Two days before my course started at MDI on Friday, I had a fall.
A rugged stone appeared from nowhere while I was running around a tomb. I fell. Hard. Bruised all over my arm and my knee. Skin off my palm. Bleeding, limbed back home, got fixed by a wife and a doc. It hurt like hell.
But now I just can’t get the Red Queen out of my head.
You see, I was trying to get somewhere. From my present state of moderate stamina to be able to run a half marathon by the end of this month. But for now I am back to where I started, which is basically nowhere. Just as the Red Queen said. I should have stuck to running on the boring treadmill (on which you really get nowhere) instead of running around the tomb of a king called Humayun who died 457 years ago.
Humayun, with his arms full of books, was descending a staircase from his library when suddenly Adhan (the call to prayer) was announced. It was his habit, wherever he heard the summons, to bow his knee in holy reverence. Kneeling, he caught his foot in his robe, tumbled down several steps and hit his temple on a rugged stone. He died three days later.
Those rugged stones are dangerous.
But hey I survived them! Just so I could tell you about the Red Queen. And her “effect.” And what it has to do with businesses and stocks.
The Red Queen is a fictional character in Lewis Carroll’s “Through the Looking Glass.” In a famous scene the Red Queen seizes Alice by the hand and drags her, faster and faster, on a frenzied run through the countryside, but no matter how fast they run, they always stay in the same place. Alice, who is understandably puzzled, says
“Well in our country you’d generally get to somewhere else – if you ran very fast for a long time as we’ve been doing.” “A slow sort of country!” says the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
Red Queen Effect in Evolutionary Biology
In 1973, Leigh Van Valen, an American biologist possessing a multidisciplinary mind, morphed this story into what became the legendary “Red Queen Effect” – the idea that there is a constant “arms race” between co-evolving species.
In his excellent book “Deep Simplicity,” John Gribbin describes the Red Queen Effect in terms of an imaginary species of frog that feeds on an imaginary species of fly.
“There are lots of ways in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one possibility. If a frog has a particularly sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year.
Because of a mutation a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the flies have got more slippery bodies.”
In other words, you run, but your get nowhere. Just like me.
In his Pulitzer-prize winning book “The Emperor of All Maladies: A Biography of Cancer,” Siddhartha Mukherjee describes the evolutionary arms race between the drugs and cancer.
“In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfield’s cancer responded briskly at first. The fraction of leukemic cells in his bone marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response was short-lived. In the winter of 2003, Mayfield’s CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had become resistant to targeted therapy…”
“… Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles’ heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.”
While the Red Queen Effect predicts you will get nowhere, the effect marches on, jumping over one discipline’s jurisdictional boundary into others’. It jumped from fairy tale land to the disciplines of international diplomacy (“arms race”), evolutionary biology (“frogs and flies”), and the field of drug discovery. It also jumped over to the field of finance.
Take a look at this woman:
She is going nowhere by climbing up on a down escalator. Funny, isn’t it? We laugh at her predicament. But what about the predicament of investors who make no real progress with their money because choices they made failed to keep pace with a down escalator called “inflation?”
The Down Escalator of Inflation
Warren Buffett has written about the effects of inflation on investors several times. Here is one except.
“Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.
High rates of inflation create a tax on capital that makes much corporate investment unwise—at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners—has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.“
Crappy Businesses are a Down Escalator Too
They ask you to keep on pouring more and more capital into profitless growth. Buffett calls the worst business to be
“one that grows a lot, where you’re forced to grow just to stay in the game at all and where you’re re-investing the capital at a very low rate of return.”
He gives example of the airline industry.
“Investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.”
Ben Graham’s “Frozen Corporation”
Graham used to talk about a fictional “Frozen Corporation” whose charter (“Memorandum of Association” in India) prohibited it from ever paying out anything to its owners or ever being liquidated or sold. And Graham’s question was
What is such an enterprise worth to public stockholders?
He was obviously talking about “value traps.” But Charlie Munger extended Graham’s metaphor by identifying functional equivalents of the Frozen Corporation in the real world.
“There is a class of business where the eventual “cash back” part of the equation tends to be an illusion. There are businesses like that – where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.”
The world is full of crappy businesses which are the functional equivalents of Graham’s Frozen Corporation. One of my favorite examples is Samtel Color, a company whose fortunes can be seen from the chart below:
This company, as far as I can make out, never made any real profit in a decade. In a capital intensive business like the Television manufacturing, the rate of obsolescence is very high. Black & White picture tubes got displaced by colour TVs and Cathode Ray Tubes got displaced by Flat Panel TVs. These plants don’t come cheap. A plant may have a useful physical life of 20 years but it becomes obsolete much earlier when customers shift preferences to the hottest new technology. For Samtel Color, this meant that its maintenance capex far exceeded accounting depreciation, resulting in no real earnings.
Such type of companies – and there are hundreds of them – face miserable choices. Either stop investing in new technology and die. Or pour more and more capital and still make no real profits. There is no real progress as they have to keep on running just to stay still. All of the dividends paid by Samtel Color over the last decade, for instance, weren’t really financed from economic earnings because there weren’t any. Rather, the money paid to stockholders came from lenders and – surprise! surprise! – from stockholders through issue of new shares for cash. That’s a ponzi scheme, isn’t it?
High capital intensity, insignificant, if any, economic earnings, and inevitably rising debt ultimately kills such companies. Regardless of how their stocks may perform in the short term, in the long-term they go nowhere (see Samtel’s stock price chart). Or they go to zero.
The Red Queen Effect haunts them.