Detecting Deception: "Trust, but verify" (Part One)

We recently concluded another earnings season, a quarterly time period that our team spends listening to tons of calls from public company executives of all sorts. During these calls, the vast majority of management teams trumpet the merits of their strategy, the quality of their businesses, and almost always argue that the "best is yet to come".

With literally thousands of public companies touting their prospects, it is a mathematical certainty that some are not telling the truth. Which management teams should investors trust? Who should be avoided? Is there a way to identify purposefully deceitful executives?

We believe that the quality of the jockey is often more important than quality of the horse.  As a result, gauging the personality of a management team is an integral part of our investment process.  We have historically favored the "quiet trumpets", that is executives committed to honestly assessing their business rather than cheer-leading their stock price. We are focused on finding passionate operators (not promoters) who are dedicated to capably executing a specific long term vision.

Making this determination is largely a subjective process that often depends on our "gut feel" (sometimes simply the absence of a slimy feeling) after meeting or speaking to a team directly. Admittedly, our batting average has not been 100%, and we occasionally are surprised to find out that we have misjudged a management team.  However, we have had success avoiding trouble by applying a checklist of sorts that seeks to eliminate self interested or overly-promotional management teams.  This list of "red flags" is pretty straight-forward and includes: 

• Excessive compensation or perquisites (company paid jets, private clubs, etc.) 
• Historical "Blow Ups" (Previous failures as public company executive) 
• Nepotism (Executives & Board members who all share the same last name)
• Dual share structures (granting majority voting control to executives who own a minority of the shares)
• Questionable related party transactions or other evidence of self dealing
• Excessive wearing of Jewelry
• Location of the company (Typically avoid Miami,  Las Vegas and Atlantic City)

After speaking to management teams we seek to confirm the accuracy of what we have been told.  This is our application of Ronald Reagan's famous "Trust, but verify" doctrine.  We get in touch with competitors, suppliers, and other industry experts to get their take and impression of the company we are researching. We also dig through archived conference calls, listening to what management was saying three or four years ago and comparing it back to reality. The tone of these calls, especially how management has responded to difficult shareholder questions, can be particularly revealing.    These additional steps help establish (or destroy) the credibility of a management team.

As students of behavioral finance, we have long been interested in improving our process to identify deception and weed out poor management teams.  We have enjoyed reading several recent studies which explore this topic in more detail and will discuss in subsequent posits:

• Detecting Deception on Conference Calls
• What we can learn from the prevalence of diving in Soccer matches
• Related Party Transactions and the incidence of fraud

 

A trip to the archives: Ben Graham, Behavioral Investor?

Given the recent spike in stock market related fears, we thought it would be timely to dig into our archives and re-visit the ideas of Ben Graham.  Long recognized as the founder of value investing, Graham also was an expert on market psychology and a critical observer of investor behavior. We have incorporated many of his core principles into our own investment process, and recognize in particular:
- the value of thorough research
- the importance of demanding a margin of safety (price in relation to value)
-Believe risk is also a direct function of investor sentiment (High expectations = High Risk).

While Graham and Dodd explain these ideas in detail in both Security Analysis and The Intelligent Investor, Graham's little known1963 town hall lecture, Securities In An Insecure World, perhaps expresses them most clearly.  The entire transcript is worth a read but we have included some relevant excerpts below:

On what it takes to outperform the market:

"Let me now make a general observation.  For obvious reasons it is impossible for investors as a whole, and therefore for the average investor or speculator, to do better than the general market.  The reason is that you are the general market and you can't do better than yourselves.  I do believe it is possible for a minority of investors to get significantly better results than average.  Two conditions are necessary for that.  One is that they must follow some sound principles of selection which are related to the value of the securities and not to their market price action.  The other is that their method of operation must be basically different than that of the majority of security buyers.  They have to cut themselves off from the general public and put themselves into a special category.

