July – September 2006

October 27, 2006

I came across an old book of Garrett Hardin “Nature and Man’s Fate”. Here is a statement I found relevant and interesting.

“There was a time when educated men supposed that myths were something of the past – quaint, irrational fairy tales believed in by our credulous and superstitious ancestors, but not by us, oh dear no! (We believe only facts, we said) Now we know better. We know now that every man, no matter how rational he may aspire to be, leads a life that is governed in its most significant aspects by myths – myths that he believes all the more strongly because he is unaware that they are myths. In fact, at the moment when a man becomes aware of a guiding myth, the myth dissolves, and his new-found wisdom is but retrospective. (And in the decay of the dying myth a new myth is spawned.)”

There are many “myths” that the stock market spawns – bull market “corrections” and their severity, primary trends, and value investing (for instance, low P/E and high ROE stocks) are some that come to mind. They help in confronting the high volatility that is part and parcel of any emerging stock market.

In the Darwinian world that investors gaze at, which are the principles of evolution that should guide our thinking?

• The Competitive Exclusion Principle: “No two organisms that compete in every activity can coexist indefinitely in the same environment. To coexist in time, organisms that are potentially completely competitive must be geographically isolated from each other. Otherwise, the one that is the less efficient yields to the more efficient, no matter how slight the difference. When two competing organisms coexist in the same geographical region, close examination always shows that they are not complete competitors, that one of them draws on a resource of the environment that is not available to the other. The corollary of the principle is that where there is no geographical isolation of genetically and reproductively isolated populations, there must be as many ecological niches as there are populations. The necessary condition for geographical coexistence is ecological specialization.” This statement has helped me to think about many sectors, including IT.
• Waste is inevitable: “Waste, in the Darwinian cybernetic scheme, produces not only progress, but also the conservation of what is. There is no heredity without its tax of mutation; most mutations are bad; their production and elimination are a kind of waste. The sentimentalist who seeks to eliminate the waste in a species by preserving all of the mutants and breeding equally of all genetic types ultimately brings about the extinction of the entire species. It is a throwing of good money after bad. It is the saving of pawns and losing the game.” There will always be losers in a portfolio – eliminate these and move on.

We continue to buy stocks that we believe are trading at material discounts to their conservatively calculated “intrinsic worth”. Some may turn out to be mistakes, others will have to yield to better ideas before they reach their potential (i.e. the equivalent of genetic mutations and “genetic waste”), and a few will turn out to be big winners as in any evolutionary game.

We believe that the valuation differential between the large cap stocks and mid-cap stocks has widened to a level where a reversion to the mean is inevitable. It is hard to find any margin of safety in large cap stocks unless liberal growth rates and terminal values are assigned to earnings.

Your portfolio reflects this bias. We would rather have a high earnings power “yield” than a low earnings power “yield” and if size has to be sacrificed at the altar of value, then so be it. There is no inevitability about returns based on size – either in the biological world or in the investing world.

Should there be any questions or clarifications that you seek, please do let me know.

Thanking you,

Warm Regards,

Chetan Parikh