As the world of investing has become more quantitative, with alpha, beta and various “factor exposures” being sliced and diced and repackaged in various ways, it is easy to lose track of the fact that businesses are just collections of people working together as a tribe.

These tribes are formed in pursuit of some mission that revolves around creating value for customers, who themselves are just collections of people. And while the company tribe seeks to create value for various customer tribes, they are operating within an ecosystem of cooperating and competing tribes with the actions of every tribe within the ecosystem interacting with each other.

(Source: Harvard Business Review)

When you recognize that investing in stocks is about financing various parts of a living ecosystem, it becomes obvious that many of the mental models that investors should draw on to inform their decision making come from fields such as sociology, evolutionary biology, anthropology, and social psychology. Yet somehow, the investment field in recent decades seems to have drawn more from models found in the hard sciences. As if there was some sort of underlying “laws of investing” – a “magic formula” – that explains the ways that stock prices move as if they were physical objects subject to the sort of immutable laws that govern chemistry, math, and physics.

While written nearly 20 years ago, one of the best investment books to draw lessons from the so called “soft sciences” is Investing: The Last Liberal Art, by Robert Hagstrom. Hagstrom is a professional investor who has written many books about the investment strategies of Warren Buffett, but in The Last Liberal Art, he explores what Buffett’s investment partner Charlie Munger has called a “latticework of mental models” drawn from a range of disparate fields including biology, psychology, philosophy, literature, sociology and more to inform the investment process.

More recently, Katherine Collins, a professional investor and a board member of the Santa Fe Institute, a world leader in multidisciplinary research on complex adaptive systems, published The Nature of Investing: Resilient Investment Strategies Through Biomimicry. In her book, Collins argues for an approach to investing based on the lessons of the biological world that “values resiliency over rigidity and elegant simplicity over synthetic complexity.”

Ecology is the branch of biology that deals with the relations of organisms to one another and their surroundings. What is equity investing other than the study of collective organisms (humans’ superpower is our ability to assemble individuals into a collective group that acts as a single super organism) and how they relate to other organisms (other companies and customer sets) and their surroundings (the economic, social, political, and cultural systems in which business is conducted)?

It was with these sorts of mental models on my mind that I recently listened to Michael Mauboussin give an interview with the Alliance for Decision Education, a nonprofit group focused on helping students learn to be better decision makers in service of living better lives and building a better society. For those of us who have spent a lot of time in the field of decision research, the formal and advisory board of the Alliance is a remarkable who’s who in the field including Michael Mauboussin, Daniel Kahneman, Garry Kasparov, Barbara Tversky, Paul Slovic, Barbara Mellers, Phil Tetlock, and Annie Duke. If you don’t know those names, just take it from me that this is like the Mount Rushmore of decision-making researchers. We referenced the work of several of them in our series about position sizing.

Michael Mauboussin is not only a leading expert in the field of decision making and the chair of the board of the Santa Fe Institute (see Katherine Collins bio above) but is first and foremost one of the most influential voices in the practice of equity investing. Our team has read most everything he has written publicly while in his roles at Legg Mason, Credit Suisse, BlueMountain Capital, and currently as the Head of Consilient Research at Counterpoint Global, a division of Morgan Stanley. The title of “Head of Consilient Research” is an uncommon one, but since consilience is “the linking together of principles from different disciplines” you can see how relevant Mauboussin’s background is to this topic.

In his interview, Mauboussin discussed the ways in which ants forage for food and in doing so clarified for us an important element of how we think about evaluating corporate management teams.

Here’s Mauboussin:

“So now I’m going to talk about social insects. This is about ant foraging. We’ll use ants as an example. You have a nest of ants and there’s a food source. Exploitation would be when the ants go out, find the food source, and then they just focus their attention on getting as much of that food into the nest as possible. The way the ants do this is they go out randomly. But they’re laying pheromone trails as their means of communication.

Once an ant finds the food, they come back. That trail gets a little stronger. The ant comes out, senses that and so that reinforces it. As they travel the same path that becomes a very strong pheromone trail, and that’s how they figure out how to do that.

