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Robertson: When “Stuff” Gets Real

We all can be tempted to follow the path of least resistance and in a competitive world there are always incentives to get the most bang for the buck. Often this means taking shortcuts to gain some advantage. In a forgiving world, the penalties for such transgressions tend to be small but the rewards can be significant. When conditions are extremely forgiving, shortcuts can become so pervasive that failing to take them can be a competitive disadvantage.

In a less forgiving world, however, the deal gets completely flipped around and penalties can be significant for those who take shortcuts. This will be important for investors to keep in mind as rapidly weakening economic fundamentals and increasing stress in financial markets make for far less forgiving conditions. When things get real, competence and merit matter again – and this is a crucial lesson for investors.

Leaders of companies and organizations normally receive a lot of attention and rightly so; their decisions and behaviors affect a lot people. In the best of situations, leaders can distinguish themselves by creatively finding a “third” way to resolve difficult challenges. In other situations, however, leaders can reveal all-too-human weakness by taking shortcuts, cheating, and acting excessively in their own self-interest.

One of the situations in which these weaknesses can be spotted is in whistleblower incidents. For example, the Financial Times reported on the illuminating experiences of one HR director who in successive jobs was requested to break rules by a boss:

“Told by a senior manager at a FTSE 100 business to rig a pay review to favour his allies, she refused. ‘After that, he did everything to make my life absolute hell,’ she says. Then, at the first opportunity, he fired her, claiming that she was underperforming. Warned that the company would use its resources to fight her all the way if she took legal action, she accepted a pay-off and left’.” 

“Her next employer asked her to manipulate the numbers for a statutory reporting requirement to make its performance look better. She refused, signed another non-disclosure agreement and resigned.”

As unfortunate as these experiences were, they were not isolated events. The HR director described such incidents as happening “left, right and centre”. The fact that such cases are extremely hard to prosecute in any meaningful way helps explain why they are so pervasive. Columbia law professor John Coffee describes: “It’s extremely difficult to make a case against the senior executives because they don’t get Involved in operational issues. But they can put extreme pressure on the lower echelons to cut costs or hit targets.”

Company employees aren’t the only ones who risk facing hostility for standing for what they believe is right. Anjana Ahuja reports in the FT that scientists can fall victim to the same abuses. As she points out, “Some are targeted by industry or fringe groups; others, as the Scholars at Risk network points out, by their own governments. The academic freedom to tell inconvenient truths is being eroded even in supposed strong holds of democracy.”

Ahuja noted that the Canadian pharmacist and blogger, Olivier Bernard, was chastised for “interrogating the claim that vitamin C injections can treat cancer.”  As a consequence of his efforts, “He endured death threats” and “opponents demanded his sacking.”

In yet another example, Greece’s former chief statistician Andreas Georgiou “has been repeatedly convicted, and acquitted on appeal, of manipulating data.” The rationale for such a harsh response has nothing to do with merit: “statisticians worldwide insist that Mr Georgiou has been victimised for refusing to massage fiscal numbers.” It is simply a higher profile case of refusing to be complicit in wrongdoing.

The lessons from these anecdotes also play out across the broader population. The FT reports:

“According to the [CIPD human resources survey], 28 per cent of HR personnel perceive a conflict between their professional judgment and what their organisation expects of them; the same proportion feel ‘it’s often necessary to compromise ethical values to succeed in their organisation’.”

Employees are all-too familiar with the reality that such compromises may be required simply to survive in an organization and to continue getting health insurance: “Most HR directors know colleagues who have been fired for standing their ground.”

Yet another arena in which expertise and values get compromised is politics. While political rhetoric nearly always involves exaggerations and simplifications, the cost of such manipulations becomes apparent when important issues of public policy are at stake. Bill Blain highlighted this point on Zerohedge:

“It’s as clear as a bell that Trump had no plan to address the Coronavirus before he was finally forced to say something Monday [March 9, 2020]. Until then it was a ‘fake-news’ distraction. He made a political gamble: that the virus would recede before it became a crisis, making him look smart and a market genius for calling it.”

Blain’s assessment illustrates a point that is common to all these examples: Each involves a calculation as to whether it is worth it or not to do the right thing based on merit or to take a shortcut. Each involves an intentional effort to reject/deny/attack positions that are real and valid. Evidence, expertise and professional judgment are foresworn and replaced by narrative, heuristics, and misinformation. While such tactics undermine the long-term success of organizations and societies, they can yield tremendous personal advantages. The good of the whole is sacrificed for the good of the few.

