We recently heard the story of a man who, in just five short years, lost half of his hundred fifty million-franc fortune simply by entrusting it to the care of one of the country's big, prestigious banks. Naturally, he is suing.
But, large as the sums involved may be, he is not alone – either in his loss or in his resort to litigation. We hear more and more such stories of late. They are stories of people who are tired of losing money, tired of being deceived, and tired of being charged fees for advice that is often dishonest, incompetent, or perhaps both.
Financial history is filled with examples of fraud and incompetence. Indeed, it is to these shenanigans that we owe the patchwork quilt blanket of regulations that threatens to suffocate us with every breath. The politicians who rush in, after the event, to sew on new squares do so ostensibly to promote fairness and transparency (though their motives may have more to do with opportunism than idealism).
Yet, despite the exponential increase in the amount of regulation and the construction of a vast and expensive enforcement apparatus, can we honestly say that any of the sheep really feel they are better sheltered from the wolves – those who would take advantage of either their naivety or their foolish greed? We do not think so. Rather, we believe that the effect of this patchwork of legalism has been to transform what used to be unsystematic risk into endemic risk – one that is an integral part of the system itself.
The phrase "unsystematic risk" is business school jargon for that which we would not expect to occur in the normal course of business. This can be contrasted with the usual risks to which an enterprise is exposed: costs may go up and profit margins down, competition may intensify, technology may render our plant and equipment obsolete, and rising interest rates, labor costs, raw material prices, and insurance premiums could devour our margins.
However, these are all problems which we – or, rather, the entrepreneur in whom we invest – can seek to overcome. They can be understood, their impact can be estimated ahead of time, and provision can be made to mitigate or adjust to them.
We can never make any investment without running these sorts of risks – indeed, the returns to our investment arise directly as the reward we earn because we are running them.
On the other hand, if the accountant is fudging the books, or if the company declares assets which don't exist, or if the CEO is otherwise deceiving his shareholders and creditors – clearly, this is a very different sort of hazard. This is what we mean by "unsystematic" risk.
A moment's thought will show that it is highly problematical – to the point of impossibility – to uncover the existence of such risks until it is too late. Fraud is generally undetectable unless one has complete access to all the books and complete freedom to question their entries. Even then, one must know what questions to ask – a difficult task in itself in today's world, where there is no shortage of executive brainpower devoted to ensuring that even the questions are well obscured.
We are free to carefully study the bridge's engineering blueprints in order to verify that it will bear the strain of our weight. But, if the engineer has falsified his calculations, or if he has made a quick profit on the side by slyly substituting materials of an inferior grade, we will have no calculable way of knowing this until the road gives way beneath us and we are plunged into the cataracts below.
The cause of failure may become obvious during the accident inquiry that will follow. The man responsible may go to prison and the inspection process may be tightened to avoid an exact repeat of his crimes, but that will be of comfort only to the surviving family.
Undoubtedly, the next crooked bridge builder will find other, newer, and more subtle ways to enrich himself feloniously at the expense of our safety and well-being.
Clearly, this state of affairs constitutes quite a problem for people who would like to benefit by crossing bridges, or by investing.
One particularly stark solution to this conundrum was revealed to me some years ago by a successful businessman in Mexico. This man explained that he went to his office every morning under the presumption that everyone he saw there, or with whom he talked, was lying to him.
His solution was no solution at all. Rather, he trusted no one, not even for the smallest task. Managing his affairs on the presumption that everyone was suspect, he could not afford to let anyone in his organization have ultimate responsibility for anything. Everything was checked and re-checked, often by my acquaintance himself.
Frankly, the idea of having to operate under such a premise is appalling. Yet, even as I was overwhelmed by this man's cynicism, I admired his vigilance. After all, he knew that he was alone in a hostile world, and he acted accordingly. He protected what was his. For that we surely cannot chastise him too much.
"Round up the usual suspects"
But what exactly should be the subject of our vigilance? What questions ought we to ask the minute someone suggests an investment? How do we deal with the possibility that we might be taking on hidden, unsystematic risks? How can we conclude that the bridge is safe to cross? Is it even possible to guard oneself from fraud?
If someone had taken the time to cut through the jargon and the specialized language and had put the issues before a New York cabby, or anyone else with a modicum of street smarts, Enron's financial footnotes would have raised such a stink in his nostrils that anyone trying to peddle him its stock would have instantly been given the "bum's rush."
