Sunday, May 31, 2009

MBAs and Ethics

Yesterday's New York Times had an article on the graduating Harvard MBA class. About 20% of the class have signed off on an ethics oath, which you can find here:
If you follow the lead, you will find the list of what these students have promised to do:
  • I will act with utmost integrity and pursue my work in an ethical manner.
  • I will safeguard the interests of my shareholders, co-workers, customers, and the society in which we operate.
  • I will manage my enterprise in good faith, guarding against decisions and behavior that advance my own narrow ambitions but harm the enterprise and the societies it serves.
  • I will understand and uphold, both in letter and in spirit, the laws and contracts governing my own conduct and that of my enterprise.
  • I will take responsibility for my actions, and I will represent the performance and risks of my enterprise accurately and honestly.
  • I will develop both myself and other managers under my supervision so that the profession continues to grow and contribute to the well-being of society.
  • I will strive to create sustainable economic, social, and environmental prosperity worldwide.
  • I will be accountable to my peers and they will be accountable to me for living by this oath.
It sounds awfully good and I should probably rejoice at this rebirth of ethics in business, but I am not particularly moved for the following reasons:

1. Life is about making choices: From the sounds of this oath, these students plan to keep everyone happy for the rest of their lives. I wish them well, but the real questions will come up when the interests of stakeholders clash (stockholders versus co-workers, stockholders versus society). They will have to make hard choices and someone will be unhappy, oath or no oath. This sounds about as good as stakeholder wealth maximization and about as useless.

2. Self interest is not a bad thing: Embedded in this oath is the view that self interest is a bad thing and that we should be serving broader interests, but whose interests are those? Ultimately, the most productive societies have been built around individuals acting in their own self interest. I think the bigger challenge is to set up processes where what we do in our own self interest works to further the collective interest. It suggests to me that we need to expand reading lists in MBA programs to include a little more Adam Smith and Milton Friedman... and a little less of whatever is on the list right now.

3. Watch out for those who are holier than thou: I don't know the people who signed this oath and I am sure that many of them are well intentioned, good people but I do remain suspicious of people who sign oaths like these. My experience is that the people who indulge in breast beating about honor, ethics and honesty are often the least dependable in the face of an ethical challenge.

Finally,the article finds the obligatory ethics professor to quote. Not surprisingly, she proclaims the beginning of a new age of ethics in business. That's baloney. After every crisis, this type of talk abounds, in conjunction with business schools flaunting their newest ethics offerings. Notice how frequently they have to make these classes required courses rather than electives. Tells you something about how much of it is window dressing... Human beings are human beings, and by the time we get them in MBA programs, their ethics are already well formed. It takes incredible conceit to think that we can put grown ups through an ethics class and change their definitions of good and bad...

Friday, May 22, 2009

Stockholder democracy...

Today's New York Times carries an article on shareholder democracy that illustrates why there are shades of gray even with proposals that seem absolutely cut and dry at the outset. This one has to do with the proposal from the SEC, allowing institutional investors to propose board members who would then be listed in the proxies that companies send out to stockholders. (Only investors who are not interested in doing an acquisition and have held the stock for more than a year can propose new directors, and even then, only 25% of the directors can be challenged) The idea seems unexceptional. Until now, shareholders have had to vote for those directors proposed by the company or write in their own alternates; only in a proxy fight do shareholders get choices. This rule change would presumably give them more choices even in the absence of a proxy fight.

The fear voiced in this article is that some shareholders may have other interests in the company that overwhelm their interests in seeing stock prices improve. The example given is of a shareholder who has taken a large position on the credit default swap market, betting that the company will fail. Such a shareholder may gain more from seeing the company default than continue as a going concern; consequently he or she may nominate directors who will drive the company into the ground.

I think that the article has a point, though I think it is also a little over the top in terms of hysteria. There are two phenomena muddying the waters of shareholder democracy. The first is investors who own hybrids - convertible bonds, debt with equity options etc., who do have multiple and sometimes conflicting interests in the firm. This is not new but it is a much bigger factor now than two decades ago. The second is that increasing presence of investors who bet not on the direction of the stock price but on its volatility. Many option based strategies are directionless - investors don't care whether the stock goes up or down - but make or lose money depending upon how volatile the stock is. The SEC's implicit assumption that all stockholders have a shared interest in the stock price going up is coming into conflict with the consequences of a more diverse set of interests in stockholders: some want the stock price to increase but some do not.

I do not have an easy solution. We could try restricting shareholder voting only to those investors who have no conflicting interests, but I don't think that proposal can be easily policed and it would not be fair. A bondholder who has an equity position is just as much an equity investor as one who does not, even though the former's interests may diverge from the remaining stockholders. I am also not comfortable with any rule that tries to define "good" shareholders and "bad" shareholders. Good and bad are in the eyes of the beholder... Ultimately, as in any democracy, we have to trust the voters to make the right judgments, even though they may bring in very different interests into the voting booth.

