Investment Insights from Mimicry in the Natural World

During their latest episode of the VALUE: After Hours Podcast, Taylor, Carlisle, and Jakab discussed Investment Insights from Mimicry in the Natural World. Here’s an excerpt from the episode:

Tobias: JT, have you got veggies there? Was that our veggies earlier?

Jake: No, no, I’ve got something. We can– [crosstalk]

Tobias: Spencer, we serve vegetables every time we do this. We have some dessert later, but vegetables are the learning portion of the podcast that Jake delivers.

Jake: So, this week’s veggies are on Batesian mimicry. This is another segment that I pulled from that book, What I Learned About Investing from Darwin by Pulak Prasad. And so, Batesian mimicry is when a harmless species has evolved to imitate the warning signals of a harmful species, and it’s typically directed at a predator that would be trying to eat them. It’s named after this English naturalist named Henry Walter Bates after he worked on butterflies in the rainforest of Brazil for over a decade, like, from 1848 to 1858. Actually, the first four years that he was working there, he was there with Alfred Russel Wallace, who was famously co-discovered, but doesn’t get as much credit as Darwin for natural selection.

So, anyway, Bates collected all of these hundred butterflies. While he’s sorting them, he discovers that some looked alike, but they actually weren’t even closely related at all. And so, it was a bit of a mystery there. He put forward the hypothesis that close resemblance between unrelated species was this anti-predator adaption. He noted that some showed very striking coloration. They flew around leisurely, almost as if they were taunting predators to eat them, which is kind of funny. But the birds were basically reasoned that these butterflies were unpalatable based on the color and avoided them.

So, basically, they were parasitizing these signals that were honest signals from another particular species, so that this Batesian mimicry gained them an advantage without having to actually go to the expense of arming themselves with poison, or the toxicity, or whatever that might be expensive to create. Maybe the best-known example of this is the milk snake that looks like the deadly coral snake, but it’s actually harmless, right? It can also be used for attraction. So, apparently, these large male green frogs will advertise their size and dominance by croaking at a lower frequency than smaller frogs. That probably just has to do with the size of them and the vibration. And then female frogs will be attracted to these low frequencies.

Smaller frogs have evolved the ability to copy that low frequency of the bigger frogs, [Tobias laughs] and they’ll preserve their territory by fooling larger males from even coming in and also attracting baits. I was thinking maybe the super lifted trucks is the human form of [Tobias laughs] Batesian mimicry of [laughs] pretending that you’re a macho man. Anyway, it also sometimes doesn’t work out so well for one party. There’s a certain species of fireflies that the females mimic the mating signals of another species, and they’ll deceive the males into coming close enough and then they’ll eat them.

Spencer: Oh, okay.

Jake: Yeah. So, then to add to our story here, 1975, an Israeli evolutionary biologist named Amotz Zahavi, I believe is how it’s pronounced, and he proposed this concept called The Handicap Principle. His hypothesis was that a signal that is costly to produce, the receiver can then interpret that it’s actually an honest trait and isn’t Bayesian mimicry, basically. So, the peacock is a classical example of this. It’s very expensive to have this large, colorful tail that attracts a lot of attention from predators, but the females see that and they see it as a sign of biological fitness, and then they want to mate with that male. So, what can we think about this in the world of investing in business? Like, what can we draw from this?

Prasad says that we should only look and give credence to those signals from companies which are actually costly to produce. So, you think about press releases, talk tends to be pretty cheap there. Management can highlight whatever they want. They could spin it how they want. Management interviews as well are pretty comparable to that. There’s lots of bromides and talking points, and rarely is it costly for them to point out what would actually might consider an honest signal. Like, every company is innovating, every company is leveraging technology, but what does that–?

Tobias: AI.

Jake: AI. Yeah, exactly. That’s all cheap, right? Conferences and road shows that they show up to not really much different. So, what about earnings guidance? This one’s interesting. The worst case is probably, Jack Welch and his time at GE where they had slush funds that were basically used, so they could hit earnings right to the penny. But there was a McKinsey study that came out about earnings guidance, and it found that there’s no evidence that providing earnings guidance affects valuation multiples, shareholder returns, or share price volatility. The only significant effect that it found, and this ties in, Spencer, some of the things you were talking about, the churn is that it increases trading volumes. So, the brokers are the only ones who win in this thing.

Spencer: Right.

Tobias: [laughs]

Jake: So, true, honest signals then like, what can we look for that? It tends to be more historical, like, them telling you something history like, our average margin over the last 10 years was 12%. Or, based on recent history, we’ve launched one product over the last three years instead of we’re going to do six projects in the next year, but what have you done historically? And probably the most honest statements and signals come from the proxy statement, that’s where you find skin in the game. This is like what you might look at some of Mike non-Gaap’s Dark Arts things that he’s written up, if you want to search for that. How’s management incentivized, what are their salaries, what KPIs are they tied to, are they sandbagging, what are the equity grants look like and the stock price for their options, how’s the board ensuring that talent is retained and incentivized, especially if their existing options are underwater, which is a more recent phenomenon?

Two special things that might look out for especially are what are called like spring loading and then bullet dodging. They’re the same thing, but opposite sides. Spring loading is when you grant options right before there’s a big positive news event. And then bullet dodging is when you delay to grant options until after a negative news event has happened and you sandbag and torpedo the stock price, potentially. Both are fall within a gray area, I think, as far as insider trading goes, but it doesn’t seem to be high up on the SEC’s list of things to worry about.

Anyway, those know, Batesian mimicry in the investment world, I think happens a lot, where people, they talking like the outsider’s book. They’ll pretend to be iconoclastic. But where does it actually show up? What are the real signals that are costly for them to produce, not just talk? Looking for those and trying to separate out costly from not costly will help you to understand, when are you dealing with the milk snake versus the coral snake.

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