Sunday, May 19, 2013

Intellectual Integrity

My brother has often quipped, “Would you believe that I am the smartest person in the room?” Most people immediately and correctly attack the question and miss the point. The point has to do with one’s belief ("would you believe") not the accuracy of the statement (smartest person in the room). Our lives as people, citizens, and investors are governed by our beliefs, not necessarily by convenient or inconvenient facts. In the realms of investing we, in theory, are protected against fraud that is incontrovertibly provable in court. What have proven to be much more damaging to us persons, citizens, and investors are lapses of intellectual integrity; intentional or not.

Gamblers’ choices

As I indicated in last weeks’ post  we are all gamblers. We cannot avoid gambling as to what the future will bring to us, good, bad, or indifferent. We make the choices as to our own actions based on our belief systems and the information that is in our possession. Much of what we use as information is derived from implications drawn from various levels of data with different degrees of reliability. In the normal course of events we make choices of which political leaders to support, where we choose to live, what jobs we take, what people/agents we choose to hire, what investments to make and in my case into what funds to invest our clients’ money. Before we immediately react and start to use the information that is on hand, we should ask the first part of my brother’s question, “Would you believe?”

Challenge the “facts” before using

We are aware of grade inflation both systematic and specific. We are also aware of résumé embellishment and political hyperbolae. Anyone who hires others is aware of the need to either disbelieve or at best filter what has been presented to us. In the investment world many answers are wrapped around a set of numbers as verification of some skills achieved in a convenient time period with the clear implication that the same supposed skill will be delivered in the future.  As we live in a time-constrained world, a media clip is meant to move portions of the swing voters, very quickly reviewed pre-screened résumés are being used by hiring managers for important positions. All too few questions are being asked to understand the full nature of what is being offered for our fast, but important decisions.

A prudent approach to examining individual security data

While I am very conscious of the costs of displays of data and the syndrome of “eyes glazing-over” from too much data, I suggest that the statistics on performance covering five and ten years as well as “since inception” results can raise the question as to intellectual integrity. Without understanding what is also happening during the period under study and particularly what a reasonable set of peers are doing does not put the data into appropriate perspective. Go back to the question as to the smartest person in the room. Are we talking about the fabled Thomas Jefferson, according to JFK dining alone in the White House, or a bunch of low achievers gathering somewhere, or a collection of Nobel Prize winners convening at Caltech? 

Another major concern of mine is that if long enough periods are chosen often the result will show misleading compound growth rates. 

Understanding under-performance is more important than celebrating the good

When I was following individual securities, I never felt that I understood a company until I found a period that they were working through problems, better yet that they had some failures along the way. Only when companies or athletes are seriously challenged does one get a clue as to their basic strength. I distinctly remember when IBM was behind in its technology and in effect, bet the company on the development and sale of the IBM 360 computer. If it had failed to deliver the promised performance, the company would have become another failed computer company. There are more modern examples of life-changing decisions that have worked; including the re-hiring of Steve Jobs at Apple and the merger of Bank One (including Bank One’s previous acquisition of First Chicago) into JPMorgan Chase. The particular set of screens that I like to utilize when analyzing companies is quarterly performance from the third quarter of 2007 until the first quarter of 2009. These periods will tell me how market sensitive their portfolios were and what changes were made during that period in terms of holdings and procedures, if any.

Focus on future investment choices

When we hire someone/firm or buy into a fund we are betting on various unknown futures. The one thing that we can be almost completely assured of is surprises. Our big risk is in choosing a candidate that has not had to recover from a bad period and particularly from an unidentified mistake. It is like going to the racetrack and betting late in the season on a horse which has a winning record of always leading from the front. What is that horse going to do when some other horse or horses are in front of the prior undefeated horse? For that horse, portfolio manager, employee, or political candidate this is a surprise situation.

Dealing with surprises and other disappointments

We are all human which is to say we make mistakes. Please protect me from persons who have never made a mistake, at least in their mind. We live in a very dynamic world where lessons should abound every single day. We need to find those that have intellectual integrity that not only admit mistakes but learn from them. In some respects the great Sir Winston Churchill made more mistakes than almost any other politician in the English-speaking world; but I believe he was the essential choice as the leader for Britain during World War II. He clearly learned from his past mistakes. He would have been a great portfolio manager in a different setting. However if one studies his actions, it is not a surprise to see him lose power after his great success and yet be recalled to leadership when conditions turned to need his strength.

Investment integrity demands

What is demanded by investment integrity is a discussion of losers as well as winners. Most importantly required is a discussion of what kind of environment helps the existing portfolio and what hurts. We would like to see who is being hired, are they complementary or supplementary? Are they broadening their knowledge base or just adding replacements to the present talent pool?

Please let me know how you handle investment surprises.
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