Commercial Evolution
A Primer on The True Nature of Commerce & Investing
The science of economics is broader than commerce, but commerce is its heart and soul. Yet, of all the businessmen I know, many well-versed in the science, not one utilizes textbook economics in their daily work. This is damning evidence that the science has run astray. No other science is so thoroughly ignored by its practitioners.
What went wrong with the science of commerce? It went astray when Leon Walras borrowed equilibrium theory from physics in the 1870s.[1] While a useful metaphor, it mischaracterizes commerce as a “closed equilibrium system.”[2] Commerce is instead a complex, adaptive, and open system that is in a constant state of disequilibrium.[3]
Nevertheless, economics continued down the physics path. Green with physics envy, by the late 20th century, the science “had become a ‘giant academic game’ in which economists wrote papers for each other, showing off their mathematical brilliance, but demonstrating little interest in the relevance of their theories to the real world.”[4]
This did not have to be. In 1898, soon after Walras took the science down the physics path, the economist Thorstein Veblen tried to correct course. He argued economics would inevitably become an “evolutionary science,” but tradition was standing in the way. As Veblen recognized,
“Even if it has been possible at any time to turn to the evolutionary line of speculation in economics, the possibility of a departure [from tradition] is not enough to bring it about. . . . [T]he [traditional method] is the easiest, gives the most gratifying immediate results, and best fits into the accepted body of knowledge . . . .”[5]
The sciences of commerce desperately need disrupting, and, as Veblen argued in 1898, the likely disruptive agent is an evolutionary perspective. Commerce is evolutionary by nature, after all, and so, too, are financial markets, which are abstractions of commercial structures that underlie them. Unlike the physics path, which rests on a metaphor, the evolutionary path is no metaphor at all.
In fact, evolutionary processes were first recognized by early economists. In 1776, Adam Smith, the father of economics, discussed the Invisible Hand, an inherently evolutionary concept, and the political economist Thomas Malthus spoke elegantly about the “struggle for existence” in 1798.[6] Charles Darwin was influenced by both economists but especially by Malthus.
In fact, Darwin credits Malthus with his concept of “natural selection,” or “survival of the fittest,” the core insight of his masterwork, Origin of Species, published in 1859.[7] There, Darwin applied the theory to biology. Since organisms possess varying and heritable traits, Darwin rightly noted:
“[C]an we doubt (remembering that many more individuals are born than can possibly survive) that individuals having any advantage, however slight, over others, would have the best chance of surviving and of procreating their kind? On the other hand, we may feel sure that any variation in the least degree injurious would be rigidly destroyed. This preservation of favourable individual differences and variations, and the destruction of those which are injurious, I have called Natural Selection, or the Survival of the Fittest.”[8]
Would anyone dare argue this is not also true of commercial firms? Many more firms are born than can possibly survive in a niche. Advantaged firms, however slight, have the best chance to survive and procreate (i.e., continue and expand their businesses) while disadvantaged firms perish. Thus, favorable commercial variations are preserved; others are destroyed. This is “natural selection.”
The commercial science of economics must recognize the evolutionary nature of its subject. This paper is a modest step in that direction. In Section I, consumer selection, the equivalent of natural selection, is addressed through a Neo Darwinian lens. Then, in Sections II and III, financial and artificial selection are discussed, respectively, before concluding in Section IV.
I. Consumer Selection | A Neo Darwinian View of Evolution in Commerce
To say commerce evolves is no metaphor. It is true in a technical sense. Any population subject to “cumulative selection” pressure will evolve, which is true if the population’s agents (1) replicate with fidelity, (2) have variable and heritable traits, and (3) replicate at rates based on their variable traits.[9] As I argued elsewhere, commercial products undoubtedly possess these characteristics:
“Products are reproduced with great fidelity by firms, which means they replicate. Products also possess variable traits, and those traits influence a product’s replication rate. Ford, for example, cannot sustain, much less expand, the F-150 product line if consumers do not select the F-150 over substitutes, and consumer selection hinges on the F-150’s differentiating traits . . . .”[10]
This is not debatable. Furthermore, as the above quote implies, the focus should be on products, not firms, which is a Neo Darwinian view. Neo Darwinism revolutionized biology. The theory says the proper unit of evolutionary analysis is the gene, not, as Darwin thought, the organism. Genes are the true “replicators,” in other words, and organisms are merely their “survival machines.”
As a leading zoologist and Neo Darwinist, Richard Dawkins, succinctly said,
“[T]he fundamental unit of selection . . . is not the species, nor the group, nor even, strictly, the individual. It is the gene, the unit of heredity. . . . [As for individual organisms, they] are all survival machines for the same kind of replicator – molecules called DNA – but there are many different ways of making a living in the world, and the replicators have built a vast range of machines to exploit them.”[11]
A similar hierarchy exists in commerce. The “replicator” in commerce is the product, not the firm. The product, whether a good or service, is the commercial equivalent of DNA. More specifically, the commercial “replicators” are the product sub-units, or “premes,” that combine to make an end-product, as genes combine to make DNA. Like the gene, the “preme” is the “unit of heredity” that differentiates product-lines.
