Sunday, June 9, 2013

The Institutional Imperative

The Institutional Imperative

What is the institutional imperative and why is it important?  This is a term that is often attributed to Warren Buffett.  In The Warren Buffett Way by Robert Hagstrom Jr., Buffett is quoted as stating that the institutional imperative exists when “(1) an institution resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”  The urban dictionary simplifies this by describing the institutional imperative as “any company’s inherent propensity to do dumb things (or avoid smart things) simply for the sake of doing them.” 

The reason I bring up the institutional imperative is because of what I wrote about in the last post with the Contrarian Manager strategy.  If it is such a great strategy why don’t more institutions implement it?  One reason would be that, unfortunately, the institutional imperative is alive and well in the investment management industry.  Many investment companies are not led by investment people, but by sales and marketing people who put an emphasis on what is selling right now and what is hot.  I’m sure there are some good leaders with a sales background in the investment industry; I just haven’t met one yet.  I have met people with a strong investment pedigree that never-the-less ended up being all about sales.  Salesmen and women want to use 4 & 5 star rated funds or popular types of funds because that is what sells.  Their focus isn’t on the client or investment returns, but on selling whatever they can.  Intelligent investment personnel realize that star ratings measures past performance, that markets have cycles, and that a fund that is rated 5 stars today is likely to be 3 stars in a few years.  Good investment firms understand that if a fund is 5-star rated today that means that everything has went right for that fund in the past, so the chances of doing it again over the next 3-5 years are slim.  High-quality institutions will ignore star ratings as they are not a good predictor of future performance.

Another reason is “what if the strategy doesn’t work right away?”  The Contrarian Manager strategy is used to increase the odds of succeeding, but it doesn’t mean you will succeed.  If it goes badly then people may say “why would you invest with a manager that clearly lost his mojo” or “everyone can see why that wouldn’t work”.  Going against the crowd can be difficult especially when something doesn’t work out right away.  For an institution they don’t want the reputation risk.  Think about a manager that wanted to own AIG after it crashed or BP after the oil spill.  People hate(d) these companies, so owning them is certainly going against the crowd, but both would have been good investments if bought/sold at the right valuations.  However, if they wouldn’t have worked out well just try explaining why you held a company that everyone hated and “knew” was a bad investment.  Try to explain why a manager you hired would own these companies.  The reputation risk can be difficult to bare.

Sometimes institutions get caught up in the moment as well.  A company I used to work for held the Fairholme fund in two separate strategies in 2010.  At the end of 2010 I was able to convince the group to completely sell out of the fund in the smaller strategy, but it remained in the larger strategy.  In 2011, the Fairholme fund lost about 32% when the S&P 500 was up 2%.  At the end of 2011 I was able to convince the group to add the Fairholme fund back to the smaller strategy, but was unable to convince them to even maintain its weighting in the larger one.  Instead the group decided to cut the allocation in the larger strategy in half, despite my objections.  The argument was that the volatility and amount of underperformance was too great.  The amount of underperformance was one of the reasons to add it back to the smaller strategy and in my experience returns trump volatility as volatility can actually be your friend.  In 2012, Fairholme was up about 35% which almost beat the S&P 500 by 20%.  In the end it was the clients that were hurt as the investment group followed the herd, on the larger strategy at least, keeping a manager after great performance and selling them after poor performance. 

Just like individuals fall into many behavioral traps, investment firms tend to fall into the institutional imperative trap.  I’ve been involved with a company where just about all the people understood that the company had major issues that needed fixed, but inertia dominated and change was almost impossible to accomplish. Another firm was dominated by sales people who made foolish investment choices.  Another firm seemed to make decisions based on internal politics.  So, when thinking about the institutional imperative it not only applies to individual businesses that you may be analyzing, but is also something to consider when you are purchasing a mutual fund, hedge fund, or hiring a financial advisor.



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