Genetics and your investment behavior

We have long observed that some individuals consistently make better decisions with their money than others.  Emotional control is often the most essential characteristic of successful investors.  Market volatility and other stresses can induce extreme emotions that cloud our judgment and prohibit us from thinking rationally.  Many other ingrained personality traits, such as one's  willingness to take risk and general tendency to save or spend, have an important financial impact.  But what causes individuals to decide and behave the way they do? Recent evidence shows that genetic inheritance plays a larger role than we may have thought.

A note on book reviews, the circle of competence, and our approach to learning

Our group enjoys reading to learn about a variety of topics and we plan on sharing our notes frequently on these digital pages.  At first glance, some of the books and articles mentioned may initially appear completely unrelated to investing.  It is our belief that the most successful investors draw on far more than a sharp pencil and a basic accounting degree.  History, in particular, offers readers the opportunity to learn both from the mistakes of others (which can be far less costly than learning from our own) and gain a better understanding of past human behavior.  We are interested in examining the events, risks, and crisis of previous generations so that we can be better prepared to manage portfolios should history, as it often does, begin to repeat itself. 

This multi-disciplinary approach to knowledge and investing has been developed in detail by Berkshire Hathaway Vice Chairman Charlie Munger.  He explained at length what he refers to as the "latticework" approach in a classic, must read, 1994 speech to the USC Business school, "A lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business."  The heart of his message is that "before you're going to be a great stock picker, you need some general education....you've got to have models across a fair array of disciplines."  To Charlie, a general education consists of models derived from mathematics (especially probability), economics, biology, physics,and engineering among other subjects.  He notes that human psychology (i.e. behavioral finance) is "an ungodly important subject if you're going to have any worldly wisdom" and that "terribly smart people [have made] totally bonkers mistakes by failing to pay heed to it".  While observing the behavior of others is important, it is also critical to understand the limits of our own abilities; "If you play games where other people have the aptitudes and you don't, you're going to lose.  And that's as close to certain as any prediction that you can make.  You have to figure out where you've got an edge.  And you've got to play within your own circle of competence."  To become better investors, we need to constantly work to expand the perimeter of our own circle of competence, and indeed, that is one of the primary goals of this blog.

Further reading on this subject can be found in Robert Hagstrom's, Investing The Last Liberal Art, which uses the latticework approach to connect models from a variety of disciplines back to Investing (below).

As a side note, we will often supply links to Amazon.com when making book recommendations.  If you have an interest in purchasing the book, we encourage you to use our link as we will receive a portion of the purchase price.  100% of the proceeds we receive will be directed to the Punch & Associates charitable foundation, a donor-advised fund that we manage.

The Behavioral Investor Blog

This blog is designed to be a professional investor's virtual library that archives our explorations of history, finance, and current events through the lens of behavioral finance.  We intend to share the most interesting information and insights we come across on a regular basis.  We will post analysis and links to articles of interest, interviews, documentaries, book reviews, charts, general musings and periodic humor.  While we may occasionally reference facts pertaining to specific companies (perhaps a general business trend or an emerging theme mentioned by an executive), we will not share our opinions or make any specific recommendations on our blog. 

Thank you for coming, we hope you find this to be a fantastic resource and we look forward to actively posting!

About Punch & Associates and Behavioral Finance

Punch & Associates is a Minneapolis, Minnesota based investment manager specializing in small and micro cap investing.  We spend our time researching under-followed and neglected areas of the market in an effort to identify fundamentally attractive companies selling at value prices.

 

We are constant observers of investor behavior and our investment strategy seeks to exploit the inefficiencies that result from market irrationality. Financial markets are often highly emotional creatures that oscillate, sometimes dramatically, across a broad spectrum of human emotions (above).  History has proven that the resulting impact on financial markets is considerable; as prices of assets begin to drift away from their underlying intrinsic values, significant opportunity is created for investors.  To capitalize on this, we engage in what we internally refer to as "theme anticipation".  This exercise is centered on identifying business characteristics, sub-sectors, and market groups that, although currently out favor, over time have the potential to capture the imagination of other investors as popular psychology and attitudes change.  While our investment process is very much research intensive and dependent on the individual fundamentals and management teams of each company, behavioral finance and ultimately investor behavior plays an important role in each step of our process.