Book Notes: What I learnt about investing from Darwin

Notes

1. The need to reduce risks
   • 2 types of mistakes- We did some thing which we should not have done- error of commission or Type 1 error
   • We did not do something which we should have done- error of omission or Type 2 error
2. No leverage - COVID , other events where companies could go bankrupt
3. Ignore M&As- AOL and Time Warner -85% of these acquisitions fail. The biggest reason why M&As do not work is opportunity cost. Opportunity cost is split into - divestment in critical areas, stagnation of existing business, missing bets in new opportunities- Eg Life sciences company Bayer
4. ROCE
   The author explains through the work of Russian geneticists Dmitri Belyaev and Lyudmila Trut how investors can identify strong businesses with multiple good traits through homing one key trait which when selected brings other favorable qualities along with it.The Russian scientists spent almost 60 years studying the behavior of wild silver foxes and how the cultivation of tameness as a behavioral trait through generations of foxes created domesticated pet dog like characteristics in them. This one trait of tameness when cultivated led to other positive traits of domesticated animals in wild silver foxes like tail wagging, sloppy ears, light colored hair. The writer draws comparison in the investing world to the metric of historical ROCE which is the single most critical metric to identify high quality businesses which have good cashflows and top management quality.WHAT IS ROCE ?Return on Capital Employed = Operating Profits/ Total Capital EmployedOperating Profits or EBIT is used to ensure that the metric does not get convoluted by taxes and only profit from operations are considered to zero in on the company's efficiencyTotal Capital Employed = Net Working Capital (excluding excess cash) + Fixed AssetsThis metric ensures that even companies with lower margins but higher ROCE can sustain itself and maintain a good growth on topline while accumulating FCFs.An important concept to consider here is the reinvestment rate that is required to ensure that the revenue growth is met. This reinvestment is the NOPAT that is put back into the business to ensure the requisite growth continues.Reinvestment Rate = Growth/ROCEFor a company growing at 10% annual sales growth, 15% margin and 25% ROCE with 30% taxes- it will still end up accumulating cash reserves of ~20% of overall sales in 5 years due to high FCFs post. In similar vein, a company with a similar growth rate and margin structire but with a ROCE of 12% will have negative cash reserves in 5 yearsExamples of companies like CostCo , Havells justify this theory.The challenges of this approach are missing out on future strong performers that would have been excluded in the list due to historical values. However, the metric does tend to help us shortlist companies versus trying to analyze a management quality through very subjective means. This approach also does not guarantee future performances but it does serve as a good starting point.
5. Robustness and Adaptability
   1. Businesses need to be robust over time yet also be flexible enough to evolve to new changes
   2. Analogy: Proteins are formed through the process of translation and transcription - DNA translate to mRNA which then transform to amino acids and then to proteins. However, amino acids or proteins are extremely robust and retain their gene identity
   3. Robustness + Evolvability
   4. Signs of Robustness
      1. High historical ROCE over a long period
      2. Fragmented Customer Base
      3. No Debt and excess Cash
      4. Built high competitive barriers
      5. Fragmented Supplier Base
      6. Stable Management Team
      7. Slow Changing Industry
   5. Signs of Evolvability
      1. Evolvability comes free to a robust business
6. Proximity vs Ultimate Trouble for a business
   1. 4 types of proximate trouble - macro, market, theme, company. Only company is an area where one needs to be careful while assessment. Vaibhav Global is a good example of such a kind of business
   2. Need to identify and not worry about major proximate causes and keep looking for fundamentally strong businesses
7. Darwin's origin of species book said that natural selection was driven by random variation among progeny of an organism, differential fitness among these variants such that only favorable ones are preserved and lastly, favorable traits should be heritable. When these repeat for millions of years, new species evolve from existing ones
8. Uniformitarianism- is the core tenet of geology- all significant changes on earth result from slow and steady natural processes spread over a long period of time. This theory made Darwin look at evolution through a similar lens of millions of years
9. Present should be interpreted in the context of history