this is called a proximate cause. Another explanation is adaptability, meaning that dung beetles grow horns to better obtain mating rights because female dung beetles will choose to mate with male dung beetles with longer horns. And dung beetles with longer horns can more easily clear paths in dung heaps, so long horns in dung beetles have a survival advantage. This is adaptability.
The first answers how its horn grows; the second answers why its horn grows so long. The type of answer that addresses how is called a proximate cause, meaning the cause that brings about the event. The type of answer that addresses why is called an ultimate cause, meaning why it needs to grow this thing. So, when investing, which one should we value more, proximate causes or ultimate causes? The author says you should be careful about the influence of proximate causes.
If a company's stock suddenly drops, there are four major categories of proximate causes. These include macroeconomic factors, market-related factors, thematic factors, and company-specific factors. These are all proximate causes that will affect stock prices and cause temporary fluctuations. The result it leads to is a Pavlovian response. A Pavlovian response is a conditioned reflex. In market investing, why is there a stampede effect, why do people buy when prices rise and sell when they fall in a herd? The reason is that everyone is afraid; afraid that this panic emotion is spreading. So, a large number of investors are not trying to study whether this company can make money, but are trying to study how others view this company.
How others view this company, whether it's due to macroeconomic reasons, market-related factors, thematic factors (is this theme popular recently?), or company-related factors, these are all short-term. If you invest in a company like Coca-Cola, can you imagine what market factors Coca-Cola has experienced? World War I, World War II, the Cold War, the "9/11" incident, it has survived all these major historical events. But many investors will sell because of these short-term reasons. This is the Pavlovian effect caused by excessive attention to proximate causes. So when you invest, you cannot be like the dog Pavlov studied, which salivated (showed a conditioned reflex) as soon as the bell rang, making decisions as soon as any factor appears in the market. What is the reason? You simply cannot evaluate all the market factors, macroeconomic factors, and thematic factors that affect a company.
This author really likes the company L'Oréal; he says he made a lot of money by investing in L'Oréal. He made a list of news related to L'Oréal from January 2009 to December 2021. This list couldn't even fit on one page; it was full of news headlines related to L'Oréal. Looking at those headlines would scare you to death; you would think this company was finished. One moment it's being sanctioned, the next it's paying a lot of compensation, and then there's a scandal. But after so many years, L'Oréal is still a very profitable company. In this process, many people were thrown off the bus and ran away. The reason is that they are too easily influenced by proximate causes and do not pursue ultimate causes.
What is the ultimate cause? The ultimate cause is that I don't need to predict. I just know that this company is really good at making money. This company solves very important problems for society. Others don't do it as well as it does, and it has been making money with this method for 50 years. This is the ultimate cause. But proximate causes do affect our minds; those various factors that cannot be fully evaluated are what everyone talks about.
So this author says Nalanda only analyzes companies, not industries. They don't care what industry is hot recently, such as photovoltaics, biopharmaceuticals, or cross-border e-commerce; that has nothing to do with you. Because in hot industries, there will also be many companies that don't make money at all. Even many hot industries are entirely unprofitable; the whole industry is a big bubble. Everyone is still guessing how to make money, and many people have already thrown their money in. In the end, the biggest losses come from the loss of principal, meaning all the invested money is gone. So, he only studies those companies that have been making money steadily for many consecutive years.
Next, the author says that investing is a historical discipline. Why? Evolutionary theory is also a historical discipline. Everyone knows how important it was for humanity when Darwin boarded the "Beagle" on December 27, 1831, and set off on his voyage to the Galápagos Islands. He was originally going to become a priest. Darwin's father was extremely disappointed in Darwin when he was 21 because he thought Darwin was ignorant and knew nothing, just playing with rabbits, pigeons, and these animals all day long. So when the "Beagle" invited Darwin, saying he could follow the ship as a naturalist on a round-the-world trip, his father was against it. But fortunately, his uncle supported him, so Darwin boarded the "Beagle."