Firms, like organisms, are merely the “survival machines” of their products and their products’ premes. As argued later, firms are built to specifications dictated by the “premetic” makeup of their product-lines just like organisms are built to the specifications dictated by the genetic makeup of their germ-lines. Products make firms more than firms make products, in other words.
Thus, like the gene-DNA-organism hierarchy so useful to the science of biology, a preme-product-firm hierarchy exists in commerce and is equally useful in the science of economics. To make the argument, the firm will be introduced as a commercial organism in Section A. Premes, products, and their interaction with the firm will be elaborated on in Section B.
A. The Firm | A Commercial Organism
A firm, like an organism, is “an open system that survives through some form of exchange with its environment.”[12] It requires energy to sustain itself. Without adequate energy, it will surrender to the forces of entropy and dissolve into its surroundings. Like any organism, therefore, a firm must “make a living” by earning an energy surplus absent external infusions of resources.
To earn an energy surplus, a firm’s energy intake, or revenues, must exceed its energy use, or costs, including its cost of capital. That is, a firm must create economic value to survive long-term, and it must at least break even to survive short-term. Accordingly, the firm’s end-product must be more valuable to consumers than the resources it employs in the production thereof.
Consumers, not investors or government bureaucrats, therefore determine whether a firm is “fit” for survival in a free market. Consumers, free to choose, exchange their hard-earned money with a firm only if doing so is profitable for them. The exchange is profitable if the utility gained exceeds the price paid. This exchange provides the nourishment a firm needs to survive.
The more profitable a firm is, or the greater its energy surplus, the “fitter” the firm is for its niche. A firm earning a 20% energy surplus, defined as returns on tangible capital employed, is producing a product consumers value far more than its cost of production. It creates economic value. The opposite is true of a firm earning a 20% energy deficit. It is destroying economic value.
The “fitness” of a firm determines how fast it can expand. A firm earning a 20% energy surplus, for instance, can expand its capital and product-line by 20% per year if it reinvests 100% of profits. A firm earning a 20% energy deficit, however, will deplete its capital and shrink its product-line by 20% per year absent infusions. The latter’s product-line will lose share to the former.
It is in this way that a species of industry evolves via consumer selection. Each firm produces a product with differentiating traits. Consumers select the product with the best value proposition. If produced profitably, firms with products consumers select for grow; firms that do not stagnate or die. The differentiating traits of the former’s product spread while the latter’s are destroyed.
All else equal, then, investors obviously should prefer “fit” firms. They can grow and are better able to survive less hospitable conditions. A “fit” firm is one that earns a high energy surplus, or organic profits, derived from a product consumers deem “fit.” We define organic profits as returns on tangible capital employed, or pretax enterprise earnings divided by tangible capital employed.
High returns on tangible capital employed, or organic profitability, attracts competition. It signals to entrepreneurs an opportunity to create value of their own. How, then, can a firm earning high rates of organic profits sustain its economics in the face of profit eroding competition? This is where an evolutionary perspective becomes most useful.
B. The Preme & The Product | The Gene & DNA of Commerce
Evolutionary theory is the best tool for assessing the sustainability of organic profitability. Excess profits cannot be sustained without durable competitive advantages, and competitive advantages are best understood through an evolutionary lens. Such a lens must be properly focused, however, on the proper unit of evolutionary analysis. In commerce, this is the product and its “premes.”
1. Hierarchy | A Preme-Product-Firm Model
A firm depends on consumers for nourishment. It is the consumer, then, and not the capitalist or government bureaucrat, that determines whether a firm, based on its product’s value proposition, is “fit” or “unfit” for its niche in a free market. As such, consumers are the arbiters of commercial fitness. Consumer selection is therefore the primary selective force in commerce.
If, as we have asserted, selection pressure exerted by consumers at the product level is the primary selective force in commerce, then products, not firms, are the proper units of evolutionary analysis. More specifically, the proper units of analysis are the sub-units (e.g., engine, brand, style) that combine to form the value proposition of a firm’s end-product (e.g., Ford’s F-150).
End-products, in other words, are, like DNA, complex structures of sub units. These sub units, like genes with DNA, battle for inclusion in end-products. If, for instance, a firm earns a 50% organic profit serving burgers from a prime, high traffic location, then competitors will replicate those defining attributes. They will not open a Chinese restaurant located 10 miles away.
