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Leigh Van Valen was a crazy-looking evolutionary biologist who came up with a theory so crazy no academic journal would publish it. So he created his own journal, published it, and the idea eventually became accepted wisdom. Those kinds of ideas \u2013 counterintuitive, but ultimately true \u2013 are the ones worth paying most attention to, because they\u2019re easiest to overlook. What\u2019s true in one field is likely true in others. Lucky for us, Van Valen\u2019s theory of evolution applies to business and investing.<\/p>\n\n\n\n
For decades, scientists assumed that the longer a species had been around the more likely it was to stick around, because age proved a strength that was likely to endure. Longevity was seen as both a trophy and a forecast. In the early 1970s, Leigh Van Valen set out to prove the conventional wisdom was right. But he couldn\u2019t. The data just didn\u2019t fit. He began to wonder whether evolution was such a relentless and unforgiving force that long-lived species were just lucky. The data fit that theory better. You\u2019d think a new species discovering its niche would be fragile and susceptible to extinction \u2013 let\u2019s say a 10% chance of extinction in a given period \u2013 while an old species had proven its might, and has, say, a 0.01% chance of extinction. But when Van Valen plotted extinctions by a species\u2019 age, it looked more like a straight line. Some species survived a long time. But among groups of species, the probability of extinction was roughly the same whether it was 10,000 years old or 10 million years old.
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In a 1973 paper titled A New Evolutionary Law, Van Valen argued that \u201cthe probability of extinction of a taxon is effectively independent of its age.\u201d He said that\u2019s the case for two reasons. One, competition isn\u2019t like a football game that ends with a winner who can then take a break. It never stops. A species that gains an advantage over a competitor instantly incentivizes the competitor to improve. It\u2019s an arms race. Two, some advantages create new disadvantages. Most species tend to get bigger over time because big things are strong. But being big also makes you slow, clumsy, and unable to hide. \u201cThe tendency for evolution to create larger species is counterbalanced by the tendency of extinction to kill off larger species,\u201d one study wrote.
Evolution is the study of advantages. Van Valen\u2019s idea is simply that there are no permanent advantages. David Jablonski of University of Chicago described it: \u201cEveryone is madly scrambling, getting better all the time, but no one is gaining ground. A species can\u2019t get far enough ahead of the pack such that it would be extinction-proof.\u201d No one\u2019s ever safe. No one can ever rest. Van Valen called it the Red Queen model of evolution. In Alice in Wonderland, the Red Queen is a scene where Alice finds herself in a land where you have to run just to stay in place: However fast they went, they never seemed to pass anything. \u2018I wonder if all the things move along with us?\u2019 thought poor puzzled Alice. And the Queen seemed to guess her thoughts, for she cried, \u2018Faster! Don\u2019t try to talk! Keep running!\u2019
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\u201cKeep running\u201d just to stay in place is how evolution works. It\u2019s how business and investing work, too. There are 32 million businesses in the United States. The Bureau of Labor Statistics tracks how many of them die each year, and how old they were at death. Dig through the numbers and one thing\u2019s clear: there is no age at which business gets easy. Companies have a high failure rate in their first three to five years. Then the challenges plateau. Averaged across industries, a business in its 25th year has roughly the same probability of dying as it did in its 10th year: What\u2019s interesting about this is that the average business cycle \u2013 the time between recessions \u2013 is about eight years. So a 24-year-old business has likely endured three recessions. It\u2019s been battle-tested. It\u2019s learned from ups and downs. But it\u2019s still as likely to die over the coming year as it was 15 years ago. Same thing for public companies. Companies tend to go public when they\u2019re mature and have things figured out. But having things figured out is fleeting. J.P. Morgan Asset Management published the distribution of returns for the Russell 3000 from 1980 to 2014. Forty percent of all Russell 3000 components lost at least 70% of their value and never recovered.
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If you invest in 100 high-risk startups, you probably expect 40 of them to fail. Then if you move on to investing in 100 mature public companies, 40 of them will probably fail, too. They might stick around longer than the startups, but the end result is the same. What does that say about competitive advantage? Or the concept of moats? It says that those things, to the extent they exist, are rarely permanent. Just like Van Valen\u2019s view of nature, things evolve but never actually become better adapted, because threats are always changing. Black Rhinos survived for 8 million years before being killed off by poachers. Lehman Brothers adapted and prospered for 150 years and 33 recessions before it met its match in mortgage-backed securities. Poof, gone.
Startups have their obvious challenges. They\u2019re trying to find their niche. But once that niche is found and perfected, old companies discover a whole new minefield. They get complacent, bureaucratic, cocky, \u00a0and unwilling to discard what once worked so well. There is never a point where a company can indefinitely coast along, cashing the chips of past success. Everyone has to keep running. Same for investing strategies. It\u2019s easy to think investing is like physics, with set laws that never change. But it\u2019s not. It\u2019s like Van Valen\u2019s evolution, where \u201csuccess\u201d is just a brief respite before the next competitor shows up and old skill becomes meaningless.
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In his book Investing, Robert Hagstrom wrote about strategies that once worked but eventually withered: In the 1930s and 1940s, the discount-to-hard-book-value strategy was dominant. After World War II and into the 1950s, the second major strategy that dominated finance was the dividend model. By the 1960s investors exchanged stocks paying high dividends for companies expected to grow earnings. By the 1980s a fourth strategy took over. Investors began to favor cash-flow models over earnings models. Today it appears that a fifth strategy is emerging: cash return on invested capital.
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I\u2019d update this. Since about 2010 the strategy that works is just revenue growth. \u201cIf you are still picking stocks using a discount-to-hard-book-value model or relying on dividend models to tell you when the stock market is over or under-valued, it is unlikely you have enjoyed even average investment returns,\u201d Hagstrom writes. You\u2019ve likely gone extinct. There is never a time when an investor can discover an investing strategy and be confident it will continue working indefinitely. The world changes, and competitors create their own little twist that exploits and snuffs out your niche. Same with careers. And job skills. And relationships. And countries. It\u2019s hard to accept that you have to put in a ton of work just to stay in place, but that\u2019s how it works. Keep running.
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