'Punctuated equilibrium'and the markets - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

'Punctuated equilibrium'and the markets

Aug 8, 2008

The famous investor, Charlie Munger, once said investors must possess a variety of mental models drawn from the central tenets of many disciplines. In this article, we shall discuss the 'punctuated equilibrium' or 'paradigm shifts' a model from evolutionary biology as it applies to stock markets. It explains the evolutionary process of business. A successful species survives by adapting to changes in its environment. It changes in ways that enhances the prospects of survival of its members. Organizations are similar to organisms. They must also adapt to their environment to survive. Hence, a parallel can be drawn from evolutionary biology to understand companies.

What is "punctuated equilibrium"?
Punctuated equilibrium is a theory, which was proposed by Niles Eldredge and Stephen Jay Gould in 1972. They stated that there was strong evidence in fossil records that there are long periods of stasis, during which virtually no evolution occurs. These long periods of several million years are punctuated with relatively short periods of rapid evolution (termed as dominant relative frequency), over brief periods (in geological terms) of 5,000 to 50,000 years.

In other words, an organism does not evolve steadily and uniformly. In fact, nothing much happens for tens of thousands of generations and, then, suddenly, in a few hundred-generation everything changes. For example, over a period of tens of thousands of years, 'shrimp' are of a certain size, and, then, all of a sudden, they change to a very different size. They do not change gradually to get bigger and bigger. They seem to change all at once.

How this can be applied in stock markets?
Investors are used to a linear world and are not able to identify non-linear growth due to a radical change over a short duration. They over look punctuated stocks that can be systematically undervalued leading to superior investment opportunities.

Investors sit around in frustration most of the time while the prices of their stocks languish. As prices of growth stocks tend to move in 'spurts', they suddenly moves briskly upwards. Investors generally assume that it is just the fickle nature of the market participants' tastes that causes the price of a common stock to grow in such an unpredictable manner. However, punctuated equilibrium causes both the species of the planet and companies to evolve in such erratic fashions.

In such a situation, investors should focus on the course of the evolution of the stock price. In other words, they should focus not on the stock's current price behavior, but on the company's genetic map. They should look at three key drivers that determine value - cash flow, risk, and the sustainability of excess returns on capital.

Cash flow is the difference between earnings and investment in future growth. Companies that experience increasing returns on capital typically benefit on multiple fronts: sales growth is exponential as a product takes off or the marginal unit costs decline over time and incremental Investment needs are low. On the risk front, the company that has locked-in its customer base has less volatile cash flows making it a less risky investment. Lastly, investors should verify if the company enjoys any sustainable competitive advantage.

Hence, it is of great importance to keep a close eye on how the business dynamics translate into stock prices, when faced with curious movements in share prices.

Equitymaster requests your view! Post a comment on "'Punctuated equilibrium'and the markets". Click here!

  

More Views on News

Top Indian Drone Companies to Watch Out for in 2022 (Views On News)

Jan 21, 2022

Several companies are adopting drone technology for regular business operations.

Insiders are Buying into these 6 Stocks Aggressively. More Details here... (Views On News)

Jan 19, 2022

While promoter holding is an important parameter, it should not be the sole reason for buying a stock.

These Penny Stocks Started 2022 with a Bang. This is what You Need to Know... (Views On News)

Jan 19, 2022

These penny stocks are up more than 30% already since the beginning of the year.

What Indian Companies can Learn from Taiwan's Semiconductor Giant (Views On News)

Jan 22, 2022

Indian companies can learn the art of dominating this specialised trade from a Taiwanese firm.

Adani Wilmar IPO: 5 Things to Know (Views On News)

Jan 22, 2022

Post-IPO, the public shareholding will be 12% and the remaining 88% will be equally held by the two promoters.

More Views on News

Most Popular

10 Indian Companies with the Fastest Growth in Dividend Payouts... (Views On News)

Jan 10, 2022

These companies have been consistently paying higher dividends for several years.

Tata Steel vs SAIL: Which Stock is Better? (Views On News)

Jan 13, 2022

With government initiatives set to boost the steel sector, find out who has a better chance of coming out on top.

Watch Out for these 4 Indian Companies Betting Big on EV Supply Chain (Views On News)

Jan 11, 2022

The upside in supply chain players could be huge but a delay in the transition to EVs, or any policy related hiccups could end the momentum.

Tech Mahindra's CTC Acquisition: Too Expensive? (Views On News)

Jan 18, 2022

Tech Mahindra's acquisition of European IT-company fails to excite investors.

These 5 Penny Stocks are Held by Rakesh Jhunjhunwala. Worth a Look? (Views On News)

Jan 18, 2022

Rakesh Jhunjhunwala is holding these penny stocks in his portfolio for several years now.

More

Become A Smarter Investor
In Just 5 Minutes

Multibagger Stock Guide 2022
Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Jan 21, 2022 (Close)

MARKET STATS