And yet, the stark truth is that the overwhelming majority of finance professionals – the CPAs, PhDs, the MBAs, the CFAs, and so forth – either could not, or would not, see that something was horribly amiss with a firm that routinely used to feature in the "Most admired company" lists of such publications of record as Forbes, Fortune, Global Finance and the Financial Times.
Thus, if we are to avoid losing our capital to "unsystematic risk" we must shed our innocence, arm ourselves with a healthy distrust of authorities and large institutions, and maintain a certain disregard of the numerical standards that most take for granted.
Listen to the cabby
Indeed, rather than assume that market professionals are paragons of disinterested wisdom and enlightened judgment, we might do well to emulate the knowing skepticism and natural cynicism of our New York cabby.
Let us always view the credit rating of a company's bonds as compromised and irrelevant.
Let us admit that our private banker is merely interested in selling us something. His opulent and comfortable office often is nothing more than a carefully constructed image to project a sense of trust.
Let us consider the phrase "independent auditors" to be one of those contradictions in terms, akin to "military intelligence" or "affordable justice."
Finally, let us take the view that, until they prove otherwise, those who manage our money and pensions are, at worst, outright charlatans or, more often than not, the biddable servants of a corrupted industry.
We realize that for some, this advice may constitute a difficult pill to swallow. However, it might not seem so extreme from the perspective of one who has been misled, bled for commissions and then sent packing. It might not seem so extreme upon the realization that the entire financial profession has been transformed into a culture of embezzlement and moral bankruptcy, eager to adhere to the letter of the law, yet devoid of any moral standard.
It might not seem so extreme to one whose retirement nest egg or college fund lies in ruins. It might not sound so extreme to our Mexican friend, who knows that it is he alone who bears the responsibility for the wise disposition of his assets.
Our Swiss acquaintance would undoubtedly agree also, as he battles in court for a redress of all these wrongs. After all, if a man with a hundred and fifty big ones – and presumably one with no shortage of willing advisors from whom to chose – can become a victim of the system, what hope is there for those with fewer resources? Do they not deserve to have an honest effort made on their behalf by those to whom they entrust their hard-won savings?
Protectors or Pandars?
The conflicted role of the professional "Guardian" Class
Though it seems we can hardly breathe today without the accompaniment of a pack of lawyers – whether "Ours" or "Theirs" – our increasingly litigious society offers few real protections from malpractice.
Even when the professionals do read the fine print found in the back of annual reports, few seem to understand the subtleties contained there – perhaps a telling sign that much of what purports to be legal clarification is, in fact, carefully crafted obfuscation.
Perhaps the most worthy service provided by a lawyer is the simple one of helping to avoid any harmful ambiguities in the terms of a voluntary contractual obligation, so that all the parties to it will know clearly and undeniably what their mutual obligations under it will be, ahead of time.
Then, whenever misfortune, misjudgement, or malice leaves one party with clear grounds for complaint that the other has not held up his end of the bargain, a good lawyer (not quite a complete oxymoron, for we know one or two personally) will again help both parties by arbitrating an equitable and mutually acceptable degree of compensation for the breach.
Too often, the lawyers come not to offer counsel, so much as to generate fees. Whether they act for the sprawling government enforcement system or plotting with the very perpetrators of injustice and inequity in order to contrive ever more complicated snares for the unwary, their work has similar results: it empowers the Enrons of the world, while disempowering private property owners. Today, the majesty of the law has degenerated into the mire of legalism and as a result has lost much of the moral foundation which gave it its eminence.
That doyen of the banking world, Old Man Morgan himself, was once famously asked whether he made a decision to lend based on income or assets.
"Neither, sir!" he is said to have snorted dismissively. "On character."
No one can know what that long-departed giant of finance would make of today's practices. In speaking about the present role of the banks, my colleague, Sean Corrigan, once said that "traditionally stewards of wealth, banks have in practice, become agents of speculation."
When one revisits the sorry stories of Enron, Tyco, Parmalat, WorldCom and a host of other assorted malefactors, there arises one common thread: in every case, their ill-doing could never have taken place without the active, purposeful, and direct participation of their bankers. These are bankers, moreover, who generally happen to command the greatest reputations themselves (Old Man Morgan's stunted successors among them). Not one of these firms would have been able to commit such enormities without the complicity or (often) the applied ingenuity of their bankers.