In his research on evolutionary theory, he made three major discoveries, each extremely important. First, natural selection. Second, sexual selection. Third, common ancestry. These are the three most important revolutionary discoveries in evolutionary theory. And all the research Darwin did did not come from any assumptions about the future; it all came from historical clues (that is, looking for historical evidence, looking at fossils, bones, bird beaks). The reason the Galápagos Islands became the most suitable place for Darwin to study evolutionary theory is that they are far from the mainland, and the species on the islands evolved independently, so a large amount of evidence could be found to support evolutionary theory. We know that the male peacock's tail is very long and beautiful. Peacocks consume a lot of energy to grow such a long tail, which puts them at risk of being preyed upon by humans and other animals. So why do peacocks still grow such long tails? The reason is that they need to attract the opposite sex; this is the principle of sexual selection. A large number of organisms expend extremely high energy to attract the opposite sex.
Moreover, Darwin proposed at that time that animals and plants share a common ancestor; what an amazing idea. The original text in the book states: "most species have evolved from very few common ancestors." Who could have imagined that the mainstream opinion at that time still believed that white people and black people did not share the same ancestor, but Darwin told you that animals and plants share the same ancestor. He was able to find such evidence; it's incredible. So, the famous naturalist and thinker Huxley once said something to the effect that: we have been so foolish for so many years not to have discovered such an obvious truth. The original text in the book states: "How extremely stupid not to have thought of that." That is, after he saw Darwin's research, he said, we are so foolish.
The research Darwin did was basically historical research. So the author says: Nalanda interprets the present only in the context of history. Nalanda sees the same set of historical facts as everyone else. Nalanda has no interest in forecasting the future.
Many companies like to do roadshows, communicate and chat with investment managers. Nalanda never participates. What is the reason? During a roadshow, the company must be packaged well, and all the words that make the company look promising are put together and told to you. It's very difficult not to be moved. And Nalanda never participates in such activities; they only look at your historical data performance. Don't tell me what adjustments the CEO will make next year; what if the adjustments fail? A good PPT is useless; what matters most is how you performed in the past.
But what is the funniest thing? Many financial reporters and investment managers, when attending meetings with these executives, ask extremely ridiculous questions. They like to ask, "What is your profit forecast for next year?" "What is your growth forecast for next year?" Such words are worthless. Because this world is changing every day, anything that happens next year could lead to a major change in the situation, so you simply cannot predict all the factors. You don't need to predict how much money it will make next year; you only need to see if this company has made money in its history.
The questions Nalanda most frequently asks are like this: "Which customer groups does your company target? How do your products or services meet customer needs? In what aspects does your company have advantages that differentiate it from competitors? How has your company allocated capital in the past? What is the company's capital structure, and why is it planned this way?" These things cannot be faked because you can see them clearly by looking at the financial statements. So, the most important method for evaluating strategy is to do a good job of financial analysis.
To obtain enough information from history, Nalanda's method is to avoid rapidly changing industries. This goes back to the same principle: you might miss Tesla, you might miss NVIDIA, but you can avoid losing your principal. We can see later how much money we can make by avoiding the loss of principal. People don't have a concept of the power law, so we always feel that investing in a Tesla is what making money is all about. But in reality, as long as the company you invest in gives you a stable growth and return of more than ten percent every year, and the power law can continue to work, the investment income will be an astronomical figure.
The next principle is called convergent evolution. What is convergent evolution? Everyone knows that about 150 species of lizards live on more than 700 Caribbean islands. We collectively call these lizards anoles. Anoles are divided into six "ecomorphs": trunk, twig, crown-giant, trunk-crown, trunk-ground, and grass-bush.
(Additional information: Dr. Jonathan Losos, a biology professor at Washington University, has been studying anoles on the four larger Caribbean islands of Cuba, Jamaica, Hispaniola, and Puerto Rico. )
The original text in the book states: "Thus, the Trunk ecomorph in Cuba looks and behaves very similarly to the Trunk ecomorph in Hispaniola, and the Crown-giant ecomorph in Puerto Rico is indistinguishable from the one in Jamaica."
Everyone, please note that there are similar types of anoles on islands separated from each other. May I ask, are these similar anoles the same species? As tourists, we see that these two lizards look the same, and those two lizards look different. According to our thinking, lizards that look the same should be the same species. But I want to tell you that these anoles on different islands are not the same species.
The relationship between the trunk-type anole and the twig-type anole on the island of Cuba is closer than the relationship between the trunk-type anole on that island and the trunk-type anole on Hispaniola. In fact, the anoles living on the islands of Cuba and Hispaniola belong to two completely different species, but because they are in similar living environments, they have evolved the same morphological and behavioral characteristics.
