More Than You Know

by Michael J Mauboussin

  When is management assessment unnecessary? Understanding management’s motivation is not particularly important for investors—perhaps more accurately, speculators—who intend to have a short holding period. In the short term, stock prices are sensitive to specific events and the vagaries of the market. In the long term, management actions are much more likely to leave a lasting imprint on a company’s performance, and hence its stock price.

  Make no mistake. Chief executive officers (CEOs) do not have an easy job, especially in the current environment. According to recent studies, forced turnover of CEOs was up sharply in 2006 versus a decade ago. And this trend is not limited to just the United States—the researchers found similar, if not more pronounced, trends in Europe and Asia.3

  So what makes for a shareholder-friendly management team? I discuss some thoughts in the following sections.

  Leadership

  Leadership is tricky to define, let alone assess. But I look for three qualities in a senior manager that, taken together, seem like a reasonable means to judge leadership. These qualities are learning, teaching, and self-awareness.

  A consistent thirst to learn marks a great leader. On one level, this is about intellectual curiosity—a constant desire to build mental models that can help in decision making. A quality manager can absorb and weigh contradictory ideas and information as well as think probabilistically. I add hesitantly that this aspect of learning is borderline academic. I like CEOs who read and think.4

  Another critical facet of learning is a true desire to understand what’s going on in the organization and to confront facts with brutal honesty. The only way to understand what’s going on is to get out there, visit employees and customers, and ask questions and listen to responses. In almost all organizations, there is much more information at the edge of the network—the employees in the trenches dealing with the day-to-day issues—than in the middle of the network, where the CEO sits. CEOs who surround themselves with managers seeking to please, rather than prod, are unlikely to make great decisions.

  A final dimension of learning is creating an environment where everyone in the organization feels they can voice their thoughts and opinions without the risk of being rebuffed, ignored, or humiliated. The idea here is not that management should entertain all half-baked ideas but rather that management should encourage and reward intellectual risk taking.5

  Robert Rubin embodies this leadership dimension:Our Treasury meetings were characterized by searching, questioning and debate, all for the sake of the fullest possible exploration of alternatives. This was a discussion, rather unusual for Washington, in which rank hardly mattered. A thirty-four-year-old deputy assistant secretary and the Treasury Secretary both felt fully entitled to express their views. That informality reflected my experience both on Wall Street and inside the White House about what kinds of discussions tended to be the most illuminating and productive. So if someone, particularly someone junior, who was often closest to an issue, seemed to be holding back, I tried to draw out his or her view. What mattered to me was the merit of the argument, not the title of the person who made it.6

  Next is teaching or the ability to communicate a simple, clear vision to the organization. Teaching requires a balance between the need to repeat a message over and over (great CEOs find themselves repeating core messages literally hundreds of times to myriad constituencies) and the need to adapt to the environment as business circumstances change. Executives with this skill include Jack Welch and Bill Gates.

  Teaching tends to come easier for executives who are passionate. I love to see leaders who have a passion for the business and, as a result, love to come to work. Success often follows passion.

  This final aspect of leadership assessment, self-awareness, requires a balance between self-confidence and humility. Self-confidence means that given a set of facts, an executive can draw on his or her knowledge, experience, and inputs from others to make a good decision. Humility is recognition that none of us has it all—we all have weak spots that we need to fortify. A self-aware executive understands his or her flaws and offsets those flaws with the talents of truly excellent people.

  Self-awareness also implies a measure of emotional intelligence—an ability to engage others and the organization on an emotional level. This skill requires not only an ability to read individuals on a one-to-one basis but also an ability to judge the organizational culture and mood.

  Incentives

  While supporting its share of critics, economics has made a great contribution to our understanding of the link between incentives and behavior. Long-term investors must go beyond typical managerial platitudes and understand what truly motivates management. The proxy statement may be the least read, and most important, public filing.

  Consider that many investors and pundits have nodded approval at the recent compensation trend away from employee stock options toward restricted stock. I don’t necessarily share this enthusiasm, because the form of remuneration doesn’t answer the basic question, “Are the incentives motivating the managerial behavior that long-term shareholders desire?”

