The key point Mr. Loyola touches on is the lack of accountability of our congressmen. There are very little “checks and balances” in the current system other than the elections themselves.

Another key point, and something we will never get tired of saying, is that one cannot forecast that the good times will go on indefinitely and assume that one can increase costs because the income is rising, incur in debt, and so on. There are always downturns, and they are made more troublesome precisely because one has loaded up the costs before the income melts away. This is an ages-old, proven concept that is apparently extremely difficult to accept and work with, and one doesn’t get more popular by saying “calm down, let’s save up instead of spend away our new-found wealth” in politics – yet that’s precisely the commendable conduct.

We try to do it with our money, which is invested alongside our clients’. It tends to make us go up less than the market in euphoric times, but it also tends to dampen setbacks when things go south. “To finish first, first you need to finish”.

The truth is that it’s way too early to assess the full effects, but analysts are already throwing around conclusions. When one thinks about it, most of the reform’s effects will happen after 2014, longer than most people’s investment horizons, which means most investors are either ignoring reform or using it as a means to speculate. Fixed income markets may be looking at greater future fiscal deficit, but haven’t acted on it yet.

IP’s position has always been to recognize our own ignorance and try not to depend on particular outcomes – without neglecting selective Healthcare exposure. We’ve chosen diversified companies over time, whose business is much more associated with a “picks and shovels” theme (such as Thermo-Fisher) or those in which there’s a strong consumer brand poised to benefit (such as Johnson & Johnson).

About the bill in general, politics can be a very volatile field – it’s a governance conundrum one could be happy to stay away from. The long debate on health reform ended with what seems to be a hard outlook for some health plan operators, but a broad tailwind for the general industry: plan coverage, by various means, should increase substantially going forward (estimated 32mm new enrollees over 10 years).

Large pharma companies are, at first, picking up the bill for the entire drug value chain (US$90 Bi fees over 10 years), which makes research equipment providers (upstream from pharma) as well as drug distributors (downstream) prone to benefit from increased coverage without a significant burden. Over time these fees should flow along the chain and, ultimately, to consumers.

The numbers that matter: US$ 131Bi in equity, US$ 62Bi in float => ~ US$ 193Bi in “capital”. Book value grew 20%. Float grew 5.8% (from US$ 58.5 to US$ 62Bi). All insurance businesses operated with underwriting profit again. Cash = US$ 30Bi (US$8Bi used in Q1 to pay part of the BNSF deal). Operational assets = US$ 30Bi but generated only US$ 1.1Bi in net profits, which shows insurance/investments did the heavy lifting. The operating units will hopefully make up their fair share of contribution in a recovery.

Bottom line: investors are still paying about capital value at current prices. It has the best governance we ever saw. If they continue to grow float, have underwriting profits and make good investments, it’s a steal. Never mind the recovery.

Enter Greece and other European “peripheral” countries. Investors are finding it hard to simply exit “crisis mode” after the traumatic events of 2007/ 2008. We won’t fall into the trap of discussing Macro issues – not our core skill anyway – because the main issue here is that volatility, that friend of the long-term investor holding a lot of cash, is on the rise. This post collects some very interesting articles by the Financial Times on the subject of Greece’s (and Europe’s) woes, just as food for thought.

Why the Financial Times, a paid source? Because it’s the best coverage of European markets and economies. We highly recommend this source.

LINKS:

Greece part of unfolding sovereign debt story – Jan. 29th, 2010 – Mohamed El-Erian, CEO of PIMCO (world’s largest bond investor) discusses the EU’s options in light of the Greece situation. The major takeaway is that there is no easy solution, and therefore no solution without its scares and fits of panic.

Tipping the scales on global rebalancing – Feb. 2nd, 2010 – Bond investors are increasingly jittery and why the US and Asia seem safer than Europe.

Medicine for Europe’s sinking south – Feb. 3rd, 2010 – Economists Nouriel Roubini and Arnab Das write about how Greece is the front line of a larger battle for European stability – and again the tone is pessimistic since no easy solution appears in sight.

EC: A toothless regent in Greece? – Feb 3rd, 2010 – FT’s Money Supply blog on the obviousness of how the European Commission’s lack of powers ultimately leads to situations such as Greece’s. Will these debacles lead to increased scrutiny and – more necessarily – intervention?

Record volumes for sovereign CDSs and Portuguese bonds hit as Greece fears ease – Feb. 4th, 2010 – Greece’s plan is greeted with skepticism and pragmatism – bond investors have apparently decided that the next country in “the line of shame” is Portugal.

We don’t have any intention to be the “ultimate source for all things Buffett”, as a lot of people already do a great job at this and we thank them for uncovering these pearls. But this video is special. The parts on “moats” add up to some of his most detailed comments yet on the subject.

We don’t think it’s any exaggeration to say that Buffett has transcended the investment realm and that this is interesting for people in all walks of life. We’re certainly making backup copies.

Price is the key, and many investors forget that it’s not enough that the business is great and the managers competent and even that the company has the “outside signs”/ usual “seals” of corporate governance or credit ratings – or even environmental best practices – when it comes to estimating a range of values… Corporate governance and alignment must be great in the real world. Unfortunately, that is very hard to find and hard to quantify, so those seeking algebraic approaches to long-term investing do so at their own risk.

Which takes us to “Anti-portfolio one”. This comes courtesy of a reader who was discussing precisely the issue of price with us a few days ago. Then he found a pearl of an article in the New York Times dated February 20th, 2000 – the peak of the Internet/ Nasdaq bubble – where a few managers listed their chosen stock to own until January 1st, 2010. That is, if you could own only one stock from early 2000 for the next ten years, what would it be?

The answers are interesting because a few of these companies haven’t survived, one was the object of a major accounting scandal, and so on. But we don’t want to focus on the companies themselves, but on the reasons given, the “case” made at the time. The arguments, especially regarding the earnings multiples at the time, seem preposterous and could be dismissed as “bubble talk”, but recent years have proven that we don’t learn this kind of lesson easily… And we go back to the point of price: yes, multiples can be misleading, but regardless of the measure, the price you pay has to take into consideration that even the best-planned strategies executed by the best managers can go wrong in too many ways.

In the other corner, “Anti-portfolio two” was found by our Healthcare analyst when he was researching a relatively newcomer to the sector and found that traditional VC firm Bessemer Venture Partners was one of the seed investors. The firm itself built an “anti-portfolio” section in their website that, well, has to be seen to be believed – and still Bessemer has done quite well… This example is about what Buffett calls “sins of omission” – he often mentions Wal-Mart, which he tried to penny-pinch and ended up losing “Billions” over time as the company became the behemoth it is today.

Finally, we’d like to thank our reader and urge others to follow his example! As always, send us your suggestions via the e-mail editor@buysiders.com .

Here’s the video, all 65 minutes of it:

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”