Written by Alex Hughes, International Analyst, StocksInValue
Article first published in StocksInValue
“Devaluation is not the way out of Britain’s problems”
– British Finance Minister James Callaghan, days before the pound was devalued by 14% on November 19th, 1967. After the event, he went on to say “Our decision to devalue attacks our problem at the root”.
“One myth that is out there is that we are printing money. We are not printing money”
– Ben Bernanke on 60 minutes in 2010 (watch video). Twenty months earlier, again on 60 minutes, Bernanke responded to the same question: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. It’s much more akin to printing money than it is to borrowing.” “You’ve been printing money?” the reporter asked. “Well, effectively”.
“I did not have sexual relations with that woman, Miss Lewinsky”.
– US President Bill Clinton, 7 months before admitting to having sexual relations with Miss Lewinsky.
Unfortunately, people lie, it is just a fact of life.
As investors we are confronted with a torrent of information from a range of sources, and identifying who to believe and who to not can be the difference between a champagne year, or painful losses.
Despite the importance of understanding people, many investors enter the market overcapitalised in the wrong skills. Most professional analysts today receive upwards of 3 years of education in dense financial analysis, and not a days’ worth learning how to assess people. The latter requires an entirely different skill set to assessing numbers, is significantly harder, and potentially more influential to returns. Beginning to address this issue starts with understanding why people lie.
There are many reasons why someone bends the truth. In an overwhelming number of cases, personal incentives tops the list. In any interaction, it’s always worthwhile considering the incentives of the other party, and how that may influence things.
Unprofitable start-ups have an incentive to portray a rosy growth outlook to foster enthusiasm for the business, so that new equity can be raised, and raised at high prices. Managers of leveraged businesses have an incentive to portray their solvency in the best light, to instil confidence in both current and prospective financiers. Business vendors have an incentive to overstate earnings, in order to achieve the highest sale price for their business.
Politicians lie to justify difficult compromises or when they seek to influence the populations thinking. Just consider the usefulness of the government’s budget projections when it is obvious they have a vested interest in promoting confidence in the economy; I suspect they are vastly more likely to be optimistic rather than realistic over time.
Perhaps the most common way investors are fooled is when their attention is directed away from the things that truly matter. When a company is confessing to mistakes, it is often what is excluded from the presentation that matters. It takes a thoughtful observer to identify this and seek out the important information, as many companies would prefer to sweep it under a rug.
The rule of thumb that ‘downgrades come in threes‘ exists because managers either underestimate the extent of the problem or they downplay it to investors, seeking to buy time in the hope that the trend can be reversed.
Investors are caught between a rock and a hard place in a classic agency problem, as the people who know most about the business have incentives misaligned with theirs. The challenge is in finding a balance between obtaining necessary facts from business managers, while not being swayed by bent truths and charisma. A healthy level of scepticism is essential. If every public statement was taken at face value significant losses would be a certainty. However, if one is a “perma-sceptic”, they will likely never trust anything or anyone, and their returns will be limited to term deposit rates.
To deal with this, we suggest two strategies:
Focus on proven managers
If your strategy involves speaking to management, it makes sense to concentrate on proven managers.
Business leaders often make forecasts about the future. By focusing on proven managers, this gives the luxury of comparing years of public statements against actual results. When a proven manager speaks optimistically about the future, investors can assess his track record of predicting future business results, arming them with an important reference point to assess the forecast.
With unproven managers new to the role, there is heightened risk that their understanding of the business drivers are less than adequate, suggesting the error rate of forecasts are likely to be greater. In more sinister cases, investors have no basis to determine whether current forecasts are more fabricated than factual.
If an investment case is predicated on trust in management, you want to make sure you are trusting the right management.
Do not talk to management
The easiest way to mitigate the risk of lies is to not speak to management. In this case, the investment process needs to rely entirely on publically available information.
There is a lot of merit to this strategy, and it is adopted by a large list of some of the best, like Walter Schloss, Buffett’s successors Todd and Tedd and even Buffett himself: “Today, everything we do, pretty much, I find through public documents.”
Management are often charismatic, optimistic and promotional, you have to be in many cases in order to rise to the top of an organisation. They also have a strong incentive to emphasise the positive and skew the conversation away from the negative; their remuneration is dependent on it. These characteristics undoubtedly influence investors thinking
By operating a philosophy un-reliant on speaking with management, investors must focus on facts, constantly question their assumptions and seek verification from un-conflicted third parties. There is a strong argument that if you can’t understand the business well enough without speaking to management, you shouldn’t invest in it in the first place.