If you actually watch ants in your backyard in the summertime, they’re kind of doing crazy stuff all the time. The scientists were studying them, and they would find out that some ants would just peel off of the pheromone trails that lead to the food source. Then they got much more scientific about studying that rate of peeling off and it turns out there’s a mathematical probability.

Here’s the thing that’s absolutely beautiful. This is the thing that’s so cool. It turns out that the probability of peeling off the path is in fact a function of the rate of change in the environment. So when the environment does not change rapidly, the ants go for mostly exploitation and very little exploration.

When the rate of change is rapid, they know that the food source may be exhausted quickly and there may be other food sources that are popping up around them. They’re going to allocate more resources towards exploration…

If you go to ecosystems in our world today, there are some environments that are extremely stable, and you’ll see almost all those species are all about exploitation. They do very little exploration. You’ll find other ecosystems that are rapidly changing. You’ll see the species there that adapt are very big explorers. They do very little exploitation per se. Then there’s everything in between.”

Note: when Mauboussin uses the word “exploitation” he is using the word as it is used in ecology to describe the way that a species competes with other competitors for scarce resources, not as it is commonly used to mean “taking advantage of something in an unfair or abusive way.”

OK, so we’re investors, not ant researchers, so why does this matter?

A few years ago, we wrote a post laying out a framework for corporate management evaluation that we referred to as Visionaries & Optimizers. We argued that both of these approaches to management can work well, but it is important to match the right management style to what a particular business needs at that point in its life cycle. Importantly, we argued that value investors as a group tend to over value Optimizers and undervalue Visionaries.

“Visionaries: Tend to be purpose-driven, intrinsically motivated, and growth oriented… massive potential if they execute on their vision… But Visionaries can make bold bets in the wrong direction… Visionary CEOs can make investments today that are designed to achieve a long-term goal, but may seem stupid in the short-term… the range of potential outcomes is extremely wide… Because of the call option-like payoffs of investing in Visionary-led businesses, their stocks also tend to trade at high multiples relative to comparable firms in their industries… The combination of massive uncertainty, unproven business models, and expensive-looking stocks is not an ideal mix for traditional value investors.

Optimizers: Typically run mature businesses where efficiency, frugality, and a repeatable capital allocation strategy are paramount to success… To be a great allocator, Optimizer CEOs need a steady source of cash flow from the underlying operations. As such, they’re often found in businesses and industries that feature recurring revenues, long-term contracts, or habitual consumer purchases… the range of outcomes is narrower given the steadier nature of the operations… Their effectiveness is regularly evident in quarterly and annual results… Value investors are much more comfortable with what we call Optimizer CEOs.”

We concluded:

“Neither type of CEO is uniformly better than the other. Much depends on the company’s stage in its lifecycle and its underlying business… a given company might need a Visionary and Optimizer at different points… you want a creative Visionary leader to solve problems for which there isn’t a known answer and to navigate dynamic competitive landscapes. Optimizers work best within relatively stable competitive settings and where best practices are known and achievable.”

So we knew that the level of dynamism in the competitive landscape, the rate of change in the ecosystem in which a company operates, was a key element of the management approach that has the best chance of success. But what Mauboussin explained in the interview is that this insight is not specific to corporate management, rather it is descriptive of how life operates everywhere. It is a “law” of natural ecosystems of which corporate strategy is just one example. Mauboussin uses ants as an example, but explains that this sort of exploitation (i.e. optimization behavior) is universally the best strategy in ecosystems that are stable while exploration (i.e. visionary behavior) is universally the best strategy in ecosystems that are changing rapidly.

Thus, the general value investor preference for Optimizing (i.e. exploitation focused) management teams makes perfect sense if the investor is investing in businesses with stable industries. But when investing in dynamic industries investors should insist on investing behind Visionary (i.e. exploration focused) management teams.