Others have arrived at a similar, albeit slightly different, conclusion. “[I]t is ultimately the fates of populations or genotypes (routines) that are the focus of concern,” argue Nelson and Winters in An Evolutionary Theory of Economic Change, “not the fates of individuals (firms).”[13] Hodgson and Knudsen adopt the same reasoning in their book on the subject, Darwin’s Conjecture.[14]
Whereas the above authors consider routines as the “replicators,” we see the replicator as premes, or product sub units. But this may be a difference of only semantics. If a preme is the manifestation of routines executed within a firm, then premes are product phenotypes and routines are product genotypes. Since premes are easier to observe, then premes make for a better unit of analysis.
But we digress. A preme is any attribute impacting a product’s value proposition. It can be as minor as employees saying, “My pleasure,” at Chick-fil-A or as major as iOS for Apple’s products. Premes are thus the “premetic material” of product-lines, and premetic material is all around us in the form of ideas. It floats about like pollen ready to fertilize a receptive entrepreneur’s mind.
Or, as Nelson and Winters wrote,
“[I]nnovation in the economic system . . . consists to a substantial extent of a recombination of conceptual and physical materials that were previously in existence. . . . [E]ach new achievement is . . . a new item in the vast storehouse of components that are available for use, in ‘new combinations,’ in the solution of other problems in the future.”[15]
As such, premetic material mutates, or changes, at warp speed. It takes only a new idea. And these mutations alter products quickly as entrepreneurs adopt the most promising bits of information. As the product-line is altered, so, too, is the structure of the respective firm in the form of employee skills, operating processes, production equipment, raw inputs, vendors, distribution channels, etc.
To earn excess profits, then, a firm’s product must offer consumers a superior, differentiated value proposition. This requires, by definition, premetic material unique to the firm’s product-line. Without this, profits erode with commoditization. Thus, the sustainability of a firm’s “fitness,” measured by organic profitability, hinges the concept of premetic diffusion.
2. Premetic Diffusion | The True Nature of Competitive Advantages
Unique premetic material is therefore the source of excess profit, and excess profit decays if the premetic material diffuses into competing product-lines. For excess profits to be sustainable, then, some firm-specific attribute must forestall premetic diffusion into the product-lines of competing firms. Such attributes are referred to as competitive advantages or economic moats.
Warren Buffett, the legendary fundamental investor, thinks in similar terms. Moreover, his analysis of economic moats is first and foremost at the product-level. As he said in 1999,
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”[16] (emphasis added)
The firm-specific attributes that forestall premetic diffusion are many. If consumers have imperfect information and the cost of a purchasing error is high, then a brand is a differentiating “success trait.” If price is a key trait consumers select for, then economies of scale that allow a firm to charge a lower price is a differentiating “success trait.” There are many more such attributes.
Back to our burger restaurant example, anyone can build a firm serving burgers, rent prime real estate, and mimic ambiance. Thus, such a firm has little, if any, unique premetic material. Premetic diffusion, commoditization, and, in turn, declining organic profitability is inevitable. Our example restaurateur’s 50% return on tangible capital employed is certain to erode with commoditization.
Turning to a real-world example, Apple’s operating system, iOS, is a trait consumers value, and its proprietary nature forestalls premetic diffusion. Android competitors must pressure Alphabet to mimic iOS’s functionality. iOS is therefore a source of durably differentiated premetic material for Apple products, which, in turn, gives Apple a durable competitive advantage.
Apple’s excess organic profitability, which was an astounding 205% in its fiscal year 2023, can be considered sustainable.[17] This does not mean Apple’s earnings will remain at 2023 levels; it merely means Apple is worth far more than the tangible capital it employs. Our example restaurateur’s firm, on the other hand, is worth no more than the tangible capital employed therein.
And note that Apple’s organic profitability is unique in its industry. The iPhone regularly accounts for 80% of the smartphone industry’s profits but claims less than 20% of global market share.[18] Why? Because only Apple has iOS while all others license Android. As a result, the primary preme in Android smartphones is a commodity, so any profits are quickly competed away.
Now for a counterexample. Ford has virtually no unique premetic material. Its products are mostly comprised of sub units, or premes, sourced from non-exclusive suppliers and, thus, are in other product-lines. Ford therefore lacks the raw material needed for a durable competitive advantage. Ford earned a horrendous 4.7% on tangible capital employed in 2023 as a result.[19]
The difference in organic profitability at Apple and Ford is due to the nature of each firm’s premetic material. Apple’s is unique; Ford’s is not. The former consistently earns excess profits; the latter consistently destroys value. Apple is worth far more than tangible capital employed; Ford is worth less. Apple’s profitability is unique to its industry; Ford’s lack thereof is the norm for its industry.
3. Firm-Level Evolution | How Products Create & Mold Firms
Before moving on from the subject, we want to mention a useful and counterintuitive implication of the preme-product-firm hierarchy. Our theory suggests products create and shape firms in the same way DNA creates and shapes organisms. It is not firms that create and shape products. If the latter was true, then commercial evolution would be more Lamarckian than Darwinian.
