Is it useful for investment managers to know which companies are predictably vulnerable to crises?
Asked to answer "yes or no" there can only be one answer. But posing the question so narrowly hides more interesting issues. How might an investment manager use the knowledge? And more fundamentally, is it really possible to estimate corporate vulnerability from the outside?
Usefulness was recently highlighted by the FT's Judith Evans. In practice the answer varies depending on whether the funds are active or passive.
Active managers are typically driven by investment returns. A recent FT Opinion asserted:
"On average, 74 per cent of remuneration is paid in cash, and tied to outperforming an annual stock market benchmark. The result is an obsession with next quarter’s earnings rather than the next 10 years"Helena Morrissey of Newton Investment Management spotted weakness at Northern Rock and sold out before it crashed, a natural reaction for a manager driven by short term horizons.
Since then, John Kay's Review of Equity Markets concluded that promoting good corporate governance is a core function of equity markets. Morrisey buys this; but it left her wondering whether she should have tried to fix, not ditched, Northern Rock. Either way Morrisey would undoubtedly use information about corporate vulnerability.
Selling out is one thing. Stock selection is another. Here we have encountered growing interest in the idea of screening companies for behavioural and organisational vulnerabilites and strengths that are visible, if not widely recognised, from the outside. Many fund managers would like to understand, in advance, who seems most vulnerable to a bad fall from grace.
The externally apparent vulnerability of BP in the years before Deepwater Horizon blew up makes a telling example. Examples of companies with hidden strengths are less common, perhaps because leaders typically trumpet strengths but gloss over, or can't see, weaknesses.
An example reported in the press recently concerns the way that Ardevora, an investment boutique, screens investments to buy or short by looking at behavioural insights such as
"favouring companies whose chief executives have little scope to meddle in the belief that [CEOs] are prone to excessive risk taking due to their "egotistical" personality type and skewed remuneration structures".
Index funds are in a different position. As Vanguard's Glenn Booraem has pointed out:
"We have no choice but to stick with the companies we invest in because they are in the indices we track. We can’t sell like an active manager can. We are permanent shareholders. It is like riding in a car that we can’t get out of.”Different incentives lead to different behaviour. Index fund managers, savers and pensioners, have a greater interest in long term performance of their portfolios and investors may come to see encouragement of good management as a differentiator between passive funds. This is probably one reason for Booraem's active stance on the long term:
"We want to make sure that the vast majority of boards and management teams are focused on long-term value objectives, like we are. As permanent shareholders, we have a key role to play in stewardship and responsible investing."But what of the fundamental question: is it possible to evaluate corporate vulnerability from the outside?
Our process for evaluating corporate vulnerability from the inside begins with a preliminary but systematic evaluation based on publicly available sources. It looks for symptoms of the long-incubating behavioural and organisational risks that regularly tip crises into reputational calamities as well as causing crises in the first place.
Whilst the confidence level attached to such an evaluation is inevitably lower than for an evaluation carried out with extensive inside knowledge, our experience is that an external evaluation is both possible and useful. It can provide detached insights into the company and identify important risk areas where information is lacking.
With an external evaluation in hand, its recipient can watch for information that confirms, modifies or fills gaps in the initial evaluation. A major shareholder, such as a Vanguard or a Newton, can systematically probe areas of uncertainty as opportunities arise in discussions with the CEO and board members. And a hedge fund can seize an opportunity, as happened when Bluemountain spotted the London Whale at work before he breached, costing JP Morgan about $6 billion.
Vulnerability evaluations are potentially useful investment tools for both active and passive fund managers. Whilst their use is in its infancy, we believe it is set to grow.
Postscript: Since this was written Terry Smith of Fundsmith publicly warned in the Financial Times against investing in Tesco - two weeks before its acocunting scandal burst: