• OUTLOOK ARENA
  • VIEWS ON NEWS
  • AUGUST 8, 2008

'Punctuated equilibrium'and the markets

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.

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407