← Enterprising Investor
Enterprising Investor
Drew Estes, CFA: Investing through an Evolutionary Lens
00:25:10
Drew Estes, CFA, a portfolio manager at Banyan Capital Management, and host Mike Wallberg, CFA, discuss Drew’s thought-provoking article, "Commercial Evolution," which explores the intersection of evolutionary biology and investment strategies. He...
Loading summary
Transcript37 lines
- [00:00]
Mike Wahlberg
Get ready for cfa Institute Live 2025 with free power packed webinars designed to inspire and inform. Led by industry experts, these concise sessions tackle game changing topics like how AI is transforming investment strategies in emerging markets. Don't just show up, show up ready. Gain the insights you need to drive meaningful conversations this May in Chicago. Claim your spot now@cfainstitute.org.
- [00:32]
Drew Estes
Foreign.
- [00:36]
Mike Wahlberg
Welcome to the Enterprising Investor, the flagship investment podcast for CFA Institute. I'm Mike Wahlberg and I'm joined today by Drew Estes, cfa. Drew is a portfolio manager at Banyan Capital Management in Atlanta, Georgia and perhaps drawing on the liberal arts degree he did before his MBA and law degrees, has written an article that may cause some of us to think a bit differently about the markets. Called Commercial Evolution, the article looks at investing through an evolutionary biology lens and draws parallels between what helps the strong survive in nature and what makes for a good investment. I note that you can also read a summary post of the article on CFA Institute's Enterprise Investor blog entitled From Darwin to Wall Street Harnessing Evolutionary Theory for Smarter Investments. Welcome to the show, Drew.
- [01:21]
Drew Estes
Yeah, thanks Mike. It's a pleasure to be here.
- [01:23]
Mike Wahlberg
So I wonder if you could just start us off by describing in general the main thrust of your paper.
- [01:28]
Drew Estes
Yeah. So what got us thinking about this is a bit of my disillusion with economics. The science has borrowed heavily from physics for about 100 years, if not longer. And one of those concepts is equilibrium theory. And it's it yields a lot of useful insights, but it is kept economists from looking at other disciplines for ideas. And I think that one of those disciplines would be biology. And that got us going down this path and we realized that economists and biologists seem to be studying the same phenomenon and that's evolution or evolutionary forces. And this is no metaphor. 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. And it's undeniable that products possess those characteristics. Right? Products are produced with great fidelity by firms. They possess differentiating traits and those differentiating traits determine the replication rate. So Ford, for example, as the F150 and it differs from other products in the market, it can't sustain that product line if consumers don't select the F150. And consumer selection hinges on what differentiates the F150 from others. So I don't think it's deniable that commerce evolves And I guess our contribution is what we would call a neo Darwinian perspective. And that is to view not firms as the main unit of analysis, which I think is common, especially among investors, but to focus on products. To us it is products that are replicating and firms are merely their survival machines, which again is a very neo Darwinian concept. And we developed a model that's based off of that. And that is the core of the article we're talking about today.
- [03:36]
Mike Wahlberg
That's where you introduce this idea of preams as the building blocks. You can talk a little bit more about that and what makes for a strong building block.
- [03:45]
Drew Estes
Yeah, so we borrowed the term meme, which was originated by Richard Dawkins. He's a leading neo Darwinian theorist and helped revolutionize biology with his selfish gene concept. And he used prem as the unit of analysis in cultural evolution. And we wanted to find a new term that was separate so that we could, you know, make it specific to commerce. And prem seemed like a, a good term to use. And to us, a premium 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. So these are really the product, the subunits of a product that combine together to create a value proposition. And they are the gene equivalent. And the product would therefore be the equivalent of DNA in biology. And the firm, of course, is the survival machine in the same way that an organism is in biology. Now, I will add that exactly where one premium begins and another pre means is a bit of a fuzzy concept, but that doesn't bother us because the same is true of the gene and biology. It's not as well defined as most people think. There's some debate about that. It's more of a concept. And I would say that the prim is equally more of a concept.
- [05:18]
Mike Wahlberg
Right. So it's this idea that the strong as in nature, the strongest gene will be naturally selected to survive within commerce. Then the strongest prem would then be the one that, that is the differentiator for. For growth and you know, long term, lend longevity.
- [05:33]
Drew Estes
Exactly. So you, you have a firm that's making a product and consumers are going to select one product over another based off of what differentiates it. And premiums would be those subunits that would differentiate it or not. And if you have a dominant product, it's very profitable because it's differentiated. Whatever the preem is that sets it apart or the trait that sets it apart is what will spread in the market as other competitors try to replicate whatever has made the firm's product a success. And it's just important to keep the focus of your lens on that level as opposed to just focusing on the firm. Because you, you miss a lot if you do that.