Another point is that these efforts are absolutely pervasive. They can be found across companies, academia, politics, and beyond. They can also be found in countries all across the world. In an important sense, we have been living in an environment of pervasive tolerance of such decisions.

A third point, and the most important one, is that now it is starting to matter. It appears that the real human impact of the coronavirus has shaken many people out of complacency. The types of narratives and misinformation regarding the market that had been accepted suddenly seem woefully out of place when dealing with a real threat to public health. As Janan Ganesh reports in the FT, “This year provides a far less hospitable atmosphere for such hokum than 2016”. He concludes, “Overnight, competence matters.”

True enough, but Ganesh could have gone further. Suddenly, additional traits such as courage, good judgment, and ethical behavior also matter. Overnight, carelessness and complacency have become much more costly.

All these things will become extremely important for investors as well. For example, information sources are crucial for early identification of potential problems and for proper diagnosis. Most mainstream news outlets were slow to report on the threat of the coronavirus even though it was clearly a problem in China in January. By far the best sources on this issue have been a handful of independent researchers and bloggers who have shared their insights publicly.

One form of news that will be interesting to monitor is upcoming earnings reports and conference calls. These events can provide an opportunity to learn about companies as well as to learn about management’s philosophy and decision-making.

Which companies are busily responding to the crisis by scrutinizing their supply chains and developing HR policies to ensure the safety of their employees? Which companies already had these measures in place and are simply executing on them now? Which companies are withdrawing guidance while they frantically try to figure out what’s going on? These responses will reveal a great deal about management teams and business models.

In addition, a much higher premium on merit will also place much higher premia on security analysis, valuation, and risk management. Alluring stories about stocks and narratives about the market can be fun to follow and even compelling. At the end of the day, however, what really matters is streams of cash flows.

Finally, a higher premium on merit is likely to significantly re-order the ranks of advisors and money managers. Those ridiculed as “overly cautious” and “perma bears” will emerge as valuable protectors of capital. Conversely, those arguing that there is no alternative (TINA) to equities will be spending a lot of time trying to pacify (and retain) angry clients who suffer big losses. Further, things like education, training, and experience will re-emerge as necessary credentials for investment professionals.

As the coronavirus continues to spread across the US, things are starting to get real for many investors. Suddenly, the world is appearing less forgiving as it is becoming clear that economic growth will slow substantially for some period of time. This especially exposes the many companies who have binged on debt while rates have been so low. Further, it is becoming increasingly obvious that there is very little the Fed can do with monetary policy to stimulate demand.

While the coronavirus will eventually dissipate, the increasing premium on merit is likely to hang around. The bad news is that in many cases it will be too late to avoid the harm caused by leaders and managers and advisors who exploited favorable conditions for personal advantage. The good news is that there are very competent people out there to make the best of things going forward.

Robertson: One Is The Loneliest Number

With passive funds continuing to grow share at the expense of actively managed funds and markets on a roll since late 2018, analyzing individual stocks can seem like a quaint if not downright outdated exercise. Indeed, many investors and advisors have become so deeply habituated to passive investing that they don’t even consider other alternatives. As a result, the exercise of analyzing individual stocks has become a fairly lonely pursuit.

This reality, however, also spells opportunity. While the rising tide of easy monetary policy lifted most equity boats for many years, the beneficial effects now are being shared by a decreasing number of the largest stocks. In addition, as the share of active management declines, so too do analytical efforts that keep market inefficiencies in check. A key consequence is that some much more interesting stock ideas are beginning to emerge for investors who are willing and able to rummage around in less visible parts of the market.

In a sense, it shouldn’t be surprising that individual stock opportunities are creeping up. After all, there are only a relatively few stocks with the size and liquidity requisite to be constituents in a broad array of passive funds. Pretty much by definition then, most stocks do not benefit so disproportionately from large flows of funds from price-insensitive investors. It also follows that without such support, most individual stocks are still vulnerable to eroding fundamentals to a greater or lesser extent.

And eroding fundamentals there are. Weak economic growth across the globe and repeated flirtations with yield curve inversion provide plenty of fodder to beat up on stocks with economic exposure. Companies across the energy sector have been hit, but so have those in transportation, shipping, retail, and plenty of other industries.

While poor economic news (and plenty of other uncertainty) is negative for stock prospects, it does come with a bit of a silver lining. Such clear detrimental forces induce investors to react, and in doing so, they often overreact. These types of situations are the bread and butter of valuation-based stock picking.

