A post on Seth Godin’s blog over Mother’s Day weekend had one sentence that “clicked” right away: “The best ideas come out of the corner of our eye, the edge of our consciousness, in a flash. They are the result of misdirection and random collisions (…)”

Nicholas Nassim Taleb had this to say about going to parties: “Go to parties. You can’t even start to know what you may find on the envelope of serendipity. If you suffer from agoraphobia, send colleagues.”

From a recent NYT article on the American University in Cairo and how it challenges students to “unlearn” in the first year: “Who am I? What does it mean to be human? These are the kinds of questions posed to undergraduate students entering this 90-year-old university during what the president, David D. Arnold, called a first year of “disorientation.” During disorientation, the students — 85 percent of them Egyptians — are taught to learn in ways quite at odds with the traditional method of teaching in this country, where instructors lecture, students memorize and tests are exercises in regurgitation.”

Charlie Munger has always talked about this: “Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

We’re sure we could come up with more “pieces” to this puzzle, and so could you, but we’ll let Mr. Munger himself sum it up perfectly for us:

“Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.”

There are many ways to “be prepared”, so here’s one: Build your own mental models with discipline and drive, sourcing as diversely as possible but always focusing on what’s really relevant, collaborating with a team of bright people both inside and outside your firm – better yet, people brighter than you.

It’s hard, patient, disciplined and long-term work, but it’s well worth it.

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

Apply it both in the big picture and the small picture – from the broadest strategic moves of your company to its tiniest daily processes. Now change the underlined word “company” for “department” if you want to go small, or “nation” and “regulatory system” if you want to go big. For extra fun, try “life”.

Q4 2009 report excerpts, part 2

“PERSPECTIVES”

Brazil

It is common for this section to be optimistic, where the managers explain why the future will be better, or at least like the past. Unfortunately, at least with regard to our expectations for our Funds’ returns, this is not the case. Results like those in 2009 are infrequent. The chances of seeing two years in a row similar to this one are very low.

In 2009 there was a fall in interest rates, the Real appreciated, and the country was in vogue, which – at least for us – was unprecedented. There is nothing to stop these factors from continuing (for one thing, because there is a certain correlation among them) and it would not even be extraordinary. But there are two problems that keep us awake. They are related to each other:

1. There is an almost unanimous feeling, internally and externally, that “now we’re off, this time it’s different”. This feeling is supported by the supposed validation of the thesis that “the global pneumonia is nothing more than simple flu” around here.
2. The big problem, of course, (and a direct consequence of the above-mentioned point) is the price base.

There is a great resemblance between the stock market at the end of 2008 and 2009: the sensation of inevitability of a trend and an almost unanimous opinion. These climates have proved mistaken in most cases.

We remember very well when IP was in its infancy, in 1989, and the Nahas case closed the stock exchanges in Brazil. We remember when President Collor froze bank accounts and investments in 1990, the Mexican crisis in 1994, the Asian crisis in 1997, the Russian one in 1998 and the Brazilian one in 1999 (the unforgettable “endogenous diagonal band” in the exchange rate). In all these cases, “this time it was different” and still “the house fell down”. Of these, the only one that seems to us to have had long-term effects was President Collor’s plan, which in fact has undermined the country’s credibility among many to this day.

Without fear of being repetitive, it is the changes in expectations that determine market fluctuations. Today, most people see the glass half full (or fuller). But there are more than enough reasons for a different view. Our growth has been supported by deficits in the balance of payments and in the fiscal balance, not based on savings or a measurable increase in productivity. The system remains jammed and very corrupt (for obvious reasons, it is impossible to state whether more or less).

No less important, in 2010 we will have presidential elections. Up to now, the economy and investors have allowed themselves the luxury of ignoring the relevant macroeconomic problems and the political risks. We have never seen a pre-election period involving a change of president with so much tranquility in the Brazilian capital market. Is it possible that everything has really changed, and that the political issue, so discredited and surreal, has embarked once and for all into a parallel universe? It would be marvelous, but in the end, “they” are the ones who define the rules, raise taxes, hamper the day-to-day routine. Like the androids of the film series “Terminator”, at each new film, precisely when the villain seems to be more harmless, he is much more dangerous. We have nothing to add to everything that is in the papers every day.  Except to stress and remind our readers that unfortunately political decisions do have an impact on the economy.

In line with this view, we closed the year with a high cash percentage. If the market continues to climb, we will still capture at least part of this rise. But the ideal scenario would be a crisis of expectations that would take prices back to levels where implied expectations were much worse than the present ones.  As a result, we could “put the turnstile back to zero”. As we have mentioned several times in the past, volatility is not a risk measurement. It is our great friend.

And what if we are wrong? We are running the risk of earning less than if we were more exposed. In fact, that is what happened this year. (…) Market timing is something we do not know how to do and do not intend to do. In the course of time, all those we have seen trying to do fine timing on a large scale, based on market “feeling”, have ended up being faced with the reality that, in the long term, this is a losing proposition. We do our timing as a consequence. We buy more when prices are low in relation to an expected reasonable value for the assets, based on well founded assumptions. We sell as the opposite starts to occur. Above all, before any other consideration, IP’s history of over 20 years has taught us that, to arrive in first place, first you have to arrive.

Global perspectives

We believe that the drastic changes at the global level have not yet ended. We continue to hold our view that current prices, in general, imply a more optimistic expectation than what experience and analysis of the interests involved recommend as prudent to follow. In fact, we see the governments of several countries (the USA in the lead) as great Madoffs, operating a great make-believe scheme. The story here is that future tax revenues will be sufficient to pay interest and all the “social” commitments. As in the Madoff case, it is much more convenient and pleasant to believe. But the truth is that the account hardly ever balances out. As in that case, the tendency is for there to be a disastrous ending for those who do believe (pensioners, long-term US Government security holders, etc.).

It is here that greater flexibility is most significant. (…) We do not propose to look at everything. On the contrary, we can reject everything that is less than optimal and concentrate on what we consider very good. At a time when it is even more difficult to find sound assets, with businesses carrying sustainable competitive advantages reflected in high returns on equity, managed competently and capably, at attractive prices, and when everything – even the traditional refuge in the dollar and in treasury paper – is questionable, this is a great advantage.

Our favorite cases continue to be independent of conventional classifications, such as by sector, geography or company size. However, certain sectors and certain geographical areas do have their biases, making them more attractive in certain situations.

In the course of the last few years, we have been trying to learn a little more about the health sector in the USA. Besides being the largest sector in the US economy, its complexity, segmentation and stratification make it the largest entrepreneurial laboratory we know of. The quantity of business models is virtually endless, given that in addition to vast diversity, the dynamism induced by the competitive, regulatory and technological aspects makes sure that there are always new models. At the very least, we have a wonderful tool gain, given that in many cases the models, or parts of them, end up being adopted by other sectors and/or in other geographical areas, giving advantages to those who have already studied and understood them.

Despite all the turbulence in the sector (in fact, thanks to it) generated by the Obama administration’s reform plans for the sector, this year we were able to reap some rewards from our effort, as in the cases of IMS Health (a position that we have already closed) (…); but we believe that there is still a lot of “juice” to be extracted from this fruit. The studies continue and it seems to us that, as in most cases, the media noise is helping to push down the prices of some assets more than could be considered normal.