- [06:16]
Mike Wahlberg
I'm curious, how do you interpret when a superior product doesn't survive? So the one example that jumped into mind while I was reading this was Betamax going back to the 80s beating out VHS, which apparently, I mean, I was just a kid back then, but apparently the, the experts say that Beta had a superior technology to vhs and yet VHS was the one that won the day. So how, how does that go with your framework?
- [06:39]
Drew Estes
It's important to note that early Darwinians thought of evolution as a perfecting process. It is not as a process of a species adapting to an environment over generations. And there's this concept in biology called adaptive landscapes. And it's a 3D representation of all the different paths evolution could go down in a particular species. And it looks like a mountain range with different, with each mountain having different peaks, with the higher peaks being the paths of evolution that would have greatest adaptive value. And what ends up happening in biology is since evolution is path dependent, once a species begins to go down one path or up one path towards a peak in the adaptive landscape, it gets locked in on that path. It's very difficult to switch to a different path up a different adaptive peak. And it's very similar in commerce. The same thing happens and specific to VHS and Betamax. My understanding the VHS was much cheaper to produce at the early stage. Therefore it was adopted much more quickly by consumers as well as the pornography industry, which is a big component of the, what's called the format wars. And what that leads to or what that led to is you had more consumers with VHS players in their home. Therefore, that pre or the VHS format was selected for by producers of movies because the addressable market was greater. And once you have more markets or more movies on that format, then the purchase of a VHS player becomes more valuable to the consumer. So it sort of locked the entire industry or value chain on that adaptive path or on that path in the adaptive landscape. And once you go down it, the network economies begin to lock you in and it becomes too costly for an industry to then start over and switch or move towards a different path of evolution. So I think that happened in the vhs, Betamax or format wars. And I think that there are plenty of examples of it throughout commercial history.
- [08:56]
Mike Wahlberg
So what, what role in marketing play in the preem definition.
- [09:00]
Drew Estes
So marketing is very important I think for most firms. And that if you, if you think about our model, the prem product firm model as we call it, the consumer and consumer selection is always at the center and what the consumer does is select the whatever is the superior value proposition as they perceive it. So marketing is about perception. You have to inform and educate the consumer about your value proposition and why it's superior to the alternative. So marketing plays a big role in this way of looking at the world.
- [09:36]
Mike Wahlberg
And by extension, I guess brands become important as part of that as well.
- [09:39]
Drew Estes
Yeah, brands can become a pream and it can be a sustainably differentiated pream or a competitive advantage that is specific to the firm and the product line in question. But I think that only really matters in two instances. I think it's when signaling is important and search costs are important. So the first would be whoever's using the product is trying to signal something to their peers.
- [10:04]
Mike Wahlberg
Right.
- [10:04]
Drew Estes
We're a social species. We want to let people know that we are part of a certain tribe or believe certain things or of a certain demographic. And products serve that function, whether it be Louis Vuitton or Gucci bags or the types of beers we drink, things of that nature. So when signaling is an important component of the value proposition to the consumer, then yes, branding becomes a very important trend. Search costs are also another example where branding is important. So sometimes there is risk in a transaction to the consumer and that they can't truly appreciate the quality or certain aspects of a product's value proposition ex ante, they can only really understand it ex post after they use the product. And sometimes the risk of that can be huge. So for example, there's a company called Jabarco Beetaroot which is owned by Volunteer. They make gas pumps for gas stations. And gas stations, of course, you know, gas pumps a fundamental part of what they do. And if your gas pump fails, then your traffic will fall off and your business will suffer. Or there could be a catastrophic event or an environmental event that's very costly to your firm. So there are huge search costs in that transaction. And the consumer, the gas station owner, is not going to be willing to experiment. So they end up really valuing a brand in that market that has got a great reputation that's been around for a while. So you see two companies, Javarto Vitoroot, designed by Volunteer and Wayne, which is owned by Dover, having really they're the only two players left in most markets. And that's another example of brands becoming a competitive Advantage.
- [11:52]
Mike Wahlberg
So I want to play devil's advocate one more time, but at the other end of the spectrum here. So we were talking about brands and strong consumer awareness of product features. But sometimes companies or stocks outperformance is related to its ability to scale. So be a low cost producer. So in that case it seems to me that the product. So in that case would be say corn or some other commodity for example, isn't really the differentiator in terms of financial performance there. So how does that square with your framework?
