Part 2 of the excerpts from our Q4 2008 report. In Part 1, we introduced and exemplified the theme of the structural fragility of incentive systems via two texts, “Own Goal” and “Dolus Bonus”. In this text, we present the core of our reflection on the subject in order to highlight the importance of raising our moral critical standards.
Q4 2008 report excerpts on moral diligence: Part 2 of 2
“ON MORAL DILIGENCE”
“What aren’t you able to bring men to do, miserable hunger for gold!”
Seneca
2008 was a long, hard and troubled year, during which the world financial system had its governance and compliance structures questioned, and the markets went completely off the rails; they were severely destabilized and shaken by a crisis of confidence that was unprecedented in complexity and scale.
It is no exaggeration to say that, from September on, the generalized uncertainty and mistrust severely dried up the liquidity of a system that had already been staggering for over a year, locking its financial and transactional gears.
The banks, whose very existence is founded on the most basic form of “credit”, their reputation, stopped believing in each other’s balance sheets and capacity to survive. They discredited their own auditors, as well as their compliance mechanisms and risk gauging and control systems. They started to doubt the payment capacity of those they finance. Insurers stopped trusting those they insure, and vice-versa.
All over the world today, producers suspect suppliers, and salesmen their customers. Contracts were and are being questioned, suspended and canceled. Voters are skeptical about the capacity of their governments to resuscitate the markets and the economy in a fair and efficient manner. And governments do not believe in the autonomy of the markets. The market, in turn, trusts neither the government nor the regulators. Investors question their advisors, who in turn question their managers, who no longer believe their economists and analysts, who do not trust their models any more. It is a long list. Bonds of trust, once broken, take time to rebuild. And many of the consequences and effects of these ruptures are yet to come.
In this context of worldwide broken trust, we would like to share with our clients, business partners and friends a reflection of a moral nature. But one that is not moralistic.
In our opinion, which differs from the consensus, to reduce the recent events to human “greed”, to deposit them in the account of the “irresponsible behavior of a few” or, at the opposite end, to interpret them as a direct, exclusive and inexorable consequence of a framework of incentive systems and the conflicts of interest associated with same – for which, at the end of the day, no-one feels responsible or accountable – is to ignore an issue that we consider crucial: it seems to us more interesting to look at the situation from a “micro” point of view, where we can in fact take action, than from a “macro” angle, where searching for culprits and definitive explanations, or even postulating solutions, is beyond our scope and competence.
In the sky-high “macro” sphere, realm of Them, the Others, we all think ourselves creditors and victims. But it is in the streets and alleys of the “micro” sphere that We are (or should be) accountable.
It seems more productive to use the crisis as a backdrop for us to reflect on potential forms of protection against our own recurrent fallibility (greed, imprudence) and the fluctuations in the alignments of interest that are intrinsic to each and every relationship.
We could hastily reach the conclusion that the design of the incentive systems that govern the relationship of agents in markets and organizations “perverts character”, instigating agents to “act”. And conclude, like Shakespeare’s Cassius trying to persuade Brutus to murder Caesar: “For who so firm that cannot be seduced?”
And how can we apply this premise on a “macro” scale? Re-designing the explicit and tacit incentive systems that govern exchanges among the agents? Establishing more and better surveillance, reinforcing regulations, imposing more controls? Frankly, we haven’t the faintest idea. It is outside our circle of competence and, honestly, we are somewhat skeptical about it.
But with regard to our own “circle of trust”, emphasizing the importance of all of us acting in a morally diligent fashion – especially in selecting our business partners, employees and investments – is definitely in the order of the day. And there is no doubt: this is an extremely important subject that generally goes unnoticed while the world moves full steam ahead, and only becomes evident and haunts us at times of crisis.
We wonder whether to ponder such a question is the quintessence of naiveness on our part. But naive and foolish is to think that only the “market’s” incentive systems are misaligned or corrupted.
Yes, in the financial sphere, there are very clear points of unbalance, which, as became evident in this and in several of the latest crises, instigate behavior that crosses, without shame or remorse, the frontier between simple “misalignment” and moral issues. As we have seen, the huge machine of transactional efficiency of the global markets intensifies this effect.
