HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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December 28, 2021

Founder Effect: Investing in the Behaviours of Long Term Success

Not everything that happens happens for a reason, but everything that survives survives for a reason. Nassim Nicolas TalebSkin in the Game – Hidden Asymmetries in Everyday Life

[Our brain] by creating originality out of random experiences, could have taken us from a mere 10 000 primates 75 000 years ago, scrambling back from the abyss of extinction, to 7bn creatures who have populated every corner of the planet and who have managed to rocket away from it and land elsewhere in the solar system. … all of it out of combined, interlocked unique imaginings of millions of minds … shared in trillions of exchanges to create the chaotic stew we call human culture.  . Chip Walker The Last Ape Standing – The Seven Million Year Story of How and Why We Survived 

The ascent of man is a fascinating and ongoing journey. The incredible acceleration of post-enlightenment human progress over the last 200 years is staggering and well documented. By comparison, our knowledge of how we evolved over the last few million years is limited and fragmentary. However, we have come to consider our prehistory as a smooth linear, almost inevitable, development depicted by gradual changes from chimp-like ancestors with dragging knuckles towards homo-erectus and into our familiar homo-sapien form. While helpful when trying to defend our origin story from the grasp of the creationists, this popular graphical representation radically misrepresents the truth of how we became The Last Ape Standing. It is a classic example of how heuristic models can outlive their usefulness. This lesson is relevant when considering how we look at the rapidly developing modern world as investors.

Over the last 20 years, studies of the fossil record combined with DNA sequencing have begun to reveal how random, chaotic and non-linear our journey to modern human existence has been. At least 27 different species of humans (and probably many more) evolved over the last few million years, many of which lived as contemporaries on the planet which today we dominate. Suppose we could observe our predecessors’ journey over this time frame. There is little evidence that there was anything inevitable about our ultimate survival and victorious outcome among the many hominid life forms and human species that were available. We are the by-product of chaotic randomness and radical uncertainty, but we don’t typically choose this as our guiding narrative or world view.

The victors write history, and, as Taleb pointed out, our use of narrative has evolved alongside a tendency to abhor the role of chance in human endeavour. We have become Fooled By Randomness, such that we overestimate causality and tend to view the world as more explainable than it is. Our curse is that we suffer from survivorship bias. We naturally see ourselves as the logical and deserving winners in life. As a result, we tend to underestimate the skewed distribution of potential outcomes in everyday life, even though our very existence is probably the fattest tail-event conceivable.

One of the unknown number of freakish random factors that led to humanity’s lottery win was the adaptation our predecessors endured as they began walking upright. A consequence of this adaptation was that our offspring were naturally selected to be born earlier for them to make it through the more constricted bipedal birth canal. The result was that human brains arrived into the world in a less developed state. Taleb argues that this gave us more skin in the game and an enhanced chance of survival. We spent more time developing our cognitive ability in the real world rather than in the secure, isolated environment of the womb. As a result, we are today the most self-aware of all known life forms allowing for the development of language and multiple other layers of emergent behaviour such as social structures, religions and political organisations, and methods of production and commerce.

The combination of chaotic, freakish randomness and outsized returns over an unimaginably long time has shaped the human society that we know today. We are now at a point where our emergent world is developing exponentially while our physiological and cognitive development occurs at the same glacial pace. As a result of this divergence, our world is more complex and, consequently, more indeterminant. Yet we continue to cling to outdated models of how our world works despite evidence that these models are becoming less helpful at predicting the future or guiding our behaviours.

An example of how we are blind to this inherent dilemma is in investment and the strategies we adopt to pick winners. The active management of equities comes in two main styles. Value, where shares are bought that trade in the market at a discount to a measure of “intrinsic value”; and growth, where shares are bought that offer access to faster-growing segments of the economy.

Both value and growth methods of stock selection are based on models of how the world works and how investors can use these models to achieve superior stock selection based on a version of valuation anomaly. Value investing is based on a world view of a Keynesian evenly rotating macro economy that tends towards equilibrium, a strategy that worked best from the 1940s to the 1970s. Growth investing focuses on the factors that might lead a particular company to grow more quickly than the average over a sustained period. A standard method looks at past financial returns that the company has delivered which indicate that the company has a defendable competitive advantage. Growth investing has been particularly successful since 2008, a period of previously unseen levels of asset price inflation stimulated by quantitative easing, Modern Monetary Theory and various forms of fiscal stimulus.

However, another way of picking winners is by behavioural characteristics rather than financial metrics. Specifically to select those businesses that demonstrate resilience and optionality. Our evolutionary success was based on adapting to our changing environment with the optionality of developing unchallenged cognitive superiority. It is logical to think that companies with similar characteristics should do well over the longer term. These companies are typically founder-led, where the people who run them have meaningful skin in the game and the mandated agency to adapt their businesses to a changing world. Skin in the game changes the risk dynamics for outside investors by more accurately aligning the interests of insiders and outsiders. As an analogy, it is preferable as an air passenger to fly in a plane where the pilot is not wearing a parachute, more closely aligning your risk profie with his.

In his book Skin in the Game, Taleb says that evolution can only happen if the risk of extinction is present. There is evidence that our direct ancestors in the last significant ice age became a small and isolated troop in the Southern tip of Africa that approximates the plight of today’s mountain gorillas. While this is unproven, what is clear is that in the relatively short number of millennia following our potential near-extinction event, we began our journey out of Africa. Our unlikely worldwide migration and our successful adaptation to its many and varied regional environments suggest we might have evolved more quickly due to this near-death experience. Population geneticists refer to the founder effect as the loss of genetic variation that occurs when a new population is established by a very small number of individuals that become isolated from a larger population. Any particular founder effect might lead to an evolutionary dead end. But in extreme cases it is thought that founder effects lead to the formation of new species. There are obvious similarities here to a founder led start-up.

In his book Zero to One, Peter Thiel, the entrepreneur and Silicon Valley VC, has likened successful startups to cults. The most significant difference is that cults tend to be fanatically wrong about something important. In contrast, people at a successful startup are fanatically right about something those outside it have missed. This founder effect as a conspiracy or insurgency to change the world is a potent glue that binds its co-conspirators. There is strong evidence that quoted founder-led or family-controlled companies outperform their peer group of listed companies over the long term. This effect can be due to several factors, but they are essentially behavioural characteristics that promote both resilience and adapability (or optionality).

Bain & Co. have applied the term the Founders’ Mentality as a critical factor to produce scale insurgency in a business. In their view, a Founders’ Mentality inculcates three key behaviours into a business: An Owners’ Mindset; A Spirit of Insurgency; and A Frontline Obsession. Their research has shown that companies that maintain the Founder’s Mentality as they age are four to five times more likely to be top quartile performers in the S&P 500. Similarly, Credit Suisse track The Family 1000, a proprietary global database of over 1000 family-controlled or founder-led listed businesses. They found that family-owned and founder-led companies have outperformed non-family-owned peers on average by 370 basis points per year since 2006.

Our over-developed cognitive capability gave us a sustained competitive advantage which allowed us to purposefully shape our world rather than depend on the process of natural selection. In so doing, we have created a fast-moving emergent world full of complexity. The main idea behind complex systems is that the ensemble behaves in ways not predicted by its components. One way to prepare for the uncertainty that complexity can deliver is to pick a small group of people we can trust to grow capital for us most sensibly, most prudently and most directly over the longer term by harnessing their founder effects. In essence, to capture the benefit of their skin in the game as they navigate their own long term growth path with resilience and adaptability.

Jeremy

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