Tuesday, May 5, 2009

Keep it simple!!

While I took issue with a great deal of what Mr. Buffett said in the last post, there is one point on which I completely agree. Keep it simple! In my valuation classes, I begin my class by promoting the principle of parsimony. In the physical sciences, this principle (also known as Occam's razor) specifies that when trying to explain any phenomenon, you start with the simplest possible explanation before moving on to more complicated theories.

In valuation, the principle of parsimony calls on us to use the simplest possible model to value any asset. However, there is a catch. The definiton of simplest will vary, depending upon the asset you are valuing. When valuing cash, for instance, you can just count the cash on hand; you don't need a model or elaborate assumption. When valuing a mature company, with stable and predictable, profits, knowing what the firm generated in cash flows last year may be sufficient to value the firm. When valuing a young, growth company, the simplest model may require you to forecast earnings and cash flows for an extended period. You may not like to do it (I don't think anyone does) but there is no real choice..

So, here is the bottom line. I oppose detail for the sake of detail and complexity designed to show the world how smart and sophisticated an analyst is. I think you risk mangling the valuations of simple assets by doing so. However, I think to argue that detail is always bad and that forecasting is dangerous works only if you decide that your investment space is going to be populated only by mature companies. If you, as an investor, are interested in buying growth companies (and there is no law that says you have to be) or valuing them, you have to face up to the truth. There is no way to value these companies without peeking into the future and making forecasts, and then adjusting your value for the uncertainty you feel about these forecasts.

Saturday, May 2, 2009

Buffett and Munger... Shock value!

Berkshire Hathaway is having its annual meeting and the financial press is falling all over itself reporting what the sage from Omaha has to say about investing. Let me say at the outset that I have expressed my admiration for what Warren Buffet does well - the fact that he has a core philosophy that he does not deviate from and his instinct for going against the grain. Over time, he and Charlie Munger, who has operated at his right hand for decades, also say things for shock value to indicate how separated they are from both academics and other portfolio managers. Here is a listing of quotes and my responses to them.

Mr. Buffett: “There is so much that’s false and nutty in modern investing practice and modern investment banking, that if you just reduced the nonsense, that’s a goal you should reasonably hope for.”

I agree entirely. There is much that is done in portfolio management and corporate finance that does not pass the common sense test. Layering complexity on stupid ideas - that leverage always increases value, that securitization can make you a more valuable company - do not make them any less stupid.

Mr. Buffett said he was once asked by a student from the University of Chicago, a hub of modern portfolio theory, “What are we learning that’s most wrong?” To which Charlie Munger quipped, “How do you handle that in one session?”

My question to Mr. Buffett would be a simple one: What exactly is your understanding of Modern Portfolio Theory? I would wager that he would come back with Markowtiz portfolios and the CAPM. If you define modern as circa 1964, he would be right. If not, he has a lot of catching up to do.

Mr. Buffett on the efficient market hypothesis, the idea that all information is instantly priced into the market: “There’s this holy writ, the efficient market theory. How do you teach your students everything is priced properly? What do you do for the rest of the hour?”

Mr. Buffett probably does not realize this but the efficient market hypothesis is really a warning to those portfolio managers who try to trade on information - earnings announcements and acquisitions, for isntance - and day traders. To be honest, 99% of investors would be saved a lot of money, if they followed the suggestions of efficient market theorists. Let's face reality. If you define an efficient market as one where investors cannot easily take advantage of market imperfections, markets are efficient to most investors on most assets most of the time... One reason that Mr. Buffett continues to generate excess returns is that he is able to strike inside deals with managers... Do you think you or I would have been able to get the deal he got from Goldman?

Mr. Buffett on complex calculations used to value purchases: “If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Spoken like a Luddite... How about an abacus, Mr. Buffett? Maybe a slide rule?

Mr. Buffett on the use of higher-order math in finance: “The more symbols they could work into their writing the more they were revered.”

Actually, I do share Mr. Buffett's concern that common sense is sometimes overwhelmed by mathematics. However, the people who are most revered in finance - Harry Markowtiz, Merton Miller and Gene Fama- are surprisingly down to earth in explaining their ideas.

Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

What would Mr. Munger do instead? Look backwards and discount forward? What part of forecasting does he think is pointless? And does he not agree with the proposition that a dollar today is worth than a dollar in year? If not, he should be sentenced to spend a year in a high inflation economy (say Zimbabwe)...

Mr. Buffett adds: “If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics my be dangerous and lead you down pathways that are better left untrod.”

Depends upon your chances of getting the birds in the bush, right? If you feel that you have a 60% chance of getting the birds in the bush, is it not worth the trade off? No wait. Talking about probabilities probably is higher mathematics and I should not do it... My bad...

Mr. Buffett on the persistence of bad ideas in finance: “The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.”

It is true. In any discipline, for every three ideas you come up with, only one will move forward. But the solution to this is not to stop having new ideas but to churn out more...