Investments as Organisms

Over time, I have reflected on questions such as, "over the long run, what makes equities the best asset class (over bonds and real estate)?" and "over the long run, what equities are the best to own?"

Increasingly, I am taking a biological answer to most of my questions. It appears that equities offer the best asset class returns because of their inherent adaptability. Equities are able to repurpose their physical, human and financial capital more easily than real estate and bonds. For this reason, equities are inherently more uncertain. Berkshire Hathaway (BRK) comes to mind as a company which continually reinvents itself to a degree that almost defies categorization. The result has been much better than if BRK had stayed with its original New England textile focus.

Generally speaking, this adaptability speaks to the importance of low leverage. Debt introduces reduced adaptability, forcing commitments to those most immediately relevant. As a result, little capacity exists to make significant change. Like living organisms with strict dietary requirements, companies with high debt levels are incapable of exploring new opportunities.

At the same time, investors hate this kind of radical adaptability. All too often, investors have seen managements play gin rummy in an impatient and capital destructive way. But the more critical issue seems to be one of managerial competence. It is difficult to argue that competence in retailing would lend itself to competence in finance.

With today's low interest rates and technology disruptions, the rate of change is accelerating. When Philip Morris announces that it is focusing on a "smoke-free world" and BP is focusing on getting away from oil and Nestle is focusing on moving away from food into nutrition, I am seeing more indications of what makes these organisms strong - a willingness to adapt and an ability to suffer.