Another sector that is still rather depressed (deservedly) in terms of asset prices, in the most developed markets, is the real-estate sector. It is difficult to know when growth will pick up, but it is certain that this will happen. Meanwhile, we continue to study the players, getting to know people and to understand the models and the “little tricks” of each sector/company.

Natural candidates are the businesses based on the pro-active and differentiated use of information. From our point of view, there are several attractions. Returns tend to be high due to the low levels of capital needed. The practical difficulty of implementation has historically been extremely high. Many companies have a vast pool of potentially valuable data, but the cases of those that manage to turn them into the great value creator they may represent are very rare. Those that set themselves up this way have a fantastic business, whose focus is the intelligent processing of information and which is “disguised” in companies classified in the most varied sectors, such as IMS Health (health sector), Amazon (retail), Google (media), Harrah’s (casinos), Co-Star (real estate), and Verisk (insurance), among others. In our traditional retail sector – an obvious candidate – despite our efforts we have found very few cases.

In short, we continue seeking companies with sustainable competitive advantages from a long-term perspective, which are able to generate value even in scenarios that are adverse for most, including those where changes in relevant paradigms occur. At the same time, we try to be on the alert for possible significant market distortions, caused by time imbalances or the application of models based on the adoption of assumptions that seem inappropriate to us.

It was also in this report that we first mentioned Buysiders.com to our clients, and we hope you all enjoy it.

In the “part 1″ we will highlight excerpts from the “Introduction” section of the report. Look for “part 2″ by Monday.

Q4 2009 report excerpts, part 1

“INTRODUCTION”

After a weak 2007 and a very bad 2008, we were pleased with 2009. Although the adjectives are in line with market behavior, as Neil Young says in one of his best-known songs, “Hey, hey, my, my (rock n’ roll can never die)“, “there’s more to the picture than meets the eye“. The restructuring of the research and management team – carried out in 2H 2008 – and, consequently, of the portfolios has been consolidated. The improvement in results, both from the quantitative and, more importantly, the qualitative point of view (addressed in the Q4 2008 report) has continued.

(…) In 2009 we had a good absolute and relative result, in a positive year for the market, when we usually have a good absolute performance but a bad relative performance. Above all, though we are very cautious and concerned regarding the market, we are very sure that we are doing the right things. As we stressed in the Q1 2008 report, we have no control over short-term returns, but we can and should control the investment analysis and management processes. Over time, the processes define the results. If we’re not yet where we would like to be in this sphere (the pot of gold is always at the end of the rainbow…), we have at least the conviction that we are evolving in the right direction.

Merge!

(…) a recurring event has been the participation of companies in our funds’ portfolios in large M&A transactions. Recently, Saraiva has acquired Siciliano, Itaúsa has acquired Unibanco (not to mention the Satipel and Porto Seguro deals), Odontoprev has merged with Bradesco Dental, and Totvs has acquired Datasul. At the other end, Globex was sold to the Pão de Açúcar Group. In the international front, InBev has acquired Anheuser Busch (Budweiser) and Berkshire is acquiring Burlington.

Two factors make this observation worthy of greater consideration.

In the first place, we have the historical observation that transactions of a “transformational” nature are risky.

If we take a broad universe of companies, there are many bad results. Daimler/Chrysler and Time-Warner/AOL are cases that spring to mind immediately as perfect examples of what may not work. On the other hand, the overall record of what Itaú and AB-InBev are today shows that we should not reject all operations of this nature a priori.

A positive indicator that seems to us to keep a good correlation with the transaction’s result is when the party that takes the initiative does so from a strong position, with a positive growth agenda. In these cases, it makes a difference to be at the right end. Even though there is usually a “premium” in relation to the acquired company’s recent stock prices, it rarely compensates the long-term investors who have “held the ice cubes in their hands”. It becomes a matter of timing, and it is not by chance that this is the category in which traces and evidence of insider trading are most commonly found.

In the opposite situation, “shotgun weddings”, where two weak parties that are under threat join together, usually lead to worse results.

Another potentially negative case is when large “depersonalized” corporations with weak governance end up being oriented, in practice, by their bankers and advisers. In such cases, what we end up seeing is an apparently unending series of senseless transactions with no effective “buy-in” by executives, generating progressive value destruction.

Another point is that in the great majority of banks’ and brokers’ reports that we see, and that are possibly the main drivers for price formation in the short term, the detailed models rarely incorporate the possibility of value destruction. The argument is that it is obviously an issue that “cannot be modeled properly”. But as we never tire of repeating, “unquantifiable” may be completely different from “irrelevant”.

How can one quantify a good management that knows how to select good alternatives and abandon those that are attractive but whose price cannot be justified (as in the case of Renner/Leader), and then efficiently manages the always difficult integrations? Our answer is that each case is different from the next one. We do (very simple) simulation exercises in order to have a range of potential values, and we invest most of our time in getting to know and understand the logic and the real incentives that motivate the managers, and the competitive market conditions within which the companies participating in the transactions operate; how the idea for the transaction arose and evolved, who their advisers are, and other qualitative factors. It is better to be approximately right than precisely wrong.

Dividends vesus Bonds

An interesting issue for those who believe in efficient markets was the situation between shares and bonds issued by high-quality global companies observed during a good part of 2009. Joseph Stiglitz, a Nobel Economics laureate, in his address to the annual meeting of the American Economic Association at the end of December 2009, fired a heavy attack at his colleagues who create models that depend on the assumption of rational behavior, when the real world insists on not fitting into this mold. During the 2H of 2009, many investors tried out their return to the markets (as they received redemptions from hedge funds or got tired of returns close to zero yielded by US Treasury securities), buying bonds.

At the height of the crisis, there were moments when fixed-income securities issued by some low-quality companies were traded at prices that seemed very low to us, but as the year advanced, that was no longer the case in most of the market.

When doing our calculations in the second semester, we could not understand the market’s logic. In several cases, the dividend yields on stocks were very close to the yields on bonds (obviously taking care to include only companies with the capacity to continue paying dividends in the future). Usually, dividends are relatively lower for the following reasons:

1. Bonds and stocks have 100% downside.
2. Bonds usually pay coupons and redemption of the principal in a given currency, fixed beforehand. On the other hand, the revenues and results of companies are generated worldwide, and the respective dividends are defined a posteriori. As there is usually a “desired” inflation rate in the systems, the current yield on the stocks of sound, growing companies should be lower, in terms of present value. In the present case, for those concerned about an acceleration in US inflation in the course of the next few years (as we are), at similar current yields, stocks of companies with quality businesses are relatively even more attractive. Obviously, the opposite reasoning applies to the hypothesis of deflation.
3. These companies pay out less than 100% of the profits for each financial year in dividends. The remainder is reinvested in order to generate increasing profits and dividends (while bond coupons are fixed).

In fact, shares of companies like Coca-Cola, Nestlé and Procter & Gamble appreciated well, and part of what seemed a distortion to us was corrected. But only part. Our philosophy cannot be reconciled with long-term fixed-income securities that carry fixed yields in dollars at the present levels, nor with stocks of high-risk companies at prices that imply optimistic scenarios that are not based on our vision of the world. We prefer to have cash or stocks of companies that are capable of generating cash, even in the most adverse scenarios, and that are trading at reasonable prices. Our experience is that even if there is zero return for some time, when opportunities finally appear, the returns more than compensate for the wait.

Q4 2008 report excerpts on moral diligence: Part 2 of 2

“ON MORAL DILIGENCE”

“What aren’t you able to bring men to do, miserable hunger for gold!”

