THE BANKER requested that I interrupt our series on family businesses and add my penny's worth to the commentary about spate of accounting scandals to hit global business. Regular readers of the newsletter will know that I don't take kindly to any type of unethical or illegal behaviour and the new readers, especially the ones from Appleton in South Africa, will have to forgive me if I get up their noses.

Firstly, these accounting scandals are nothing new. Secondly, the most basic rules of investment would have kept you from sharing in the woes of Enron, WorldCom, Tyco, Global Crossing, Qwest, Elan, Vivendi etc. Thirdly, regular readers of this letter will recognise the basic rules of investment because one cannot discuss various investment issues without frequently referring to the basics. It is the equivalent of trying to live without breathing. Fourthly, and probably most importantly, the above scandals have not dented my trust in global or American business one bit.

For the basics I wish to revert to the Sage of Omaha (Warren Buffett), the Father of Security Analysis (Benjamin Graham) and the inventor of Scuttlebutt (Philip Fisher). If you or your financial advisors don't know any or all of these people I strongly advise you to get to grips with what they have to say about investment before you invest another cent. It is said that we base 80% of our decisions on 20% of our knowledge base and the same holds true for investment decisions. In my opinion, at least 80% of worthwhile investment knowledge has been put forward by Graham, Fischer and Buffett. Without having learnt what they taught, I most certainly would not have committed my working life to investment.

In the first chapter of the bible of investment (Security Analysis by Graham & Dodd) Graham gives us the definition of investment:

An investment operation is one, which upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

In chapter six Graham states, 'For many analytical purposes it is sufficient to take the material at second hand... But for a full-scale analysis the practitioners will generally find it advisable to consult the original sources to make sure that nothing of importance is overlooked'.

Basically, what the authors are telling us is that you either have to do your own homework or entrust your investments to somebody who does theirs. You should only invest in companies that, after you have patted them down several times, promise to hand back your original investment - AT LEAST!

In addition to doing your homework, you need to stick to your knitting.

Warren Buffett and his right-hand man, Charlie Munger, preach that you need to 'invest within your circle of competence'. Know what you own and own what you know. I want to emphasise this point because it is extremely important. Stated simply, if you do not understand a business then you must not investin it! If you ever had a look at the books of Enron (which I did about twoyears ago) you would most likely have closed them in about ten minutes -which I did. In my case it was probably due to my own intellectual shortcomings. However, even if you had done your homework, you would most likely have come to the conclusion that it is close to impossible to get your head around the company's business.

An extremely important concept in investment or business that you need to grasp is what I call aligning your interests. The quickest I ever had a layman grasp my imperfect attempts to explain this concept was last week when I explained it to John, a South African Airways Boeing 767 pilot. You see, a passenger and a pilot share in exactly the same risk on a flight. If the plane goes down, so do the passengers and the pilot - there are not parachutes for anybody. Unfortunately, in the world of business it does not work that way. In the business world it is disturbingly easy for a pilot (i.e. CEO) to crash numerous planes and leave a string of bodies behind, while escaping relatively unscathed. In fact, it can turn out to be a very lucrative pastime indeed. The pilot receives money to get on board the plane (the joining incentive), to fly the plane (salary) and when he walks away or the plane crashes (the golden handshake). It's also not called a golden parachute for nothing - the plane crashes but the pilot gets out before it does and very wealthy to boot!

Management decide how much they get paid, whether they issue themselves

stock options and if there will be performance requirements linked to those options. Quite shockingly, managements have regularly decided to re-price their options because the company did not meet the required returns. My oh my, wouldn't I like to be able to simply re-price my shares every time they didn't return exactly as much as I wanted them to.

Unfortunately, as a shareholder there is very little you can do about errant managements, apart from making sure you are in a position comparable to catching a flight. You want to partner with managements that think like pilots and are competent people with integrity. Management and shareholders must share the same risk. I am a proud Berkshire Hathaway shareholder. My CEO/pilot, Warren Buffett, has more than 90% of his family's net worth invested in Berkshire and he earns a salary of $100,000 a year. That salary represents slim pickings for running a $102bn company. If our plane (Berkshire) falls then Mr. Buffet is going to feel it a lot more than I am because I don't have close to 90% of my money in Berkshire. Choose your pilot wisely! As my chief pilot, Warren Buffett advises to only invest with people you respect and admire. Invest with people who treat you as the owner of the business and respect you as such. It is never worth risking your money with people who did not earn your respect. I would much rather face bad times with management that has integrity than good times with management of questionable integrity. It is imperative to remember that as an investor, which necessarily implies over the long-term, you always buy both the good times and the bad. Any business will face good and bad times. However, with outstanding management the bad times are a walk in the park compared to the alternative. One of the greatest things about investment is that you can choose who you associate with. Buffett says, 'I choose to work with every single person that I work with. That ends up being the most important factor. I don't interact with people I don't like or admire. That's the key. It's like marrying'.

The companies under discussion ran up debt, used off-balance sheet items (which you could pick up from the annual reports) and purchased companies left, right and centre. Management issued themselves share options as if they were going out of fashion, mostly sold their shares in the company and hardly ever bought shares with their own money. There is a single event that would have kept me from investing in Vivendi. Last year the company purchased a Park Avenue (New York) duplex for the CEO at the time, Jean-Marie Messier, at a cost of $17.5m! Not with my money you don't! Now imagine you owned a business and the guy who ran it did all the above? Guess what? If you invested in Vivendi, he did.

Unless you are prepared to do your homework thoroughly, invest in your circle of competence and partner with people you respect and admire then you have no business investing. You are trying to go to the North Pole without thermal clothing. You won't survive!

There are (and always will be) numerous outstanding companies out there that are run by equally outstanding and admirable individuals. The Enron, WorldCom and other disasters assist investors by depressing the market, thereby allowing them to buy outstanding companies at attractive prices. So don't complain. As a business perspective investor, or simply an investor, you should be able to separate yourself from the herd and see the opportunity in all of this doom and gloom. As was the case in every previous prolonged bull market, so too will future markets experiencing "irrational exuberance" produce the Enrons, WorldComs, Vivendis and Elans of this world.

As the Sage said, 'You never know who's swimming naked until the tied goes out'.

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2002/07/12 10:16 View Archive