The lessons I have learnt from Pulak Prasad’s book – What I learned about investing from Darwin

This is a summary of what I have learnt from Pulak Prasad’s book – What I learned about investing from Darwin.

Pulak Prasad’s fund Nalanda Capital invests in Indian public market companies. They do a phenomenal job of it. One rupee invested in Nalanda’s first fund at its inception in 2007 would be worth 13.8 INR in September 2022. As compared to that, one rupee invested in the Sensex would have been worth 3.9 INR and worth 4 INR if it was invested in the Midcap Index. In short Pulak and Nalanda have been really really good investors over a reasonable amount of time.

As is the case with most investors, Pulak has a very clear investment philosophy which he pursues with religious zeal. This philosophy can be summarised in three sequential, straightforward steps.

1. Avoid big risks
2. Buy high quality at a fair price
3. Don’t be lazy – be very lazy

Obviously there is a lot of detail to these three steps. Those details are what the book is all about. Pulak’s inspiration for his investment philosophy comes from Darwin’s theory of evolution. His love affair with the theory of evolution started with Richard Dawkins’, The Selfish Gene , a book recommended by the great Charlie Munger.

This is my attempt to distill the best lessons from the book. I loved this book a lot and I am making this effort to internalise these lessons. I hope it also helps some people who don’t have the inclination or time to read the book. Although let’s be honest. Summaries never capture the full essence of a book.

This book is in three parts. I am sharing the summary of part 1. Will share the other two parts shortly.

Section 1 – Avoid Big Risks

This is the most important lesson of the book. A great investor is also a great rejector. Over a long period of time, success comes not from getting more hits but from avoiding bad bets. This is a piece of wisdom universally shared by almost all the great investors.

To understand this we first need a lesson in statistics. There are essentially two types of errors

• Type 1 Error – When you bet on something which is a bad investment by mistaking it for a good one.
• Type 2 Error – When you don’t make a bet on a good investment by wrongly believing it to be a bad one.

They key question in an investors life is this – which type of error can you live with and which type should you avoid.

The choice between type 1 or type error is essentially a choice between two investment strategies. Either 1) make lots of investments so that you dont miss any of the good opportunities, even if it means ,making some bad ones , or 2) be highly selective in your investments to avoid bad bets, even if it means losing out on some good investment opportunities.

Pulak answers all these investment questions with multiple examples from studies of evolution. They are fascinating to read about and they really get you interested in studying evolution. For the purpose of this summary, however, I have avoided getting into too much detail. ( My favourites are the silver fox study done in Siberia by Dmitri Belayev and Lyudmila Trut and the study of finches on Daphne Major by Peter and Rosemary Grant)

The key insight from evolution which Pulak uses to answer the investment question – All species have evolved by developing a sophisticated survival instinct. One which believes in avoiding all threat to life at any cost. There are many references in the book. I will use the one about male red deers and their mating rituals.

Female red deers called hinds live in groups called harems. The males who are called stags target them for the purpose of reproduction. Often two stags end up competing for the same harem of females for the purpose of mating. In such a case they need to fight to decide who gets to mate. The reward of winning the fight is the chance to mate. Mating is important for the species to survive and evolve. These are the two choices for the male red deer.

• Type 1 error – Get into every fight that you feel you have a reasonable chance of winning. You will win many and get a chance to mate often. In the process, you will also lose a few fights and get injured or even disabled in the process.
• Type 2 error – Avoid fights as much as possible. Even if it means backing out of fights you could possibly win. This means fewer chances to mate. But you avoid any chances of injuries.

What does the stag do?

Reduce the risk of injury or disablement as much as possible. Avoid an actual fight at all costs. They have developed some very interesting rituals as an alternate to fighting. They start off by roaring loudly at each other to show off their strength. Often this could go on for more than an hour. Sometimes, one deer backs out at this stage. If this doesn’t work, they try intimidating each each by walking parallel to each other with stiff legs. This shadow fighting is followed by some other tactics to intimidate or show off their strength. These rituals serve as very reliable proxies to asses relative strength. Most of the time, one of the stags decides to back out based on how he assessed his opponent’s strengths during these fake fighting rituals. As a result, very very few duels actually happen. The proxies are not accurate. There is a good chance that the stag backing out could have won an actual duel.

But the stags prefer to make the type 2 error while avoiding type 1 errors at all costs. They won’t fight unless they are very sure of winning. They end up losing out on many mating opportunities. But the rule in the red deer world is very clear. Avoid any risks to limb or life at any costs. These rituals and rules which are an evolutionary development have helped the red deer survive. Other species which haven’t followed this “ survive at all costs” dictum have gone extinct.

The answer for the investor is the same. Avoid type 1 errors at any cost.

There’s also a mathematical illustration of this point for those of you who aren’t convinced by Darwinism and needs a rigorous proof.

Assume there are 4000 investment opportunities in the market out of which 1000 are good ones.

There are two investment strategies

In one, the investor invests aggressively and makes more type 1 errors ( makes a bet on a bad business 20% of the time) and make less type 2 errors ( doesn’t make a bet on a good business 10% of the time ). In such a case what is the probability, that if they make an investment, it’s a good one?

Success Probability = good investments / total investments( good + bad) = 1000*90%/ ( 1000*90% + 3000 *20%) = 60%

( Explanation 90% times invested in the 1000 good businesses and 20% time investment in the 3000 bad businesses )

In the second strategy, the opposite happens – conservative investing by reducing type 1 errors or fewer bets on bad businesses ( 10% of the time ) and more type 2 errors or missing out on many good investments ( 20% of the time ). In this case the success probability changes to

Success Probability = 1000*80%/ ( 1000*80% + 3000 *10%) = 73%

Now imagine a third strategy. Where both types of errors happen 20% of the time.

Success probability is now = 1000*80%/ ( 1000*80% + 3000 *20%) = 57%

Two clear observations

1. Even an investor who is able to correctly bet on good businesses 90% of time makes only 60% good investments because of their bad bets.
2. The power of the risk aversion philosophy is very clear. Decreasing type 2 errors by 10% ( strategy 3 to strategy 2) increases your investment success by only 3%. But reducing type 1 errors by 10% ( strategy 3 to strategy 1) increases your investment success by on 16%.

It’s very clear that investment success comes from avoiding type 1 errors as much as possible. You are better off being highly selective in your investments to avoid bad bets, even if it means losing out on good opportunities

So how does Nalanda reduce type 1 errors?

By eliminating the known avoidable types of risk. Pulak lists the types of situations that he avoids at costs.

• Avoid promoters who don’t have a clean record. He only invests in companies where the promoters have the highest integrity.
• Avoid turnaround stories.
• Detesting Debt. Avoid highly leveraged companies.
• Avoid companies which which have a propensity for mergers and acquisitions
• Avoid rapidly evolving industries
• Avoid misaligned owners – government owned companies, Indian listed subsidiaries of global companies, Indian conglomerates

Let me know if you liked this post and want me to share my learning’s from the rest of the book. Thanks