First, what is the difference between Lamarckian and Darwinian evolution? According to Lamark, offspring inherit acquired traits from their parents. A giraffe’s neck stretches longer as it reaches for higher branches, and the giraffe’s offspring inherit longer and longer necks as a result. To be true, as the discovery of DNA shows, an organism’s DNA must change throughout its life.
Clearly, Lamark was wrong. An organism’s DNA is set in stone, which confirms Darwin’s theory of natural selection. Giraffes’ necks did not grow longer from stretching. Rather, giraffes with longer necks were advantaged in the struggle for survival. Giraffes with the “long-neck phenotype” birthed “fitter” offspring, which caused the “long neck” genotype to dominate the gene pool.
So, why do we believe commercial evolution is also Darwinian? To make our argument, we must better define the firm. A firm is not a company, which is a legal construct that can contain one firm or many. A firm is narrowly defined as the resources employed in the production of a product-line. Each product-line has its own firm, although firms within a company can share resources.
Now, think about how a firm, as we define it, emerges. It emerges once an idea fertilizes the mind of an entrepreneur, the idea germinates into a fully conceptualized product, the entrepreneur attains the resources necessary for production of the product, and the process of production begins. Only then has a firm been born, and this can occur within or without an existing company.
Product conceptualization, therefore, comes before the firm, and the entrepreneur uses the premetic material, or product sub-units, available to him during conceptualization. Only thereafter will the entrepreneur begin to build a firm, and the firm will be built according to the specifications of the conceptualized product. Thus, the conceptualized product is, quite literally, the firm’s DNA.
Back to our restaurant example. Our entrepreneur decided there was demand for a burger concept in a prime location. Those were the “success traits” consumers would select for. Only then could the entrepreneur design a firm capable of producing an end-product with those premes. He then acquired prime real estate, bought burger specific equipment, found reliable beef supplies, etc.
A product was conceptualized by a restaurateur who then designed a firm around the idea. The product therefore created and shaped the firm. And whether the firm succeeds or not depends on whether consumers select the firm’s product. If consumers select the product, the firm will expand, and its premetics will spread; if not, the firm will die, and its premetics will cease to exist.
That is Darwinian. But what about a firm’s adaptations thereafter? Imagine that our restaurateur notices consumers selecting for faster service in the market. In reaction, our entrepreneur opens a second drive through line. This, too, is Darwinian. The change constitutes a new product iteration with slightly different premetics. Like a new generation of a genetic-line, the firm has adapted.
Such a view, albeit more technical than most investors care about, is useful. For one, it focuses the investor’s attention on products rather than firms, much less companies. Second, it better illustrates the nature of a firm’s evolution. Amazon, for instance, does not distribute online because it lacks storefront; it lacks storefront because it distributes online. The product creates the firm.
II. Financial Selection | The Investor’s Role in the Evolution of Commerce
Consumer selection at the product level, like natural selection at the genetic level in biology, is the most fundamental evolutionary force in commerce. But it is not the only evolutionary force. Another form of selection pressure, financial selection, is exerted by investors, and it resembles sexual selection in biology. Investors, after all, decide which entrepreneur’s ideas are funded.
Before diving in, financial selection must be defined. Financial selection is any capital allocation decision. This includes (a) primary decisions to fund the birth or growth of a product-line, (b) secondary decisions to acquire all or part of existing firms whether in private or public markets, and (c) tertiary decisions to hire third-party capital allocators to make secondary decisions.
The different levels of financial selection make this subject particularly interesting. Selection pressure is applied at each level – primary, secondary, and tertiary – and each level incorporates information from every other level. Financial selection is therefore comprised of nested selection filters that coevolve with one another, which can lead to powerful feedback loops.
Furthermore, financial selection itself is a nested filter within consumer selection, as will be argued below. Suffice it here to say that, as sexual selection is to natural selection, financial selection is a byproduct of, and an aid to, consumer selection. Financial selection, which is comprised of nested selection filters, is therefore itself a premetic filter nested within consumer selection.
But we are getting ahead of ourselves. First, in Section A, the nested nature of sexual and financial selection within natural and consumer selection, respectively, is discussed. Then, in Section B, the powerful feedback loops inherent in the nested nature of financial selection are discussed, which can lead to large exaggerations of consumer selection outcomes in the short-term.
A. The Basics | The Nested Nature of Sexual & Financial Selection
Natural selection, under the principle of “survival of the fittest,” determines which organisms can reproduce. Only survivors are around come mating season, after all. Sexual selection, on the other hand, determines which organisms do reproduce. Not every survivor finds a mate, and not every mate is a survivor. Despite mating errors, however, sexual and natural selection are connected.
Sexual selection processes are naturally selected for. Sexual selection processes must generally favor “fitter” organisms in the parenting of offspring. Otherwise, the process would tend to produce “unfit” offspring who die before mating, which is unsustainable in perpetuating a species. Thus, sexual selection processes are nesting within natural selection processes.