This also relates to another point that seems nearly forgotten. It wasn’t all that long ago that investment research was dominated by company-specific work. Before the financial crisis in 2008, Wall Street research emphasized company analyses. Investment platforms such as Motley Fool and Seeking Alpha (among others) emerged to address the widespread appetite for company-specific insights. Even casual conversations often revolved around stock tips.

While much of that activity was overdone and not especially useful, the key tenets of equity analysis remain as valid as ever. With the opportunity set beginning to open up again, now is a good time to either refresh those skills or develop them anew. More specifically, the thrust of such efforts is to identify the degree to which situational factors affect a company’s cash flow stream and then to determine if the market’s reaction is excessive.

As an example, one of the stocks I have found interesting is a small-mid cap supplier to the food and beverage industry. It has been around for a long time and sells all over the world; less than half of its revenues are in the US. Because it sells to the food and beverage industry, its revenues are fairly stable. While they don’t go up a whole lot, they don’t go down a whole lot either.

This particular company is also a leader in its industry. It dominates market share and as such, it provides significant logistical and reliability advantages to its customers. On top of all this, it is also a technology leader and finds various ways to monetize its position.

The company does have debt, but the debt level is manageable given the stability of the business and its prodigious generation of cash flow.

Based upon this description of fundamentals, how would you expect the stock to have performed? By way of comparison, the S&P 500 produced a total return of 31.5% in 2019 and finished with a trailing price/earnings multiple of 21.75. Would it be up by half as much as the S&P500? Flat? Maybe down a bit?

The reality was far harsher. Not only did the stock fail to keep up with the S&P 500 last year, it crashed on the order of 50% after a negative earnings surprise. This was interesting for two reasons. First, it was left with a price/earnings multiple in the mid-single digit range which is nearly unheard of in such overvalued markets. Second, the stock fell to a level below its lows during the Great Financial Crisis over ten years ago, despite being in a far more benign economic environment. To value buyers, this starts to sound interesting.

Obviously, not all cheap stocks will outperform and there are plenty of other factors that can come into play. Further, if economic conditions continue to erode, a number of companies will be negatively affected and could run into serious trouble. This is certainly happening in the energy industry right now.

But that’s not the point. The main point here is to recognize the world of individual stocks is becoming increasingly bifurcated. On one side is the glossy veneer of index averages regularly pushing higher. These are driven be a relatively few mega cap tech names that seem to be nearly impervious to negative news.

On the other side is a growing group of stocks that are not only vulnerable but seem to be hypersensitive to such factors. This is a different environment than a few years ago when it was extremely difficult to find any stock that was cheap. Something has changed.

This opens up new challenges and opportunities for investors. A big challenge is that the mega cap tech leaders today are unlikely to remain impervious to bad news forever. One of the great lessons of the internet boom in the late 1990s is that tech companies are not immune from economic pressures.

Many will be surprised to find out this is still true. Whether it comes in the form of reduced capital spending by companies, lower discretionary spending by consumers, or lower advertising spend as corporate budgets get squeezed, technology businesses are still very much affected by economic conditions. As it turns out, these conditions affect all their customers.

Another big challenge is that with major indexes near all-time highs and with little earnings growth to support those prices, common passive strategies are set up to deliver exceptionally poor returns over the next several years. As a result, the returns from passive investing may very well be insufficient for many investors to reach their goals. The ride over the last ten years has been terrific, but the next ten will likely be very different.

There is also opportunity, however. The best chance investors will get to realize the kinds of returns that can really help them is to return to the hard work of uncovering undervalued companies. Such an endeavor is the bread and butter of active investors and focuses on identifying cash flows and determining how sustainable they might be. Competitive advantages are important and often come in the form of less tangible attributes such as an organization’s capacity to learn and adapt. It takes a lot of work, but the opportunities exist.

While the work of toiling on individual company analyses can be a lonely endeavor, especially while passive strategies remain in the spotlight, it is also a valid way to extract decent returns from an otherwise overvalued universe of options. Indeed, such efforts may be the last best hope to realize attractive returns for some time to come.

David Robertson: “Best Used By”

Most people have had an experience or two with something that is out of date. Whether gulping down some spoiled milk, biting into some moldy bread, or sipping a glass of wine that has turned to vinegar, the experience tends to be shocking, unpleasant, and memorable, all at the same time. The lesson quickly learned is that you need to pay attention to how “fresh” certain things are to avoid an unpleasant experience.

