Tuesday, April 7th, 2015
a way in

Investigative research, such as investment due diligence,the research puzzle | My last posting was about “defining due diligence.” requires an objective look at the evidence at hand.  In addition, if your goal is original, independent work, it helps to have conceptual avenues to pursue that might yield differential information.  In doing due diligence, you should always be looking for “a way in” that aids in understanding the organization under review.

Often, one presents itself when you least expect it.  Some little thing that seems inconsequential at first doesn’t fit the pattern of the whole.  The range of possibilities is endless, especially if you are doing an on-site visit and are open to clues in the environment.  Thus, finding that gateway to understanding can be quite unexpected.

But you can’t count on that happening.  Therefore, a list of prepared questions can help you control the agenda and avoid the standard topics that aren’t going to add any value for you compared to what’s already in the public domain.  (If the agenda of the organization you are evaluating trumps your own, you’ve already lost the battle.  That’s such a simple concept — and so very important — but it’s widely ignored.)

Some examples of “ways in”:

~ In early August of 2014, GT Advanced Technologies had a market capitalization of over two billion dollars.  A couple of months later, it was bankrupt.  Market wags got a kick out of the fact that Jim Cramer had promoted it.  But the real story was that many big-name asset managers were sizable owners.  So, did they not read the company’s filing on August 7?footnoted | Here’s a research firm that did.  Aren’t their analysts expected to look at 10-Qs?  Did they not do so?  How and why was the warning missed or ignored?  What kind of risk management do the portfolio managers do?  (Etc.)  In a half hour of asking questions, you could find out quite a bit about the difference between investment process on the page and in practice.

~ Alibaba is another tell.  An online juggernaut, it also features an odd governance structure that poses some unusual risks.   So, what do the owners of the stock think of that?  Mostly, they don’t.  They see the promise of the business and the movement of the stock.  Therefore, questions about how they consider governance in their decision making are there for the asking.  It’s relatively easy to pin managers in a corner on governance matters, giving you perspective just because you’re willing to ask questions that illuminate their process from different angles.

~ Liquidity and market structure concerns are being voiced more and more, especially in regards to fixed income and “liquid alternatives.”The Prudent Fiduciary Digest | Howard Marks really revved up the debate, as noted in the latest edition of my newsletter for asset owners.  Therefore, managers are now being queried about those risks.  Most of the discussion is fuzzy, yet predictable.  But, those important issues are at the heart of risk management — if managers can’t or won’t address the issues in detail, that should be a red flag.

One general topic is a gold mine of inquiry right now:  valuation.  Based upon the pricing of stocks and bonds today, many analyses argue for suppressed returns going forward.Office of Financial Research | This OFR brief is an example of some of that reasoning.  Say you’re evaluating an asset manager:  What are their capital market assumptions?  Where do they come from?  How do they change (if they change) in response to valuation levels?  Are the assumptions actually linked to subsequent actions?

To be clear, there are no right or wrong answers, although there are ones that fit or don’t fit with a firm’s stated philosophy and process.  In particular, for many managers, the vague we-sell-stocks-when-they-are-overvalued part of the advertised sell discipline is revealed as being at odds with what actually happens, or at least as being based upon relative rather than absolute valuations, two quite different things.

With some notable exceptions, active managers tend to proceed with the assumption that any relationship between valuation and future returns is long-term in nature and that their job is to stay fully invested no matter the pricing structure.  Whether because of the dictates of a specific mandate or their own career-risk calculations, it is easier to play along than to make a stand at any particular juncture.

For investment advisors, consultants, and asset owners, the valuation question hits much closer to home.  Unlike asset managers, who focus on the squiggles of market activity (and expect to see the freight train of imminent risk coming down the tracks before it arrives), this group is specifically charged with thinking about the long term.

Therefore, any discussion about whether valuation levels give guidance for near-term results goes out the window.  Either you believe that current pricing affects future returns, in which case you should adjust your actions accordingly, or you don’t believe it (and you can proceed as you always have).  But you can’t mix and match.  To quote John Minahan:  “If you are in a low-return environment, accept the low returns.  Do not take risks unless you expect to get paid for those risks.”CFA Institute | The quote is from a CFA Institute roundtable.

There are always gaps between beliefs and behaviors.  When you find them, you have a way in.