Do you understand? That is to say, on the island of Cuba, the trunk-type anole and the twig-type anole, which look very different, are relatives. Looking at their genes, their relationship is very close. And on another island, the crown-type anole that looks the same as the Cuban crown-type anole is not a relative; their genetic relationship is very distant. If you don't understand, then let me ask you, do dolphins and sharks look alike? You will find that dolphins and sharks look very similar, but one is a mammal, and the other is a fish. This is called convergent evolution.
Why is convergent evolution so important? Think about it, Australian marsupials (like the thylacine, wombat) and non-marsupial animals (like the wolf, marmot) are not the same species, but why do they look so similar? Because the survival problems they need to solve are the same. So, animals like pangolins and anteaters, which feed on ants, must grow a long tongue. This is called convergent evolution.
What inspiration does convergent evolution have for investment? You need to know that profitable companies are similar. That is to say, the probability of you inventing a way to make money and then telling investors that only your company makes money this way in the world is extremely small. Therefore, when Nalanda invests, it will definitely choose companies whose profit models converge. An Indian job search website is particularly profitable. To study this website, Nalanda began to study China's Zhaopin and Liepin, as well as some recruitment companies in the United States. It found that whether in the United States or China, as long as it is a large country, recruitment websites are very profitable. Plus, this Indian job search website itself has been very profitable in the past period, so Nalanda holds its stock for the long term. This is the convergent model.
Daniel Kahneman also said that if you want to make a decision, you need to understand the external perspective. What is an external perspective? For example, you want to write a one-million-word novel, and you say: "I plan to write ten thousand words a day and finish it in one hundred days." This is an internal perspective, meaning you yourself believe you can finish a one-million-word novel in one hundred days. From the perspective of Daniel Kahneman, the author of "Thinking, Fast and Slow," Nobel laureate in Economics, and famous psychologist, if you have never written a one-million-word novel, you'd better ask others how long it takes them to write a one-million-word novel. For example, you can ask Mo Yan or Yu Hua, "How long does it usually take you to write a one-million-word novel?" This is called the external perspective. It's the same principle as convergent evolution. If others do something, what kind of cost and what kind of state it usually requires, then you will most likely be in a similar state.
This author said that there was a time when someone recommended him to buy airline stocks, saying that airline stocks had recently skyrocketed because the pandemic was over, and now airline stocks would rise sharply. Then they went to study airline companies and found that all large airline companies in China, the United States, the United Kingdom, and Australia were not profitable. Since Chinese and American airline companies are not profitable, why should Indian airline companies be profitable? They thought it made no sense. So their company did not invest in airline companies. This is called not investing in individual companies. It does not mean that money should be diversified and invested in many companies, but that I invest in this company because I know its profit model is effective and is also valid in other companies. Is it possible for a company to create a profit model that others don't know? Maybe there will be in the future, but the risk is too great.
Many people say: "When you were doing Fan Deng Reading, no one else was like you, explaining the content of a book and selling it for money." But to be honest, I never thought we created a new business model. Our model is exactly the same as Procter & Gamble's model of selling laundry detergent, which is that you have distributors, your product is useful to others, and then you sell it through distributors. It is not an original, special business model. So, convergent evolution is very important. When a company tells you a lot of fancy ways to make money, you should investigate whether their methods have succeeded elsewhere.
Next, it talks about how investing is about discerning signals. The author says that so-called investors are just large signal decoders. What is a signal decoder? Every company is sending out signals: my company is good and worth investing in. But some signals are true, and some are false. For example, everyone hears a chorus of frogs in the summer. There is a type of frog called the green frog. Do you know which green frog's call is cooler? It's the low-pitched frog call. Green frogs that make this sound are larger and more likely to gain mating rights. So what is the result? Many small green frogs, whose bodies are not large, have gradually learned to make low-pitched frog calls. This is called releasing false signals.
There is also a common animal on the beach, the fiddler crab, which holds up a large claw. The size of the fiddler crab's claw is related to mating rights; the larger the claw, the more it can attract the opposite sex. The problem is that many fiddler crabs lose their claws when fighting. What to do? It will quickly grow a fake claw. The fake claw looks exactly the same as the real claw, but it has no strength and cannot fight; it will fall off in a fight. This is an example of releasing false signals in nature.