Parmalat, for instance, raised over u20AC14.5 billion as it built its paper pyramid: a vast sum from which banks were happy to take millions in fees. None of these banks lent Parmalat their own money, instead they acted as facilitators to channel other people's funds into what one such bank even named, with breathtaking audacity, "Buconero" – the "Black Hole"! But who were these poor people who bought the paper?
Some firms, one can only assume, took the resulting bonds and pushed them down the line to their own portfolio managers, ultimately to be stuffed into the investment accounts of private clients. Others were undoubtedly passed to yield-hungry external investors.
These are representatives of institutions who routinely plough ordinary folks' pension moneys and life premiums into such worthless claims, without a second thought. They make habit out of bamboozling the willing fools at "Road Shows" peddling not snake oil, but statistical fictions of how well these securities will do against those of their "benchmark" peer group.
There is hardly a top banking house which was not involved in these shell games, though all now either protest their innocence or buy off the pursuing state prosecutors with ex gratia legalistic blood money.
In either case, the bank's defenses are dubious: were they guilty of abetting fraud, or were they, too, merely duped? If a bank acted fraudulently, then it may be flatly condemned on that basis. On the other hand, if it had been duped, the implication is that it was unable to determine the creditworthiness of a significant borrower. In either case, what value can it now add in the management of other people's money?
We can also ask, would the same banks so readily rely on the say-so of the borrower if they had been investing their own shareholders' money – much less if their personal fortunes were at stake? We think not.
In the rush to assign blame, many have suggested even more laws be passed and even tighter standards exacted. While perhaps well intentioned, these people miss the point. Banks fuel the expanding government, and also facilitate corporate malfeasance. The public expects government to do something, but stops short of demanding that the beast that is the Fed be demolished.
Those who doubt that abolishing the Federal Reserve Bank would make banks more responsible, ought to consider this. On November 2002, the following words were uttered by Chairman Alan Greenspan, delivered before the elite of the Council for Foreign Relations:
"… Worldwide borrowing by telecommunications firms in all currencies amounted to more than the equivalent of one trillion U.S. dollars during the years 1998 to 2001. [This] financing… strained debt markets."
"… In the event, of course, prices of telecommunication stocks collapsed, and many firms went bankrupt. In decades past, such a sequence would have been a recipe for creating severe distress in the wider financial system. However… banks have more tools at their disposal with which to transfer credit risk and, in so doing, to disperse credit risk more broadly through the financial system… instruments that are more complex and less transparent – such as credit default swaps, collateralized debt obligations, and credit-linked notes – have been developed and their use has grown very rapidly in recent years"
"The result? …such instruments appear to have effectively spread losses from defaults by Enron, Global Crossing, Railtrack, WorldCom, Swissair… from banks, which have largely short-term leverage, to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all… Many sellers of risk protection, as one might presume, have experienced large losses." [We added the emphases.]
There is a term in international finance for the perverse incentives to recklessness which come into play when lenders and borrowers know the authorities will step in to save them from the worst consequences of any follies in which they indulge: it is called "moral hazard."
Yet the supposed guardian of sound money, the man who responded to a bubble of his own making by slashing short-term interest rates to forty-year lows is not guilty of mere moral hazard. We see him here taking a reckless delight in the devious sophistication with which his precious banking friends got off scot free in the Bust, by bilking those with "no liabilities at all" – i.e., the ordinary savers to whom they were supposed to be tending!
It should come as no surprise that banks no longer seek to earn a profit by using their skills in capital allocation. They no longer direct their small depositors' savings to the purpose of fruitful enterprise. The old days are gone.
Instead, they, too, have been afflicted with a callous gigantism, swelling their balance sheets enormously and encompassing a revolution in their capital structure and financial ratios.
Nowadays, the banks make money by trading on their own account. They make it by financing consumption rather than by facilitating thrift. They make it through the fees to be had by cloaking everything in a fog of opacity and deception, using "special purpose vehicles" and offshore trusts and their ilk. They make it by unleashing an orgy in the creation of potentially explosive, highly-leveraged and ever more arcane derivative instruments and "structured products" to be used for the exploitation of their clients. In all of this, they nurture the next generation of Enrons and Parmalats.
If we cannot trust the banks, what of the "independent" credit rating agencies, such as Fitch IBCA, Standard & Poors', and Moody's?
