Gustavo Ballvé on March 6th, 2012
Corporate Governance, Food for thought, Home, Mental models, Portfolio Management, Risk management

I’ve been re-reading many things on paper that I have to decide whether to keep (in electronic format) or throw away. This 2007 article by Malcolm Gladwell is a very good read. It’s about puzzles vs. mysteries and the frameworks for solving each of them. Gladwell’s argument is that while one needs more information to solve puzzles, in the case of mysteries there’s a trade-off between the quantity/quality of the information one has and the quality of the analysis/processing one does with it. That is, mysteries are more open-ended (some may not even have a “solution”), requiring several methods and angles and, in some, more information can actually harm your ability to solve the mystery. While the parallels to investment research are pretty clear, but I’d suggest one more application for this article: market regulation.

I’ve been thinking a lot about market regulation, Dodd-Frank and SarbOx – i.e. the increasing requirements for clear definitions and more disclosure in the name of “transparency”. As the article argues, more disclosure in Enron’s case would likely make it even more difficult for analysts to see that there was something wrong going on. And in that particular case, the people who “smelled trouble” in the company did not need such disclosures – the warning signs were all there in the public filings. From the article:

“To Schwarcz, all Enron proves is that in an age of increasing financial complexity the ‘disclosure paradigm’—the idea that the more a company tells us about its business, the better off we are—has become an anachronism.”

What’s more, to assume that more disclosure is good embeds some assumption that the disclosure is done in good faith… That the intent is to inform and not to confuse. In the US legal system, there’s even a name for the practice of giving too much information to distract from the real problem or to make it harder to find the “needle” in the “haystack”: “document dump“.

However, there’s another side to the issue and Gladwell covers it. On page 5 of the article I wrote a note that read “isn’t the supposed inadequacy of increased disclosure a problem of skills gap, that is, a problem of analysts not having enough practice with the arcane financial stuff, not to mention the lack of real incentives to actually dig deep enough?” Let’s look at both parts, skills gap and incentives.

The “skills/framework” gap was addressed later in the article. One professor said it was Wall Street’s fault that it did not keep up with Skilling and Fastow’s inventions and the over-complications of analyzing Enron. Here’s an excerpt:

” ‘In order for an economy to have an adequate system of financial reporting, it is not enough that companies make disclosures of financial information,’ the Yale law professor Jonathan Macey wrote in a landmark law-review article that encouraged many to rethink the Enron case. ‘In addition, it is vital that there be a set of financial intermediaries, who are at least as competent and sophisticated at receiving, processing, and interpreting financial information . . . as the companies are at delivering it.’ (…) Macey argues that, as Enron’s business practices grew more complicated, it was Wall Street’s responsibility to keep pace.”

He’s right in the sense that one has to be paranoid about what one doesn’t know, and the best idea is to assume one doesn’t know much. If one needs a set of skills, there are increasingly efficient ways to acquire it for oneself or hire it, for the long term or temporarily (consultants). But consider, as we always insist on, the choice of pre-filtering ideas, say, by business model… Every now and then you will come across an 800-pound cow being priced as a 100-pound large dog, and then it may make sense to pursue the skills you need to better judge the opportunity. But in most occasions, when faced with the equivalent of Enron’s 3,000 “partnerships”, you’re probably better served by putting that idea in the “too-hard” box and waiting for the fat pitch (better explained in the second part of this August 2011 post).

To introduce the incentives part, here’s another excerpt:

” ‘There have been scandals in corporate history where people are really making stuff up, but this wasn’t a criminal enterprise of that kind,’ Macey says. ‘Enron was vanishingly close, in my view, to having complied with the accounting rules. They were going over the edge, just a little bit. And this kind of financial fraud—where people are simply stretching the truth—falls into the area that analysts and short-sellers are supposed to ferret out. The truth wasn’t hidden. But you’d have to look at their financial statements, and you would have to say to yourself, What’s that about? It’s almost as if they were saying, ”’We’re doing some really sleazy stuff in footnote 42, and if you want to know more about it ask us.”’ And that’s the thing. Nobody did.’ “

Does it mean analysts were all dumb, not good at accounting or too trustful? Apart from whatever skills gap there could have been, and discounting the sell-side’s conflicts of interests, the fact is that most buy-side analysts and portfolio managers are also under short-term oriented pressures – either for their portfolios to keep up with the indexes (or the “peer fund group” etc.); or to produce ideas quickly and to “defend” them once they’re into the portfolios. Who could blame managers for owning Enron when it was the market darling, had gone up so much, had “geniuses” at work, had revolutionized the energy market and so on, right? Wrong. Who can blame analysts for overlooking public information when it was relatively buried in footnotes – who reads footnotes, right? Wrong again. How to build an organization, team and processes that take these pressures into consideration is not the subject here, but it’s the main challenge for long-term, value-oriented managers.

So in light of the Puzzles vs. Mysteries, more disclosure vs. too much information trade-off, the supposed skills/framework gap, and the incentives structure, what can we take away from the increasing market regulation and the required disclosures for more “transparency”? Is the financial system bound to get safer, or just more predictable in some areas and more unpredictable in others? Is investing going to be easier, or harder than ever? I’m not that optimistic at all.

To me, it all means being convinced once again that I’m too dumb to understand all industries/ businesses; all the rules, tax codes and GAAP recommendations; and all incentive structures. It means that “the filter” is ever more important, and that once I’ve chosen the things I can do relatively well, that I’ll work relentlessly to improve in that realm. And that if I’m patient and disciplined about the opportunities bound to come my way, I’ll have some measure of success at an acceptable level of risk.

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