Asimov’s laws of investing
On investors adopting a do-no-harm and prevent-harm mindset, like Asimov's robots
How should investors engage with their investee companies? With sincere apologies to the great Isaac Asimov, I tweak his Three Laws of Robotics to fit the topic at hand:
1. An investor may not harm a company or, through inaction, allow a company to come to harm.
2. An investor must not second-guess judgment of managers except when in conflict with First Law.
3. An investor should protect his interests by exiting, if above laws are irredeemably violated.
My original inspiration for these laws arose from private equity, where I spent a few misguided years. Promoters who swallowed the private equity pill experienced a particularly severe side-effect, called value-add. Recently minted MBAs, usually emboldened by a stint in consulting, doled out copious advice on how they were running their business all wrong. While seasoned promoters mostly ignore such pipsqueaks, taking money from someone makes it harder to tell them to self-fornicate. Investors nudged promoters to prioritize growth over quality, under false hope that this would compensate for overpaying in an auction. Value-add has transitioned many a company from a fine focused franchise to a confused, diffused mess.
While public market investors may not have the same clout, they aren’t immune to the same intrusive tendency. I’ve been in cringe-worthy meetings where an equivalent investor confidently advised long-standing managers on the following lines:
· Focus-group of one: “You should really launch lemon flavour”
· Management by looking around: “Up ad-spend. I didn’t see your ad on CNBC last night”
· It’s only money: “Why all this manufacturing? Just buy from China. “
· Easy answers: “Struggling with exports? Do M&A in Europe, like that other guy”
· Sweeping anecdotes: “I did a call with someone. Your quality sucks”
At one level, even annoying investors are harmless if managers entirely ignore them. In reality, it’s hard for even the most secure managers to fully cut out persistent noise. First level of harm is business drift and distraction. Companies’ focus gets nudged away from a proven path chosen by experienced insiders. At the least, some short-termism creeps into management thinking. Second level of harm is the crying wolf effect. Nagging dents investor credibility so much that when real harm arrives (say, large M&A), investors aren’t taken seriously.
Assume that we’re dealing with a business with a decent track record, run by experienced, trustworthy managers (if not, real problem lies elsewhere anyway). Investors are better served with an inverted objective function: do no harm. Occasionally, stretch this to: prevent harm. Choosing between these two depends whether the topic at hand lies within the core or outside the core.
In matters pertaining to the core business, investors have no active role. Management is best qualified to make judgment calls, on both operating and strategic issues. They have also earned the right to re-allocate capital to grow the core and incrementally invest in adjacent areas. Investors are best served by (1) understanding management’s approach and (2) independently tracking if this approach is delivering results over the medium-long run. On occasion, such tracking may reveal slip-ups, even in a well-run company. Even then, an investor’s primary role lies in recognizing the problem and gauging its severity. Fixing the problem is entirely in management hands. Since no business progresses along a smooth path, investors should allow enough time to distinguish temporary blips from lasting troubles. At the extreme, if the core seems irredeemably problematic, an investor simply follows the third law listed above.
Outside the core, counter-intuitively, roles are reversed between managers and investors. Management may not automatically possess superior judgment in a new domain. They may even be the overconfident ones here. Since surplus cash (partly) belongs to investors, they have some say in its deployment into new areas. Even with less domain knowledge than management, an investor might just have a wider and wiser perspective. An ‘outside view’, built from observing thousands of companies over decades, can beat an ‘inside view’ when it comes to unfamiliar terrain.
The concept of an ‘outside view’ is one of the most critical constituents of sound real-word judgment, whether in investing or otherwise. An outside view approaches every problem along the following lines. First, the problem at hand is neither new nor unique, but an instance of a class of similar problems. Second, odds of success for the class are known (and, in this case, poor). Third, opportunity cost, due to reduced focus on core, further worsens odds. Lastly, some general principles can be derived. Let’s delve deeper.
Every good business comes with a curse: more cash than the core can reabsorb. The problem of finding use for this cash is far from new. By definition, this cash can go to a venture outside the core or be returned to shareholders. Most companies attempt the former, before reconciling to the latter. Without incumbent advantages, even storied management has no inherent advantages in a new domain. New ventures, whether organic or inorganic, have yielded terrible results in the past. Acquisitions fail over two-thirds of the time. Diversification into an unrelated area essentially has same odds of success as any start-up. Further, senior management attention gets diverted from the core, making it fall well short of its unhindered potential. Since the core of a good business is very valuable, even a small weakening in its compounding does way more indirect damage than direct damage from the risky new venture. This bleak ‘outside view’ can be more apparent to objective investors than to passionate management. Effectively framing this outside view to prevent or limit harm is the #1 value-add an investor can provide.
What general principles does history offer on venturing outside the core? Ideally, don’t. If you have to, view it from a perspective of limiting downside rather than achieving upside. Ask the question: even if it blows up, how can I keep my core unscathed? Answer: keep it small, organic and closer home (geographically & philosophically). Fund it with equity, not debt. Keep doing post-mortems, to contrast results with projections. You’ll (finally) realize the superiority of simply returning money to shareholders through regular dividends and occasional, opportunistic buybacks.
More than the details, investors’ basic philosophical orientation is key. A value-add mindset of an outsider trying to improve the core is highly counter-productive. I’ve seen investors so engrossed in adding value that they failed to stop their companies from ruinous government tenders or disastrous acquisitions. With a do-no-harm mindset, investors only try to swat away distractions, keeping management doubly focused on strengthening the core for the long run. You’ll do amazingly well, by merely doing no harm.
(Originally published in February at https://www.linkedin.com/pulse/asimovs-laws-investing-anand-sridharan/)