I recently came across a great piece discussing Investing with Honor, which I think very nicely complements our investing philosophy. The article was written by John Glotermann from Obermeyer Asset Management Company and published in Marc Faber's August Monthly Market Commentary. Through all the noise in the market and with all the bad players trying to take a piece of the pie without a long term imperative, this discussion really helps remind us of our responsibilities.
Investing with Honor
“The greatest way to live with honor in this world is to be what we pretend to be.” (Socrates)
Much is continually written about investing and investment markets - what’s working, what’s likely to work, and why. Articles, presentations, and blogs on investing draw a large audience because it is a big business and a high stakes activity that has the potential to change lives. But not much is written about the concept of honor and investing. If there were ever two words that seem disconnected, it is those.
What prompted this topic was a CFA conference I attended in Chicago where a presenter highlighted that a recent poll showed that the investment industry ranks barely above politics in the public’s esteem. This shocked me, as yes, there are indeed scandals here and there, but for the most part I am more impressed than not with the thoughtfulness and character of my colleagues in the investment business. Upon reflection, this perception may be because not all professional investors act honorably.
Honor can seem like an elusive, ill-defined concept. It is a term not often heard in modern society. As Justice Potter Stewart famously described obscenity, “I know it when I see it.” Honor is easiest to recognize when it’s amongst us. And while honor has many meanings, in the context of investing perhaps the best is from the Webster Dictionary (1913) that says that honor is “a nice sense of what is right, just and true, with course of life correspondent thereto; strict conformity to the duty imposed by conscience, position, or privilege; integrity; uprightness; trustworthiness.”
Professional investment managers encounter conflicting views of what is right and proper from the media, academia, clients, and their peers. They are also bombarded with fantastical headlines about bubbles, crises, and other turmoil – and often criticized for holding contrary views. It is easy to see why many in the investment profession adopt a reactionary disposition and adapt their beliefs to conform to the larger group. But a select few investors remain steadfast in their pursuit of long-term returns. They accept the responsibility that comes when others entrust them with their hard-earned savings. Each day they work to protect and grow the assets they manage. They are not swayed by short-term mandates, return-chasing, or expressions of fashion. It is these men and women whom we recognize as investing with honor.
What clarified the importance of honor for me was a recent reading of The Pacific and Other Short Stories by Mark Helprin. The main character of “Jacob Bayer and the Telephone” was asked why he had no interest in becoming rich. In reply he said he was entranced by the notion of truth, saying, “But riches last for a generation or two and honor lasts forever. After you depart, your riches are divided, but your honor is indivisible.”
To invest with honor leads to the kind of decision-making that enables a proper vetting of the bad risks. It will liberate the investor to do the right thing for his or her clients no matter what happens in markets or which way the wind blows. And it enables the manager to focus on what is relevant, where real risks are, and emphasize the long-term focus that is required to earn higher risk-adjusted returns on average.
The following ideas are what it is to invest with honor:
1. Treat any capital invested as a resource that belongs to clients: A sense of stewardship rather than ownership should drive behavior and override all other considerations. Managers must avoid overconfidence and overemphasizing their personal biases, constraints, limitations, views, hunches or guesses into their investment process. They should be open to all possibilities, weighing all relevant information as best they can and diligently examining risks as well as the upside cases. They should avoid speculating or putting clients’ capital at risk of a permanent loss and forget about trying to outsmart others in the short term. Markets are rather random in the short term and good investing takes time.
2. Avoid the “performance derby”: A term coined by Seth Klarman, the “performance derby” refers to the goal of the vast majority of mutual funds and institutional investors and their focus on relative returns instead of absolute returns. Relative returns can be good for business in the short-run, but pursuing them can easily lead to taking the wrong risks. Lots of investment businesses/managers promote great performance when they have it, but great performance never lasts. No one outperforms always…it is not possible and no one should pretend that they can. At best, strong performance comes and goes, but high averages are earned. Professional investors should be frank with clients about this and should instead promote their philosophies and processes and discourage performance chasing. To suggest that good performance or good years predict continued strong performance, or is exclusively caused by special knowledge or skill, is disingenuous at best and dishonest at worst.
3. Provide value: In the investment business, it is well-known that benchmarks (such as the S&P 500) can be invested in for almost no cost - so very little, if any, value is created by those managers that deliberately create portfolios to mimic or not deviate too far from an established benchmark - and value is destroyed when accounting for fees paid. Value comes with out-of-the-box ideas, the courage to be contrarian, more patience than other investors, a higher level of thoroughness, and examinations of underappreciated yet real risks such as obsolescence, poor corporate governance, excessively aggressive accounting practices, and generally avoiding overpaying for investments. Investing to provide value is honorable. Risk also becomes part of the equation because if you underperform, yet do it with proportionately less risk, value is created.
4. Consider whether the issuing entity - whether it be a company, government, pool, or derivative - is worthy of financing: Investments are not all created equal. Businesses are different, managements operate with diverse incentives, competitive environments change, balance sheets vary, market liquidity comes and goes, investor preferences are fickle, and valuations go from great to terrible. Yet many professional investors claim that their way is the best way and they give fifty reasons as to why. But some issuing entities are simply not worth financing because they’re either over-capitalized so there is little return to be had, they are under-capitalized and so are at risk of bankruptcy, or they are not proper stewards of shareholder capital. Investment banks that ran 30:1 leverage in 2007 started off over-capitalized, which led to bad decision-making. This in turn led them to over-leverage themselves and to be under-capitalized and at risk of insolvency requiring a taxpayer bailout. But the whole time, corporate governance was poor meaning they were really never good investments all along.
Each day, it is imperative for managers to consider honor in what they are doing: “the duty imposed by conscience, position, or privilege.” The fiduciary standard (a standard under which many managers operate and which means that clients are owed a “duty of care” and a “duty of loyalty”) is a good start, but it probably does not go far enough. You can still act with loyalty and care and not act honorably.
Unfortunately, there are tens, maybe even hundreds of thousands of “professional investors” with millions of clients who do not even operate with a fiduciary standard and, in fact, are fighting/lobbying the SEC to not have it imposed on them and their investment operations. But to raise the issue of honor as food for thought, and to try to identify honorable behavior in investing for others, we may begin a productive conversation that makes the industry better and finally improves the profession’s dismal ranking in the public’s esteem. Nothing could be more important in making sure that investment capital gets to the companies, governments and pools that will treat it the best, which will make us all better off.
-John Glotermann, Obermeyer Asset Management Company