Tuesday, May 27th, 2008
look at the little things

In doing due diligence on investment organizations, I am often struck by the interplay of internal dynamics that affects the ability of a firm to meet its goals and those of its clients.

There are those “big things” that are often discussed — investment philosophy, culture (although some firms tend to shy away from that term), and people — that are the building blocks of the organization. And, of course, there is an investment process that is meant to deliver outstanding results.

But most of the time, it’s the little things that indicate whether all is well, and often what seems like an inconsequential element is critically important in the scheme of things.

For not only are those little things windows through which you can see whether the grand design of the firm is being carried out, but the smallest assumptions and actions can grow over time to change the future of an organization, for the better or for the worse. Spotting them early is the key to the ultimate purpose of due diligence — understanding the firm in question and its likely evolutionary path.

A recent observation (in hindsight) from Warren Buffett in Fortune illustrates the point. He was asked about the difficulty banks are having valuing mortgage-backed securities. In a couple of sentences, Buffett summarized the sausage making of CDOs, and then quickly disputed the idea underpinning such structures,

“. . . that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior — it isn’t super-senior or anything. It’s a bunch of juniors all put together. And the juniors all correlate.”Fortune | The subheading of this interview, which appeared in the 4/8/08 edition, was subtitled, in part, “With Wall Street in chaos, Fortune naturally went to Omaha looking for wisdom.”

It is the kind of simple and cogent observation for which Buffett is known. And yet, isn’t it ironic that Berkshire Hathaway is by far the largest holder of Moody’s stock? A little assumption by Moody’s somewhere along the way (that the juniors could be transformed through some sort of alchemy into another thing entirely) was institutionalized and pushed to the breaking point, mirroring the developments at myriad other ratings agencies, banks, brokers, money managers, etc. For owners of Moody’s stock, it meant a loss of around fifty percent in the last year.

It was a little thing that became bigger than you could imagine. At any point along the way, the firm’s internal review processes could have identified the weakness inherent in the assumption, or those relying on its ratings or investing in its stock could have done so. That few did says much about the state of due diligence in our markets today.