The same thing happens with social norms, albeit with a longer time frame. Historical practices that were once met with widespread acceptance are today considered unreasonable and uncivil. The main point is that times change; some can adapt, but others either cannot or do not. Since business success depends on resonating with customers, employees and investors, it matters when belief systems get stale.

For better and worse, the financial news has been rife with examples of rich and powerful people being discredited by their statements and/or behaviors. This has happened to such a degree that it looks like a pattern. The cases are too numerous to dismiss as anomalous.

One of the more recent incidents involved Ken Fisher, who runs a firm with over $100 billion and is worth $3.6 billion himself. At a financial conference, zerohedge reported, he “shocked attendees when he compared gaining a client’s trust to ‘trying to get into a girl’s pants’.”

Those comments alone might have been easy to pass over. Offensive, sure. But they could have been dramatized, or taken out of context, or just not that important. Fisher, however, decided to eliminate any possible doubt that he really meant what he said when he added:

I have given a lot of talks, a lot of times, in a lot of places and said stuff like this and never gotten that type of response.

As such, the comments were revealing in a couple of ways. First, the absence of any real contrition indicated he stood behind what he said. He did, however, seem disappointed that he had lost the respect of a lot of people.

Most importantly, he seemed genuinely surprised that anyone might take issue with his comments. That surprise was most likely caused by having fallen dangerously out of date with social norms, and that says something about Fisher.

In a very different example, Jorge Paolo Lemann, head of the private equity firm 3G Capital made comments at a conference last year that also demonstrated a disconnect with the real world, albeit in a very different way. The Financial Times reported Lemann’s comments at the time:

I’ve been living in this cosy world of old brands, big volumes, nothing changing very much,” he said. “You can just focus on being efficient and you’ll do OK. And, all of a sudden, we’re being disrupted in all ways.

The idea that food and beverage products are “not changing very much” seems almost laughably out of touch. Anyone who ever eats out, goes to restaurants or bars, goes to the grocery store, watches tv, follows social media, or interacts with other people is overwhelmed by the amount of change in the food and beverage industry. It is no secret that younger customers want different things.

It is also no secret that these changes have been developing for many years, as has disruption in the food and beverage industry. As a result, Lemann’s perception that disruption happened “all of a sudden” says more about him than about the market. Specifically, his beliefs about the “cosy world of old brands” had become seriously outdated.

To Lemann’s credit, he admitted that he felt like “a dinosaur”, so at least he eventually came around to realizing this. It did not come easily, however. It took a shocking rejection of his underlying assumptions about the market, in the form of poor financial results, for him to eventually change his views. Rather than observing gradual change over time, it was more like getting hit with a 2×4 upside the head.

Yet another example is that of Christine Lagarde, the new head of the European Central Bank. Shortly before her term began, the FT reported on comments made primarily to a European audience. In particular, she declared:

We should be happier to have a job than to have our savings protected.

In one sense, it is understandable that Lagarde might want to establish continuity with ECB policy, even if it is problematic in many respects. In proclaiming what people should prefer, rather than listening to what people actually do prefer, however, she also revealed a degree of arrogance and condescension that come across as passé in today’s more egalitarian ethos.

It may be tempting to write off these examples as just some innocuous bits of disappointing behavior. It’s not like it is illegal to have outdated beliefs, and there are certainly plenty of scandals involving illegal activities among the wealthy and powerful class to grab our attention. Further, outdated beliefs can even be a bit humorous when revealed unintentionally.

It would be a mistake to dismiss such incidents, however. For one, these are not isolated incidents but rather are emblematic of widespread behaviors and belief systems. The incidents reported are indicative of similar instances that happen every day. The FT describes the landscape:

In decades prior, Mr Fisher’s remarks may have elicited a warm hum of laughter from the usual greying, male crowd. He may even have impressed some would-be allocator in charge of a family office or endowment with his maverick touch. Not so today. Instead, this has ended up being a costly mistake.

Another problem is that many leaders seem unaware of how completely their personal belief systems fail to comport with those of society as a whole. To be fair, the belief systems of a society are moving targets; they change over time.

The Economist explains,

Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart.” A key factor is that the composition of society changes due to demographics. The Economist explains, “many socially conservative old people have died, and their places in the polling samples have been taken by liberal millennials.” 

While there have always been generational differences, part of what makes today’s differences so interesting is the magnitude and breadth of those differences. The generation of Millennials is much more diverse than the Baby Boom or Silent generations. Millennials, as a group, are also far better educated. It’s no wonder that significant political differences exist.