Seneca

2008 was a long, hard and troubled year, during which the world financial system had its governance and compliance structures questioned, and the markets went completely off the rails; they were severely destabilized and shaken by a crisis of confidence that was unprecedented in complexity and scale.

It is no exaggeration to say that, from September on, the generalized uncertainty and mistrust severely dried up the liquidity of a system that had already been staggering for over a year, locking its financial and transactional gears.

The banks, whose very existence is founded on the most basic form of “credit”, their reputation, stopped believing in each other’s balance sheets and capacity to survive. They discredited their own auditors, as well as their compliance mechanisms and risk gauging and control systems. They started to doubt the payment capacity of those they finance. Insurers stopped trusting those they insure, and vice-versa.

All over the world today, producers suspect suppliers, and salesmen their customers. Contracts were and are being questioned, suspended and canceled. Voters are skeptical about the capacity of their governments to resuscitate the markets and the economy in a fair and efficient manner. And governments do not believe in the autonomy of the markets. The market, in turn, trusts neither the government nor the regulators. Investors question their advisors, who in turn question their managers, who no longer believe their economists and analysts, who do not trust their models any more. It is a long list. Bonds of trust, once broken, take time to rebuild. And many of the consequences and effects of these ruptures are yet to come.

In this context of worldwide broken trust, we would like to share with our clients, business partners and friends a reflection of a moral nature. But one that is not moralistic.

In our opinion, which differs from the consensus, to reduce the recent events to human “greed”, to deposit them in the account of the “irresponsible behavior of a few” or, at the opposite end, to interpret them as a direct, exclusive and inexorable consequence of a framework of incentive systems and the conflicts of interest associated with same – for which, at the end of the day, no-one feels responsible or accountable – is to ignore an issue that we consider crucial: it seems to us more interesting to look at the situation from a “micro” point of view, where we can in fact take action, than from a “macro” angle, where searching for culprits and definitive explanations, or even postulating solutions, is beyond our scope and competence.

In the sky-high “macro” sphere, realm of Them, the Others, we all think ourselves creditors and victims. But it is in the streets and alleys of the “micro” sphere that We are (or should be) accountable.

It seems more productive to use the crisis as a backdrop for us to reflect on potential forms of protection against our own recurrent fallibility (greed, imprudence) and the fluctuations in the alignments of interest that are intrinsic to each and every relationship.

We could hastily reach the conclusion that the design of the incentive systems that govern the relationship of agents in markets and organizations “perverts character”, instigating agents to “act”. And conclude, like Shakespeare’s Cassius trying to persuade Brutus to murder Caesar: “For who so firm that cannot be seduced?”

And how can we apply this premise on a “macro” scale? Re-designing the explicit and tacit incentive systems that govern exchanges among the agents? Establishing more and better surveillance, reinforcing regulations, imposing more controls? Frankly, we haven’t the faintest idea. It is outside our circle of competence and, honestly, we are somewhat skeptical about it.

But with regard to our own “circle of trust”, emphasizing the importance of all of us acting in a morally diligent fashion – especially in selecting our business partners, employees and investments – is definitely in the order of the day. And there is no doubt: this is an extremely important subject that generally goes unnoticed while the world moves full steam ahead, and only becomes evident and haunts us at times of crisis.

We wonder whether to ponder such a question is the quintessence of naiveness on our part. But naive and foolish is to think that only the “market’s” incentive systems are misaligned or corrupted.

Yes, in the financial sphere, there are very clear points of unbalance, which, as became evident in this and in several of the latest crises, instigate behavior that crosses, without shame or remorse, the frontier between simple “misalignment” and moral issues. As we have seen, the huge machine of transactional efficiency of the global markets intensifies this effect.

But it is worth looking at this issue very closely: to well- trained eyes, conflicts of interest are easy to see. In many cases, like the Wall Street bonuses, they are explicit.

But “misalignments” – that is, the imperfect convergence of interests among agents – are much more difficult to see. Primarily, they belong to the sphere of the tacit. They are multi-dimensional and fluctuate over time. They are much more difficult to pick out in contracts or schemes. Preferences change over time. They are volatile, ambiguous and conflicting. Anyone who has had friends or partners knows exactly what we are talking about. By definition, there is no “perfect” alignment of interests. Or do you think that this malady is exclusive to the financial market?

Yes, structurally, we live under the aegis of a generalized misalignment of incentives – from our government systems to mechanisms for remuneration and promotions in companies, which, given time, could even be corrected, improved, or at least better watched over, controlled, punished.

But the other side of the coin, what demands our attention a great deal is that, despite the “structures”, “systems”, “markets”, the social pressure to follow tacit rules and behavioral consensuses, the struggle to deliver significant results, to be better than the competitors, there is ALWAYS the option, as a matter of principle and discipline, to use from the very beginning a high moral filter for everything we do.

The option to say “I will not take part in this”, “No, I will not invest in this fund with the best Sharpe Ratio without fully understanding the process that generates this irreproachable performance”, “No, I will not manage this company or investment fund aiming at short-term results”, or “I will not do business with these people of questionable reputation” DOES EXIST. Always.

This posture is valid with regard to managing our own business – as usual, it is always easier said than done – but it also extends to the people close to us, and is especially critical with respect to the business partners we select – in relation to whom our degree of control is clearly lower.

It is not by chance that, as long-term investors, one of the aspects that we most consider in filtering our potential investments are the people involved and their motivations. What type of partner do we want? Has the company in fact an owner or owners? Who are they? Where do they come from? What are their aims, their ambitions for themselves, for their families and for the company? What do they value and despise? How are they called to account? How do they measure their progress, their success? How do they act in relation to their associates (business partners, clients, suppliers, etc.)? What are the values that are really adopted and practiced by the company: how are they reflected in the behavior of the owners and employees? How do the explicit and tacit incentive systems of the different areas of the company interact among themselves?

Fully understanding how the organization chart of a potential investment really works in real life (in greater or lesser harmony with the company’s explicit incentives) should be covered in a special chapter in each and every book on valuation.

It is astonishing how powerful an analysis based on people and their motivations can be. What is more, this “social auditing” should also be extended to the company’s “neighbors”, the key points in its value chain.

For example, when we “analyze” a company that sells products and services to another, it is crucial also to know: WHO is really responsible for the purchase of the company’s product? How is HE compensated? How is HE, the buyer, profiting from the purchase? What is HE placing at stake?
In short, if the misalignment of interests among “agents” (always flesh-and-blood people) is a fact of life, there is only one reasonably effective way to deal with this: to make use of a high moral/reputational filter and to keep within our circle of trust just a few business partners/associates, but good ones: competent, ethical and genuinely aligned.

A good example of moral diligence to be followed is that of Warren Buffett, whose control and governance system for the companies in which he invests is, at first sight, rather “loose”. And even so, he gets it right much more often than not.

In the words of Charlie Munger, his partner at Berkshire Hathaway: “it’s wonderful to be trusted. Some think if we just had more compliance checks and process, virtue would be maximized. At Berkshire, we have subnormal process. We try to operate in a web of seamless trust – deserved trust – and try to be careful whom we let in.”

Part of their secret: a very good eye for evaluating a person’s character (and the ability to audit their reputation with a couple of phone calls). But obviously the two men only developed this sharp perception because, at a given moment in their careers, they gave this filter a disproportionally high weight in evaluating potential investments. This makes all the difference.