  Take employee stock options. A strong argument can be made that typical option programs do not provide employees with appropriate incentives. Specifically, in bull markets, all option holders stand to benefit, and in bear markets, all suffer, without any clear distinction between companies that deliver superior performance and those that don’t. Throw in option repricing (heads I win, tails you lose) and muddled thinking about option accounting, and it’s not hard to see why options never satisfied the incentive question.

  Restricted stock also fails to answer the incentive question clearly. What is the basis for the magnitude of the stock grant? If grants are not clearly tied to economic performance, and grant recipients are not in a position to influence the stock price (the majority of employees), then how are stock grants acting as an appropriate incentive?

  I believe that incentives—if they are truly to have an impact on day-to-day behavior—must link directly to a facet of the business that an employee can control. This means aligning incentives at all levels of the firm with the appropriate value drivers is central in getting the execution managers and owners demand.7

  Managers often trumpet an “ownership culture” and seek to distribute equity widely throughout the organization. While employees are pleased to be shareholders, I suspect that most think about their stake using “mental accounting.” They consider the stock in a mental account that is separate from their cash income, don’t count on the stock for day-to-day budgeting, and don’t consider it when they do their jobs.

  Another critical judgment is whether managers are paid to deliver accounting or economic performance. In the cases where there is a large owner-manager, this potentially huge agency cost rarely arises. But for managers who are paid to deliver earnings per share (EPS) growth, or for those who perceive EPS growth to be the be-all and end-all (still too large a group), the risk of significant agency costs is immense. To be more concrete, you want managers who, when facing a choice between adding to accounting earnings or economic value, always opt for value.

  Consider the following from Enron’s in-house risk-management manual as the antithesis of this ideal:Reported earnings follow the principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed to accounting, rather than economic, performance.8

  Incentive is defined as what motivates effort. Long-term shareholders should look for proper incentives. And in reality, these are rare.

  Capital Allocation

  All roads in managerial evaluation lead to capital allocation. I define capital allocation as apportioning the firm’s resources so as to generate long-term returns in excess of the cost of capital. As money managers know all too well, capital allocation is the name of the game.

&
nbsp; How do you assess capital allocation skills? The first step is to carefully study past capital allocation choices. How and where has management invested the firm’s capital? Have the investments earned sufficient returns? If so, why? If not, why not? Past capital allocation often provides a good indication of the business’s capital appetite and often reveals management’s focus and preferences.

  Mergers and acquisitions (M&A) deserve special mention. Innumerable M&A studies come to the same conclusion: most acquisitions destroy value for the acquirer and those that create value add very little. This is not to say that M&A does not create value in the aggregate—of course, selling shareholders tend to do well. The problem is that acquirers often offer a control premium that exceeds the present value of the synergies.

  Reversion to the mean is the microeconomic equivalent of the grim reaper: all high-return companies succumb to it sooner or later (great managers make it later). Significant M&A activity almost always suggests a company’s returns are gravitating to the cost of capital.9

  The second step in assessing capital allocation skills is interviewing managers to understand their capital allocation framework. How do they think about their investments? Do they have a realistic understanding of potential shifts in the industry? Do they understand competitive strategy?

  Consider the observation of Warren Buffett, one of the great capital allocators in American business history:[T]he heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

  Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

  The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business. CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

  In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)10

  Finally, a word on people. Does management understand how to put the right people into the right jobs? Too often companies seek to promote executives with the “right stuff”—good communication skills, smarts, and success in a specific context—without full consideration of their actual work skills and experience. As a result, these companies misallocate human capital, with poor results for both the business and the executive.

  The Bottom Line

  Assessing management’s leadership, incentives, and capital allocation discipline is essential for long-term shareholders. Despite a heightened focus on corporate governance, few boards are sufficiently proactive to appropriately address these areas. I’ve attempted to give some guidelines in thinking through some of the issues.

  Part 2

  Psychology of Investing

  INTRODUCTION

  Cigar-chomping Puggy Pearson was a gambling legend. Born dirt poor and with only an eighth-grade education (“that’s about equivalent to a third grade education today,” he quipped), Pearson amassed an impressive record: he won the World Series of Poker in 1973, was once one of the top ten pool players in the world, and managed to take a golf pro for $7,000—on the links.

  How did he do it? Puggy explained, “Ain’t only three things to gambling: Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself.” For good measure, he added, “Any donkey knows that.”1

  The first two of Pearson’s prescriptions are in the realm of investment philosophy, last part’s topic. But the third, “knowin’ yourself,” falls squarely in the psychological domain.

