What I learned about Investing from Darwin - Pulak Prasad

1. Avoiding Big Risks

   1. Two types of mistakes: Doing things we aren't supposed to (type 1), and not doing things we are supposed to (type 2).

   2. The risk of these two errors is inversely related; minimizing the risk of a type 1 error typically increases the risk of a type 2 error, vice versa.

2. A Great Investor is a Great Rejector

   1. Assume there are 4000 listed companies, with 1000 being "good" companies and 3000 being "bad" ones.

   2. If someone says they are right 80% of the time, that means if he encounters a bad idea, he rejects it 80% of the time. If he encounters a good idea, he invests in it 80% of the time. Thus, his type 1 and type 2 errors are both 20%.

   3. You'd think the probability he makes a good investment is 80%. Wrong. It's 57%.

      1. Out of 1000 good investments, he invests in 800. Out of 3000 bad investments, he invests in 600. In total, he invests in 1400 companies. 800/1400 = 57%

   4. If he becomes better at rejecting bad investments and reduces his type 1 error from 20% to 10%, he will select 300 bad investments out of 3000 as opposed to 600 previously. Assuming his rate of type 2 error is the same, he invests in 1100 total companies. 800/1100 = 73%.

   5. However, if he decides to become better at investing in good businesses, so he reduces his type 2 error from 20% to 10%. This means he will select 900 good investments out of 1000 as opposed to 800 previously. Assuming his rate of type 1 error is the same, he invests in 1500 total companies. 900/1500 = 60%. Not as good as 73%.

3. How to filter High Quality Businesses

   1. Many believe that good management teams are a characteristic of high quality businesses. But it's very hard to identify whether a management team is good or not. At the end of the day, they're all good salespeople trying to sell their company.

   2. Instead, use ROCE. It tells us how much a company earns on the amount it invests.

   3. A consistently high-ROCE business is likely to be run by an excellent management team.

4. Gauging the Competitive Position of a Business

   1. Darwin discovered that the success of a species is not dependent on its being it being the best but simply being better than the competition. Same applies to businesses.

   2. When two friends hiking in a forest spot a lion, one starts putting on his running shoes. His friend says, "What are you doing that for? You can't possibly outrun a lion." The man replies, "I know, but I need only to run faster than you, not the lion!".

5. Honest & Dishonest signals

   1. As investors, we're bombarded with many signals, many of which are dishonest. Examples include press releases, management meetings, earnings guidances. All these signals try to impress investors that are generally quite easy to impress. You should avoid them.

   2. Anthony Bolton was a superstar fund manager in the UK with a track record of 19.5% annualized return for 28 years. He came back from retirement to launch a new fund, however, the fund significantly underperformed the market and he had to leave a few years later.

      1. Key point was that this new fund was based in China. He mistook Chinese investment signals as British ones. He didn't realize that Chinese companies were typically fundamentally dishonest and that he should've been more skeptical.

6. He sells under three conditions

   1. A decline in governance standards

   2. Egregiously wrong capital allocation

   3. Irreparable damage to the business

   4. But, even in this conditions, he "waits" it out a few years because one should always expect short term fluctuations in every business.

7. "A critical element of our investment philosophy is that we do not confused stock price fluctuation with business punctuation."