Podcast Summary: Enterprising Investor – "Drew Estes, CFA: Investing through an Evolutionary Lens"

Podcast Information:

• Title: Enterprising Investor
• Host: Mike Wahlberg
• Guest: Drew Estes, CFA, Portfolio Manager at Banyan Capital Management
• Episode Title: Investing through an Evolutionary Lens
• Release Date: September 16, 2024

1. Introduction

In this episode of Enterprising Investor, host Mike Wahlberg engages in an insightful conversation with Drew Estes, CFA, a portfolio manager at Banyan Capital Management. Drew discusses his thought-provoking article, "Commercial Evolution," which applies evolutionary biology principles to investment strategies. This innovative approach draws parallels between natural selection in biology and product success in commerce, offering a fresh perspective for investment professionals.

2. Main Thesis: Investing through an Evolutionary Lens

Drew Estes introduces the core concept of his article, emphasizing a shift from traditional economic theories influenced by physics to a more biologically inspired framework. He argues that viewing commerce through an evolutionary lens can uncover deeper insights into market dynamics and investment opportunities.

Drew Estes (01:28): "Commerce evolves in a very technical sense. So to evolve, a population of agents really just needs to replicate with fidelity, possess heritable and variable traits, and replicate at differential rates based off of those variable traits."

3. Key Concepts

a. Products vs. Firms

Estes proposes a neo-Darwinian perspective where the primary unit of analysis is the product rather than the firm. In this framework, products are analogous to genes, with firms acting as their survival mechanisms.

Drew Estes (01:28): "We would call it a neo Darwinian perspective... products are replicating and firms are merely their survival machines."

b. Premas as Building Blocks

Drawing inspiration from Richard Dawkins' concept of memes in cultural evolution, Estes introduces the term "prem" to describe the subunits of a product that collectively create its value proposition.

Drew Estes (03:36): "A prem is anything that impacts the value proposition of a product. It can be as small as employees saying 'my pleasure' at Chick-fil-A or as major as the real estate location for a grocery store."

These premas function similarly to genes, determining the success and replication rate of products in the market.

4. Case Studies and Examples

a. VHS vs. Betamax

Estes utilizes the VHS vs. Betamax "format war" as a prime example of his evolutionary framework. Despite Betamax's superior technology, VHS prevailed due to lower production costs and greater market adoption, illustrating how path dependence and network effects can influence commercial evolution.

Drew Estes (06:38): "VHS was selected for by producers of movies because the addressable market was greater... it locked the entire industry on that path."

b. Cable Companies

The discussion extends to cable companies, highlighting how early market entry and scale advantages can dominate undifferentiated products. Estes points out that despite the eventual emergence of alternatives, the initial scale allowed incumbents to maintain market dominance.

Drew Estes (12:19): "Their focus was more on the multiple that the market would give them rather than the economics of these assets once they're in the ground and built."

c. Apple Investment

Estes shares a personal investment example where his evolutionary lens guided successful decisions, specifically investing in Apple in 2016. Recognizing Apple's differentiated value proposition through proprietary technologies like iOS and the App Store, Estes capitalized on the company's sustainable competitive advantages.

Drew Estes (19:25): "We recognized that the iPhone was a very different nature... those were preams, if you will."

5. Role of Marketing and Branding

Marketing is pivotal in shaping consumer perception, which in turn affects product selection and replication rates. Brands can serve as strong premas, especially when they signal social status or reduce search costs for consumers.

Drew Estes (08:59): "Marketing is about perception. You have to inform and educate the consumer about your value proposition and why it's superior to the alternative."

Brands like Louis Vuitton or well-established cable companies exemplify how branding can create sustainable differentiation and competitive advantages.

6. Financial Selection and Market Dynamics

Estes introduces the concept of financial selection, likening it to sexual selection in biology. This involves the allocation of capital across markets, influencing which products and firms thrive based on investor preferences and market trends.

Drew Estes (14:54): "Financial selection is like sexual selection... These feedback loops feed on themselves and can lead to bubbles and malinvestment."

He discusses how capital allocation can either propel companies like Amazon to success or contribute to market inefficiencies through phenomena like overbuilding in the cable industry.

7. Comparison with Previous Models

Estes critiques existing evolutionary commerce models, specifically referencing Nelson and Winter's complexity economics from the 1980s. He argues that focusing on products rather than internal firm routines provides a more accurate and insightful framework for understanding commercial evolution.

Drew Estes (21:05): "We think that products at the end of the day are truly what's evolving... it puts the consumer and consumer selection at the center of the model."

8. Conclusion and Advice

As the discussion winds down, Estes offers reflective advice based on his experiences. Emphasizing the importance of focusing on the business rather than merely the price, he cautions against letting a bias for buying cheap companies overshadow a thorough analysis of their business fundamentals.

Drew Estes (23:48): "Your thesis should be all about the business, and pricing should come later... view your willingness to step in and buy as some sort of behavioral strength, it might actually be a bias."

Notable Quotes with Timestamps

• Drew Estes (01:28): "Commerce evolves in a very technical sense. So to evolve, a population of agents really just needs to replicate with fidelity..."

• Drew Estes (03:36): "A prem is anything that impacts the value proposition of a product..."

• Drew Estes (06:38): "VHS was selected for by producers of movies because the addressable market was greater..."

• Drew Estes (08:59): "Marketing is about perception..."

• Drew Estes (14:54): "Financial selection is like sexual selection..."

• Drew Estes (19:25): "We recognized that the iPhone was a very different nature..."

• Drew Estes (21:05): "We think that products at the end of the day are truly what's evolving..."

• Drew Estes (23:48): "Your thesis should be all about the business, and pricing should come later..."

Final Thoughts

Drew Estes presents a compelling framework that integrates evolutionary biology into investment analysis, offering a novel lens to evaluate product success and firm viability. By focusing on products and their subunits—premas—Investors can better understand market dynamics and identify sustainable competitive advantages. This episode provides valuable insights for investment professionals seeking to enhance their strategies through interdisciplinary approaches.

Additional Resources:

• Article: Commercial Evolution
• Blog Post: From Darwin to Wall Street: Harnessing Evolutionary Theory for Smarter Investments on CFA Institute's Enterprising Investor Blog