We’re looking back to our recent letters to our shareholders and every now and then we’ll post some quotes we’d like to share with you. Since this is the first installment in this series, we’ll dwell a little bit longer in one specific subject – risk management.
Our 1st quarter 2008 report marked the period in which our flagship fund celebrated its 15th birthday, but 2008 as a whole was also special because IP itself turned 20. This report also marked the beginning of a series of texts in which we discussed IP itself – our risk management philosophy/ culture, our analysis process, our “diligence filter”. These excerpts tell a little bit about us.
Q1 2008 report excerpts on risk management
Summary:
For IP, the management of risk is strongly intertwined with our daily and absolute commitment with the quality – current and future – of our analysis process and investment decision making.
- According to our experience, there is not algorithm or ‘triple A rating’ that could replace the common sense and discipline in risk management. We usually pay a high price for the illusion of precision. We believe, as do Keynes and Buffett, that “it is better to be roughly right than precisely wrong”.
- The great financial institutions downfalls arise, in short, from motivations, incentives, judgments and behaviors of people. Flesh-and-bone folks: shareholders, executives, employees and other stakeholders.
- To understand a little bit more of our daily investment routine, getting closer to IP’s ‘inner workings’ can hopefully help the reader to understand how we end up mitigating some very important risks without even needing to speak formally and explicitly of “risk”.
- For IP, our ‘risk management’ is deeply intertwined with our day-to-day activities. We believe our key risk mitigation process is, simply put, our strong commitment with the quality – current and future – of our analysis process and investment decision making. The fact that a significant amount of IP partner’s wealth is invested in the funds is also very relevant. In this regard, we fully agree with Bernstein: “Risk is a choice, not a fate”.
- At IP we cherish the habit of “permanent preparation”, which is slowly accomplished, in ‘baby steps’, throughout time. We believe that this “always alert” frame of mind help us to “connect the dots” fast when the planets get aligned and the big opportunities arise.
- We have learned, with each of our mistakes, that it is extremely healthy to be suspicious of ourselves and of our own certainties. The surest we are of a matter, the more actively we seek counter-evidences that may eventually prove us wrong. Over time this is a very efficient ‘risk control’ tool.
Expanding on IP’s “inner workings” as they relate to risk management, we select more excerpts. You may recognize some parts from our “Why we Write” page above, and that’s no accident or coincidence, as we hope you’ll see.
WITHIN IP: NETWORK, PROCESSES AND DISCIPLINE
(…)
Among the daily micro-practices that define us as investors, the awareness of our cognitive, analytical and informational limitations is, by far, the most relevant one. First, because by systematically and structurally doubting our “knowledge”, we avoid the excesses of excitement and confidence with respect to our investment ideas. Second, because the internalization of that belief lead us to channel our efforts to the development of process, systems and methods that mitigate these limitations. As usual, pretty simple stuff.
We believe that true, sincere intellectual humbleness is critical so that we may approach each investment decision as it was the first, without the arrogance of the “I already know that”, “it works like this” frame of minds. It seems easy, but it is not. In the investment world, it is relatively common to experience absolute and relative financial success very early In life. As a result, it’s quite common to start to take yourself too seriously, to believe that you have almost “magic” talents and abilities. A deadly chain of thought that cannot only impair you intellectually, behaviorally and socially, but ultimately hurt you big time as you get betrayed by your own (mis-)judgments.
(…)
We believe, just like the physicist and outstanding professor Richard Feynman, that “The first principle is that you must not fool yourself – and you are the easiest person to fool”.
In these almost 20 years, we have learned with each of our mistakes that it is desirable and extremely healthy to be suspicious of ourselves and our own certainties. The surest we are of some issue, the more actively we seek counter-evidences that eventually prove us wrong or at least raise a “reasonable doubt”. A simple assertion or conjecture disguised as a ‘thesis’ can make or break an investment case.
(…)
To assume that, by definition, we cannot know everything we need and would like to, in a world where relevant information is abundant, but disperse, and time, attention and individual “processing” capacity are finite, is a first and very important “liberating” step. But how do we proceed from this point on? How to transform that restriction in a driving force?
We believe, like Bob Rubin, that “(…) rejecting the idea of certainties and needing to make the best judgments possible about probabilities, should drive you restlessly and rigorously to analyze and question whatever is before you – and to treat assertions as launching pads for analysis, not as accepted truths – in pursuit of better understanding.”
At IP we seek to fight our structural cognitive limitations acting with discipline and dedication in 4 fronts:
1) Investing our attention in the acquisition of “frameworks”, “mental models”, “vocabularies” and information of several disciplines, industries, companies, geographies, business models, vehicles and investment structures.