As a result, some social beliefs are changing quickly. The Economist illustrates with the example of gay marriage:

“As recently as the late 1980s, most Americans thought gay sex was not only immoral but also something that ought to be illegal. Yet by 2015, when the Supreme Court legalised same-sex marriage, there were only faint murmurs of protest. Today two-thirds of Americans support it, and even those who frown on it make no serious effort to criminalise it.”

One important consequence is that this rapid change in social beliefs is exposing a number of leaders and managers as being distinctly out of touch. Whether it be Fisher making vulgar comments to a group of financial professionals, Lemann professing how stable big food brands are, or Lagarde telling people they should prefer jobs over savings, each of these figures revealed that they have completely missed important changes happening across society.

In a sense, it is a bit sad when leaders reveal such striking shortcomings. They can seem like beached whales; potentially majestic but so desperately out of their element. One day they were swimming in a set of beliefs that they fully understood and the next, they were stranded and helpless.

This phenomenon is not harmless, however, and can affect investors in a myriad of different ways. One important way is through the boardroom. Board members are normally chosen for their business acumen, contacts, and decision-making ability, among other things. Because these qualities often tend to improve with age, most board members are more experienced.

While all those qualities are valuable, all of that experience can also engender certain belief systems that are not helpful at all. Indeed, “experience” can also engender a great number of lessons learned in past environments that are unlikely to recur in future ones. 

This can create a real problem. Whether intentionally or not, the behaviors and beliefs of board members get propagated through the entire company. This point was made clear by the Economist in summarizing Ben Horowitz’ new book: “Leaders set the tone. If they lie, shout or swear, then others will do the same.” Likewise, if they make lewd comments, ignore rapidly changing consumer preferences, or treat people as “subjects”, others will also do the same. It usually doesn’t take long for such behavior to thoroughly permeate an organization.

An excellent example of this was Uber. Back in the summer of 2017, when Uber’s board was trying to deal with the unseemly behavior of Travis Kalanick, board member David Bonderman made things worse. As the FT reported, “it took less than seven minutes before Mr Bonderman … interrupted fellow board member Arianna Huffington. As Ms Huffington was telling staff that research showed boards with one female director were more likely to appoint a second, Mr Bonderman interjected: ‘Actually what it shows is that it’s much more likely to be more talking’.” Is it any wonder that Uber had a “corporate culture known for being aggressive and sexist”?

Although many forego the opportunity, there are things investors can do to reduce such risks. Proxy statements reveal a number of “tells” that indicate which boards and which companies may be especially prone to outdated belief systems, most of which revolve around an element of insularity. For example, low board turnover, concentrated power among a few long-serving members, and boards that are “captive” to a powerful CEO/chairman are all indications of potential problems.

Another investment consequence of outdated belief systems involves the competition for talent. Perhaps no business is more affected by the clash of conflicting belief systems than that of business schools themselves.

Nitin Nohria of Harvard Business School notes in the Economist that “younger alumni and incoming classes want ‘the place of work to reflect purpose and values’.” Jonathan Levin of Stanford’s Graduate School of Business (gsb) highlights the responsibility of business schools “to recognise the societal consequences of corporate actions.” Simply put, a lot of tomorrow’s managers and leaders don’t want to work within the belief systems of some of today’s managers and leaders.

Of course, stale belief systems are not solely the purview of leaders and managers. Since belief systems tend not to change much at the individual level, once they become stale, they tend to remain stale. As the Economist notes. “It is hard to beat bias out of individuals …”

When this happens on a large scale, it can create systemic risk. For example, a lot of people have experienced enormous appreciation in financial assets over their careers. Given this powerful experience, it is easy for one to believe that it always makes sense to invest in financial assets.

This creates consequences for all investors. Price discovery becomes much more a reflection of an entrenched belief system and much less an ongoing analytical exercise. Prices become disconnected from fundamental reality.

What can cause things to change? Certainly, beliefs can change. It is possible that investors stop believing that central banks can, and will, continue to support financial asset prices. It is also possible that investors start getting more squeamish about valuations.

Sooner or later, however, the thing that will definitely cause change is demographic replacement. Older generations that have fared extremely well by owning financial assets are gradually being replaced by younger generations that have had far less positive experiences. When a tipping point is reached, attitudes towards stocks are likely to change just as quickly, and permanently, as they did with gay marriage.

In sum, outdated belief systems are a fact of life and are often harmless. The main lesson though, is that there are absolutely situations in which stale beliefs can cause extremely unpleasant experiences. Fortunately, there are ways for investors to identify the risk and manage it before it becomes a problem.

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