October 2016 IssueLong scroll reading

What Price Integrity?

By Edward A. Studzinski

“Question in a Field” by Louise Bogan

Pasture, stone wall, and steeple,
What most perturbs the mind:
The heart-rending homely people,
Or the horrible beautiful kind?

From: The Maine Poets


So we watch now the public flogging of senior officials of Wells Fargo by our esteemed members of Congress, which is not to say that the flogging is not deserved. It is well deserved. But it does call to mind the New Testament, “Let he who is without sin …. “ Given that the mutual funds at Wells’ were the old Strong funds, it begs the question as to whether the culture of the Strong funds influenced the Wells culture?

In any event, the Board of Directors for Wells Fargo finally seems to have found some backbone, or perhaps it is the fear of being next under the klieg lights. They took the action of clawing back substantial amounts of compensation from some of the executives at Wells, especially the CEO. He of course should have no problem with this, since he has several times indicated he was taking responsibility for the things that occurred. Of course, that was perhaps before he understood that “taking responsibility” was going to cost him in excess of $40M but hey, it’s better than some of the alternatives.

So at this point, many of you are saying well, that’s the banking industry, or that’s the investment banking industry, both of which are riddled with conflicts of interest that lead to questionable behavior. That can’t happen in the highly regulated mutual fund industry. I must remind you of the market-timing scandals of a few years ago, where with the tacit cooperation of the mutual fund companies involved, financial advisers, taking advantage of different market openings and closings relative to the valuation of a mutual fund at the end of our trading day, would time the purchase and sale of international or emerging market funds. And yes, people were caught, fines were paid, and some people went to jail. And some mutual fund executives, having good lawyers, were barred from the securities business for a year or two. And then things returned to the status quo.

Sure, there was more compliance regulation and people, with lots of paper to show that form was being exalted over substance. But when it came back to the basic question of knowing right from wrong, I don’t think anything changed then or has changed now. In fact, looking at two of the major East Coast cities where some of these shenanigans took place, I have the distinct impression that polite society (all the fashionable people) was more upset that the individuals involved had been caught, rather than wanting to deal with the question of whether anything wrong had been done.

Gretchen Morgenson, obviously descended from Viking stock, wrote a piece for the September 25, 2016 New York Times about how the proxy voting of mutual fund managers is “infected by conflicts of interest.” She quoted Erik Gordon, a professor at the Ross School of Business at the University of Michigan who said, “Funds often avoid challenging management on executive pay and corporate governance because they want to be included in corporate defined-contribution benefit plans.” The conclusion – fund companies would not put at risk gathering assets if they irritated people in the corporate world. I will add one observed fillip to that. If the fund companies are subsidiaries of foreign asset gathering/financial management firms, there is a second level of conflicts. You see that in the UK when the fund managers and corporate managements all attended the same public schools and Oxbridge. In France you see it where they all attended together or are graduates of L’Ecole Polytechnique. And in Switzerland, as a friend of mine explained once to me, it comes as a result of their time spent together in their period of mandatory service in the Swiss Army.

So how does it all work? Many years ago, I saw that a fund manager that I respected had filed a 13(d) notice with the SEC with regards to a holding in his fund. A 13(d) filing would disclose that the fund had more than a 5% ownership position of a company’s securities, and would be the equivalent of telling the world that you were seeking discussions with management about possible change of control events, among other things, and allow you to approach other like-minded shareholders. Some months later I saw him and asked how it had turned out.

While he had achieved what he wanted to achieve in terms of making the company’s management more shareholder-friendly, he said that he would never do it again. When I asked why, he said it was like going out on a tree branch and having it sawed off behind you. The chief investment officer of his firm had made a point at all management committee meetings of criticizing the filing, saying that it would antagonize the corporations that they were doing business with and keep the firm from getting additional corporate business. To this day, I don’t believe that manager ever filed another 13(d). And the message was not lost on the firm, with the culture changing definitively to a do not make waves approach. The chief investment officer meanwhile has taken out tens of millions of dollars in compensation, spends at least fifty or more days outside the firm a year, and the uniqueness/performance of his clients’ funds has moderated over time. Is this is a function of the firm’s analysts learning the danger of being too curious?

So assuming there is a problem in the investment industry, how do we fix it? I don’t think sending people off to sit for a year or two in Danbury to consider the error of their ways does it. Some years ago I worked in banking and served on an asset/liability committee. I would listen to the discussions of non-performing loans, which were usually real-estate related and often not the loans of what I will call the “little people” but rather commercial loans to real estate developer/golfing buddies of senior management. Tiring of listening to these ongoing tirades against loan officers who had merely been meeting their quotas (sound familiar?), I opined one day that most of these loans had personal guarantees, so we could probably send a serious message by filing suit against the delinquent borrowers. We would then send the sheriff to serve process on a Friday night at the country club when all of the right people were sitting there having dinner. Suffice it to say that my suggestion was not appreciated.

