Run Baby Run, Says the Red Queen, Or You Will Go Nowhere

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:

Screen Shot 2015-12-01 at 08.53.39.jpg

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.


35 thoughts on “Run Baby Run, Says the Red Queen, Or You Will Go Nowhere”

  1. This reminds me of the following discussion from Alice in Wonderland:

    Alice asked, “Would you tell me, please, which way I ought to go from here?”

    “That depends a good deal on where you want to get to,” said the Cheshire Cat.

    “I don’t much care where…” said Alice.

    “Then it doesn’t matter which way you go,” said the Cat.

    “…just so long as I get SOMEWHERE,” Alice added as an explanation.

    “Oh, you’re sure to do that,” said the Cat, “if you only walk long enough.”

    ~ Lewis Carroll, Alice in Wonderland

    The capital destroying companies, and investors in them, are all going SOMEWHERE. And they will surely reach there…where Samtel lies currently. Such is the potent and damaging power of poor returns on invested capital + inflation!

  2. Take care sir, you never know, u may still be able to run half marathoner on 30th, as it happens from mind and body will recover

    Sent from my iPad

  3. some of my thoughts about red queen effect :

    +. One way to get somewhere (inflation adjusted) is to have shorter life cycle like the flies; moving from one deal to another constantly in search of better returns ….. don’t know but Risk Arbitrage ?!!! running at double speed then country is moving.

    ” most of the money i have made has been due to qualitative analysis ….. but the a good and sure amount of money is to be made out of pure quantitative analysis ” WEB

    you do them with pretty much frequency i suppose.

    or. short time contract base businesses with little Capex requirement … viz. real estate broking, consulting …… trading. may be BYD

    +. or in the super long term … businesses with extreme pricing power, quintessential services ….. with a one hell of a moat

    viz. Decision Resource Group (DRG) Acquisition by Piramal Enterprises. and from Berkshire lore …… Iscar cutting tools business and Lubrizol specialty chemical company or EIL from Priyank bhai

    CHARLIE MUNGER: “Yeah, you know, Iscar
    and Lubrizol, to some extent, are sisters under
    the skin. You’ve got very small markets that
    aren’t really too attractive to anybody with
    any sense to enter and (inaudible)( fanaticism ?) in
    service, so if you have any more like that why,
    please give Warren a call.”

    +. as the reflection was made by St. Darwin we have too many offspring …….. like flees …….
    diversification in co.s with good management and after three years(or short) concentrating positions. more filters can be used.

  4. Professor, do you think a situation such as Haryana Capfin would qualify as a “Frozen Corporation”? Promoters are well entrenched too, with a 70% stake. Even though the company is selling at an extremely large discount to its value to a private owner, does the company’s assets hold any relevance for a minority investor? Which begs the question, can any price be called ‘too low’ for a minority stake in such a company?

    1. Difficult to answer that one Taha, particularly when one looks at the opportunity cost of missing investing in cheap stocks of growing companies with catalysts in place. This stock was a case in my class last year…

      1. Hi Taha and Prof,

        one should only look to invest in holding companies where there is a possibility of a promoter sell out.

        one example which I can think is Oscar Investments (the holding company of ranbaxy)
        it went up something like 10x when Singh brothers sold their stake in Ranbaxy to the Japanese.

        I know a few names where there is a possibility of a sellout but these are long long term kind of investments.


      2. If it is possible, it’ll be great if you could share the material of the class case study. Would love to get any additional insights on how to think about such a situation…

  5. One way to avoid the “red queen of inflation” is to invest in businesses with pricing power. But pricing power in itself, will attract competitors, which will force the business to invest heavily just to keep the moat intact. So, this is akin to a ‘red queen’ of a ‘red queen’ effect?!

  6. One of the most interesting red queen effects for me to watch is the one in governance and especially tenders , where rules are made to gain more value by the government and circumvents are found by participants to capture more value. But the frog seems to be well tied in his own mess it seems.

    1. Agree with Mihir. Added to the Frog’s own mess is the illusion of “fair playing field” especially in E-Auctions or Govt. tenders. Kickbacks and collusions have a way of finding their way into anything that the Govt does…electronic or otherwise.

  7. Dear Sir,

    I think it might be relatively easier for a value investor to identify Samtel type of companies, which don’t make even PAT profits or whose ROEs are very low. The more vicious type would be something like Sanghvi Movers. I have been looking at this company for sometime now and have been so confused. In their history of operations, they have never made any FCF (cumulatively). They have always operated with debt and have high capital intensity. But they make good returns which are again re-invested in the business. It is not even clear whether they are expanding their capacity or just replacing old assets – i.e is it actual maintenance capex but paraded as growth capex? Their incremental ROCEs have dropped in last 2 years, but the challenge is understanding whether that is a structural shift or whether it is a temporary cyclical drop. How does one evaluate such businesses? Any thoughts would be helpful.