- [12:19]
Drew Estes
That's a great question. Something we've thought about a lot. And I would just start by by saying, you know, the prem product firm model is all about the product and it's, it's trace one differentiates it. And whether profits are sustainable or not is going to depend upon, you know, the diffusion rate of whatever the differentiating traits of the product are. And as you say, sometimes you can have an economies of scale advantage and what is an otherwise undifferentiated market. But I think to just start there ignores how a company gains economies of scale advantage. Right? It doesn't just wake up one day with greater market share than its competitors, which is a requirement to achieve a scale advantage. You know, something else has happened, whether it be a first mover, therefore you just got a head start, or it started out with some superior value proposition to begin with, or it was a survivor of an industry shakeout, something, something of that nature. And I think a great example of an undifferentiated product that does benefit from a scale advantage would be cable companies, which is something that we have invested in in the past. So their cable companies are really broadband companies. It's all about the Internet. For the Internet is a pipe into your home that delivers access to the web and it's undifferentiated for the most part. But cable had a huge scale advantage in local markets because they were first movers about over half a century ago. They hung wires or buried wires throughout the nation to deliver video. And then they adapted that product to emerging demands for Internet and they had enormous advantages there. And that just made it difficult for a second competitor at the local level to ever really emerge. To begin with you had dsl, but it's not even really a competitor today. It's so inferior. And I think that's the way that I would think about it. And in the example of cable, it's not that their product was differentiated, it's that they, their scale advantage made it difficult for a second alternative to ever even a emerge and now that we see some overbuilding throughout the industry, it is showing the issue of that because once an over builder comes in, you know, it's kind of destroyed your scale advantage in that local market. And since you're undifferentiated, you suffer from everything that any perfectly competitive market participant would suffer from.
- [14:55]
Mike Wahlberg
I want to talk about a subcategory that you spent some time on in the paper and that's what you call financial selection. Can you explain what that is and what its comparables are in the genetic example?
- [15:04]
Drew Estes
Yeah. So natural selection is another filter of commercial evolution. Just like in biology, you have natural selection, which is a probably and definitely the most dominant force in biology. But you also have sexual selection, which is nested, right? It's built atop natural selection. But it's different in nature and the same is true in commerce. You have consumer selection, which is the equivalent of natural selection. But then you also have financial selection, which is like sexual selection. And there are all these different nested filters within that. So you have primary level decisions where an entrepreneur has an idea and then he must create a firm built to the specifications of the product he envisions or she envisions. And then he must go out and raise capital to make that a reality to build the firm. And he or she will engage in all sorts of rituals to do that and attract financial partners in the same way that animals engage in mating rituals. And then you have secondary level selection where people like myself will trade the equity of a firm. That's another filter. And then tertiary level decisions where people will select managers such as myself to make secondary level decisions for them. And it's all nested within each other and feeds on itself because they co evolve together. For instance, if people at the secondary level, those portfolio managers in the stock market that possess a trait for growth, if they do well, they'll accumulate power and resources and they will become a bigger factor in financial selection. Tertiary level decision makers will select for that trait when they're picking secondary level managers, so their power even grow greater. And then at the primary level, you'll see firms adapt to those realities because a firm and its management is always going to seek a higher multiple for its stock. And if growth is what people value at the time that's the dominant force in financial selection, you'll see a growth at all cost sort of mentality begin to spread in the real economy. And so again, these feedback loops feed on themselves. And it's in my opinion, what leads to bubbles at times as well as malinvestment. Which ultimately results in recessions.
- [17:31]
Mike Wahlberg
Yeah. So you're effectively talking about the allocation of capital across the markets being a separate force in there. And one thing I thought of in reading this was just this idea of throwing capital at any business for long periods of time. Sometimes it works, sometimes it doesn't, sometimes it creates bubbles, sometimes it's Amazon. Right. They didn't make any money for a very long time, very long period of time, but a lot of capital was allocated to them and arguably that's worked out for them over time.
- [18:01]
Drew Estes
Yeah. And just going back to our cable example. Right. Talk about cable companies. It is overbuilding of a cable company has happened throughout history in various times and usually goes in cycles. The economics of the builder have almost always been horrendous. But what you saw during the pandemic and post pandemic is cable companies really maximized the their or exercise their pricing muscle and did very, very well. And the financial markets gave them multiples that were far in excess of the cost to build a cable plant. And that of course attracted the attention of investors. They began pouring money into the industry and overbuilding like crazy. And I, I don't think that their focus was so much on the economics of these assets once they're in the ground and built. It was more of a, if I build this and pass so many homes and get so many subscribers, my cost is going to be X, but the multiple that the market will give me is going to be two times X. So that's what their focus was on. And you've got these overbuilders throughout the nation and I doubt that the results are going to be great for them, but it will impair the incumbent cable company in the process.
