The Value of Virtue

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

1. A higher level of corruption translates into lower domestic investments and economic growth
2. Higher levels of corruption hinder Foreign Direct Investments
3. Higher corruption leads to lower tax revenues
4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
6. Higher corruption leads to higher student dropout levels in universities and high schools
7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
2. There must be some kind of economic merit associated with that power
3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

• Protestantism;
• Former British Colonies;
• Higher GDP;
• Common Law versus Civil Law-based legal systems;
• Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
• Longer exposure to democracy;
• Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

• Relative salaries in the public sector;
• Degree of political stability in a country;
• Endowment with natural resources;
• Degree of state intervention in the economy;
• Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

• Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
• About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
• Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
• Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
• And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

• Return on Equity (for the P/B analysis)
• Return on Assets (for the Tobin’s Q analysis)
• Profit Margin (net)
• Research and Development Expense / Sales
• Dividend Payout
• Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
• Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
• Earnings growth (5 years)
• Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

• Country level average Return on Equity (for the P/B regression)
• Country level average Return on Assets (for the Tobin’s Q regression)
• Inflation
• GDP growth
• And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

How do people invest? The difference between group and individual decision taking – with a small side-step to the credit crisis

By Erik L. van Dijk

In our previous entry on Fund Manager Selection we noticed what the typical flaws of private investors and their advisors are. Now, before turning to decision taking by the so-called specialists in part 2 of the series on Fund Manager Selection, it is good to take into account resulst from a great paper by Barber, Heath and Odean from the Haas Business School at the University of California Berkeley. In their paper Good Reasons Sell; Barber, Heath and Odean, published in Management Science in 2003 they point out that individual investors take different decisions when being part of an investment club. 

A lot of the research focusing on differences between private and institutional investors incorporates agency-related factors in one form or another. The Agency Theory, going back to the original work of Mike Jensen and Bill Meckling in the mid-70s, indicates that situations in which a principal / decision taker is working in his own self-interest can lead to different outcomes when – for example because of the decision framework or company structure getting too large – he/she outsources part of the decision taking to an agent. Supposedly the agent is required to act totally in the interest of the principal / decision taker, but one can never exclude that the agent will incorporate his/her own agenda with goals/targets in the overall decision framework. Consequence: the end result can easily be less good than what the principal expected.

Before turning to investment decisions by institutions in a future post on Fund Manager Selection (part 2 of the series started yesterday), it is good to re-analyze the Barber et al. paper. In their paper they publish results from tests in which they distinguished between individual investors who took their investment decisions alone, and those who worked together in a group. Now with investors in an investment group still being the sole owner of their share of the overall group portfolio, the agency aspects don’t apply. Any difference in investment style of people in groups versus people on their own is therefore the sole result of behavioral factors.

The results are astonishing. People do decide differently when in groups. And not just that: people in general use decision processes in which ”good reasons” are guiding them more than conscious cost-benefit-analysis-based decision taking! Both the individual investors and the clubs in the Barber et al. study underperformed the benchmark, both on a net and gross basis. In other words: professional investors as a group do outperform. And that implies that the fun, anecdotes about King Kong beating the specialists with stocks picked by throwing darts are demagogic. The tests of monkey versus specialist do always incorporate 5 or less stocks and one ot the key characteristics of a good specialist portfolio is diversification. Taking away the diversification from the specialist, is like taking away bananas from the monkey. If you don’t give him his yellow, curvy food, he won’t be able to pick any stocks, let alone outperform.  

But the differences between the good, bad and ugly in both investor categories can be substantial. And that holds for both the professionals and the amateurs.

One standard mistake made by private investors is that they forget to diversify. Research has indicated that it is best to diversify a portfolio over 15-20 different, if possible not too-correlated holdings. In case your portfolio is too small: stick to funds and avoid individual stocks or other securities. The average investor club or individual diversified his/her portfolio over 5-10 holdings. The excess risk that results from this is one reason for the relatively meagre performance. Diversification was a bit better in the groups, but there diversification did not follow the lines of correlation reduction. It was more a way to ensure that everyone in the group had something funny and interesting to do, with others being able to mingle in the discussions. I.e. we diversify the research, but please make sure that the group discussions in the meetings that decide on portfolio changes are ‘fun’ with all respected members being able to show how knowledgeable they are.

This phenomenon can explain why securitized portfolios that were so instrumental in explaining the credit crisis were not diversified enough. A good group process would be one in which bottom-up specialists prepare things, bring their research into a meeting with eachother and with top-down specialists, with the latter than deciding ultimately about allocations. That is not what is happening in the case of investment clubs I am afraid. Actually, it is not even true for most institutional decision processes either. As top-down specialists, we believe that our cooperation with Noble Prize laureate dr Harry Markowitz (mr Diversification if you like) has helped us to take an objective stand by using a helicopter view in which we give credit to the bottom-up specialists that we categorized as best-of-breed.

