Lindy Effect & Stock Market

Investors often look at various theories to understand and predict stockmarket behaviour. Lindy Effect is one such theorised phenomenon whichhelps explain certain aspects of choosing stocks. Shreya Chaware deepdives into the Lindy Effect and deliberates on whether it can be useful inthe investing process

It is always interesting to analyse the success of some ofthe world-class portfolio managers such as WarrenBuffet. Investors often attempt to replicate the portfoliostrategy of the winners with the simple objective ofbeating the markets and it is no secret that a majority ofinvestors put in a lot of efforts to understand how Buffet pickshis stocks. If you are one of those investors who are eager tounderstand how he processes his investment decisions and ifyou were told he consciously or subconsciously uses LindyEffect in his investment – you would want to know more aboutthis enigmatic phenomenon. [EasyDNNnews:PaidContentStart]

While Buffet has never claimed to use Lindy Effect in hisinvestment decisions, his manner of stock selection supports itsthesis. So, what is Lindy Effect, and can it be useful in theinvestment game? Simply put, Lindy Effect suggests that the lifeexpectancy of a non-perishable item is proportionate to thepast life of the item. The concept of Lindy Effect, even thoughan old one, came into limelight when famous author NassimNicholas Taleb introduced the concept of Lindy Effect and itsinterpretation in his book titled ‘Antifragile’. According to Taleb,who is also famous for his book ‘Black Swan’, for the perishable,every additional day in its life translates into a shorteradditional life expectancy.

For a non-perishable like technology,every additional day may imply a longerlife expectancy. Thus, if we were to applythe interpretations of the Lindy Effect tothe stock market, the message is thatcompanies that are old and with provencapabilities are more likely to survive andhence reward shareholders in the longterm. Equities in the long run are slavesto earnings. And if the estimated futurecash flow is high for a companyimmaterial of its age, the valuations willbe high, in reality. This is where thecontradiction lies, in the sense that we seea new-age company trade at a hugepremium to its traditional counterpartwhich works against the Lindy Effectsuggestions.

For example, new-age companies such as Zomato or Paytmwere able to garner growth investors’ attention and fetch a heftypremium valuation for themselves while established companieswith decent cash flows listed for decades together traded atdiscounted valuations. However, if one were to interpret theLindy Effect and apply it to investing, the focus is on riskinessof the investments as well. Lindy Effect simply states that theolder proven companies simply have a better chance of survivalthan the new companies. It does not mean that all the newcompanies may not survive and the Lindy Effect also does notsuggest that all the old companies will continue to survive andprosper.

However, what it suggests is that on an average the oldercompanies will tend to survive longer than the new companies.When you focus on the Lindy Effect interpretation and connectit with the stock market or the investment world it simplysuggests that older the company you invest in better would beits survival rate and hence the dividend-paying capacity willalso exist as the cash flows are expected to be steady andconsistent for such companies. Buffet’s investment philosophysuggests a bias for matured well-established companies at theright valuation. A huge chunk of his portfolio is made up offour stocks – Kraft Heniz, IBM, Wells-Fargo and Coca Cola. All these four companies are well-established and have more than100 years of existence value.

Cryptocurrency or Gold?

Consider the example of cryptocurrency. Because it isrelatively new, the Lindy Effect saysits chance of survival is less.Therefore, if you compare gold andcryptocurrency using the Lindy Effect,gold has a higher chance of survival.

However not all old companies can survive and hence oneshould remain cautious. If we take an example of our ownBSE-listed companies, we will find that not all old and largecompanies have survived over the years. For example, BallarpurIndustries, Indian Organics, Indian Rayon, PremierAutomobiles and Peico Electronics are some of the erstwhileold established companies which were also constituents of theBSE Sensex that are now either struggling today to remainprofitable or have been phased out all together. Interestingly,there are companies which were incorporated more than 100years ago and have been listed on bourses and are still doingwell. According to Lindy Effect, such companies may survivelonger than the newer ones.

Also, if we compare the Sensex composition of 1986 with thecurrent composition, we find that only seven Sensexconstituents of 1986 have been able to keep their place in BSESensex intact. HUL, ITC, Larsen and Toubro, Mahindra andMahindra, RIL, Nestle and Tata Steel are the companies whichhave managed to remain part of BSE Sensex over severaldecades. This means that not all old and large companiescontinue to grow even though they may survive longer.

Conclusion

One of the simple ways to interpret the Lindy Effect is that ideasthat have been around a long time are more likely to be aroundin the future than new ideas. Old ideas are tried and true whilethe new ones are unproven. When it comes to application ofLindy Affect in the equity world, investors must focus onmatured businesses with steady predictable cash flows.Dividend-paying companies with high dividend yields shouldbe preferred for investments rather than new-age companieswith unpredictable cash flows and astronomical valuations.Bottom-up stock selection rules work the best for any longterminvestor.

However, one more additional factor that needs to beincorporated is the age of the company. Older the companybetter the safety net for investors i.e. if you were to buy theargument of Lindy Effect. That said, buying a company by onlylooking at its age and ignoring fundamentals could behazardous for investors. We have seen some old companies dieand we have seen some new companies thrive and create wealthin the long term. Lindy Effect suggestions can be used byconservative ultra-long-term investors focusing on thedividend-paying capacity of the companies.

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