Old Rules Out, New Rules In – What Investors Should Demand Going Forward

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Given the present market bloodbath, there are many ongoing discussions on what the sensible investment strategy should be going forward, and whether one should still be investing in face of economic uncertainties at all.

Most solutions favour an old-school approach. Many personal finance writers have gone back to basic principles of investing such as dollar-cost averaging, diversification, looking at the long term, be calm when the market is fearful, etc. Many are viewing investment through a mostly unchanged framework as what we have become accustomed to. But my question is, in a time when the corporate world, government bodies, and media complex have abdicated or neglected to perform their roles, why aren’t investors moving towards a different paradigm?

Here are some ways that I see the rules of investing change in the coming decades.

Long-term sustainability. Once a successful business becomes a publicly traded company, the management team willingly subjects themselves to continual scrutiny by the market. Dozens of analysts pore over the company’s quarterly and yearly forecast and issue their own estimates. After each earning call, those whiz kids compare and contrast their estimate to the actual numbers and company forecast, and issue their “buy” or “sell” recommendations. The market then reacts, sometimes violently, if the quarterly numbers greatly exceed or disappoint the analysts.

As a system, we have a stock market that rewards short-term gains and profits. By doing so, we inadvertently create unsavory incentives for the management team to maximize short-term profits at the expense of pretty much everything else.

Remember Chainsaw Al? A self-proclaimed turn-around artist, Al Dunlop infamously presided over Sunbeam over a decade ago. Within three months of his installation as CEO, Sunbeam had cut over half its employees and eliminated 87% of its products. Employees saw working for him akin to trench warfare, many exhausted from having unrealistic goals imposed on them. Upon his firing, it became clear that massive accounting fraud had taken place. Revenues had been padded through various dubious or outright illegal revenue recognition techniques. The company was cash strapped. Share prices shot up from $12 to $53, before falling back to $11.

Dunlop was an extreme example from another time. More current incarnations of companies and individuals buckling under the market pressures of high performance are numerous. Enron and Worldcom all carried on the tradition of growing through accounting trickeries.

Looking forward to the investment environment, I imagine the investors would be very wary of overly aggressive CEOs whose claims to fame are quick turnarounds accompanied by massive restructurings. Maybe investors would be more interested in slower and steadier progress that are on par with the general economy, and have long-term, sustainable trends supporting their growth.

Shafeen Charania coined the termIntegrity, transparency, accountability (ITA)” as qualities that investors will place most value on in the new investment environment. He likened the corporate imperative to act with ITA to the initial challenges faced by the green movement.

In the beginning of green, companies that chose to act did so knowing that while it was the right thing, costs would initially be higher than returns. They felt in their hearts and stomachs that green was a societal imperative, and that others would come around. They engaged the world on this basis, sacrificing the perception of being less-profitable for the reality of being more right. So too must the out-behave community act.

He goes on to say:

Integrity, transparency and accountability (ITA) are not where a company will out-innovate or out-perform their competitors, but rather where a company out-behaves. This could also be where a company creates market advantage, where they can capitalize on the perception of mistrust and outshine the rest to be recognized as having a management ethos and discipline that can be trusted, that won’t be rapacious, that will be open and honest and accountable. This could also be a really effective marketing strategy, one that results in (like Whole Foods) market and price advantage.

My gut says companies that out-behave are more sustainable than those that don’t. They are potentially better long-term investments because they are less likely to get caught out, but will be able to capitalize on the those that do, capturing market share, talent, etc., when the ill-behaved are outed (AIG, GM, Madoff, etc.). Imagine if there was an ITA-compliant directory of companies from which you could choose your insurance, banking, investment provider, or where you could buy your car, etc. Would you go there if you just found out that you’d been “Madoff’ed”?

In face of an investment landscape that has been all but ravaged by incompetence, greed, short-sightedness and outright corruption, sustainability and steady growth might not be a bad deal after all. The investment industry has long been plagued by its lack of transparency and secretiveness when it comes to strategy, and investors have been more or less silent on this information asymmetry as long as money rolled in.

Less than a decade ago, Enron and Worldcom rocked Main Street with its unscrupulous practices. The solution was to impose tougher accounting regulation. But instead of addressing corporate integrity and accountability at its source – to be upheld by corporations themselves, the investors relegated those issues to the regulatory bodies. Now the alarm has struck again, the SEC and various other watchdog bodies are under attack for their lack of oversight. This is justified. But this extricates responsibilities from investors themselves. And this cannot go on.

The corporations and the investment industries will only change when the consumers demand it so. Government mandated monitoring will exert some pressure, but this pressure will tighten or relax along with the wind of politics and ties to the industry itself. The only unwavering voice that can have a long-term influence on the behaviour of corporations is from the consumers. Without a collective call for corporate responsibility, and without subsequent consumer behaviour modification that either rewards or punishes certain corporate actions, most businesses will continue to place the achievement of short-term goals before sustainability and corporate responsibilities (the stockholders – us, demand it so!), and investment managers will continue to invest in those volatile and supposedly high-performing stocks (its customers – us, demand it so!).

Diversification will take on slightly different connotations. Traditionally, an average investor focuses on investment classes such as bonds, preferred stocks, common stocks, mutual funds. And for the higher-worth investors, hedge funds. To diversify, we look at the bond/stock split, and within stocks, we look at large/small cap, tech versus pharmaceuticals, commodities, and different regional indexes. This strategy didn’t work too well this time. The increasingly inter-connected web of global commerce has rendered much of the benefits of diversification meaningless.

Many people have discussed the issue of self-education when it comes to investing and personal finance. But unless you are an accounting and finance whizz, can you make sense of a public traded company’s EDGAR filings? Even if you can, how can you be sure of their various off-shore financing vehicles and securitized debt obligations are recorded correctly? If you invest in a mutual fund, those quarterly reports paint a vague picture of your holdings. How much information can you squeeze out of that coloured pie-chart, when up to 1/3 of your money is sometimes placed in the dubiously named “others” category?

I hate to bring up Madoff’s name again. But when I read about how some of his victims were not aware of their involvement in his scheme until the bottom fell out, because their investment advisor had put all their money in one of his feeder funds, that makes me cringe. Going forward, I want to know where my money is going to. That might constitute micro-management. But unless the investment industry can demonstrate its trust-worthiness, I don’t mind that.

The rise of peer-to-peer lending is as interesting as the idea of Kiva and various other micro-financing initiatives. Kiva works on a micro level to help individuals in developing regions who may not be able to secure a loan through any other means. The domestic peer-to-peer lending program takes bank out of the equation, and allows lending on a more individual, grassroot level. They are different in application, but the core idea to me is the same. Both are highly transparent, both are highly personal, and from what I hear, loan repayment statistics are pretty good.

Now my question is, what if we apply the idea of peer-to-peer lending on a more macro scale, and allow for corporations to solicit loans from the general public, without relying on the bank as middleman and spin master. This is already done with much of corporate debt using public auctions, so the customers here are mostly institutional. But for small to mid-sized companies, can direct lending from an investor to a business become a viable way to grow that may be cheaper, more sustainable and creates more goodwill for the business; and allow an average investor to invest directly in a transparent, responsible, and sustainable business? Warren Buffet has done this on a mass scale for decades with success, but his success can hardly be replicated without his money. Short of buying shares of Berkshire Hathaway, can we find a similar investment model for the average investor along the same line?

picture source: ‘gilad

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