Institutional investors enjoy privileged access to the CEOs of listed companies and most investors who do not have such access envy these mighty fund managers. However, it is not obvious to me that access to management is an unalloyed positive for investors. In our interactions with management teams over the last couple of years, my colleagues and I have run into four sets of issues.
Deceived by the CEO’s overconfidence: CEOs tend to have a highly developed sense of self-confidence. Whilst this has its advantages, it also engenders a sense of overoptimism as a result of which the CEO genuinely does not appreciate just how difficult it is for his firm to deliver on aggressive promises. An example today is in the power sector where over the past 3-4 years numerous companies have been floated on aggressive generation timetables. Despite our power analyst, Bhargav Buddhadev, repeatedly documenting that in India: (a) delays in the commissioning of power plants is the norm; and (b) implementation challenges with Chinese power generation equipment is the norm, most CEOs we meet refuse to acknowledge either of these issues.
In fact, the Duke Survey of CFOs has shown that this is not a problem restricted to India – in the US 100% of managers are 100% of the time more optimistic about the prospects of their firm than they are about the economy. The danger for investors who meet such CEOs is that they fail to assess downside risks properly.
Overawed by authority: in the wake of World War II, the American social psychologist, Stanley Milgram, wanted to investigate why so few Germans stood up against Hitler’s anti-Semitic policies. Milgram devised a celebrated experiment in which he invited his subjects to administer electric shocks to pupils if the so-called teacher (a person wearing a white coat and carrying a clipboard) indicated that he was unhappy with the pupil’s performance. The subjects could administer shocks to the pupils ranging from 75 volts to 450 volts (i.e. a fatal shock). Despite being shown no proof of the teachers’ actual qualifications and despite not being put under any pressure to administer the shocks, 85% of Americans were willing to administer shocks up 285 volts. Milgram concluded that authority exudes its own power which most of us find hard to defy. Now, replace the man in the white coat with a real CEO who has fame, wealth and experience. Indian CEOs understand the impact that this dynamic creates and exploit it well.
Done in by “confirmation bias”: numerous studies show that most of us interpret facts to fit our version of the world and to justify the positions we have already taken. Most investment professionals are time constrained individuals who would have already devoted time & effort to researching a company before meeting management; in fact many fund managers meet management after having decided that this is a stock they like. Hence for a time constrained fund manager, a meeting with a charismatic, confident CEO could result in the fund manger interpreting the meeting to suit his established hypothesis.
Lied to: When I began my career in the UK, I used to think of CEOs as the modern day answer to snake oil salesmen. After a couple of years, I realised that most of the time, CEOs are not lying – their overconfidence leads them to sincerely tell stories. However, sometimes CEOs are economical with the truth. The problem is that most of us are poor at identifying liars. Kassin, Meissner and Norwick ran an experiment in 2005 which showed that both ordinary civilians and police investigators were poor at spotting lies. DePaulo, Lindsay, Malone and others pointed out in 2003 that the majority of the body language signals we use to identify liars (eg. someone who avoids eye contact, is fidgety and gives irrelevant information) have no correlation at all with whether people are telling the truth or not!
So can investors get the benefits that arise from meeting management whilst minimising the negatives highlighted above? The answer lies in meeting “sector experts” who do not work for listed entities. These could be either consultants to that sector, regulators of that sector, retired managers from that sector, suppliers to and consumer in that sector or experienced journalists specialising in that sector. Not only will these experts have less of a vested interest in selling a “growth story” to you, they are also more likely to give a balanced picture of the risks & rewards facing the company.
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