Assume, for instance, a species faces strong natural selection pressure for speed and agility due to heavy predation. Females with a sexual preference for males that correlates most closely with speed and agility will produce offspring with higher survival rates. Since behavioral instincts are inherited, the sexual preferences of these females will take share in the species’ gene pool.
Organisms, humans included, do not consciously “decide” which mate is “fittest,” however. They cannot assess genetics. Instead, they must rely on evolved instincts that, in most cases, manifest as sexual preferences for observable proxies of “fitness,” or phenotypes. Sexual preferences, in other words, tend to hinge on proxies and correlations, not direct observations.
For example, in the above hypothetical, speed and agility are difficult traits to observe. Females, then, are more likely to develop sexual preferences for more observable traits that correlate with speed and agility. Perhaps robust hind quarters are a good proxy. If so, a mating ritual that tests the robustness of male’s hind quarters like fighting via kicking will likely emerge in the species.
Instinctual sexual preferences are thus a byproduct of natural selection. Sexual selection, in other words, is an additional genetic filter designed by, and nested within, the ultimate genetic filter – natural selection. As such, sexual selection does the bidding of natural selection, which accelerates the evolutionary process by increasing the reproduction rate of the “fittest” organisms.
Likewise, consumer selection, under the principle of “survival of the fittest,” determines which firms can produce. A failed firm cannot make a product, after all. Financial selection, on the other hand, determines which firms do produce. Not all winning products are funded, and not all funded products win. Despite financing errors, however, financial and consumer selection are connected.
Financial selection processes, as with sexual selection, are “naturally selected.” The process must favor “fitter” firms in terms of profitability, which is a byproduct of producing a product consumers deem “fit.” Otherwise, financial selection would encourage the production of “unfit” products and, in turn, firms unable to survive. Thus, financial selection is nested within consumer selection.
Back to our restaurant example, assume again that the market faces consumer selection pressure for faster service. Restaurant investors with a financial preference that correlates most closely with the “fast service trait” will fund firms with higher survival rates. This preference will produce better returns and spread among investors as investors with such a preference accumulate capital.
Yet, investors rarely, if ever, directly observe premetic “fitness.” This is because premetic “fitness” depends on how consumers value a product, which is subjective. As such, premetic fitness is hard to observe directly, especially for investors not at the primary level. Investors instead rely on evolved instincts that manifest as preferences for observable proxies correlated with “fitness.”
To continue the above example a secondary level investor in public markets may be unable to find data on the speed of service at various restaurants. The investor may still select for it, however, by relying on observable proxies like organic profitability and market share trends. These would correlate with “fast service” since a slower operator would show negative trends.
Instinctual financial preferences are thus a byproduct of consumer selection. Financial selection operates as an additional premetic filter designed by, and nested within, the ultimate premetic filter – consumer selection. As such, financial selection does the bidding of consumer selection by ensuring firms with “fit” products emerge and grow while those with “unfit” products do not.
B. Feedback Loops | When Financial Selection Exaggerates Consumer Selection
Each level of financial selection influences the other. If “growth” investing enjoys a long period of success, for example, it will be deemed “fit” and favored at the tertiary level. The “growth” trait will spread at the secondary level as investors adapt to tertiary level demands. A “growth at all cost” mentality will then spread at the primary level as firms adapt to secondary level demands.
These feedback loops feed on themselves and regularly go too far. Famous examples include the canal mania of the 18th century, the railroad mania of the 19th century, and the internet mania of the 20th century. In each case, the bubble grew from a bit of truth – consumer selection favored these technologies. Financial selection, however, simply took it too far too fast.
This is happening again today, albeit on a smaller scale. Investors with a “growth” preference at the secondary and tertiary level have earned great returns for 15 years.[20] The “growth” preference accordingly took share of capital, and firms aligned with the “growth” trait reaped the rewards with ever-higher valuations. This drastically altered primary level decisions in two industries:
Auto Industry | Tesla is favored by “growth” investors due to superior growth. Consumers clearly deem Tesla’s product “fit” and, as noted below in Section III.A., so do governments. Thus, Tesla’s valuation exceeded that of most competitors combined.[21] Tesla’s competitors altered their primary level decisions accordingly. Despite highly profitable, or historically “fit,” internal combustion engine (or “ICE”) product-lines and deeply unprofitable, or historically “unfit,” electric vehicle (or “EV”) product-lines, they massively expanded EV product-lines and starved ICE product-lines.[22] Now, EV production exceeds demand.[23] Capital losses are likely absent a drastic improvement in the “fitness” of EV product-lines.