- [19:19]
Mike Wahlberg
Are there any examples you can give when you applied this framework to your own investing? When it worked or perhaps when it didn't?
- [19:25]
Drew Estes
Yeah, absolutely. So as for an example where it worked very well, we invested in Apple in 2016 when it was very cheap. The market at the time seemed to believe that the iPhone was just a widget and it was going to be commoditized, just as Nokia or Motorola or what ultimately happened to BlackBerry and therefore its profits are going to decline. And I just. We recognize that the iPhone was a very different nature than those more analog devices. Software was a much bigger component. They had iOS as well as the App Store, which were proprietary to Apple. Those were, those were preams, if you will. And since they were proprietary, those premiums were foreclosed from diffusing into other product lines. So we figured that the iPhone was a far more durable business than market gave Apple credit for. So we bought Apple in 2016. It has been a wonderful investment and I think we've been proven right in that regard. So. Yeah, that'd be, that'd be the example that comes to mind.
- [20:39]
Mike Wahlberg
Well, buying Apple in 2016 is certainly a defensible move, so well done on that.
- [20:44]
Drew Estes
I wish they all worked out that well.
- [20:46]
Mike Wahlberg
Yeah, exactly. Don't we all? Yeah. You never buy enough in the time in times like this, right?
- [20:51]
Drew Estes
That's right.
- [20:52]
Mike Wahlberg
Financial authors in the past have actually tackled this parallel, but landed on a different stream than you did being products. Can you talk a bit about that and why you believe your interpretation is better than what they landed on?
- [21:05]
Drew Estes
Yeah. So there are quite a few people that think very deeply about how evolution applies to commerce. And there's an entire field of economics called complexity economics that this falls under. And in the 1980s, there was two gentlemen, Nelson and Winters. They wrote a book and they took a Neo Darwinian perspective as well, but they used routines as the gene analog routines being processed within a firm. And it just seemed unconvincing to us, which is why we came up with a pre product firm model. So we think that products at the end of the day are truly what's evolving. And ferns are more like their survival machines, which is more closely aligned with how Neo Darwinians think about biology. And it also puts the consumer and consumer selection at the center of the model, which we also believe is what is actually occurring. Consumers don't select firms really. Right. They select products, and that's the force being applied. So it just seemed like a better approach and a far more useful approach. And it also leads to some, I guess, counterintuitive insights that I think is the byproduct or centerpiece of any good mental model. And that is that firms don't create products as much as products create firms. And our model captures that. So an entrepreneur will come up with an idea, conceptualize a product, and then that dictates the firm that they will build around it. So the product truly is very similar to DNA for a firm. And for example, Jeff Bezos didn't create Amazon and decided he was going to sell books online. He, he decided he was going to sell books online and then built a firm that had those capabilities. And as the product evolved, so too did the firm. And I just think our model is, is more useful and, and is better aligned with, with what's truly going on. I must, if I must say that even though it's very unsettled today.
- [23:34]
Mike Wahlberg
So we're coming to the end of our conversation here, unfortunately, Drew, and I wonder if you could answer our two point question at the end here for me. What was your first job in the industry? And if you could go back and take yourself for coffee on your first day, what key piece of advice would you offer yourself?
- [23:48]
Drew Estes
Well, my first job was as a portfolio manager at Banyan, which is still where I am at. I came here right out of a law school, so I was fortunate in that regard. And I think if I had to give myself a piece of advice at the time, it would be don't view your willingness to buy cheap companies that are out of favor as necessarily a strength. It might be a bias of yours, and a bias you need to recognize and work around. Doesn't mean we're value investors. So it doesn't mean that we're not looking for cheap stocks, and they certainly are. But if the price is the core part of your thesis, you're probably on the wrong track. Your thesis should be all about the business, and pricing should come later and kind of at the end, just decide whether you should make the investment or not. And I think it's very easy for people earlier in their careers to focus too much on price before the business and view their willingness to step in and buy as some sort of behavioral strength of theirs, when again, it might actually be a bias they're going to have to find a way to work around throughout their career.
- [25:00]
Mike Wahlberg
I've been speaking today with Drew Estes, CFA Portfolio Manager at Banyan Capital and author of Commercial Evolution and From Darwin to Wall Street, Harnessing Evolutionary Theory for Smarter Investments, available now on CFA Institute's Enterprising Investor Blog. Thanks for sharing your insights today, Drew.
- [25:17]
Drew Estes
Thanks, Mike.
- [25:18]
Mike Wahlberg
I'm Mike Wahlberg, and this is me, the enterprising investor.