But living systems cannot actually be fully separated from each other. Every company is part of an industry that is part of a sector that is part of a national economy that is part of a global economy. And there are times when the rate of change increases not just in a particular industry, but across the entire global economy. One of the major events that can increase the rate of change across all industries is the development of a major new technology. And so in recent decades, we have seen the emergence of the global internet cause just about every industry to change the way they do business.

We live in an age of disruption. It isn’t just a technological revolution. A decade ago, we experienced the worst global financial crisis since the Depression and now we are living through an unprecedented global pandemic. As we discussed in our post last year about widening and shifting Overton Windows across a range of very important social contracts, we are living through a period of time when change itself seems to be the only constant.

But as Mauboussin explains, neither exploitation nor exploration is the best approach for every organism at every point in time. And in fact, successful organisms deploy both strategies in different mixes depending on the circumstances.

The whole point of ants exploring is to find a food source to exploit. If a group of ants was made up exclusively of explorers, each time they found a new food source they would leave it behind while they explored for something new.

The same issue is true for management teams. The whole point of a CEO being a Visionary is to explore in search of a profitable niche you can optimize. If once you find that niche you keep exploring rather than optimizing for profitability, your search was in vain all along.

But while Visionaries can hyperactively explore for something new and forget to actually feast on the profit pools they find, Optimizers face the opposite risk. In mature industries, Optimizing management teams may be successful for long periods of time. But once change returns to the ecosystem in which they operate, they can be caught flatfooted and forgotten how to explore. This dynamic is at the heart of the posts we wrote (Part I and Part II) about hugely successful, legacy consumer brands facing a slow death as the internet has enabled massive changes to the ecosystem of sales, marketing and consumer preferences.

This inability of a management team to recognize the shifting needs between optimization and visionary behavior was why we sold out of our position in TimeWarner back in 2016, when it became clear that the company was more focused on preserving their dividend rather than investing aggressively to make HBO into a global direct-to-consumer media company to rival Netflix. And it was our recognition that the legacy media companies were too busy Optimizing to prevent Netflix from successfully exploring their way into a massive profit pool that gave us the confidence to invest in Netflix after we exited TimeWarner.

Today, while Disney, along with the other legacy media companies, have finally realized they had been too focused on optimization and not enough on exploration, Netflix, long the Visionary in the space, has gotten more aggressive in Optimization in order to reap the rewards of the Exploration they did so well.

Years ago, while the legacy media companies attempted to prevent their users from sharing passwords, Netflix made clear that they didn’t care about this. In fact, they joked about users sharing passwords and teased their rivals. But today, Netflix’s exploration has landed them a prime seat at a massive profit pool. And so, they’ve begun experimenting with limiting password sharing.

Is this the right moment to optimize? Neither we nor Netflix management can be sure. But testing out optimizing behavior after successful exploration is exactly what the very best Visionary teams do. Importantly, Netflix’s Optimization tests with limiting password sharing is focused in the mostly mature US market, not the still rapidly growing international markets where a Visionary approach is still the name of the game.

There are always ports in even the most violent storms and making sure that our portfolio is made up of a mix of Optimizers operating in relatively stable industries along with Visionaries operating in dynamic industries is an important source of risk reducing diversification. And what is critical is that we, as well as the management team who we have invested behind, recognize when change has come to their industry and it is time to be more Visionary, or when a formerly dynamic industry settles into a more stable equilibrium and it is time to focus more on Optimization.

There is so much knowledge in the world beyond what is taught in an MBA program or in books about stock picking. Investing is intrinsically a natural act of providing resources to an organism operating within an ecosystem. Investing is a form of participating in the living ecosystem in which the human race organizes itself into groups and then engages in both competitive and cooperative value generating behavior.

You can slice and dice securities into derivatives and factors, arbitrage away mathematically calculated measures of risk, and mechanize the investment process to the extent that it is no longer recognizable as part of a living ecosystem. But while this may seem attractive, as we’ve seen time and again in recent decades, these mechanized abstractions of natural reality end up crashing and burning as it becomes clear that their artificial reality had ceased to accurately represent the messy reality of the living ecosystem that they were attempting to model.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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