Here again, we would challenge anyone to recall a single instance when one of these august bodies has issued an unequivocal alarm call early enough to allow those who might have heeded it to have baled out with most of their principal intact.
Rather, just like the banks, credit agencies give every appearance of being either embroiled in conflicts of interest (note that they are paid their fees by the very borrowers they are supposed to police) or are simply not up to the job of analysis upon which they base their existence (a fraud of a different kind, but a fraud, nonetheless). The issues with credit agencies are serious and are compounded by the fact that they are mostly immune from any serious competitive pressures such as would force them to be continually honing and improving their product fast enough to keep up with the black arts of financial engineering.
This lack of competition results from government interference in the free market. It springs from a decision made by the SEC, back in 1975, to classify them as "nationally recognized statistical rating organizations" (NRSROs) and thereby to perpetuate their stultifying oligopoly.
Ironically, the feeling that the Big Three are indeed biased to their American paymasters and licensors has led the European authorities, on occasion, to examine whether they should set up their own, local cartel to treat their home-grown corporate champions with kid-gloves, too.
Although the credit agencies are not accountable to any outside voices and although their record as forecasters is a parlous one, they continue to exert a significant influence in the financial markets. Their ratings are still regarded – albeit less so – as official seals of approval, or a kind of appellation controlée of debtors. Of course, this is convenient for everyone. The banker or bond arranger can use the agencies' "independence" as a sales gimmick, while their endorsement also provides the money manager a reputational, as well as legal, cover in the event of any subsequent mishap.
Since their very business is dependent on maintaining the illusion that their verdict is both sound and impartial, credit agencies can wax vehement in their own defense. However, for all the noise they make when anyone dares to question the validity of their methods, or the independence of their assessments, this cannot drown out a deep and abiding suspicion that the supposed guarantees they offer are more than superficially useful and that an over-reliance on them are responsible for much more harm than good.
Keep the red flag flying
We have laid out all the above in the hope it might prove useful in clarifying and identifying some of the little-regarded sources of risk. We will skip past the densely packed minefields of accounting and auditing (q.v. Enron, WorldCom, Parmalat, et al.) for another time.
In the end, if we should not rely on the rules and accounting standards, or on mathematically tractable entities, to mark out dishonesty and incompetence, and if we cannot identify malfeasance directly from an Excel spreadsheet, what hope do we have to survive? Or, must we withdraw from the market completely, perhaps pausing only to bury a few gold coins in the soil? Perhaps not.
Far from that, we believe there are a number of readily comprehensible, qualitative and perhaps intuitive considerations to which we can turn when examining the securities of a company. Any one of these signals should give rise to serious doubts about the overall suitability of a given investment. If more than one such factor is in existence – and believe me, these bearers of bad news tend not to travel alone – a huge red flag should prompt us to utterly reject the investment altogether. It is far better to overlook a good company not fully understood than to pack a portfolio with unmarked dirty bombs; however en vogue they might be.
For every investment idea rejected out of a sensible exercise of prudence, there are a multitude out there somewhere – presently unknown or perhaps not yet even founded – that are far more worthy of interest and money.
Six (financial) flags
Not enough "stuff" – Deficiencies in net tangible assets. This is clearly a basic banking approach to lending that can also be used by equity investors. When a company's balance sheet is stripped of intangible assets, u2018other assets' and any other items which are only financial in nature, what is left is the tangible asset base – the "stuff" the company really uses to pay its suppliers, hire its workforce, repair and upgrade its equipment and to generate wealth for its owners. If there do not seem to be enough of these in comparison to the rest of the entries in the accounts one should start to wonder whether stocks and machinery have been replaced by smoke and mirrors. The wellspring of "write downs" starts with a hollow balance sheet.
Mergermania – Excessive acquisition activity is also a sign of ill health. Nothing truly great was ever built via a process of fevered acquisitions. This is not to dismiss all takeovers, regardless of circumstance, but to point out that they are usually far more lucrative for the corporate financiers and insiders than for the company stockholders. Frequent acquisitions are a sign of weakness, of misplaced priorities and of the inability to enhance worth from within.
More growth – and at any price. In practice, this usually means growth at too high a price. Market share is not what matters but return on capital. Profitability is what counts, not mere turnover, much less "eyeballs" or any of the other New Era nonsense metrics. No honest business ever grew in an uninterrupted geometric progression – especially not one in double digits. Life just doesn't come in such neat packets, no matter what Jack Welch might say in his latest airport executive pep-talk.
