• 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.

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