If on a scale from one to ten, traditional investors give a weighting of 3 or 4 to traits such as integrity, character and values, in Buffett’s case, where the horizon for carrying an investment is “forever”, there is no other way: the weighting must be close to 10, and in the hierarchy of desirable attributes of a good investment, precede all others.

Buffett applies a high moral filter, he says, always seeking three characteristics in his potential business partners: integrity, energy and intelligence. In this order. And in his own words: “if your candidate does not have the first, the other two will kill you”.

On the other hand, it is important to stress that, sometimes, basing a good part of the process of selecting business partners on an apparently robust moral filter, but without due diligence, has the opposite effect. In cases such as that of Madoff, the exaggerated trust that many of his victims placed in the investor’s most obvious traits (former Nasdaq chairman, a link with charity and the Jewish community, several of his investors had an irreproachable reputation, his intermediaries were renowned companies, the fund always delivered good, consistent results, though not extraordinary, and for years on end) created an aura of “integrity” around him that made his scheme very convincing for a long time. In this case, the “moral” trait took part in the selection process, but diligence was insufficient. The golden rule is “Trust. But verify”.

Well, taking all that into account, what should be done from the practical point of view to safeguard ourselves, at the “micro” level, from our own mistakes?

Firstly, having a very clear notion of our suggestibility and susceptibility (recurrent fallibilities and biases), and controlling it with principles, values, discipline, systems, internal processes, and a competent, aligned team; demanding a significant margin of safety; and knowing that, even though well-meaning and alert, we can be (and are) fooled by our senses, judgment and evaluations of information and – even more important – people.

Secondly, building an environment that will clearly promote incentives other than just material ones (starting with the selection of people using an ever higher “moral filter”), in harmony with the principles and values practiced in the company (selection of associates/counterparties – few, competent, honest and aligned – who share these principles).

Thirdly, being morally diligent – with ourselves and our business partners. This applies to the evaluation of the companies in which we invest, to the people we hire and keep in our team, to the people who render us services, to our business partners, and to our clients as well.

CONCLUSION

We used as a backdrop reflections on “incentive systems”, like those that marked the present financial crisis – and, along with several other factors, helped to gear it up – in order to throw a somewhat solitary light on another place: the importance of raising our standards, our moral filter, ever higher when making our choices, less as agents of a transactional system, but more as responsible members of a community.

When we reflect on last year, one of the most important things we have learned is that there is no better risk control than to be surrounded by good business partners and few, both in-house and outside: competent, well educated, ethical, and genuinely aligned with and committed to us for the long term.

In this respect, we seek always to be on the alert – and even so, now and then we err in evaluations and judgments.

To elect a high moral filter as a crucial instrument for risk control has a high “visible cost”. The universe of investments that we can consider is drastically reduced (it is not for nothing that we seek to invest in companies on a global scale, so as to expand our reach without having to lower our governance and management-quality benchmark). The universe of employees that can be hired and eligible partners, ditto. In short, as a rule, our number of potential business partners falls a lot.

On the other hand, the “invisible benefits” generated by this more conservative conduct are extremely valuable to us. And in our assessment, they more than compensate the visible costs.

A good way to think about moral diligence is to make use of an old friend: the margin of safety concept. Just as we must invest in companies whose price offers a significant margin of safety in relation to our perception of their value, we must also require a “margin of safety” when we assess the moral contours of an opportunity for an investment or partnership.

The fact that we seek to be always on the alert does not mean that we always get it right, whether internally or externally. Last year is a good example of that.

But the simple fact that we pay attention to the importance of being increasingly morally diligent with ourselves and with our associates helped us to minimize some of the mistakes made and to correct them relatively quickly. Our portfolio today is, to a large degree, a positive result of these changes.

(…)

As a final message, a very simple observation: properly exercising what we call moral diligence implies doing more with less. The universe of investments, counter- parties and partners that can be considered is reduced. And that is precisely the direction we’re following. We want few but good business partners with whom we can cultivate and nourish relationships that transcend the transactional.

To have a select group of clients and business partners who admire and trust you is immeasurably more valuable than an infinite number of clients and business partners that maintain a merely transactional relationship with your company. In this respect, we feel privileged.

We agree once more with Buffett and Munger: “we try to operate in a transparent web of seamless trust – deserved trust – and try to be careful whom we let in.”

Q4 2008 report excerpts on moral diligence: Part 1 of 2

Introduction: “OWN GOAL”

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

Friedrich Hayek

During the Shell Caribbean Football Cup in 1994, two countries were fighting for classification for the second phase of the competition: Barbados and Grenada. Barbados needed to win by a difference of two goals. If it won by only one goal or if it lost, Grenada would be classified. But if there was a draw, the story could be different.

A new rule adopted by the organizing committee introduced a novelty. So as to make the spectacle more exciting, incentivizing the teams to be more aggressive in “tough”, close matches, the organizing committee came up with the following formula: if a game ended in a draw, there would be extra time. What is more, any goal scored during extra time (and while the “golden goal” was in force there could only be one per game) would be worth two when the balance of goals was counted; the key criterion for the decision, if the teams had reached the same number of points.

Because of this rule, the game became very interesting. Barbados was winning by two-nil up to the final minutes. But at the 38th minute of the second half: Grenada scored a goal, making it 2 x 1.

Now under the gun, Barbados tried to strike a third goal for a few minutes, but soon realized that it was not going to be easy. After scoring the goal, the Grenada team fell back, closed in and was firmly on the defensive. The pressure on Barbados was high. With the game almost over, its players were visibly tense. But after weighting their options, they acted rationally: thanks to the new rule, it would be much safer to score an own-goal and force the game to be extended (when one goal would be worth two), rather than try to score against the Grenada team, which were in heroic defense.

And that’s exactly what happened. After exchanging a few passes with his goalkeeper, Sealy, full-back of the Barbados team, kicked the ball into his own goal, causing the game to be drawn at two-all.

But that is not yet the strangest part of this game.

On kick-off, at the 40th minute of the second half, the Grenada players went on the attack, but were visibly downcast. After 2 minutes of a desperate attack, they reckoned the alternatives: if they scored an unlikely goal against Barbados during the last few minutes, they would be classified. But if they scored a goal against themselves, they would lose by a difference of one goal, a result that would also place them automatically in the next phase. Therefore, they launched themselves full steam ahead in pursuit of the saving own-goal.

What was seen after that was a true slapstick episode: the Barbados players anticipated the Grenada team’s move and divided themselves in the field between defending both their own goal and that of their opponents (from themselves). Sealy, the Barbados goal-scoring full-back, placed himself beside the Grenada goalkeeper in order to defend their goal from their own team!

The game ended in a draw, and at the fourth minute of extra time Barbados scored the golden goal and was classified. The players were not punished, because “both teams were genuinely trying to advance to the next phase, following the rules of the competition”.

The moral of the story: designing incentive systems laden with good intentions and believing in our ability to foresee the consequences (direct, indirect, and those that will arise way ahead, as the result of the autonomous interaction of the “agents” of the system in question), seems much easier than it really is.

In the present context, in which governments and regulating bodies appear as a lifeguard to restrain and remedy the limitations and disorder in the free market, it is good to have examples such as this as a reference, in order to recall the tremendous iatrogenic potential of regulations: the “remedy” very often kills rather than cures.