So what investors need to identify are the false signals released by a company. So how to judge whether a signal is honest or dishonest? There is a very important principle in biology called the handicap principle. What is the handicap principle? It means that if the cost required to generate a false signal is extremely high, then this signal is very likely not false. For example, birds (American house finches) having red or orange feathers is very unlikely to be a false signal. The reason is that they use a large amount of carotenoids in their bodies to make their bodies brightly colored (supplement: research confirms that males with brighter body colors are more favored by females and are healthier), and carotenoids are very precious and difficult for these birds to obtain (animals cannot synthesize carotenoids themselves and must obtain them by eating plants, bacteria, or fungi). This is called the handicap principle.
So if you want to judge the authenticity of a signal, you need to understand the handicap principle. The original text in the book states: "when signals for a particular trait are costly to produce—he rightly termed such signals “handicaps”—and cannot be matched by another with a lower quality of that trait, they can be deemed “honest.”" Understanding this, you will know that it is very easy for a company to release low-cost false signals.
What are low-cost dishonest signals? The most typical ones are product press conferences, news interviews, face-to-face meetings with the CEO, roadshows, and future profit expectations. These are all false signals that can be released without too much cost; everyone should not believe them. What are truly effective honest signals? The original text in the book states: "Lend credence only to those signals from companies that are costly to produce." For example, its past operating performance and financial performance. Of course, some companies will commit fraud, such as Enron and General Electric in the past, which both had fraud scandals. But the financial reports of the vast majority of listed companies can still be trusted. Only by looking at a company's operating data over the past three to five years, or even longer, such as its Return on Capital Employed, can you know whether the signals released by this company are true or false.
Through the above content, we know how to buy high-quality companies at a reasonable price.
Section III: Don’t Be Lazy—Be Very Lazy
The last chapter talks about why you shouldn't sell easily; this is entirely mathematical thinking. Everyone needs to understand how important it is not to sell easily.
First, the matter of evolution is different from what each of us imagines. For example, how did an elephant's tusks become so long? Most of us believe that after elephants were born, it took many years for their tusks to gradually grow to this length. This is not the case. The process of evolution is often characterized by small long-term changes and large short-term changes. That is to say, within a relatively short period (such as 10 or 20 years), the change in the length of elephant tusks may be more drastic, eventually stabilizing and maintaining this state for a long time.
There are two famous studies here, one of which is Kurtén's (Finnish scientist) research on brown bear teeth. Kurtén focused on the length of the second lower molar of North American brown bears for a long time and found that when measuring the speed of evolution in short cycles, evolution is quite fast; when the measurement cycle is lengthened, evolution actually slows down. The second famous study is the research on Darwin's finches by the Grant couple. I think this research is very touching and incredibly difficult, so I'll share this experiment with everyone. Everyone knows that scientists doing research is much harder than we imagine. These two scientists are named Peter Grant and Rosemary Grant; they are husband and wife and also emeritus professors at Princeton. They went to the Galápagos Islands to study Darwin's finches, selected a small island called Daphne Major, and first landed on the island in 1973 to start this project.
This island has no roads. If you want to land on that island, you first have to sail your boat to the bottom of a cliff, and then the scientists have to climb rocks to reach the island. Moreover, there are basically no supplies on the island; all supplies have to be carried by themselves, and they have to carry supplies for half a year at a time. That is to say, these scientists have to live on this uninhabited island for half a year each time they go, and all the supplies are carried up by them climbing rocks.
Later they discovered that when the weather on Daphne Major was severely dry, the original text in the book states: "Almost all the greenery disappeared from the island, and the only plants that survived the drought were cactus bushes. The finches fed on seeds of all sizes. The small and medium-sized seeds disappeared very soon, and the finches were then left with only large and hard seeds. But only the finches with larger beaks could break open these larger seeds". Therefore, only finches with large beaks could survive.
So after a few years of drought, the beaks of the birds that could be seen on this island became larger and larger. After the birds' beaks became larger and larger, the island experienced another heavy rainfall. After the heavy rainfall, there were another two years of drought. The original text in the book states: "This time, tiny seeds were abundant... and large seeds became rare." Large-beaked finches couldn't eat the small seeds, so they started to die, and small-beaked finches became more numerous. So if you observe the birds' beaks in the short term, you will find that the birds' beaks are sometimes large and sometimes small, constantly changing. Finally, they came to a conclusion: The original text in the book states: "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."