These resources form a tacit knowledge mosaic that: a) creates context(s) for us to understand and organize the innumerable stimuli we receive, helping distinguish what is relevant and what is not; b) functions as a repository of information with potential to be used in the future; c) encourages our creativity, providing us with perspectives and starting points different from the “average view” for everything we do.
The experience shows us that we take very long to learn and organize new ideas in such a way as to use them on a functional, actionable manner. Therefore, we encourage all in the team to keep track of companies, businessmen and fund managers they admire, to regularly read on the most different subjects and travel frequently, as well as to keep in touch with people with more experience and knowledge than us in matters that are of our interest now or that have a good chance to draw our interest in the future.
At IP, we really nurture the daily habit of “permanent preparation” which is accomplished very slowly, little by title, baby step by baby step, throughout time. We believe that this “always alert” mindset help us “connect the dots” quickly when the planets align and the big opportunities arise.
(…)
2) Building up and developing a local, national and international “intelligence network”.
Although we truly appreciate Renaissance-like generalist wisdom, both individually and as a ‘closed’ group we do know that at IP we are not even close to knowing in-house what would be considered ‘sufficient’ about several matters that drive and influence investment decisions.
According to our experience, it is not very “wise” to leave out of consideration, in a strict process of evaluation of investments, the input of people who know much more than you about some key points of your analysis. A tiny, single judgment error can jeopardize a whole investment thesis.
Sure, many times some of the marginal knowledge required is indeed in-house: for example, we have among partners and employees, specialists in governance, regulation, structuring of deals, marketing, commercial, information technology and operations, which assist upon demand the analysts of all sectors in their projects. Each partner of IP has a set of functional expertise and abilities that add value to the group.
However, there are also thousands of formal and informal specialists spread throughout Brazil and worldwide. They are former company administrators, regulators, shareholders, investors, consultants. They are very useful on several manners: as independent source of information on companies, people background checks (administrators, shareholders), as ‘devil advocates’, for specific aspects of an investment thesis, and are also useful to make us get quickly up to speed with respect to relevant themes that take place in countries different from ours.
The value of that network is immeasurable. Building it up and nurturing it requires precious time and effort. To replicate it is not easy. Our almost 20 years of existence and the tradition of supporting the companies where we invest in, respecting their managers and shareholders help us a lot.
3) Developing and improving systems and processes that help to process “in parallel” the information gathered collectively.
At IP we are highly concerned with the storage and the flow of the information we generate, and that is so precious to us. There is no use in gathering lots of information generated by the “permanent prospecting” of analysts described in (1) and the “intelligence network” mentioned in (2) if both the information and the analysis are not prepared and stored in such a way as to be easily accessible in the time and place where the “end user” effectively needs to use it.
Besides, this information is much more valuable when it is disclosed to the right people and generates discussion and reflection among the internal and external members of the “IP Network”. This interaction magnifies relevant ‘marginal’ knowledge generant.
With this purpose in mind, we created 5 years ago, an intranet that allows the synchronous participation (in real time) and asynchronous (the information is stored and the user participates when it is more convenient) of partners, employees of IP and selected guests, and it is accessible from anywhere in the world.
The system itself is very simple. The key to make it work is the relentless willingness to make it happen. It took a lot of time to get widespread adoption. But once it did, it became part of our lives. Gains in terms of organization, productivity and alignment of the group have been significant.
4) Really doing what we say we do: following in a relentless, disciplined way a value oriented investment philosophy with a long-term investment horizon, supported by independent, fundamental research.
In order for the tacit knowledge built up throughout the time to be transformed in decisive insights, so that hypotheses and ideas generated in various nodes of IP Network evolve towards becoming grounded investment decisions, a differentiated “research” method subordinated to a strong investment philosophy is key.
Although various institutions allege orientation to value, long-term horizon, deep and independent study, etc., we know that it is a very difficult promise to deliver on a consistent manner. There are always several ‘short-termish’ temptations that can make you compromise your principles.
In short, throughout this first 2008 report we sought to show that at IP, given the risk and uncertainty inherent to each and every investment decision, we try to overcome our incomplete information and structural cognitive limitations with permanent preparation, discipline, processes and method. Which at the end of the day should provide the basis for sound judgments.
The management of risk in IP is strongly intertwined with our daily and absolute commitment with the quality – current and future – of our analysis process and investment decision making. The fact that a significant amount of IP partner’s wealth is invested in the funds is also very relevant. In a way, we fully agree with Bernstein: “Risk is a choice, not a fate”.
Tags: foodforthought, ipreports, mentalmodels, quotes, riskmanagement