The list of curious examples of measures that backfired, though “carefully designed” by the most diverse entities and organizations, is rather long. In Brazil, the taxation of commercial flows between jurisdictions in accordance with the principle of origin, one of the main factors of the tax war that has overtaken our federalist system, feeds a well-known perverse incentive: the transport of goods between States follows a tax-efficient route, making our already precarious logistics system even more unproductive and inefficient.

In the United States, the institution of the Prohibition in 1920 to eliminate crime in the country proved to be a resounding failure: it was expensive to implement and enforce, generating, as collateral effects, a rise in violent crimes, an explosion in consumption of stronger, home-made alcoholic drinks (the number of deaths due to cirrhosis in the period remained stable) and a huge drop in tax collection.

In French Hanoi, a law created to end a plague of rats paid the “hunters” for each rat carcass. It ended up stimulating gigantic rat-breeding operations.

In China, in the 19th century, peasants received a reward from foreign paleontologists for each fragment of dinosaur bone found. In order to maximize their remuneration, the peasants used to break the bones into several small pieces.

Finally, a more current and universal example: the medical reimbursement system for insured patients which remunerates the treatment of illness, rather than its prevention, is one of the simplest and most harmful misalignments of interests that we know of.

Frédéric Bastiat, acclaimed by Schumpeter as “the best economics journalist the world has known”, called our attention to “the difference between a bad economist and a good one”. “The first only sees the direct, short- term consequences of actions, while the second observes the indirect consequences in the longer term.” According to Bastiat, “To understand the immediate consequences of a law is not enough to judge its efficacy. It is necessary to try to uncover, a priori, all its long-term consequences for society as a whole. The more politicians concentrate on solving specific problems, the greater the disaster becomes on a broad scale. An economic policy consisting of immediate measures, with its simple, miraculous promises, causes a much greater impression than an invitation to intellectual exercise.”

But the problem of incentive design is even more serious. Because the market is dynamic and operates as a complex adaptive system, it goes on “learning”, “evolving” and becoming “autonomous” over time, as its agents interact, cooperate and compete among themselves. Therefore, some of the consequences of new schemes and regulations, positive or negative, are by definition unknown at the time they are formulated.

What is more, it does not help, as we say in Brazil, “to hide the sun with a sieve”: any incentive scheme or system, tacit or explicit, can be bypassed. As Andy Grove says: “For every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal”. If you pay your programmers to solve bugs, do pay them also for quality and new features, or several of them will create real “bug factories”.

That is why it is important for us to use high moral criteria when selecting our business partners, associates, and even our clients, in order to restrain one-dimensional and undesired behavior.

Although Academia and the media focus mostly on financial incentives, we can roughly divide the types of incentives into three groups: material/financial, moral/social and punitive/coercive.

The punitive incentive is simple: going off the tracks implies being dismissed, imprisoned, sued, etc. Monetary incentives are old acquaintances: powerful motivators, they encourage people to wish… for more financial incentives. The problem is not that they don’t work. They work too well, encouraging people to focus their attention on a behavior that is directly associated with compensation. When money becomes more obvious, vivid, people find it much more difficult to see long-term dysfunctions or ethical dilemmas involved in the process of obtaining their results. People will tend to focus only on doing what matters in order to capture the incentive.

Finally, we have moral interests (doing the “right” thing because it is “right”, and full stop), as well as social and personal interests. No matter how much some theorists may lead us to think the opposite, people are not mere economic agents, acting with a view to maximizing their material interests. They have other aspirations and goals. They are moved by passion and ideals. They want to be inspired. To dream. To accomplish. They have interests that are sometimes ambiguous and conflicting. Competing motivations. They give in to peer pressure. Their ambitions and preferences varies over time and are subject to interference.

To believe that people only act because they want to retain or accumulate wealth is to suffer from extreme short sight in relation to what we are and do.

Curiously, exceptional performance, in several domains – including the financial market itself – does not necessarily originate from extrinsic rewards, but from intrinsic motivation. In the words of the serial entrepreneur Richard Branson: “I never, ever thought of myself as a businessman. I was interested in creating things I would be proud of.” Buffett himself refers to Berkshire Hathaway as his “canvas”, and likes to say that he feels like a Michelangelo.

Moreover, sometimes transactional incentives are in fact clearly subordinated to moral incentives. A recent example: six nursery schools in Israel imposed a fine in cash in order to encourage parents who used to be late collecting their children to arrive on time. The result of the measure was somewhat unexpected: instead of decreasing, the delays doubled in number. And they remained high even after the fine was removed. The relationship had changed from the social, personal sphere (“if I delay, the teachers will suffer, they will take longer to get home”), to the transactional realm. The moral cost of the offense became low.

Thus, the design of an incentive system is only successful – that is, when the resultant between the explicit incentives vectors and the different variables that influence the behavior of the agents that are the scheme’s target, points in the desired direction – if it is permeated by a clear set of solid principles and values.

Moral behavior is not exercised by creating ethics committees and drawing up codes of conduct. Hanging the mission, principles and noble values on the wall is also far from enough. Companies need a code of conduct, but one that is tacit, anchored by the reputation and behavior of their leaders.

The environment in which incentives are (re)created and propagated is absolutely crucial for the net result of behaviors not to point in the wrong direction. Very often some explicit incentives are subsumed by tacit incentives, which are undeclared but embedded in a company’s culture.

Social relationships are marked by the uncertainty regarding future reciprocity. The obligations of the parties involved are diffuse and uncertain – they bear risks of defection or exploitation/opportunism. It is our understanding that in any relationship, and especially in long-term ones, the material and financial incentives should be clearly subordinated to broader personal and social interests, and simple moral principles and values, such as honesty, integrity and respect, as long as they are genuinely experienced in everyday life. The logic of the transaction should be subordinated, as a matter of principle, to long-term relations. Always. And this must be unquestionable, not negotiable.

In our view, the best possible system of alignment is for us to select our associates and business partners with great zeal. They should be few and competent, well educated, ethical, and genuinely aligned and committed to our way of seeing things, to our long-term vision. This is far more efficient than trying to “sew up” incentive systems that are real strait jackets and that, at the end of the day, can be escaped from if the alignment between the parties is not genuine, legitimate.

Introduction: DOLUS BONUS

“The iron rule of nature is you get what you reward for. If you want ants to come, you put sugar on the floor.”

Charlie Munger

In the first half of the last century, some of the wealthiest university professors in the whole world were art historians, who earned their living less by their teaching gifts, and more by the strength of their opinions. As experts, they attested to the authenticity of works of art by the great masters, especially the old, classical painters. Their job: to certify that a painting was in fact a Rembrandt, a Rubens or a Titian.

At that time, documental study and technical laboratory analyses were still very incipient, and the attribution of authorship of a work of art was done with the naked eye, based merely on connoisseurship1, a very subjective process which required sensitivity and experience. Some specialists went so far as to smell and even lick the paintings – let’s agree, it worked at least to identify the “Botticellis” produced that same week – but the appraisal of works by means of photos was common practice, especially in intercontinental transactions.

The experts were true authorities. For the appraisal of a work of art, they would receive a commission, a percentage of the sales price that could range from 5% to 25%. Obviously, if they confirmed it as genuine, they would earn astronomical figures. If they belittled it as false or as a work by some other, “lesser” painter, their earnings were much more modest.

Great collectors such as J. Pierpoint Morgan, Andrew Mellon and Henry Clay Frick entrusted the selection of these experts to their dealers.

Competition was intense, and frauds common. Little by little, the tycoons were learning to protect themselves, selecting only the more reliable and experienced as business partners.