  Psychology may be the most underappreciated, undertaught, and under-contemplated facet of investing. It is critical because it helps explain what errors you are likely to make under various circumstances, offers insight into how others will influence your decisions, and provides perspective on how you should behave. In most cases, a traditional business school education won’t help you much in these crucial areas.

  In the last few decades, behavioral finance has considerably narrowed the gap between finance theory and psychology. For example, Daniel Kahneman and Amos Tversky developed a theory that concretely demonstrates how humans operate suboptimally versus what standard economic theory suggests. But even today, behavioral finance falls short of providing investors a cohesive approach to markets. The goal of this section’s essays is to provoke you to evaluate your decision-making process.

  When people mention psychology, they are almost always referring to how individuals behave. But there’s an important and often-overlooked distinction between individual and collective decisions. Both are relevant, but collective decision making is really the key when dealing with markets.

  Make no mistake, improving individual decision making is valuable, as Pearson’s admonishment to “know yourself ” suggests. On that level, this section delves into topics like how stress affects decision making, the tricks people use to convince you to do something, and intuition’s double-edged sword.

  Why are collective decisions central to markets? The main reason is that individual errors often cancel out: if you and I are both overconfident but you say buy when I say sell, our independent mistakes may still result in an accurate, or efficient, price. In fact, diversity of opinion looks like one of the necessary conditions of a well-functioning market.

  So for the most part, a true picture emerges from lots of investors erring independently. Since each individual is a small part of a greater whole, asking an individual to explain the whole is folly. Once you recognize that point, you’ll realize the talking heads on television satisfy a human need for an expert, without providing the value of an expert.

  So individual independence is good, but it doesn’t always prevail. The reason is that humans—like many other animals—are inherently social. While being social has lots of pluses, it also has some minuses. Take, for example, imitation. Imitation is incredibly useful in life, especially when someone has valuable information that you don’t have. But like other things in life, too much of a good thing is bad. Mindless imitation can lead to consequences from the inane (the pet rock fad) to the disastrous (market crash of 1987).

  So when you’re dealing in markets, it’s not enough to have your own view, you have to consider what other people think. Neoclassical economics likes to treat humans as deductive processing machines; we can go from general premises to specific conclusions. The trouble is, in all but the simplest situations (think tic-tac-toe), we simply don’t have the computational ability to operate deductively. Indeed, humans tend to be superb pattern recognizers—so good, in fact, that we see patterns where none exist. Toss out rational decision making, and things start to get complicated.

  Investing is interactive, probabilistic, and noisy. As a result, successful decision making requires an investor to have a good grasp of psychology. Unfortunately, there’s no one source with all of the answers, and improvement requires constant effort. But there’s no way to avoid it. As Puggy Pearson once said, “Everything’s mental in life.”2

  10

  Good Morning, Let the Stress Begin

  Linking Stress to Suboptimal Portfolio Management

  It has become evident time and again that when events become too complex and move too rapidly
as appears to be the case today, human beings become demonstrably less able to cope.

  —Alan Greenspan, “The Structure of the International Financial System”

  Why Zebras Don’t Get Ulcers

  What would be tops on a zebra’s list of things that cause stress? Well, a zebra certainly worries about physical stressors. A lion has just attacked you, you’ve succeeded in escaping, but the lion is still after you with lunch on its mind. Evolution has assured that zebras, like most animals including humans, respond very effectively to these types of emergencies.

  Now draw up the list of things you find stressful. There probably isn’t much overlap with the zebra’s list. For the most part, the kinds of things we worry about are not physical, but mental—work deadlines, the performance of the stock you put in the portfolio last week, personal relationships. Humans deal largely with stressors that are psychological and social.

  In his delightful book Why Zebras Don’t Get Ulcers, renowned brain researcher and stress expert Robert Sapolsky highlights a crucial point: the body’s physiological responses are well adapted for dealing with short-term physical threats. Those are the kinds of threats that we humans have faced for most of our existence. The problem is the psychological stress that we experience today triggers the same physiological responses. The source of our stress is different, but the reaction is the same. Psychological stress, if chronic, can lead to severe health and performance problems because it throws our bodies out of balance.1