A cheerful pessimist who survives

Pulak Prasad of Nalanda Capital, while preferring to operate discreetly, authored an insightful book entitled “What I Learned About Investing from Darwin”. In it, he elucidated how his deep fascination with evolutionary biology taught him the fundamental principles of long-term investing.

One part of the book resonated with my thoughts on investing. In the book, Pulak talks about a scientist, Dmitry Konstantinovich Belyayev, who embarked on a groundbreaking experiment. He selectively bred silver foxes for tameness, a trait he believed was key to their domestication.

Belyayev, a Russian geneticist, began the experiment in 1959 to study the process of domestication in real time. He was particularly interested in understanding the domestication of wolves into dogs. However, instead of using wolves, he chose silver foxes as his subjects. The experiment was based on a simple premise: by selecting for tameness, Belyayev believed he could recreate the process of domestication. In simple terms, he wanted to put Darwin’s theory of evolution to the test and see if he could turn silver foxes into dogs.

With each new generation, he and his team would test hundreds of foxes, and the top 10% of the tamest ones would be selected to parent the next generation. Over time, the foxes began to exhibit physical traits that were not directly selected for, such as curly tails and floppy ears. Belyayev realised that these traits were correlated with tameness. This phenomenon is known as ‘domestication syndrome’. Domesticated animals, across various species, exhibit certain common traits, including changes in body size, fur colouration, and reproductive cycle timing. They commonly develop wavy or curly hair, floppy ears, and shortened or curly tails.

In “On the Origin of Species”, Darwin had already observed that drooping ears, a feature absent in the wild except among elephants, are ubiquitous among domestic animals. Domesticated animals display distinct behavioral changes, often showing a willingness or eagerness to interact with humans. Belyayev, in a sense, showed that by selecting for a single trait, probably the right trait, of tameness, all other domestication features come for free.

Today, the domesticated foxes at an experimental farm near the Institute of Cytology and Genetics in Novosibirsk, Siberia, are inherently as calm as any lapdog. They also look eerily dog-like. This is the result of what is known as the silver fox, or farm fox, domestication study.

The parallel to investing is striking. Pulak and his team of investors have developed a unique approach to identifying potential investments, drawing inspiration from the silver fox experiment. They concentrate on a single factor: high historical returns on capital employed. This focus allows them to swiftly pinpoint businesses that exhibit the characteristics they desire.

Just as the foxes, selectively bred for tameness, unexpectedly developed appealing traits such as cuteness, businesses with high historical returns on capital employed tend to exhibit a suite of desirable features. They are often steered by exceptional management teams, boast robust competitive advantages, demonstrate astute capital allocation, and possess the ability to undertake business risks without succumbing to financial perils. Much like the unexpected transformation of the foxes, these traits emerge organically in businesses that consistently deliver high returns on capital employed.

My take on the single most important ‘trait’ is not a financial metric. In investing, conservatism plays a similar role, like tameness did in the silver fox experiment. By prioritising conservative investments, investors inherently select for traits that contribute to long-term success. These include the ability to stay invested during market downturns, better risk-adjusted returns, and the capacity to identify and capitalise on lucrative opportunities.

What does conservatism mean? Conservatism is a multi-faceted concept. It begins with modest expectations for returns, grounded in a realistic assessment of potential outcomes. It extends to having a conservative approach towards forecasting business performance and earnings, where one relies upon historical data, rather than speculative extrapolations of current trends, especially at the peak of a business cycle.

Conservatism also implies a healthy skepticism towards ideas that seem too good to be true or are currently in vogue. It discourages treating investing as a popularity contest, where the most hyped stocks are automatically considered the best. Conservatism encourages investors to operate within their circle of competence, investing in industries and companies they understand well. Lastly, and perhaps most importantly, it advocates for the avoidance of leverage, recognising the potential risks that borrowed money can introduce to an investment portfolio.

Conservatism in practice: what does it look like?

Investors are often enamoured by recent returns, policy narratives, the latest world-changing technology, or the confidence of a fund manager. The list is endless, with a few common features: novelty, promises of extraordinary returns, an easy path to riches, or a sense of confidence in some higher authority. Conservatism shuns all of this. Pulak Prasad makes use of the concept of ‘circle of incompetence’: if you recognise that it's nearly impossible to succeed when operating within your circle of incompetence, you'll likely avoid it. By focusing on what you know and understand, your circle of incompetence widens. This leaves less room for adventurism and excitement.

For most people who aren’t professional investors, a well-diversified multi-asset portfolio held over the long term with appropriate expectations of returns (probably a few percentage points above inflation) could embody conservatism in action.

Two ideas from Charlie Munger best describe this sentiment:

Cheerful pessimists survive, and hence, they spend more time compounding.

When it comes to an investing-oriented silver fox experiment, conservatism is the trait that I am experimenting with. What about you?