What impact does this have on our investments? The author says they chose a time to buy and sell stocks and named it after these two scientists, calling it the Grant-Kurtén investment method. The original text in the book states: "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." That is, the stock prices of even the best companies will encounter fluctuations because a large number of people do not understand evolutionary theory, and a large number of people buy and sell stocks based on hearsay, so once the stock price fluctuates, it is the best time to buy high-quality companies.
So when to sell? Don't look at valuation. The author says we don't sell a stock based on valuation. Why? Because after you buy a stock, you are actually in an anti-fragile state. What is an anti-fragile state? It means if you bought this stock at a price of $10, your maximum loss is $10, but the upside potential could be $100, $200, or even $1000. So for them, they are not in a hurry to sell stocks when the stock price fluctuates greatly and the valuation changes. They will choose to sell shares under three circumstances: The original text in the book states: "1. A decline in governance standards 2. Egregiously wrong capital allocation 3. Irreparable damage to the business" Only when these three situations occur will they decide to sell stocks.
I don't know if everyone has heard a criticism of evolutionary theory (correction: the original book refers to phyletic gradualism), which is: "Since you say that the giraffe's neck grew longer bit by bit (to eat food higher up, its neck grew longer and longer), then why haven't fossils of medium-necked and short-necked giraffes been found? What is the reason for this?" Many people even believe that phyletic gradualism is a lie because of this criticism.
Actually, Darwin's explanation is, the original text in the book states: "The geological record is imperfect." What does this mean? Organisms do not change uniformly during evolution. For example, a giraffe's neck does not grow longer uniformly. For a company, its growth process is not a uniform growth of 20% per year. A company's growth process may be a sudden growth to a plateau, and then a long period of boring stagnation. Just like a giraffe's neck, it suddenly grew longer in a short period and then maintained the long-necked state for many years. Because the long-necked state lasted long enough, it was easier to leave fossils, so most of the fossils you can see are long-necked. So, companies, like organisms, are stagnant most of the time and undergo changes in short periods. This short-term change is very drastic.
Like our company, to be honest, I can clearly feel that our income grew from 0 to 1 billion; we enjoyed a period of rapid progress, which was very pleasant. After reaching 1 billion, it stopped there. Our annual income has been 1 billion for several consecutive years. Our investors are very anxious, saying: "Why isn't it growing anymore? Why isn't it growing to 2 billion, 3 billion?" I said because our growth capacity in the first stage is just like that. Just like a giraffe, its neck grows to a limit and cannot grow any longer. You can't expect a giraffe's neck to keep growing until it reaches the moon. So, until the next time it grows again, you have to endure such a boring period – although it's a long boring period, as long as a company continues to make money, it's a good company – and then find the next possibility for a sudden leap. This is the process of company evolution, just like biological evolution.
In 1972, scientists Niles Eldredge and Stephen Jay Gould published a famous article, the original text in the book is: "Punctuated Equilibria: An Alternative to Phyletic Gradualism."... The two believed that the entire history of the organic world is like a long period of evolutionary stagnation (no obvious morphological changes), but interspersed with short periods of rapid evolution of new species.
And they say: Do not confuse "insufficient fossil evidence" with "no fossil evidence." Although fossils of the evolutionary process of giraffes have not been found, there is a lot of evidence for the evolutionary process of other organisms such as finches and snails.
What is the experience related to investment from this? The original text in the book states: "1. Business stasis is the default, so why be active? 2. Stock price fluctuation is not business punctuation. 3. Take advantage of the rare stock price punctuations to create a new “species.”" (Correction: The book actually states "As permanent owners, we want to own successful businesses that will maintain their rewarding run. That sounds straightforward, but the problem is that there are very few successful businesses. Throwing a dart at the business landscape will land us in real trouble. So we don’t. We invest rarely. We should not sell once we own a “winner”... So we don’t. We sell even more rarely than we buy.")
This is the experience they gained. The author says the first point is personal experience. He says: "I can't give you a very full argument, because no one can guarantee anything in investing, no one can tell you that if you do it according to a certain method, you will definitely make money. I can only tell you from my personal experience that long-term holding is a good thing." The second point is a conclusion he drew after studying the fate of Fortune 500 companies. Third, you can look at industry concentration. Industry concentration around the world is constantly increasing. What does increasing industry concentration mean? It means that large companies are getting bigger and bigger, their ability to make money is getting stronger and stronger, while the ability of small and medium-sized enterprises and individual investors to make money is getting worse and worse. So, the rise of industry concentration also means that it is right for you to hold these stable large companies.