Among the dealers of that time, Joseph Duveen was undoubtedly the most famous in the intermediation of works of the great masters in the New York- London- Paris circuit. Through his company, Duveen Brothers, he was one of the protagonists and a great beneficiary of one of the largest transfers of cultural assets of all times: from 1890 to 1929, fast-rising American entrepreneurs, industrialists and bankers took possession, on a large scale, of European cultural treasures. And for the first time in History, not by force of sword or cannon, but by the “invisible hand” of capitalism.

Duveen’s internal intelligence service could be the envy of many contemporary organizations, capable of advising him of the first signs of any fatal illness in the Great Houses of Europe, or of imminent insolvency in the English or French aristocracy, besides always keeping him informed of the secret preferences of American tycoons. The “dealer king” recommended butlers, chamber-maids and chauffeurs to his clients, taking care to keep them on his own payroll.

Duveen had a spectacular eye for art objects (evidenced by the clearly positive outcome of countless legal battles about the authenticity of art objects in which he was involved), but in order to countersign the authorship in transactions involving works of art of the Renaissance period, he counted on the advice of the eminent professor of the history of art, Bernard Berenson, who endorsed pro homine the authenticity of the works in his collection.

Berenson was, in fact, the greatest authority on Renaissance painting at the time, and used all his connoisseurship and reputation as a historian and “independent” critic to validate the authorship of dozens of works of art in support of Duveen. A secret contract with the dealer guaranteed him the payment of a fat percentage for each work sold in the course of 27 years.

One of them, the “Madonna and Child”, was first appraised by Berenson as “in bad condition, without defined origin”, when Duveen acquired it in 1895, and a few years later it was re-classified by Berenson himself as an authentic “Bellini”, allowing Duveen to multiply tenfold the price paid for the work.

The majestic Villa i Tatti, Berenson’s property in Florence, is a most beautiful witness to the degree of wealth he attained through his agreement with Duveen and others. It is important to observe that, in the course of time, several of his ascriptions eventually proved to be wrong, though most of them were correct.

In short, during the formidable “bull market” in the art sector at the beginning of the last century, a real virtuous circle of incentives was closed: the favorable opinion that made the professor rich also endorsed the dealer and the seller. What is more, the buyer was not left out either: with the expert’s guarantee, he became the owner of a certified work of art. To have a “Raphael” certified by the seal of Berenson was worth much more than just a “simple Raphael”. Finally, if we add to all that the tax benefits granted at that time for donations to public collections, we have a true “heavenly feast”.

It was not by chance that the period prior to the First World War was a Golden Era for art dealers, when the prices of some works of art reached levels that would only be seen again in the eighties. Not only was demand high, but also Duveen and his team were always trying to keep the market up by nourishing the rivalry between the legendary Fricks, Altmans and Huntington family with information and intrigue, using the contemporary press with great skill (especially the New York Times).

The similarity between this “virtuous” circle of fees and commissions and the merry-go-round led by brokers, investment banks, rating agencies, investors and companies of the modern world is evident. So is the vast range of misalignments and conflicts of interest inlaid in the model. And if Duveen went so far as to sell the work “Aristotle contemplating Homer’s bust” four times, always pushing the price up, Avis, the car rental firm, has been bought and sold no less than 18 times since it was founded in 1946 – probably handing to lawyers and banks, in fees and commissions, a good deal more than the value of the whole company at today’s price.

With regard to the chain of US sub-prime loans, consumed from Oslo to Bangkok in their re-securitized clothing, or the IPO feast here in Brazil, they are very similar in general lines. With an aggravating factor: the relationships, and the processes of placing, packaging and selling securities, have been “industrialized”. There was a loss in art and romantic style, but a gain in scale and productivity. And simple but powerful ideas, such as “Europe has art, America has money”, may be exploited and geared up today in a much more efficient way – at least for some time.

Systems such as the financial markets, which depend on cooperation and exchange, are founded on a framework of reciprocal trust. Whether working for institutions or for their own account, people must trust their counterparts.

At the heart of the natural credit system, in particular, lie two fundamental aspects: personal reputation and the community. The crucial decision in granting credit is “will this guy pay me?”. It is not just a matter of cash generation capacity, but of character and reputation. The roles played by those who grant the loan and those who take it are important, very important, in the local social network. The purpose of the credit is key.

In today’s financial system, relations between the agents exist more and more on a strictly transactional basis. Technology, interconnection between markets, de-regulation, securitization, and with them the profusion of new, increasingly complex products, which nobody has the time to decipher but everybody wants to consume, have created a gigantic efficiency machine. If on the one hand this efficiency has permitted huge scale “gains”, on the other, it has reduced relationships and credit to their transactional dimension, multiplying the moral hazard exponentially, changing social and local links into pasteurized transactions that are global in their reach but without anyone socially responsible for them. The system’s gears gave us the right to act physically, without doing so politically or morally. There is no “personal” responsibility, reputation cost, when promoting a credit that is going to be re-packed, priced, ratified and consumed very far from where it originated.

Innovations such as mortgage pools extinguish the social element in transactions. Derivatives and swaps too. The direct relation between the person who lends and the person who takes the loan is dissolved. Social pressure disappears. And the result is that, adding the markets’ transactional steamroller to the greed of the agents, geared up by incentive systems where conflicts of interest are obvious and the vigilance of regulating bodies is insufficient and inoperative, Alabama sub-primes end up being thrown outspread out, together with their tranche fellows, reaching remote beaches on the other side of the world, in the hands of investors hungry for higher but guaranteed returns. Credit scores and agencies’ ratings have shown themselves to be very bad proxies, not only for payment capacity (cash-flow), but also for “reputation”.

After being reduced to one dimension alone, limited to its transactional component, credit had its real risk disguised for creditors and borrowers. This, added to the opacity and high leverage of financial institutions with laughable risk controls, and the excessive complacency and credulity of agents throughout the consumption chain, instead of efficiently promoting the much-celebrated transfer, re-distribution and dispersion of risk, ended up contributing, as a catalytic agent, to a real metastasis of the system’s liquidity.

—

Note: Also read Part 2: “On Moral Diligence”

Q3 2008 report excerpts on sticking to one’s investment philosophy

GOING FORWARD

Hungarian writer Albert Szent-György tells an interesting story, immortalized in a poem by Czech author Miroslav Holub.

At the end of the past century, a young lieutenant in the Hungarian army participating in military maneuvers in Switzerland sent a detachment on a reconnaissance mission by the Alps. Time passed by and the unit did not come back. It was very cold and the wind was merciless. The wind chill was getting worse by the minute. Snow soon arrived. Heavily. It fell non-stop for two days. And the detachment was still unaccounted for.

The lieutenant suffered, as he feared for the worse. He had deployed his own unit to a sad ending on the icy mountains.

On the third day, a welcome surprise. The group returned alive. Tired and weak. But safe and sound.

A delighted and curious lieutenant asked: “How wonderful, boys. God be praised! Where were you after all? How did you manage to get here?”.

- “Lieutenant, it was tough. We got lost, night fell and the snow came. We were terrified. We completely lost hope in surviving. But suddenly, one of the soldiers found a map in his pants’ pocket! A true miracle… Of course this calmed us down. We set the base amid the storm and withstood the blizzard. Then it was very easy: we analyzed the map to understand approximately where we were and we headed back here”.