Media Industry | Likewise, Netflix is favored by “growth” investors due to superior growth. Consumers clearly deem Netflix’s streaming product “fit,” and its valuation blossomed. Legacy media companies, on the other hand, saw their valuations decline as consumers deemed their linear pay-tv product’s “unfit.”[24] Yet, Netflix did not turn free cash flow positive until 2020. Nevertheless, legacy media companies invested huge sums to replicate Netflix’s product, which impaired their linear pay-tv businesses further, and their streaming businesses are suffering huge losses.[25] Consumer selection made this change inevitable, but financial selection caused an overly abrupt destruction of their linear pay-tv businesses.
Clearly, consumer selection always serves as the controlling mechanism of financial selection. Financial selection cannot for long favor firms with “unfit” premetics. Capital is nourished by profits, after all, and profits accrue to firms with products that consumers deem “fit” to buy. Thus, in the end, financial selection plays a subordinate and supportive role to consumer selection.
Financial selection can, however, exaggerate the demands of consumer selection over the short-term, and it regularly does. The exaggeration can grow large at times due to the nested nature of financial selection filters. The feedback loops feed on each other and become self-reinforcing. Consumer selection corrects this only once the resulting disequilibrium hits a tipping point.
III. Artificial Selection | The Government’s Role in the Evolution of Commerce
Examples abound of selective breeding and its profound impact on species. Look at the vast array of domestic dogs, all of which share a common ancestor.[26] The stunning diversity of breeds was achieved by breeders systematically selecting for certain traits, or phenotypes, one generation at a time. This eventually produced Miniature Dachshunds and Great Danes alike.
The process of selective breeding differs from the process of natural selection in only one way. It is the breeder, not nature, that selects for “fit” or “unfit” traits. In other words, the breeder’s hand guides the evolutionary trajectory of a species rather than the hand of Mother Nature. Over time, the selectively bred species is at risk of being rendered totally “unfit” for survival in the wild.
Likewise, in a free market, Adam Smith’s Invisible Hand, or consumer and financial selection, guides the evolutionary trajectory of products and firms. Modern governments, however, do not fully trust consumers and investors with this power. As a result, the Heavy Hand of the State regularly interferes to guide the evolutionary trajectory of a species of industry.
In Section A, quasi-free economies like the United States are discussed. Here, the Heavy Hand of the State guides the Invisible Hand of the market. In Section B, controlled economies are discussed where there is only the Heavy Hand of the State. In the former case, State selection is in addition to consumer and financial selection; it is in replacement of in the latter case.
A. Quasi-Free Economies | In Addition to Consumer & Financial Selection
A prime example of a quasi-free market is the US auto industry. Governments concluded that consumers do not adequately consider pollution in their selection of autos. In an effort to guide the industry towards producing cleaner autos, the State dictates maximum pollution levels, subsidizes EV consumers and producers, and, in the extreme, threatens to prohibit ICE autos altogether.
Such State intervention is, by definition, at odds with consumer demand. It would be superfluous otherwise. If the intervention is marginal, like slightly better fuel efficiency each year, then State regulations usually suffice. If, on the other hand, the intervention is dramatic and uneconomical, then more State action like a de facto EV mandate is needed to alter the evolutionary trajectory.
Both marginal and dramatic interventions must be considered by investors. Dramatic interventions, however, are of particular importance. Such interventions can render an entire industry unable to survive in the free-market jungle if the resulting products are not in demand by consumers. Such an industry eventually becomes dependent upon State support. It becomes a “pet industry.”
The US auto industry now qualifies as a “pet industry.” Despite huge firm and consumer subsidies, only Tesla has a profitable EV product-line in the US. Ford, for example, lost $37,000 per electric vehicle sold in the third quarter of 2023.[27] Without more aid, much less continued aid, Ford’s massive investments in EVs are at risk. Massive capital losses are certain absent more intervention.
Investors in such industries must be very cautious. If such dramatic State intervention continues, uneconomical investments will, too. This impairs the profitability and “fitness” of the firms. If, on the other hand, State intervention recedes, it effectively puts the firms in a “pet industry” back into the wild after having diminished their “fitness.” In either case, investors face dramatic losses.
B. Control Economies | In Replacement of Consumer & Financial Selection
Control economies have a dismal record. The reasons are many, from negative incentives to a lack of price signals leading to political, rather than economical, resource allocation. One reason that is rarely discussed, yet arguably the most critical, requires evolutionary theory to fully understand. Control economies lack product diversity, and diversity is the raw material of evolution.
As a result, control economies cannot evolve. Why does this matter? Because living standards cannot rise if the evolutionary process is stifled, and the evolutionary process requires innovation induced product diversity to function. In a control economy, even if a profit motive exists, there is no competition or consumer selection to incentivize entrepreneurs to innovate within their niche.
It is well established in orthodox economics that innovation is the source of society’s improving living standards.[28] Innovation, after all, is what gives us better quality products at lower costs. So, to say a lack of innovation damns control economies to stagnation and ultimate failure is the same as saying a lack of product diversity and, thus, a stifled evolutionary process is the cause.