But it is worth looking at this issue very closely: to well- trained eyes, conflicts of interest are easy to see. In many cases, like the Wall Street bonuses, they are explicit.
But “misalignments” – that is, the imperfect convergence of interests among agents – are much more difficult to see. Primarily, they belong to the sphere of the tacit. They are multi-dimensional and fluctuate over time. They are much more difficult to pick out in contracts or schemes. Preferences change over time. They are volatile, ambiguous and conflicting. Anyone who has had friends or partners knows exactly what we are talking about. By definition, there is no “perfect” alignment of interests. Or do you think that this malady is exclusive to the financial market?
Yes, structurally, we live under the aegis of a generalized misalignment of incentives – from our government systems to mechanisms for remuneration and promotions in companies, which, given time, could even be corrected, improved, or at least better watched over, controlled, punished.
But the other side of the coin, what demands our attention a great deal is that, despite the “structures”, “systems”, “markets”, the social pressure to follow tacit rules and behavioral consensuses, the struggle to deliver significant results, to be better than the competitors, there is ALWAYS the option, as a matter of principle and discipline, to use from the very beginning a high moral filter for everything we do.
The option to say “I will not take part in this”, “No, I will not invest in this fund with the best Sharpe Ratio without fully understanding the process that generates this irreproachable performance”, “No, I will not manage this company or investment fund aiming at short-term results”, or “I will not do business with these people of questionable reputation” DOES EXIST. Always.
This posture is valid with regard to managing our own business – as usual, it is always easier said than done – but it also extends to the people close to us, and is especially critical with respect to the business partners we select – in relation to whom our degree of control is clearly lower.
It is not by chance that, as long-term investors, one of the aspects that we most consider in filtering our potential investments are the people involved and their motivations. What type of partner do we want? Has the company in fact an owner or owners? Who are they? Where do they come from? What are their aims, their ambitions for themselves, for their families and for the company? What do they value and despise? How are they called to account? How do they measure their progress, their success? How do they act in relation to their associates (business partners, clients, suppliers, etc.)? What are the values that are really adopted and practiced by the company: how are they reflected in the behavior of the owners and employees? How do the explicit and tacit incentive systems of the different areas of the company interact among themselves?
Fully understanding how the organization chart of a potential investment really works in real life (in greater or lesser harmony with the company’s explicit incentives) should be covered in a special chapter in each and every book on valuation.
It is astonishing how powerful an analysis based on people and their motivations can be. What is more, this “social auditing” should also be extended to the company’s “neighbors”, the key points in its value chain.
For example, when we “analyze” a company that sells products and services to another, it is crucial also to know: WHO is really responsible for the purchase of the company’s product? How is HE compensated? How is HE, the buyer, profiting from the purchase? What is HE placing at stake?
In short, if the misalignment of interests among “agents” (always flesh-and-blood people) is a fact of life, there is only one reasonably effective way to deal with this: to make use of a high moral/reputational filter and to keep within our circle of trust just a few business partners/associates, but good ones: competent, ethical and genuinely aligned.
A good example of moral diligence to be followed is that of Warren Buffett, whose control and governance system for the companies in which he invests is, at first sight, rather “loose”. And even so, he gets it right much more often than not.
In the words of Charlie Munger, his partner at Berkshire Hathaway: “it’s wonderful to be trusted. Some think if we just had more compliance checks and process, virtue would be maximized. At Berkshire, we have subnormal process. We try to operate in a web of seamless trust – deserved trust – and try to be careful whom we let in.”
Part of their secret: a very good eye for evaluating a person’s character (and the ability to audit their reputation with a couple of phone calls). But obviously the two men only developed this sharp perception because, at a given moment in their careers, they gave this filter a disproportionally high weight in evaluating potential investments. This makes all the difference.
If on a scale from one to ten, traditional investors give a weighting of 3 or 4 to traits such as integrity, character and values, in Buffett’s case, where the horizon for carrying an investment is “forever”, there is no other way: the weighting must be close to 10, and in the hierarchy of desirable attributes of a good investment, precede all others.