Still curious, the lieutenant asked to see the map and analyzed it calmly. After looking carefully, he shouted: “Boys, this is the Pyrenees map, not the Alps…”

There are many ways to interpret this story. The one we deem most interesting to our goals is quite simple. At critical moments, when we quickly need to give pragmatic and effective meaning to situations that are new and potentially adverse, it is far more important to have “a” map on hand than “the right” map.

First, due to the peace of mind and calm that the “map” brings us, preserving our rationality and preventing us from hesitating when we need a clear mind in order to act – or even wait.

Second, because old, familiar references work very well as a starting point from which we build a new intelligibility, setting the route. This happens because of the leads that the new environment offers us, and the answers we reap by gradually interacting with the new surroundings.

The “map” is the base on which we let our “contextual intelligence” flow, making sense of cues brought by the new environment.

(…)

At IP, we are lucky to be able to draw on a simple “map”, which we take off our pockets on each and every occasion. Or better: it is usually more efficient in moments such as now, when the rationality of a battered and bruised market simply wanes.

Independence. Rationality. Patience. Discipline. Conservativeness. Long-term horizon. And the mandate to buy stakes in good businesses that have honest and competent managers, requiring a discount, a significant safety margin compared with its value. It can’t get any simpler.

In the words of Seth Klarman, the manager of Baupost Group and whose simple and to-the-point book “Margin of Safety” we recommend for those who do not mind spending $1,200-1,500 on it at Amazon or eBay (for this reason, it is the most-frequently stolen book from U.S. libraries):

“Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. (…) By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor – room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies.

Following a value approach won’t be easy for everyone, especially in today’s media- dominated, short-term oriented markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk averse strategy in a world where nearly all of us are, or should be, risk averse.”

In extreme situations, it makes all the difference to have very clear principles coupled with a simple, hands-on philosophy executed with discipline.

(…)

But every crisis has new components, and this one is no exception. This time there’s an aspect that makes it quite different for us as well: there’s no clear macro- economic model to be aimed at. It’s not like derailing emerging economies struggling to emulate the US. It’s the US drifting, and some of the core assumptions of its model shaken to the ground.

This is the closest we’ve got to the end of the world as we know it, at least from the investments stand point. Not because of the price swings or panicked faces, but because it exposed the systems flaws to a degree that makes it very likely that fundamental global changes will be made. That’s always dangerous territory, as for the need for change doesn’t necessarily comes attached with good solutions. A statement attributed to Venezuela President Chavez illustrates the risks we fear the most: “I nationalize strategic companies and get criticized, but when Bush does it, it’s OK.” Our take: really nasty people can build self-serving arguments and sell them to the masses under current circumstances.

And in addition to the expected increase in regulation in general, several of the traditional “ism’s” may stage a come back, haunting us. Interventionism, nationalism, protectionism. As well as beligerence. And we sould always keep in mind that regulated economies have also shown us their flaws and limitations.

It became crystal clear that markets didn’t work that well after all, although many will continue to defend the Efficient Market Theory, use VAR and to reel off Greek letters, just as some people still believe in witchcraft and other more controversial super-natural forces.

The better analogy we can come up with is the fall of the Berlin Wall. An era is over, the task is daunting. The world order will be revamped. The US will have to consume less and produce more, in a major way. We’re talking culture here. The financial system, a central cog will have to be redesigned, rebuilt and booted. The “awe” factor of the crisis here is a plus, but it is still likely that it will take time. The world map has changed.

The Western world lacks leaders with standing and clear, sensible vision. (…) All in all, it’s indeed difficult to coordinate a group when interests diverge, governance is terrible and the interdependent elements do not even share an understanding of how and to what extent they are interdependent.

Europe tries to sketch a coordination effort. But it seems a rather fragile institutional arrangement. On the other hand, Putin and the Chinese clearly are on a roll. They certainly can lead, but how good would this world be for “us”? And will the new US president be up to the task?

Most prices have come down. Sharply. Most deservedly so. The probability of tax increases in the US has gone up, as well as the magnitude of them. Production and consumption are likely to be rebalanced in a global level. A slowdown seems inevitable.

(…)

Zooming in on Brazil, besides the global drag effect (we don’t subscribe to decoupling – we believe globalization is inevitable, for good and bad) some corporate governance issues arised that unfortunately confirmed our fears that we’re still in stage 4 or 5 (at the most) of a 10 stages race.

(…)

SO, WHAT SHOULD WE DO?

As we lack a new “map”, we took our old one off the pocket.

Self-servingly enough, we believe the best solution is to have shares in the best managed companies, preferably high on intelligence, brands and systems. Asset light and nimble, and yet “entrenched” in their economic moats. There’s the obvious risk that we’re behaving like the man that only has a hammer: everything is treated like a nail. But our reasoning goes like that: those companies seem more likely to continue to generate returns in the new order, whatever it might be. It is way more difficult for governments to seize/run/tax them. They’re more fluid/mobile. They have revenues in multiple geographies and currencies. They depend less on discretionary credit. They are needed.

We choose to invest in “inevitable” companies. Businesses that do not need much capital. And have robust balance sheets.

In this credibility crisis that is affecting from banks to governments, companies to currencies, to enjoy some diversification through companies with solid franchises and competitive advantages and the capacity to make money in any new order is extremely desirable. When we can do it at attractive prices, it’s a no-brainer.

(…)

CONCLUSION

The ongoing world crisis, whose magnitude is unprecedented and whose effects are still uncertain, laid bare the excesses and the vulnerability of the capitalist system as we know it. Throughout this year, more than 10 large financial institutions worldwide, boasting venerable auras and grandiosity, proxies of stability and safe havens for many investors, died along the way. The crisis of confidence that ensued helped remind us how much the independent asset management model, when alignment is truly enforced, enables and strongly reinforces the possibility of choosing among counterparties.

FORGING AHEAD

Our “map” to traverse the coming periods is the same one we have always had. It is neither mind-blowing, nor creative. It is widely disseminated, and without any glamour.

Again: Independence. Rationality. Patience. Discipline. Conservativeness. Long-term horizon. And the determination to buy stakes in good businesses that have honest and competent managers, exacting a discount to their value. It can’t get any simpler.

In times like these it is easy to single out severe distortions as international capital flows, de- leveraging, redemptions and forced sales lead prices to disconnect completely from the value of assets. But it does not mean we will rush in. The moment calls for caution, provided that the dominance of these technical and psychological factors may leave things even more interesting for patiently-waiting investors.

But it is too naive to think that the market will surge when things start to improve. Price formation has to do with the balance between supply and demand for assets, and not with present results. And some of today’s prices already discount far more than the drop in forecasts for results. Thus, why shouldn’t we act?

What a legitimately scared market considers a loss, we see as an opportunity to exercise one of our very few (if only) but decisive competitive advantages: time horizon arbitrage. For those worried about the coming quarter, half-year or year, the uncertainty that we are witnessing is just unbearable. Not to mention that in true copycat fashion, being sensible now equates to selling at any price. It really seems that the “map” guiding everybody was printed backwards. At the best time to invest, they disappear.

(…)

We are witnessing a very delicate moment for the world. But by looking through the perspective that interests us the most as investors, we may be facing a historic opportunity to buy exceptional assets at very attractive prices. This is usually the seed of expressive compounded returns in the future.

Our proposition as an asset manager is to diligently invest the assets of third parties (and our own too) without being worried about consistently producing, year-on-year (much less month-on-month), the greatest returns in the industry or offer the smallest volatility in the market.