The implication is clear. If a State wants better living standards, it must embrace the evolutionary process. To do so, innovation must be encouraged, for it supplies the product diversity needed for evolution to occur. That means the profit motive must be nurtured, not suppressed, to incentivize entrepreneurs to innovate, and consumers must be free to filter “fit” from “unfit” innovations.
IV. Conclusion | Applications of Evolutionary Theory for Investment Practitioners
To get to the nature of something, keep asking why. Why do investors invest? To earn returns on surplus. Why does surplus earn returns? It finances profitable firms. Why is a firm profitable? Consumers select its product. Why do they select a product? A superior value proposition. Why is a value proposition superior? It is different. Why is it different? Unique premetics.
Returns on surplus, or capital, are therefore derived from unique premetic material. Accordingly, investors must think in an evolutionary way, and a Neo Darwinian perspective is most useful. A firm is merely the “survival machine” of its product-line and the premes it is comprised of. Thus, a successful investor will select for “fit” firms, or those with unique premetics consumers’ desire.
Identifying “fit” firms is not a difficult task. Simply find firms that earn high rates of organic profit, or high returns on tangible capital employed. The more difficult task is to predict the sustainability of those high rates of profit. This hinges on the nature of a firm’s product-line, the uniqueness of its premetics, and the durability of that uniqueness. Only then are high rates of profit sustainable.
To do this, the investor must focus on the product-line. Assess the value propositions of products able to nourish a consumer demand. Identify the traits, or premes, that consumers select for. Then, identify the premetics a firm must possess to incorporate those “success traits” in its product-line. The firm’s profits are sustainable only if the needed premetics will not diffuse through the market.
What forestalls premetic diffusion and results in a durable competitive advantage? There are many firm-level attributes that forestall premetic diffusion. Patents are obvious examples. So are brands when consumers lack information and the cost of errors are high. If price is the key “success trait,” then economies of scale matter. There are many more.
Investors must beware of the powerful feedback loops inherent in financial selection. In the short-term, as Benjamin Graham said, markets are voting machines; they are weighing machines in the long-term. Thus, in the short-term, financial selection can devolve into a popularity contest. The successful long-term investor will ignore this and anchor his preferences in economic “fitness.”
Generally, this means an investor should align his preferences with the consumer selection process, but there are exceptions. When the State interferes in a market, it is selectively breeding a species of industry. This may merely alter which firms are the “fittest” based on State preferences. It may, however, render the species of industry altogether “unfit” for investment if taken too far.
These are only some of the applications evolutionary theory offers investment practitioners. Yet, the sad state of economics, the commercial science, offers little value. Green with physics envy, the science is focused on what can be measured. Like the drunk looking for his keys under the lamppost, when asked if that is where he lost them, he replies, “No. But this is where the light is.”
[1] Eric Beinhocker, The Origin of Wealth (Boston: Harvard Business School Press, 2006), 48-75.
[2] Beinhocker, The Origin of Wealth, 74.
[3] Beinhocker, The Origin of Wealth, 70.
[4] Beinhocker, The Origin of Wealth, 22 (citing John Cassidy, “The Decline of Economics,” The New Yorker, December 2, 1996, 50, available at: https://www.newyorker.com/magazine/1996/12/02/the-decline-of-economics).
[5] Thorstein Veblen, “Why Is Economics Not an Evolutionary Science?,” The Quarterly Journal of Economics 12, no. 4 (July 1898): 394-95.
[6] Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (Shine Classics, 2014), 242-43 (original published in 1776); Thomas Malthus, An Essay on the Principle of Population (The Online Library of Liberty, 2011), 20, https://oll-resources.s3.us-east-2.amazonaws.com/oll3/store/titles/311/Malthus_0195_EBk_v6.0.pdf (original published in 1798).
[7] Charles Darwin, The Autobiography of Charles Darwin (The Project Gutenberg eBook, 1999), https://www.gutenberg.org/cache/epub/2010/pg2010-images.html (originally published in 1876) (stating, “I happened to read for amusement ‘Malthus on Population,’ and being well prepared to appreciate the struggle for existence which everywhere goes on from long-continued observations of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. The result of this would be the formation of new species. Here then I had at last got a theory by which to work . . . “).
[8] Charles Darwin, On the Origin of Species (New York: Signet Classics, 2003), 77 (original published 1859).
[9] Richard Dawkins, The Blind Watchmaker (New York: Norton & Company, 1996) 191 (claiming, “[I]f any entity, anywhere in the universe, happens to have the property of being good at making more copies of itself, then automatically more and more copies of that entity will obviously come into existence. Not only that but, since they automatically form lineages and are occasionally miscopied, later versions tend to be ‘better’ at making copies of themselves than earlier versions, because of the powerful process of cumulative selection.”).