No, decision taking in investment clubs follows a different path. Barber et al. show that ‘good reasons’ are the dominating factors explaining buy decisions. ‘Good reasons’ are labels and categorizations providing a seal of approval / quality stamp to individual stocks, albeit that the same could apply to mutual funds. Factors that fall under the ‘good reason’ definition could be; i) incorporation in a most-admired list (e.g. the one by Fortune); ii) strong sales growth of a firm over the last 5 years; or iii) strong stock returns over the last 3 years. With respect to the incorporation in most-admired lists: compare what we wrote in our previous contribution about advertising by mutual funds! And the 3-year return track record is of course one-on-one in line with what we wrote about raw returns in our previous post. ‘Good reasons’ are useful quality stamps, but not necessarily so for achieving above-average investment results: you have to pay for them. ‘Good reasons’ firms are more expensive, so that net results on ‘good reasons’ portfolios can be lower than on a contrarian one. That is how markets work: if something is more desirable, more people want it. And this higher demand translates into a higher price.

The fascinating thing is that people in an investment club are not agents, but principals! So, why do they decide the way they do? In our contribution on Fund Manager Selection by institutional investors we will show that the old adage ‘No one ever got fired for buying IBM’ is an important explanation in an agency setting. But the Barber et al. research indicates that there is more at stake. Group decision taking incorporates innate behavioral problems that can lead to sub-optimal investment decisions with or without agency complications. Investment portfolios should – in the end – lead to diversified mixes of individual holdings or mutual funds that are sufficiently different. Selection of different things involves different qualities. Different qualities require different type of people/specialists. Group processes with different people might lack the ‘social fun’ or a group process in which all like each other, respect each other, have fun working together. And that is where things go wrong. It is most likely that this problem plays a bigger role, the bigger the organization is. Investment clubs are normally limited to just 10-15 people, and already with those small numbers, the problems are tantamount.

Interestingly enough, it is not true that this problem arises solely in groups. Be they institutional (with agency problems included) or private (principal-only). Barber et al. show that the ‘good reasons’ problem is also bothering most individuals on a stand-alone basis when selecting stocks, albeit to a lesser extent. We can extrapolate this behavioral finding into another plea for making sure that boutique, smaller asset management firms in which a charismatic set of key personnel plays a leading role are not forgotten within a diversified portfolio of funds.

Bottom line: taking the right investment decisions – be they the selection of fund managers or the buying or selling of individual stocks, bonds or other securities – is a complicated thing. Too often, do we show weakness to quality-related factors, or non-investment-related agency factors, or do we fall prey to naive extrapolation of historical results. The ‘good reasons’ work by Barber et al. confirms this.

Conclusion: good investing requires a complicated skill set, that is unfortunately less readily availabe than we would like. It is not very helpful that the average marketing or business development executive of big financial institutions tries to make us believe that they are big because they are the best in everything they provide. The same holds for investor relations personnel (or the CFO or even CEO) of stock-market-listed firms trying to convince investors to buy their shares and hold them longer. The difference between ‘the good’, ‘the bad’ and ‘the ugly’ is complicated when it comes to finding the best investment portfolio. Avoiding ‘bads’ and ‘uglies’ alltogether will lead to underpermance. Buying the bads is not an option either. The best strategy should lead to a diversified mix of ‘goods’ (‘quality’) and ‘uglies’ (contrarian strategy components), but as a decision taker you need a strong stomache to defend the latter category, especially in harsh times.

POSTSCRIPTUM

Application example 1; Emerging Markets 2008

The fact that Emerging Markets – even the ones with strong fundamentals – lost more in the credit crisis than struggling but bigger (‘good reasons’) developed markets gives you an idea about what we mean here.

We at Lodewijk Meijer continue to believe that only a robust, cost-benefit-based approach in which all pluses and minuses are made transparant to the final decision taker (‘principal’) can lead to structural outperformance. That is why we combine ‘best-of-breed’ specialist products of a mix of large firms and boutiques in a framework in which we only play the top-down, objective outsider role based on a framework that we developed together with Noble Prize laureate dr Markowitz. Humble when necessary, bold when based on something and boring when it comes to risk: that is the right way to go for investors in this new era. Unfortunately too many decision takers didn’t come to that conclusion yet.

Application example 2; Will our leader be capable of getting us out of the current crisis?

And that does also seem to hold for the ones that are trying to lead us out of this credit crisis. Initially the G7 leaders and ministers of Finance tried to do it themselves. With the smaller developed nations playing copy-cat in their own country. But hey guys, if you let liquidity first flow towards the Chinese and Arabs through the acquisition of products, oil or direct investments, don’t be surprised that – when suffering a problem – liquidity is somewhere else. The receivers of liquidity in the aforementioned nations did not automatically send it back to Wall Street or London. Sure, sooner or later it will come, but at their convenience. Only now, months down the road do we see markets slightly improve and leaders change talk from G7 to G20. Finally! The initial money spent was printed money of future tax payers. If we want it or not, cost-benefit-based thinking would imply direct talks with the Chinese, the Arabs and other sovereign wealth investors. Our leaders have to be bold and humble at the same time when doing so. Difficult, but possible.