In the U.S. market, eventually 51% of stocks will go to zero. The original text in the book states: "From 1926 to 2016, of the approximately 26,000 common stocks listed on the New York Stock Exchange, the American Stock Exchange, and NASDAQ, 51 percent of these stocks lost their entire value." This is a very scary number because in the U.S. stock market, delistings are very common, and 51% of stocks will eventually go to zero. So if you invest in those things where you're taking a gamble, your money might end up being completely gone.
Stock price changes do not equal qualitative changes. When everyone hears that a large company, like L'Oréal or Walmart mentioned earlier, has bad news, its stock price will fluctuate, but as long as it has not undergone a qualitative change, it's fine.
Regarding how to avoid getting involved in speculation (correction: the book talks about how to resist the temptation to invest in bad companies), the author's suggestion is "don't put sweets in the fridge." What does that mean? It means if you want to lose weight, don't put sweets in the fridge. If there are no sweets in the fridge, you won't sneakily eat them at night. So their method is that they don't even look at or contact these emerging industries and unproven companies because there are already too many good companies to study. Why bother studying those risky companies that might not make money?
Major crises are extremely rare, so if you encounter a major crisis, don't miss it. Good investors will not miss any major crisis.
There is a particularly interesting story about an animal in the book. Everyone knows how long the usual lifespan of a housefly is? The original text in the book states: "A housefly lives for a month, a mosquito for one to three months, and a cockroach for up to six months. Unfortunately, most insects live only for a brief period." But there is one exception. There is an insect that can live for 17 years, and this insect is called the periodical cicada. Periodical cicadas are very interesting. After they hatch on the ground, they immediately burrow into the soil, directly into the earth, and then survive by sucking the sap from the roots of plants and trees, staying underground for 17 years. The original text in the book states: "After that time, the adults emerge together in billions (some say even trillions) beginning in the second week of May, get into a mating frenzy". That is, trillions of periodical cicadas emerge from underground all at once and mate frantically. Then, the original text in the book states: "The eggs hatch in about six weeks, the nymphs drop down from the trees and burrow underground, and the seventeen-year cycle begins again." Finally, the adult cicadas die on the ground. It spends two periods on the ground in its lifetime: once at birth and once at death, spending 17 years underground in between.
This evolutionary strategy is called "predator satiation." What does it mean? You want to eat me? Eat as much as you want, because I come up in trillions at a time. Let you eat as much as you want; you definitely can't eat them all. This is the periodical cicada's survival method. It uses this method to live much longer than other insects of the same type, able to live for 17 years. So Nalanda's investment method is to buy a company's stock and then not move, becoming its second-largest shareholder, just keeping it there, waiting for it to continuously create wealth.
In the final chapter, the author tells us about everyone's misunderstanding of compound interest. Although we repeatedly emphasize compound interest and the power law, please believe me, our imagination of compound interest is always insufficient. There is a very shocking case in the book about rabbits in Australia. Everyone knows that Australia has a rabbit plague. Where did the rabbits come from? In 1859, a man named Thomas Austin imported 24 rabbits from England (at that time, there were no requirements to prevent species invasion). After importing them, to satisfy his own hunting hobby, he planned to release these 24 rabbits into the wild.
Now, suppose you could travel through time to 1859, and you are Mr. Austin's advisor, advising him not to release these rabbits. What would you do? We now know that rabbits have become a disaster; Australia simply cannot control these rabbits now.
This author did a statistic, saying that by the 5th year, if you tell Mr. Austin: "Don't release the rabbits anymore, hurry up and catch them." Mr. Austin will tell you: "Where are the rabbits?" Because in the 5th year, there are only 108 rabbits, so you can hardly see them. By the 10th year, Mr. Austin still says: "Where are the rabbits?" Because in the 10th year, there are only 482 rabbits. By the 20th year, you say: "Hurry up and kill the rabbits." He says: "Where are the rabbits?" Because at this time there are only 9,700 rabbits. In the 35th year, you remind him again, and he still says: "Where are the rabbits?" At this time, there are only 900,000 rabbits. But by the 45th year, Mr. Austin will say: "I see a few rabbits." At this time, there are 17.5 million rabbits. By the 55th year, Mr. Austin will say: "It's okay, no hurry, rabbits are very cute, just a few." How many rabbits are there at this time? There are 350 million rabbits. By the 66th year, Australia will be anxious and use all kinds of methods to kill rabbits. At this time, there are 10 billion rabbits.
