Vulnerability Evaluations in Investment

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.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

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.

 Anthony Fitzsimmons is Chairman of Reputability LLP and author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”









 

John Kay on Learning from Mistakes

We are delighted that Professor John Kay has allowed us to reprint this column, first published in the Financial Times, which discusses an important organisational risk:- inability and unwillingness to learn from mistakes.

Having just booked a flight to Berlin in June with Germanwings, I thought it might be useful to explain why.

Air travel is extraordinarily safe. About 1,300 people died in commercial aviation accidents last year, the highest figure in a decade. Almost half of these were victims of the two incidents involving Malaysia Airlines. Tyler Brûlé has described the fear of flying that led him to abandon a flight to London after hearing about last week’s Germanwings Airbus crash in the French Alps. The chances of a man of Mr Brulé’s age, 46, dying in any two-hour interval is about one in 1m. There is an additional one in 5m chance of being killed during a two-hour flight. On the other hand, sitting in an aircraft protects you from many more common causes of death, such as a car crash or a fall down stairs.

Despite the continued growth in traffic, aviation deaths have been declining. Improvements in aircraft design have reached a stage at which it is almost inconceivable that a major incident will be the result of a mechanical failure. Modern Airbus and Boeing models “fly by wire”, which means that every action by a pilot is mediated by a computer and most of the time aircraft literally fly themselves. Chesley Sullenberger’s 2009 “miracle on the Hudson” landing was an exceptional feat of skilled aviation — but as his Airbus landed on the river it was the machine, not the pilot, that had selected the gliding speed and angle.

The dangerous moments on board an aircraft are when the pilot is overriding the electronic systems. They may do so for good reason but with bad outcomes, as when the crew of Air France 447 from Rio to Paris misjudged their response to adverse weather conditions and lost the plane in the Atlantic; or with malevolent intent, as in the Germanwings incident. Passengers should worry, not that the crew are not in control but that they are.

But another reason modern air travel is reassuringly safe is that investigation into accidents is honest and thorough. Airlines and aircraft manufacturers do not like the public exposure of defects in their products; but they have tended to respond by addressing the defects rather than resisting the exposure. And generally accident investigators have been allowed to do a thorough job without political interference.

The most notable exception was the attempt by Egypt, under the dictatorship of Hosni Mubarak, to influence the findings of US investigators into the loss of EgyptAir 990 in 1999. The passenger jet disappeared into the north Atlantic under the control, like the Germanwings aircraft, of a pilot widely thought to have been suicidal . And the full truth of the downing of Malaysia Airlines MH17 over Ukraine is never likely to emerge. But when French President François Hollande, German Chancellor Angela Merkel and Spanish Prime Minister Mariano Rajoy travelled to the crash area last week, they went to show concern and establish what had happened rather than to deflect blame.

This is the behaviour we are entitled to expect in any industry: but it is not what we generally see. The bodies that regulate drug safety do not enjoy the same protection from lobbying as air accident investigators. And so the pharmaceutical industry has largely lost the public trust achieved by the “just culture” of the airline industry, which is more concerned to encourage openness than to attribute blame.

And the contrast with finance could hardly be greater. It is unimaginable that we might have had a dispassionate investigation of the financial crash of 2008. Nobody died in that crash — but to avoid mistakes in the future it is first necessary, in any given situation, to undertake honest assessment of the mistakes of the past. That is why our planes are growing safer and our finances are not.

First published in the Financial Times on 1 April 2015. 

© John Kay 2015  http://www.johnkay.com