Today's post is a continuation of Ed Rempels article "Conrad Black Lessons – Is “Management Integrity” an Oxymoron? – I.
One of the truly amazing things about Warren Buffett, beyond his amazing returns (23%/year for over 30 years) is how rarely he lost money on any investment. Almost all of his holdings have made money for him. He is often quoted as saying: “My favourite holding period is forever.” He buys great companies and holds them forever.
This same philosophy has also worked for other successful investors that hold their investments for a very long time, such as Bill Miller, who beat the S&P500 15 consecutive years while having only a 3% turnover within his fund.
What is the secret to picking long term winners? It is a combination of a great business and great management – and making sure that your management has integrity.
This is very different from the ordinary investor. Individual investors usually buy an investment because of some tip they heard, because it has a low P/E, a high dividend payout, because it is up or because it is down – all with little knowledge of the company or the management.
Professional investors have computers that can give them a short list of companies that fit any criteria. For example, they ask for companies with a low P/E, growing profits and a high dividend payout ratio and they immediately have a list. However, nothing in their computers can tell them if the management of the company has integrity.
Evaluating the management is one of the most difficult parts of successful investing. Almost any manager can present a positive image, show you good stats, and claim to have integrity. So identifying them requires assessing a manager as a person, looking at long term results and talking to people that know them.
With individual companies, accounting rules still leave lots of room for playing games with profits. One of the problems with bonuses and stock options is that they compensate managers for having big short term moves, instead of long term, steady success. Like the Conrad Black story, mergers, acquisitions and company reorganizations are full of opportunities for management to try to get money for themselves, instead of for shareholders.
Since many investors are looking for “consistent returns”, managers usually smooth their profits, hiding profits in good years so that they can pull them out in a bad year and have nice, smooth profit results. Back when I was an accountant, I learned quickly that management preferred smooth profits and learned all the tricks to make sure our profits were consistent month to month.
Fund managers play many games, as well. Month end dressing is common. Since many investors look at the top 10 holdings, on the last day of a month, the fund manager can buy stocks that are currently popular and then sell them on the first day of the next month.
Fund managers that are salaried employees of a large bank or insurance company are usually primarily just trying to keep their job. This makes many of them closet indexers. If your allocation is almost the same as the index, then you don’t get fired when you have a losing year.
Style creep is also common. In 1999 when everyone thought value investing was dead, some value investors quietly loaded up on growth stocks. Lately, even many growth investors have been loading up on cyclical resource stocks.
With all these common ways to cheat, are managers all bad? The truth is that the majority of managers are basically honest, but will stretch their integrity a bit to make more money and they will persuade themselves it is “common business practice”. Few are deliberately dishonest.
Fortunately, the world has quite a few exceptional managers that are always honest and working for the benefit of their investors – in companies and in mutual funds.
Long term, exceptional corporate managers and fund managers operating with integrity are out there. It is well worth our time to search for them and do research on them – and then invest with them for the long term.