Gustavo Ballvé on December 20th, 2009
Banks, Corporate Governance, Diversified financials, Food for thought, Home, Industries, Insurance

Alice “Snowball” Schroeder last month wrote a piece on Bloomberg called “Wall Street makes it hard to earn a legal living”. While IP has always discussed the obvious conflicts of interest for all the market’s agents, and the sell side in particular, Alice misses a turn in the road somewhere – falls down the rabbit hole? – and turns this article into quite the generalization. The issue of conflicts of interests deserved a better effort. Background: Formerly Morgan Stanley’s star insurance analyst, Ms. Schroeder left in 2003 to write the only (so far) authorized Warren Buffett biography, Snowball (by the way a nice book in its revealing details, but other books offer better practical insight into Mr. Buffett’s methods). So Ms. Schroeder is supposed the be the “expert” on how Wall Street works because she has “been there, done that”. Currently her sources of income, supposedly, are book royalties, speaking gigs and writing assignments at such publications/ properties as Bloomberg.

Her former experience makes it all the more shocking that she could come up with such generalizations as “there is only so much alpha – that excess return above a baseline average – to be had in an efficient market”. Efficient market??? One would think that she would use her time with Warren Buffett a little better.

Take this sentence: “The harder that money managers, traders and analysts must work to get information that gives them an edge, the more likely some are to cross a legal line.” Her point is that one must have an edge to get alpha, and since some people obviously will cross the legal line to get this edge, therefore the incentive is there for everyone to behave in legally unclear territory (her own words are stronger than this).

Wow. The logical implications of this line of thinking in other aspects of life are just too obvious to explore, so let’s stick to our own bread-earner.

Sometimes “edge” is as simple as having a long-term horizon while others panic with short-term fluctuations. Sometimes “edge” is receiving the same information everyone else is receiving and processing it in a more sensible context, depending on one’s general latticework of frameworks, mental models and past experiences – all of which is taken to the next level when one has a team of bright people with diverse backgrounds just itching to get their hands on a problem of this sort. Sometimes edge is checking an information against suppliers, customers, competitors and industry consultants’ opinions. Some people are even finding edge in the “wisdom of crowds”, e.g. sites where investors share their best ideas for the sake of gaining access to other investors’ ideas.

That’s called diligence, also referred to as “hard work”.

Incentives for criminal behavior have always existed, and incentives to deter it – threat of punishment, corporate culture, moral standards – have always been around, too. It is no “privilege” of Wall Street, as much as it is no privilege of authors, engineers, politicians… OK, we may be wrong about that last one.

I wish we could end this right here, but Ms. Schroeder doesn’t stop there. She says banks are so crooked as to need a break-up between its many different areas. Since everyone is chasing the same “alpha” inside a bank, “The aggregate number of people trying to carve fees out of investor returns simply overwhelms the potential gains for stockholders.” And then she completes the thinking: “Breaking up the banks into their constituent parts and forcing them to return to privately funded partnerships might reduce the apparatus that provides all parties with the incentives to cheat.”

Even if that wasn’t a generalization, who’s forcing anyone to invest in bank stocks? It’s precisely because such conflicts sometimes exist that we have always been very careful when approaching investment banks as investment opportunities. From what we’ve seen, the model doesn’t seem like it is built for shareholders, so we have a general aversion to these stocks. That doesn’t mean we advocate government intervention to change it! We just vote with our feet and stay out. If we are to tamper with investment banks’ model, why not tamper with insurance companies? Asset managers?

As if it wasn’t enough, she adds the coup de grâce: “(…) I sense a breath of change in the air. Kids who left college to import crafts made by women war refugees in Sudan are beginning to be envied by junior bankers who toil 80 hours a week creating spreadsheets. That’s a trend to be encouraged. Aspiring young bankers and hedge-fund managers, be assured of this: The more of you who choose to import crafts from Sudan, the easier the rest of you will find it to make a living legally on Wall Street.”

Should we point out that these things are cyclical and there used to be a time when everyone wanted to be an internet start-up slave? Then VC, then oil, then private equity, then… then…

Well, the overall message here is to remain very skeptical of what you read, no matter who it comes from. It’s amazing that Ms. Schroeder used her position as a “former player” to perpetuate such old stereotypes and “make-sense” generalizations. In the end, it can all be forgiven if she was just trying to sell more magazines…

BONUS: if you’ve read this far, here are books we think are also very useful on Mr. Buffett:

1) The Essays of Warren Buffett: Lessons for Corporate America, edited by Laurence Cunningham. It’s a selection of “best moments” from Mr. Buffett’s own annual report letters – organized by topic, which makes it the best overall AND reference source on Buffett’s thinking.

2) The Warren Buffett Way, by Richard Hagstrom. An analysis of Buffett’s classic investments – hits and misses – by one the portfolio managers at Legg Mason. A more direct, investment-oriented book, a perfect complement to the classic above.

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