A large part of my professional survival revolves around not getting suckered. By charlatans. By stories. By charlatans bearing stories. I am not only referring to dodgy promoters. I include well-meaning folks who take a cut out of my activity or peddle opinions for a living. While it helps to have a sceptical orientation, it’s far from adequate. Low gullibility has to be woven into a process, rather than be a happenstance of a personality type. I can’t be a perma-cynic either, as occasionally, the right answer is to believe in something good. What’s needed are actionable guidelines that incorporate an appropriately sceptical lens into an investment process.
Since our impressions of people are notoriously unreliable, the answer lies in judging track records instead of people. While this appears straightforward, it can get tricky. Avoiding pitfalls requires us to parse a track record so as to separate skill from luck and controllable from uncontrollable. As we’re using the past to judge the future, we have to catch achievements that are ephemeral, if not outright fake.
First, track record over people
This may sound odd, but I don’t evaluate people. Certainly, not in isolation. To not get suckered, a key mental switch is to judge people on how they’ve done rather than on how they seem. I judge management only by the businesses they’ve built. This is surprisingly hard, as buggy humans are wired to weigh moving stories over boring statistics. Especially when it comes to listed companies, everything I need is in public domain: return on capital, balance sheet quality, cash flow, competitive position, risks taken and not taken, treatment of minority shareholders. It’s criminal negligence to take a meeting, let alone form judgment, without studying delivered track record in depth.
In a messy world, it’s impossible to isolate causality and truly figure out why someone did well. Oftentimes, business success even over the medium term is due to cleverly hidden luck: favourable environment, upcycle, benign input costs, accidental events, windfall profits, competitor missteps. To distinguish skill from luck, there’s no substitute to giving time. Lots of time. My preferred time-scale for track record isn’t years but decades. Over a long enough time-frame, luck and external factors tend to average out, leaving a track record that’s meaningfully reflective of competence.
Absolute numbers are misleading, as context matters more than people. It’s way easier to make money in some industries than in others. A bottom-quartile IT-services firm earns 30% return on capital, while a top-decile construction firm struggles to reach 10%. Similarly, declining franchises may still churn out optically impressive numbers while losing market share every year. These eroding ‘rent’ businesses face significant headwinds to long run compounding which aren’t apparent in their absolute performance. The best judge of managerial competence is ‘alpha’ within its industry. Has the company consistently outperformed peers, not merely in terms of gaining share or making money, but in the manner in which it has gone about the same. The company in question should stand out among its peer set, on both input and output metrics. Since performance within an industry is way more controllable than performance of an industry, a relative orientation helps isolate how management did on controllable factors.
Absence as evidence
Two of investing’s most important criteria – risk and values – are better revealed by what was not even attempted than by what was done. I consciously study a management’s considered inactions, especially where they deviated from that of peers. Management that has been singularly focused and avoided M&A deserves bonus points in a neighbourhood where the rest went batshit crazy. Knowing which consumer durable brands stayed away from a large government tender is quite revealing. As is not herding into fashionable but ruinous segments. Red lines that weren’t crossed, despite peer pressure, are a true certificate of character. This applies to investors too. I am most proud of landmines that I consciously avoided.
Most important, a sense of internally consistency
A track record, by itself, is necessary but not sufficient. There’s no assurance that it’s either real or sustainable. To bridge this gap, we need a filter that’s quite fuzzy. Genuinely good businesses just make sense, all around. Everything neatly fits. Financial track record feels internally consistent with a host of qualitative factors such as people, reputation, behaviour, communication, conservatism, competitive position, industry nature and how this business differs from peers. Even within the numbers, there’s a feeling of consistency across balance sheet, capital structure, working capital, self-funded growth, dividend policy, capital allocation, cash flows and P&L. No warts or sore thumbs. Comfortably passes the smell test. An anomalously impressive track record is way more likely to be Madoff than Bradman.
Lastly, fit between people and paper trail
I am not entirely averse to meeting people. I am only averse to using meetings as the primary basis to form an impression. After forming a view based on holistically assessing track record, it is useful to meet the people behind the numbers. My most common reaction after a meeting isn’t “Wow, whattay CEO”, but “Fits. Nothing new.”. The idea of a meeting is to confirm this last leg of internal consistency. When I have a great track record and a so-so first impression, I usually ignore the latter. If I am forced to skip a step in this list, I’d skip the meeting.
I get impressed by people, indirectly. By what they’ve achieved over a long period of time. By their achieving it in a manner that I am comfortable with and that I can make sense of. Most often, the people behind a stellar track record aren’t impressive in a shallow good-hair, good-English sense. They tend to be understated and dwell on downside over upside. If there’s a trait that stands out in such folks, it’s intellectual honesty. They narrate their story with a sense of candour, admitting mistakes, delivering bad news first, mentioning risks I hadn’t even thought of and not hyping up the future. Their track record speaks a lot more than they do.
Judging people is overrated. Judging track record is underrated.