    1. How much cash flow will they generate if they stop buying cranes? If they stop growing, how much will be the earnings that can be taken out without feeling the need to put them back in the business?

      FCF is not same as owner earnings. Owner earnings = operating cash flow less maintenance capex – additional maintenance working capital deployed. While estimating operating cash flow care should be taken that items which should be treated as expense, haven’t been capitalised because that would inflate operating cash flow numbers.

      Conversely, in some companies items which could perceviably be capitalised are treated as expense (marketing and branding in FMCG companies, R&D in Pharma companies). In such cases, operating cash flow numbers which are used as a base from which owner earnings are estimated, are understated. Therefore owner earnings often exceed reported earnings.

      1. I am not sure if Samtel Colour was easy to identify as a trap back then. I am reproducing a mail which I received below. These are not good arguments by any stretch, but 2007 was a market where cheap stocks with high quality were hard to come by. In such times, there were investors who bought in to cheap stocks with low quality.

        On Sun, Aug 19, 2007 at 1:37 PM, XXXX wrote:
        Research Note on Samtel Colour…..

        Samtel Colour Eq 46 crs top line Rs 1200 crs Market cap just Rs 70 crs

        Co had capacity of 11 mn picture tubes having three existing lines. It had recently increased the lines from 3 to 5 which made co sink into deep financial mess. Co reported loss of Rs 35 crs for the full year out of which Rs 25 crs was for Q4 alone. This includes a one time write off of Rs 30 crs (under the head stock adjustment) which means in effect the co has earned Rs 5 crs for the March quarter.

        In the March quarter results co also announced confirming that it went into financial mess due to extension two news..

        “Despite increased Sales Company is passing through liquidity tightness because of delay in ramping up of the two new lines and insufficient accruals. Company has decided to restructure its debts and has submitted a proposal for Corporate Debt Restructuring under the CDR guidelines issued by the Reserve Bank of India. The proposal is under evaluation by the lenders”

        Co has debt of Rs 375 crs and as we understand from the CDR proposal co will not repay any principal or even interest for next 2 years as a package of CDR and also will go for OTS. It is also expected to see reduction of interest rates to 12%. Co has interest liability of 18 crs p a.

        Co has successfully commissioned its fifth line in March 2007 for picture tubes for 27″ and 29″ flat screen (mainly for exports) by spending Rs 400 crs and immediately bagged an order of 2.5 mn picture tubes p a for three years. This should transpire into good bottom line in 08. We expect Samtel should announce top line of Rs 1200 crs and bottom line of Rs 53 crs for 08.

        Samtel has the gross block of Rs 900 crs whereas the debt is just Rs 375 crs which is again subject to OTS and CRD. Book value per share is Rs 60 and Networth of the co is Rs 280 crs. At current market cap of Rs 70 crs there is strong case of making a multi bagger investment in Samtel Colour Ltd.

        India Advantage Fund has sold close to 2 mn shares which were quietly grabbed by market maker. Also ICICI Venture has sold off its entire stake in the market.

        Most of the market players had entered Samtel during 2005 at Rs 80 levels with lot of value in it which has now eventually come a bottom where even industry fortunes are changing with demand revival in flat screen segment. Samtel with Rs 1200 crs top line yet available at Rs 16.

        In view of the fact that a smart investor has cornered more than 3 mn shares in Samtel in June 07 at Rs 18 thr blokc deals is a fair indication of revival of interest in this co.

        Company has issued and alloted 22 lacs (2.2 million) Warrants having optional right of conversion into equity shares to Promoters Companies namely Roxy Investment CEA Consultants & Teletube Electronics at Rs 90.18 per warrant to be converted into 2.2 million equity shares of Rs 10/- each at a premium of Rs 80.18 per equity share within a period not exceeding 18 months from the date of allotment.

        There is an additional trigger for stock re-rating. Co has 12 acre land which it is planning to sell at Rs 90/92 crs which means Rs 20 cash coming in the books of accounts.

        We strongly recommend buying this stock for at least 1 to 2 years perspective with price target of Rs 95.

      2. Hi Narayanan,

        If i would have read your samtel note in 2007.
        I certainly would have added Samtel as one of top holdings in my portfolio.

        Probably I might already be having many future samtels in my portfolio who would show their two colours in 3-5 years.


  8. Dear Prof Bakshi

    Hope u have recovered in the interim.

    The “red queen effect” is a interesting phenomenon. Some businesses like the airline business are wonderful examples as you clearly mentioned.

