Darwin's market run

Charles Darwin's seminal work ‘The Origin of Species' changed the way humans perceived a gamut of fields including biology, religion and anthropology. His famous work has also been touted in economics to justify controversial phenomenon ranging from monopolies to racist tendencies.

To pose Darwin's theory in a slightly incomplete nutshell: Through a mechanism of competition for limited resources among organisms of same and other species, fitter ones or those that have traits which are conducive to compete in a certain environment are promoted.

The prize for this competition is relatively greater success with which more desirable traits are passed on through successive generations.

Well, so much you may already be aware of. But did you ever consider putting these theories in the context of investments?

‘The Origin of Species', in addition to being a work of scientific genius, doubles as a useful source of nuggets on markets and corporate strategy. Read on to know how.

CORPORATE APPLICATIONS

‘Survival of the fittest' is the best known catchphrase, and a slightly cruder version of the theory explained above.

Let's start with the obvious parallels; companies will succeed when they possess superior traits such as a healthier balance sheet, more competent management and intrinsically favourable operating economics .

But a question Darwin makes, which is similar to investment thinker Philip Fisher's line of questioning, is “which traits will enable the company to not just thrive today but continue to succeed well into the future? “

Consider the Indian steel sector, for example. You could place a bet on a range of companies which possess different traits, but operate in the same macro economic environment. Options could be any of the following: a cash and iron-ore rich yet saddled with old-equipment SAIL, a slightly leveraged yet high-capacity, low-integrated and operationally tight JSW, three, a highly leveraged company with an optimal product mix such as Bhushan Steel or research intense and finally, a partially integrated Tata Steel which is as much a bet on global operations as it is a bet on India steel consumption.

While all of the above companies depend on globally-determined steel prices, the outcome in terms of how profitable each company is depends on individual traits they possess.

DISCOVERY

Once you've discovered a competitive and unique trait in a business, an important question is how easily that trait can be replicated by others. This results in the quest and emergence of a competitive advantage which manifests itself as a superior product or in the form of higher returns for investors.

But here again, individual self-interest seldom lines up with that of the larger market. There is no such thing as a collective bargain or great product for the market as a whole. A one-size-fits-all approach is likely to lead to very poor results for market players.

A case where prospects of profits of many dwindle when the same scenario lead to profits for an early few is the IPO frenzy witnessed in late 2007. Successive craze among investors seeking out the profit enjoyed by early participants in IPOs led to wilder pricing with every passing offer. Increasing premiums paid for often sub-par businesses provided very little margin of safety for investors.

Another case where interest of the group came in increasing conflict with self interest was with derivatives trading in the subprime mess.

Here again, in an attempt to profit from plunging home prices, sophisticated investors of all shapes and sizes bet on or against the event.

However it turned out to be collective delusion with an interlinked system which resulted in a domino-like setting, triggeringlosses in successive participants rather than dispersing risks, as it was intended to be.

FINAL RUN

The competition is on two levels; first among sector participants looking to improve profitability through improved operations, products or services.

The second level is of market participants who are looking to spot winners in the first level.

This two-way battle for superior returns results in a surfeit of market opinion often with little differentiation. In a highly competitive setting, investors will weigh what they know disproportionately and may, in the process, develop a blind spot towards new emerging problems or competition.

A case in point, Nokia was the much celebrated number one cellular phone producer in the world, till emerging competition in the form of Apple among others not only displaced the cellular major but placed them in an unfamiliar position of frozen incumbent.

Such a position is not restricted to companies which produce innovative products or services. Several sectors see participants add massive capacity and in the process undertake huge amounts of debt to fund it, only to eventually find that their target market is over-supplied, leaving producers with little pricing power.

Steel pipe makers or pockets of cement producers are a few of the sectors where the effects of this phenomenon are laid bare.

What Darwin can lend the investor is the ability to ask several valuable questions: What are the uncertainties facing the industry or investor as a result of competition?

Will that scenario mean significantly worse industry economics such as lower profitability?

Asking these questions could save the investor a great deal of pain that results from uncertainties, which are inherent in markets.

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