Separating the green frogs from the rhino beetles; What I Learned About Investing from Darwin

The corporate world is full of green frogs, whereas we investors routinely behave as if they are rhino beetles.

Green frogs, like most animals, have a short window for mating.  During this crucial period, males need to defend their territories aggressively to maximize their reproductive success.  Larger males advertise their size and dominance by making calls (croaks, if you prefer) of lower frequency compared to smaller frogs.  However, some small green frogs have found a way to lower the pitch of their signals, thereby communicating that they are larger than they are.  This enables them to preserve their territories by fooling the females and larger males.  

Male rhino beetles, on the other hand, appear to lead a more upright life. They bear horns that are highly variable in size – small males have unimpressive stubs, and larger males sport horns that can be two-third of their body size.  Scientists have shown that large horns can be borne only by large healthy males, and smaller males haven’t yet figured out a way to build larger horns.  In other words, a male rhino beetle, whether with large or small horns, is sending out an honest signal to its competitors and potential mates about its state of health and virility.  

No textbook on evolutionary theory is complete without a lengthy discussion on ‘signaling’.  Signals have evolved specifically to alter the behavior of the receiver in ways that benefit the signaler and are used to communicate with and influence the behavior of prey, predators, mates, competitors, friends and family.  While we call ourselves investors, an evolutionary biologist would not be remiss in branding us as ‘signal decoders’.  As outsiders to a company, the only thing we rely on is signals being emitted by companies – some direct and others indirect; some comprehensible and others bizarre; and most important, some honest and others dishonest.  

A dishonest signal is one that does not reliably communicate the trait it is supposed to. We at Nalanda treat the following signals from companies as fundamentally dishonest (even though they may be coming from ‘honest’ companies), thereby ignoring them or assigning them fairly low weightage:

1. Press releases or press interviews: Many companies resort to regular press releases and interviews related to product launches, management changes, strategy shifts or organization changes.  To begin with, I am deeply suspicious of companies that are in the press regularly (don’t they have anything better to do?).  But even those that are not professionals at managing the press through their public relations consultants rarely have anything useful to say for a long-term investor.  We obviously read all the public information shared by companies (thank you, Google), but don’t trust any of them unless we are able to independently verify the statements from other sources.   
2. Investor conferences or road shows: We have never invested in a company on the basis of a slick conference presentation or an impressive road show, and never will.  In most cases, these are chest-thumping marketing jamborees, and not an honest analysis of industry structure or competitive positioning.  Please don’t misunderstand me – we do attend conferences and road shows, but our level of discounting is stratospheric.
3. Future projections: For reasons not clear to me, many companies feel compelled to provide guidance on future earnings.  I have sat on many company boards, and managements at these companies can’t reliably predict the next quarter – let alone next year – numbers.  We don’t build forward projections for companies, nor do we state valuations in terms of forward multiples.  The companies who provide earnings guidance may not be dishonest, but their projections are.  
4. Face-to-face meetings:  This may seem strange at first glance given that we spend a lot of time with management.  However, we rarely accept management’s assertions at face value, and in cases where their statement is critical to our investment thesis (e.g., ‘we make the best quality products’), we perform multiple cross-checks from a variety of external sources.  We consider management meetings a good way to build longer term relationships, not as a definitive way to test our key hypotheses on investment.  I am not suggesting that managements lie to us in meetings (although some of them do), but that we take their words with a huge pinch of salt.  

If we can’t trust these signals, what kinds of signals can we rely on?  Let’s turn to Amotz Zahavi for an exquisitely elegant answer.  

In 1975, Amotz Zahavi, and Israeli evolutionary biologist, proposed his famous handicap principle which asserts that only those signals that are costly to produce (and hence are handicaps) can be considered reliable.  For example, male elks with larger antlers attract more mates presumably because their message to female elks is: look how healthy and virile I am because I carry these massive unwieldy antlers.  Ditto for the male rhino beetle with large horns, the peacock with gaudy and colorful feathers or the dude with the shining red Ferrari.  All of them are showing off ornaments that are very expensive to produce/procure and hence accurately communicate the state of well-being of the signaler.  

Zahavi’s lesson for us investors is self-evident: lend credence to only those signals that are costly to produce.  Let me briefly discuss some of these signals:

1. Past financial performance: I have always been baffled by the inordinate amount of focus and attention by our community on future projections when the past is a much more reliable indicator of quality.  Producing high return on capital employed (ROCE) or free cash flows or profitable revenue growth over long periods is a very expensive signal and we ignore it at our peril.  Conversely, companies that claim to have a great future having delivered poor historical returns should be treated with scepticism if not ridicule.  
2. Competitive position: One can’t dissimulate one’s market position, and leadership can be a costly and reliable indicator of the quality of the company. In many sectors (e.g., banking, e-commerce, airlines, healthcare), some leading companies can and do ‘buy’ market share, but in these cases, the warning signals from deteriorating balance sheet become too loud and patently honest to ignore.  
3. ‘Because she said so’: While most people show positive bias in evaluating self and their kids, they can be remarkably candid and accurate when it comes to analysing other people and their own spouses.  Nalanda uses this well proven human quality to actively solicit positive and negative signals on companies.  We spend many months speaking to dealers, competitors, ex-employees, suppliers, and industry experts to get a holistic understanding of the company and the industry.  We consider these ‘scuttlebutt’ signals to be as powerful and informative as historical track record.  In fact, in some situations, we have rejected companies despite them having stellar financials because our investigations have revealed shenanigans that led us to question the veracity of those numbers.  Good reputation is a very costly signal because building a name for oneself in any industry consumes enormous management time and effort over many years, if not decades. 

The collapse of FTX is a classic example of an honest signal completely ignored in favor of numerous dishonest signals.  FTX had some of the world’s leading investors like Sequoia, Tiger Global, Temasek, and Softbank.  They were all enamored and blinded by the public persona of Sam Bankman-Fried (SBF) who defied convention by appearing in shorts and t-shirt even in high profile conferences.  Even if SBF had been honest (which he wasn’t), his signals were clearly dishonest.  Bravado and bluster are easy to manufacture, and so these signals are cheap and dishonest.  

One honest signal of FTX’s success would have been the quality of its balance sheet.  And who went after this honest signal?  Not reputed investors like Sequoia or Tiger, but a journalist!  This reporter found a copy of Alameda Research’s balance sheet (SBF’s proprietary hedge fund) and concluded that its financial position was very worrisome since most of the fund’s assets were tied up in FTT, a token created by FTX!  It wasn’t long before everything unraveled.  

Green frogs and rhino beetles redux.

Written by Pulak Prasad.
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