We need regulation and the ability for compensation to be clawed back from investment management and mutual fund executives. Draconian? Yes, but I think it is the only thing that will change certain kinds of behavior. That is why I favor the new fiduciary standard rules that go into effect next March. In anticipation of those rules, we are already seeing change. State Farm has announced that its ten thousand agents will no longer be selling mutual funds, come next March. Some funds have already started eliminating multiple classes of shares, with differing levels of fees (which you would need a translator to decipher). I look for the 12(b)1 fee to disappear. I also look for the platform availability of mutual funds to change dramatically (but how no one knows), as well as the business models of the Schwabs and TD Ameritrades of the world.

Two Book Recommendations

A book I have read, and would commend to all of you, is The Outsiders, by Will Thorndike, a Boston-based private equity manager. It talks about those eight Chief Executive Officers in years gone by who excelled at capital allocation. And it is capital allocation that drives shareholder returns over the long-term. What these people understood to a fault was that in the long run, the increase in per share value of a business was what was important (and hence our focus in the old days at Harris Associates upon ascertaining the business value of an enterprise per share, its relation to the current share price, and the sustainability of growing that business value per share over time). Other points to keep in mind – cash flow rather than reported “accounting” earnings drives value growth and the lack of a corporate bureaucracy can be liberating in terms of stimulating entrepreneurial creativity and minimizing costs. Independent thinking is essential to success as opposed to group grope. Anyone familiar with the hedge fund community in New York in recent years knows of breakfasts, lunches, and forums, where many of them would gather to exchange ideas with each other about the next trading sardine. Share repurchase can make sense when it is justified by the mathematics. It does not make sense when it is done to eliminate the dilution from executive option compensation packages which are in effect transferring ownership of the corporation from the public shareholders to management in a creeping takeover. And trying to please Wall Street or the investment banking community is for the most part, a loser’s game.

Of the eight CEO’s mentioned, along with their companies (and to a lesser extent the CEO’s next act companies), at Harris I was the equity analyst who recommended and followed General Dynamics, RALCORP (the successor Bill Stiritz act), and General Cinema (an investment failure but an education in its own right). Ralston Purina I got to see as it was folded into Nestle, which I also recommended and followed. Berkshire Hathaway I have owned as a direct investment personally since 1982 and little more need be said about that. And I take my hat off to my former colleague Bill Nygren, whose analysis of TCI and its many succeeding iterations coming out of the brain of John Malone has created more value for Bill’s investors than many portfolio managers achieve in an entire lifetime of investment management. So, read the book. Creating wealth is NOT about picking stocks. It is about understanding how business value is created and sustained. And I salute Mr. Thorndike for surviving an environment in Boston where most investment managers focus on illusory expectations of growth.

My other book recommendation is a book I have on my list to read, entitled A Gentleman In Moscow by Amor Towles. Back in the late 1980’s, I was managing and researching equities (yes Charles, I was always an equity analyst first) for a bank trust department in Indiana. I had come to the conclusion that most sell-side (Wall Street firm originated) research was drek, and conflicted to boot, given the investment banking relationships that seemed to drive most stock purchase recommendations. So I tried to find research that was independent and original, and could also be purchased with commission dollars in lieu of the Wall Street crap. One of the independent brokers I was dealing with called me up one day to suggest that I should talk to a gentleman from a new research boutique called Select Equity. Being a curious person I said why not, and not too long after that, a gentleman named Amor Towles showed up in my office in Hammond, Indiana. And I ended up becoming a subscriber to Select Equity’s research pretty much until I moved from the bank to Harris Associates. Until that time, Amor was my contact with Select. The theme here is that Select Equity’s focus was quality businesses with HIGH RETURNS ON INVESTED CAPITAL where management excelled at capital allocation. Pretty much around the time I joined Harris, Select made a business decision and shifted from selling their investment research to running money themselves. They have been extraordinarily successful at it, and have continued in the same vein as always, not letting asset growth morph into style drift which corrupted returns.

I had lost touch with Amor, until a month or so ago, I started seeing blockbuster reviews of A Gentleman In Moscow. I learned that a few years ago, Amor had retired from Select, and started to do what he had apparently always wanted to do, which was be a writer of literature. I am pleased that he has succeeded. And I look forward to sitting down with A Gentleman In Moscow on one of those occasions when I can shut out the distractions of internet, the election campaign, etc., etc., and just enjoy a well-written story. I am happy to say that I have known Amor Towles, and can say unabashedly, he is a true scholar and gentleman.

This entry was posted in Edward on by .

About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. Until January of 2012, he was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the eleven plus years that he was in that role, the fund increased more than 35 times in size. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the aerospace & defense, financial services, and spirits & tobacco industries, having followed and owned companies as diverse as Alliant Techsystems, Catellus Development, GATX, General Dynamics, InBev, Kirby, Legacy Hotels, L-3, Nestle, Partner Re, Philip Morris International, Progressive Insurance, Rockwell Collins, Safeco Insurance, Teledyne, Textron, and UST. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing from Northwestern University. A Chartered Financial Analyst, Ed belongs to the Investment Analyst Societies of both Boston and Chicago. He is admitted to the Bar in Illinois, the District of Columbia, and North Carolina.