This is compound interest. Why am I telling you this number? To make you understand something: the most shocking thing about compound interest is not the final 10 billion, but that by the 10th year, you still feel no change. This is the scariest part. What does this have to do with our investment? It means you have to know that as long as this company is a little bit better than other companies, and this little bit of goodness persists for many years, you will find that it forms a huge advantage.
Many people who trade stocks have a favorite strategy: when it rises by 50% to 80%, they stop and take the profit. This kind of thinking will not make money because you don't understand the power law; you don't know what the result will be if this curve continues. Moreover, this author studied the people on the Forbes magazine's list of the top 500 (correction: it is the list of the world's top 25 richest people) and said that if you look at the list of the world's top 25 richest people in 2022 (Elon Musk is number 1, and Zhang Yiming is number 25), everyone on this list has one common characteristic: they have never sold their assets. For example, if you founded a company called Microsoft, and this company is very good – Bill Gates' biggest loss was selling a large amount of Microsoft stock to buy other things. If Bill Gates hadn't sold his stock to allocate other assets, he might still be the richest man in the world – if you can persist in holding your good assets, this company can create vast wealth for you.
The book lists several reasons why Nalanda is not in a hurry to sell assets. The first reason, which can be taken as a joke, is that those who never sell their assets are the richest people. The second reason, the original text in the book states: "there is evidence that long-term high-quality stocks make money (a lot of money!)." The third reason, the original text in the book states: "Since an unbeatable formula for wealth creation already exists, why not just copy it?" Meaning, save yourself some effort, just go for convergent evolution; if you see others making money this way, you just do it that way.
There is a case in the book. On the Forbes magazine rich list in October 1988 (this rich list is the list of the top 400 richest Americans), Sam Walton ranked first with a fortune of 6.7 billion US dollars, and number 197 was Shelby Cullom Davis. Almost no one knew this person. How did he get into the Forbes list in the one-hundreds? This person is very interesting; he didn't do any fund investments; he only managed his own finances. He became one of the top hundred-something on the Forbes list by managing his own money, and he always only bought stocks of one type of company. His first investment capital was his wife's dowry, 50,000 US dollars borrowed from his wife. This 50,000 US dollars reached 261 million US dollars in 1992 (two years before his death).
The original text in the book states: "Davis bought about a hundred insurers that made up three-quarters of his portfolio". That is, he used most of his investments to buy stocks of insurance companies, and he did this for decades. Did he make wrong decisions? Yes, he once tried to speculate by buying junk bonds and lost 23 million US dollars in one go. But you need to know that although these 23 million US dollars were completely lost, relying on the investments in those stable insurance companies, it didn't have much impact on his total assets.
Nalanda has also had decision-making errors and failed in investments in some companies, but because their main core assets are these high-quality assets, the impact is not significant. Only under the premise of stability can you try various new possibilities. This is why the author advises not to sell casually.
Finally, the author says that many people, after listening to his advice, will say: "This is unreasonable. How can making money be so easy, so simple?" But the fact is, some people in the stock market "scheme and plot," but have they made money? We inquire about this news and that news all day long, nervous to death, but instead, we don't make money. But buying, holding, and not moving has made so many people rich. Why don't you try to understand and learn this method?
An even more ridiculous opposing argument is: "Then what do I do all day? If it's as simple as you say, buying stocks and leaving them there, then what do I do?" The author says you have plenty of time to travel, you can enjoy life, you can read books, you have so many books you haven't read, why don't you go read books? Why do you have to buy and sell stocks? Most people "invest" by buying and selling just to satisfy their gambling addiction; they are betting on their judgment, but actually, they could live a much easier life.
I know that after listening to this book, everyone will surely have many feelings and may disagree. It doesn't matter; we can't convince everyone. But, you can think about it; perhaps it can bring you a beautiful old age. Thank you, everyone. See you in the next book.