Buffett applies a high moral filter, he says, always seeking three characteristics in his potential business partners: integrity, energy and intelligence. In this order. And in his own words: “if your candidate does not have the first, the other two will kill you”.
On the other hand, it is important to stress that, sometimes, basing a good part of the process of selecting business partners on an apparently robust moral filter, but without due diligence, has the opposite effect. In cases such as that of Madoff, the exaggerated trust that many of his victims placed in the investor’s most obvious traits (former Nasdaq chairman, a link with charity and the Jewish community, several of his investors had an irreproachable reputation, his intermediaries were renowned companies, the fund always delivered good, consistent results, though not extraordinary, and for years on end) created an aura of “integrity” around him that made his scheme very convincing for a long time. In this case, the “moral” trait took part in the selection process, but diligence was insufficient. The golden rule is “Trust. But verify”.
Well, taking all that into account, what should be done from the practical point of view to safeguard ourselves, at the “micro” level, from our own mistakes?
Firstly, having a very clear notion of our suggestibility and susceptibility (recurrent fallibilities and biases), and controlling it with principles, values, discipline, systems, internal processes, and a competent, aligned team; demanding a significant margin of safety; and knowing that, even though well-meaning and alert, we can be (and are) fooled by our senses, judgment and evaluations of information and – even more important – people.
Secondly, building an environment that will clearly promote incentives other than just material ones (starting with the selection of people using an ever higher “moral filter”), in harmony with the principles and values practiced in the company (selection of associates/counterparties – few, competent, honest and aligned – who share these principles).
Thirdly, being morally diligent – with ourselves and our business partners. This applies to the evaluation of the companies in which we invest, to the people we hire and keep in our team, to the people who render us services, to our business partners, and to our clients as well.
CONCLUSION
We used as a backdrop reflections on “incentive systems”, like those that marked the present financial crisis – and, along with several other factors, helped to gear it up – in order to throw a somewhat solitary light on another place: the importance of raising our standards, our moral filter, ever higher when making our choices, less as agents of a transactional system, but more as responsible members of a community.
When we reflect on last year, one of the most important things we have learned is that there is no better risk control than to be surrounded by good business partners and few, both in-house and outside: competent, well educated, ethical, and genuinely aligned with and committed to us for the long term.
In this respect, we seek always to be on the alert – and even so, now and then we err in evaluations and judgments.
To elect a high moral filter as a crucial instrument for risk control has a high “visible cost”. The universe of investments that we can consider is drastically reduced (it is not for nothing that we seek to invest in companies on a global scale, so as to expand our reach without having to lower our governance and management-quality benchmark). The universe of employees that can be hired and eligible partners, ditto. In short, as a rule, our number of potential business partners falls a lot.
On the other hand, the “invisible benefits” generated by this more conservative conduct are extremely valuable to us. And in our assessment, they more than compensate the visible costs.
A good way to think about moral diligence is to make use of an old friend: the margin of safety concept. Just as we must invest in companies whose price offers a significant margin of safety in relation to our perception of their value, we must also require a “margin of safety” when we assess the moral contours of an opportunity for an investment or partnership.
The fact that we seek to be always on the alert does not mean that we always get it right, whether internally or externally. Last year is a good example of that.
But the simple fact that we pay attention to the importance of being increasingly morally diligent with ourselves and with our associates helped us to minimize some of the mistakes made and to correct them relatively quickly. Our portfolio today is, to a large degree, a positive result of these changes.
(…)
As a final message, a very simple observation: properly exercising what we call moral diligence implies doing more with less. The universe of investments, counter- parties and partners that can be considered is reduced. And that is precisely the direction we’re following. We want few but good business partners with whom we can cultivate and nourish relationships that transcend the transactional.
To have a select group of clients and business partners who admire and trust you is immeasurably more valuable than an infinite number of clients and business partners that maintain a merely transactional relationship with your company. In this respect, we feel privileged.
We agree once more with Buffett and Munger: “we try to operate in a transparent web of seamless trust – deserved trust – and try to be careful whom we let in.”
Tags: corporategovernance, corporatestrategy, ipreports, mentalmodels, moraldiligence, moralfilter, portfoliomanagement, report, riskmanagement