    I think the interesting piece is understand whether a industry which hasn’t displayed this trait could possibly move into a phase where it is running in the same place for long periods like 8-10 years before it resumes moving forward. A lot of it could happen because of technological changes where the participants have to keep investing to stay ahead of the pack. Samtel and Moser Baer are examples that are mentioned above but there could be examples which are not so obvious. For ex Indian telecom business had a great run ( Ex Bharti as a stock) but we could possibly be in a phase where the industry is working very hard for either the consumer or the government and not for the stock holders for long periods of time.

    Do u think that a significant number of industries could go thru these phases without we realising it ?



    1. Ninad, if we watch the money spend on capex and additional working capital and asking hard questions about the logic behind such expenditure, we should be on top of things. Any time a business requires additional capital (fixed or working) which will do nothing for rise in unit volume and/or market share, the money spent is an expense. When competitive conditions deteriorate, such “required” expenditure always goes up. It’s usually a warning signal of things to come…

  9. Well done! Something truly out of Poor Charlie’s multi-disciplinary approach 🙂 Wonder how you found that woman on the escalator video though!
    Another add-on here could be the case of the fund manager who increased earnings from 10 on a capital of 100 in the base year, to 11 in the second year and cited a 10% increase in profits.
    Wonderful post. Get well soon; Keynes was right when he said: in the long run, we are all dead… 😉

  10. A very simplistic article which drifts away from the main point…the pernicious effect of inflation.

    You quoted Ben Graham’s Frozen Corporation.Isn’t Berkshire Hathaway something like that?There is little chance of dividends or it ever paying out anything to its owners or ever being liquidated or sold !

    Samtel Color is in an industry with fast technological obsolescence and high capital intensity.But guess what?So is Apple and Apple is the most valuable company on the planet !!

    1. I think it’s extremely likely that BRK will pay a large dividend one day. That’s because of its size and consequent inability to produce more than $1 in value for every $1 retained; and (2) BRK’s stated dividend policy in Warren Buffett’s letters. So, for the moment the question of BRK being an example of Graham’s “Frozen Corporation” does not arise. This could, of course, change, if there is a change in policy after Mr. Buffett is no longer alive – which again, in my view, is very unlikely.

      As for Samtel Color vs. Apple, I think one should look, not at the exceptions but at the “averaged-out experience” i.e. the baseline rate. There are many many more Samtel Colors in the world than Apples. In fact, high-tech industry ranks high on list of industries with very high mortality rates. Why are mortality rates so high? I think a big part of the reason is rapid obsolescence where a lot of the capex recorded on books is not true capex, but large amounts of money is spend on new plant and machinery just to stand still relative to competition. Very few companies can race ahead of competition and stay ahead. In the high-tech world, only the paranoid AND the lucky survive.

      Contrast that with the kind of businesses BRK owns. It owns a business which makes bricks in Texas that, Charlie Munger once said, “uses the same process as was used for making bricks in Mesopotamia.”

      BRK’s businesses on average are less likely to become obsolete by new technology than the average technology company. That isn’t to say that BRK hasn’t suffered from obsolescence. After it’s textile operations were shut down because Buffett figured that new technology investment would have let it stay alive but would have prevented it from ever earning meaningful owner earnings and so it was just not worth it to keep it alive. And World Book’s franchise was destroyed by Microsoft Encarta, which was made obsolete by Wikipedia…

    2. Apple is valued more for its brand and its ability to have created a cult for its products. Its pricing power is its differentiation. The day it loses its ability to invent and subsequent pricing power, it will get classified as Samtel Color.

      To make life simpler, if I think like a businessman, whatever I bring back home for my wife, kids and savings after the hard work during the day is owner’s earnings. Unless, I do not splurge it on unnecessary expenses (aka extraordinary expenses) or I do not buy expensive cars or so on. As WB says, good investing requires good business acumen…



  11. Calling a company that doesn’t pay a dividend a frozen corporation is rather simplistic. One can’t count that as the only determining factor. Cause that would mean ascribing no value to the productive utilization of retained earnings, an obvious fallacy.

    Yes, if a company isn’t going to pay out anything to it’s owners and neither is it expected to grow in underlying value, or may grow but at rates well below expected future rates of inflation over the long term, then that looks more like a frozen corporation. And as professor has pointed out, Buffett’s explicitly stated dividend policy will mean a dividend for shareholders well before BRK reaches that stage. Buffett has spent his whole life solely searching for situations that grow money at a rate well above inflation, and his track record is enough of a testament to his expertise at that. I think with such a background it is insane to think that he will let his company resemble anything close to a frozen corporation.

    Also, pointing out Apple to justify a non-speculative investment in the fast paced tech industry is like someone citing “A man who smoked 3 packs of cigarettes a day and lived to be 99!” to justify smoking 3 packs a day… 🙂

  12. Sir, Great way to explain things, its a very good article. Sir whats your view on Wind Energy producing companies, like in India Orient Green Power Ltd

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