Thursday, April 24, 2014

East Coast Asset Management's Q1 2014 Letter - The Economy of Evolution

I always enjoy Christopher Begg's letters, but this one I thought was especially good.

Link to: The Economy of Evolution
In our first quarter letter you will find our portfolio update and general market observations. Each quarter we highlight one component of our investment process. This quarter, in the section titled The Economy of Evolution, I will discuss business evolution and how some businesses are more fit for adaptation than others. I will illustrate a theme and new position in the portfolio that serves as a tangible example of the discussed concepts.
Darwin’s Wedge
In an 1856 manuscript of On the Origin of Species, Darwin compared nature "to a surface covered with ten thousand sharp wedges . . . representing different species, all packed closely together and all driven in by incessant blows." Sometimes a wedge, a new species, driven deeply into this imaginary surface, would force out others, affecting species across "many lines of direction." This metaphor is an effective way to describe the interconnectivity of species and the importance of external impacts. Charles Darwin was influenced by his reading of Malthus’ prediction on population growth and how limited resources would lead to an eventual catastrophe. He used the hammering of wedges image as a metaphor to emphasize that there was limited space for organisms to adapt, and that their ability to do so depended not upon absolutes but upon niches. 
Just like with species, businesses and investors face “Darwinian wedges.” These wedges can be subtly hammered in over time, or they can be more extreme, forcing immediate extinction of certain businesses. Wedges come in all forms: government regulation, a disruptive competitor, or environmental impact, to name a few. 
Three Darwinian wedges we are following today are: 
1. The Amazon Effect: Amazon is one of the greatest predators to brick and mortar retail commerce. The incessant hammering blow of a market share focus versus profit is, and continues to prove, a virtuous cycle. Just like the Wal-Mart effect on many small businesses, extinction is inevitable for those that cannot adapt to their changing food source.  
2. Climate Change: The science seems overwhelmingly in support of a need to reduce the world’s global carbon footprint. There are many businesses and industries that will continue to help this effort toward emissions reduction, and there are emitting industries whose extinction seems inevitable.  
3. Gas Evolution: Through advances in technology (horizontal and deep water drilling) the world has found a relatively clean energy source that can help significantly reduce carbon emissions and meet a growing world energy demand. To move natural gas we will need to re-plumb the world’s gas and oil supply chain – liquefaction, gasification, transportation, storage, as well as adapt geographically to where it makes economic sense to refine and store these energy assets. 
Descent of Business
An investor I respect shared a conversation with me that he had with Charlie Munger, who asked him, “What percent of businesses will be better ten years from now than they are today?” This investor’s answer was 15%. Charlie replied, “I would have said 20%, but you are right.” 
The invaluable lesson is that most businesses fail to adapt. What made most businesses successful is likely not the exact same system that will drive their success into the future. While altruistic principles are forever static, systems often get crushed under the weight of change. For some large businesses, they also may face the law of large numbers, where it becomes increasingly more difficult to drive the level of change to have compounding benefits.