[10] Drew Estes, “The Evolution of Products,” Banyan Capital Management (October 14, 2021), https://banyancapital.com/wp-content/uploads/2021/10/2021-Q3-Website-Letter-Signatures.pdf
[11] Richard Dawkins, The Selfish Gene (Oxford: Oxford University Press, 2006), 14 and 26.
[12] Richard Nelson & Sidney Winters, An Evolutionary Theory of Economic Change (Cambridge: The Belknap Press of Harvard University Press, 1982) 113.
[13] Nelson and Winters, An Evolutionary Theory of Economic Change, 401.
[14] Geoffrey Hodgson and Thorbjorn Knudsen, Darwin’s Conjecture (Chicago: The University of Chicago Press, 2010), 61.
[15] Nelson and Winters, An Evolutionary Theory of Economic Change, 130.
[16] Warren Buffet, “Mr. Buffett on the Stock Market,” Fortune, November 22, 1999, https://www.berkshirehathaway.com/1999ar/FortuneMagazine.pdf.
[17] Apple, Inc., Form 10-K, published September 30, 2023, https://d18rn0p25nwr6d.cloudfront.net/CIK-0000320193/faab4555-c69b-438a-aaf7-e09305f87ca3.pdf (2023 operating income before depreciation and amortization was $125.8 billion and capital expenditures were $11 billion for cash enterprise earnings of $114.8 billion. Tangible capital employed averaged $55.8 billion in 2023.).
[18] Andrew Orr, “Apple continuing command of global smartphone profits, and the lead is growing,” AppleInsider.com, published on September 29, 2022, https://appleinsider.com/articles/22/09/29/apple-continuing-command-of-global-smartphone-profits-and-the-lead-is-growing.
[19] Ford Motor Company, Form 10-K, published December 31, 2023, https://s201.q4cdn.com/693218008/files/doc_financials/2023/q4/Ford-2023-10-K-Report.pdf (2023 operating income before depreciation and amortization was $13.15 billion and capital expenditures were $8.24 billion for cash enterprise earnings of $4.91 billion. Tangible capital employed averaged $104.95 billion in 2023.).
[20] See, e.g., Dan Weil, “The Case for Investing in Value Stocks,” The Wall Street Journal, published June 2, 2023, https://www.wsj.com/articles/investing-value-stocks-2be29ad9; see also, “Value: Why Now? Capturing the Comeback in Its Early Innings,” AQR Capital Management, First Quarter 2023, https://www.aqr.com/Insights/Research/White-Papers/Value-Why-Now-Capturing-the-Comeback-in-Its-EarlyInnings.
[21] Stephen Wilmot, “How Much is Tesla Worth? You Decide,” The Wall Street Journal, published September 28, 2023, https://www.wsj.com/finance/stocks/how-much-is-tesla-worth-you-decide-78b25ab1.
[22] Nicole Lepre, Spencer Burget, and Noah Gabriel, “U.S. Investments in Electric Vehicle Manufacturing,” Atlas Public Policy, published January 12, 2023, https://atlaspolicy.com/wp-content/uploads/2023/05/U.S.-Investments-in-Electric-Vehicle-Manufacturing-2023.pdf.
[23] Mike Colias, Nora Eckert, and Sean McLain, “The Six Months that Short-Circuited the Electric-Vehicle Revolution,” The Wall Street Journal, published February 14, 2024, https://www.wsj.com/business/autos/ev-electric-vehicle-slowdown-ford-gm-tesla-b20a748e.
[24] Sarah Krouse, “Streaming Tops Cable-TV Viewing for the First Time,” The Wall Street Journal, published August 18, 2022, https://www.wsj.com/articles/americans-spent-more-time-streaming-than-watching-cable-tv-in-julya-first-11660827184.
[25] Joe Arney, “For legacy media studios, streaming has dried up revenue. Can they change the channel?,” College of Media, Communication, and Information, University of Colorado Boulder, published February 1, 2024, https://www.colorado.edu/cmci/news/2024/02/01/research-media-studies-striphas-streaming-studios-mergers#:~:text=Building%20out%20their%20own%20streaming,the%20device%20and%20the%20content.%E2%80%9D.
[26] Anders Bergstrom, et. al., “Grey wolf genomic history reveals a dual ancestry of dogs,” Nature 607 (June 2022): 313-20.
[27] Stephen Wilmot, “Ford’s Cost Problem Isn’t Just About EVs,” The Wall Street Journal, published October 27, 2023, https://www.wsj.com/business/autos/fords-cost-problem-isnt-just-about-evs-f2024192.
[28] Michael Greenstone and Adam Looney,” A Dozen Economic Facts About Innovation,” The Hamilton Project, published August 2011, https://www.brookings.edu/wp-content/uploads/2016/06/08_innovation_greenstone_looney.pdf.