Too many trips to the well. Frequent recourse to the financial markets for funding is another danger sign. A good business makes money by reinvesting its profits, not by slowly mortgaging itself to its bankers or by continually diluting its owners.
Too much fine print. If the annual report has more fine print than a budget edition of "Gone with the Wind," the firm's shareholders will only get to dream of Tara; they will never know her. Well-run companies have simple and straightforward accounts. Lots of fine print can either imply the company doesn't know what it's doing – or that it doesn't want you to. In the end, more often than not, fine print raises more questions than it answers.
Lack of substantive ownership by those at the top – and presumably by those in the know – is hardly a ringing endorsement of a business. If the CEO and his buddies only hold stock through option grants and never actually pay for their holdings, and if the members of the board have better things to do with their pensions than to waste them on the company they supervise – who are we to argue?
Five (Behavioral) flags
Managing the stock, not the company. We believe that in an entrepreneurial setting, the price of common stock is merely the reflection of wealth rather than wealth itself. To the extent that the Street and the stock ticker become the focus of a company's management, we would swiftly avert our own gaze. Wise, long-term decisions cannot be made when most strategies adopted are aimed at flattering the next quarter's numbers. In recent years, in fact, CEOs will even give "guidance" to analysts as to future sales and profits – a practice which, at heart, is designed merely to support and cater to share price management.
Tell me something I don't already know. More often than not, a firm which insists on calling in consultants at every turn becomes hooked on the avoidance of full managerial responsibility, no matter how it may justify it. Consultants often know little more (and sometimes quite a lot less) about a business than the people working there. Typically, they are an expensive way to confirm the Boss in something he lacks the resolve to implement himself. Quite often, consultants are also a sure sign of a firm in which ideas have dried up because of poor internal communication, strained employee relations, or limited understanding of the customer.
Who are those people cluttering up the shop? In the free market, the consumer is king and anyone who loses sight of this simple truth is likely to be thrown out of the kingdom. By succumbing to the lure of Wall Street – induced empire building, many companies have lost sight of whom they serve. The same condition often causes them to neglect their employees also – meaning they end up with unhappy people on both sides of the counter.
Packing the Court. If you think that the board of directors has been picked in order to curry political favor, or to provide a chorus to sing "Yes!" in harmony to the CEO, beware! Does the company routinely offer sinecures to petty aristocrats, or does it participate in the revolving door back-scratching of those on the government-boardroom-bureaucracy carousel? Does the board consist of a fashionably correct ethnic or gender-based mix – where the persons concerned seem to have been chosen for PR reasons, not on personal merit? Are there figureheads around the table, rather than independent and respected voices who can defend the shareholders from the worst impulses of a dictatorial CEO?
Rock'n'Roll Cowboys. The CEO is the person employed by the owners to put their capital to work in running a business. Let us not forget, he is (admittedly very expensive) hired help. His role is to serve the owners to the best of his ability. An inveterate show-off, less well known for his business acumen than for his yachting exploits, his mistresses, his sports sponsorship, his politics, or any of a number of other extra curricular pursuits, would not make it past the selection panel if you and I had been asked to sit on it. If the guy wants to be an Emperor, let him emigrate to Ruritania. If he wants to be a rock star, let him go take a few guitar lessons. Meanwhile, I want to invest in an entrepreneur who is too busy running the company for such distractions and is humble enough to know that there is always more he does not know than there is that he does. The first guy will doubtless make himself rich: the second might make his owners rich instead.
We earnestly hope the foregoing has given the reader a few pointers as to where he should start exercising "street smarts" in the selection of investments. Once honed and directed, these intuitive skills – when wedded to the analytical capabilities which anyone can acquire with a little study – should act as a defense mechanism against the many elusive unsystematic risks that plague our financial world.
In the end, one can only trust his own judgment, intuition and skepticism, not only in investment selection but also in the selection of those to whom he conveys fiduciary duty.
If one can manage to spot the red flags, warning signs and maintain discipline in the face of great challenges – resist the tug of the ticker tape and the smooth talk of the stock salesmen and uppity bankers – then that person might just stand a chance against great odds.
We reckon that's a lesson which is worth at least half of a hundred and fifty million francs.
With gratitude to Mr. Sean Corrigan for his considerable contribution.
October 7, 2004