Our goal is to offer high absolute returns in the long- term, above the cost of opportunity of our investors, but always adjusted for the risk we are willing to take. And as our longtime investors know it, our vision of risk is much broader than the idea of “volatility”.

We see in the diligent search for great distortions, instead of leveraging, the best way to seek long-term results with low risk. In Buffet’s own words: “I like to shoot fish on a barrel. But I like to do it after the water has run out.”

Today and during its 20-year existence, IP remains bound by its values of rationality, ethics, discipline and conservativeness. And that is how we are going to manage the company and the funds in these new times, sure, as usual, that in order to arrive first, you need to arrive.

Q2 2008 report excerpts on investment analysis

A GOOD INVESTMENT ANALYSIS IS NOT PRECISELY AN “ANALYSIS”. NOR “INVESTMENT-RELATED”

(…)

The widespread impression that persists is that even among value-oriented funds, to assess investments consists essentially of systematically applying a pre-defined set of routines and mechanisms, with special emphasis on building complex financial models which, mired in naïve scientism, confuse and disorient more than they reveal.

(…)

Many seem to believe that valuing a company diligently consists of setting young men who have recently graduated or concluded their MBAs to read prospectuses, half a dozen annual reports and the same amount of conference calls, to talk two or three times with the company’s management, ask about their “sustainable competitive advantages”, apply Porter’s 5 strengths model, and the grand finale: process a discounted cash-flow model, making a cut of 10 to 15% in the management’s projections in order to avoid, of course, potential “execution errors”. To lend an even more “professional” aspect to the process, one adds to this basic “conservative” scenario another more optimistic one and a pessimistic one, and – voilá, the cake is ready.

In our experience, evaluating investment opportunities is not limited to this type of mechanical proficiency. It does not assume training by means of analysis manuals and “kits” that, once learnt by heart, are applied on an industrial scale by anyone, as the occasion dictates. This “pasteurization” leads, in the best of cases, to consensus, to the average.

After all, “analysis” does indeed involve discipline, sweat and hard work, but it is more finesse and interdisciplinary integration than brute force.

Evaluating investments is a much broader, richer and more interesting process than the idea evoked by the word “analysis”.

“PASSIVE” ANALYSIS

In the first place, any “investment analysis” process starts well before we have even selected an asset as the object of evaluation: it happens every day, every second, in a “passive” manner, without our intervention. After all, every new stimulus or item of information we receive daily only makes sense when it fits into a pre-established network of beliefs, values, myths, and mental models, which we have built slowly in the course of time. When we encounter the “new”, our conceptual frameworks, truths and prejudices “arrive before us” and fit this marginal information into themselves.

This discovery brings important consequences: if we know a priori that we only succeed in giving meaning to the “new” when we fit it into the patchwork of values, frameworks and previous experiences that we gather throughout our lives, we have the obligation, the responsibility, to build and renew – pro-actively, day after day – this network of mental models and experiences, so that we are better prepared to know, at the proper time, how to give a practical meaning, rapidly and precisely, to the most varied business situations that may appear. Considering that, from the perceptive point of view, you only reap what you plant, the solution is to plant all the time.

In short, given that part of the “analysis” is carried out passively, we have the responsibility to turn the game around, playing an active and vigilant role in forming our perceptive and interpretative apparatus.

In this context, it is fundamental to be pro-active in seeking new and exclusive sources of information, in building and nourishing high-level relationships, travelling to see the evolution of the industry in other countries and to better understand the movements in the supply chains at global level, reading voraciously about many different subjects, and so on.

ANALYSIS AS A SYNTHESIS

The etymology of the word “analysis” leads us to the meaning “to separate a subject into pieces and understand the inter-relations between its parts” or, in a wider sense, “to examine with care”.

However, paradoxically, the desired output in an investment “analysis” process is in fact, a synthesis. What is sought is an ingenious, clear and well- structured re-combination of a collection of information and judgments gathered from different sources, into a “whole” that enlightens with clarity the process of deciding whether to buy or sell an asset.

That means identifying, after research that is often exhaustive, two or three key points that clearly define the reasons for a distortion between the price and the value of the asset under analysis.

Just as in traditional, empirical research, the process of conceiving and formulating the key hypotheses to be verified requires perspicacity, imagination and creativity.

ANALYSIS AS A NARRATIVE, INTERPRETATIVE ACTIVITY

To “analyze” is to manipulate concepts, to reason in an abstract manner. To produce meanings, build stories, raise hypotheses. A good investment case is, in general, only a simple story, with a plot. And a clear conflict as its focus point: the market’s consensus view against the analyst’s alternative view, that is, the distortion between the price and the perceived value of the asset.

ANALYSIS AS AN ACTIVITY OF AN ADVERSARIAL AND INVESTIGATIVE NATURE

Investment analysis is, from beginning to end, an eminently investigative process. A good analyst starts from a hypothesis – or from a set of them – and pro- actively seeks both confirmatory and disconfirmatory evidence to assess the strength of his “thesis”. With the same impetus. He is not satisfied with easy answers: he pursues the necessary information wherever it is. Provided it addresses a key point of the analysis, the more difficult it is to obtain, the more valuable and exclusive the information.

Analyzing an asset in a diligent manner sometimes involves interviewing shareholders, managers, clients, suppliers and employees of the company in question.

Obviously, each of the persons involved – especially the managers – is not exactly in line with us. It seems obvious that this should be considered in an “analysis”, but it is not. Even experienced analysts let themselves be influenced by the contagious optimism of an articulate and well-prepared CEO, by the enthusiastic statement of a good CFO.

In our experience, it is a crucial part of an analysis process to profess skepticism when one is presented with any information, regardless of the origin. There is no neutral information.

But it is one thing to make contact with these agents in order to meet a schedule and tick off the items on the due diligence worksheet. It is quite another to see these interactions as opportunities to test hypotheses, confirm or discard evidence, raise new questions. And to an experienced analyst, the key questions are those picked up on the spur of the moment.

More senior analysts not only make this kind of visit after preparing well, in advance, but also know that each interaction represents an opportunity to produce an important, decisive insight.

As Ken Fisher says regarding his legendary father, Phil, in the excellent foreword to the classic work “Common Stocks and Uncommon Profits”:

“In looking at companies, he always prepared himself in advance before meeting the management (…). He always wanted to be prepared and he wanted the company to know he was well prepared so they would appreciate him”.

“But his very best questions always popped out of his mind, unprepared, never having been written in advance, because they were the angle he picked up on the fly, as he heard the answer to a lesser question. Those creative questions were the art. It is what, in my mind, made his querying great.”

“The art is to get more questions – and the right questions – flowing from the answers you receive to prior questions. I’ve seen people who rigidly run down a standard question list, regardless of the answers they get. What question best flows from the answer is key. And so on. When you can do that on a real-time basis, you are a composer, an artist, a creative and investigative investor”.

CONCLUSION

The “investment analysis” process, as we see it and try to put it into effect at IP, is more complex, far-reaching and stimulating than may seem at first sight. Strictly speaking, it is not even just “analysis”, nor just “investment- related”. And it starts clearly with a choice: to adopt, a priori, an active, skeptical and vigilant posture in relation to information and knowledge throughout the process.

And the cost of this constant vigilance and continuous preparation, which is paid well before reaping the benefits, is quite high. But in respect of “investment analysis”, this is the path we have chosen to follow.

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”.