Monday Morning Memo: Expensive Lesson on the Cheap

Thorough investment research and due diligence doesn’t promise stellar performance or returns, but it can sure go a long way in averting unnecessary losses. Take this article in the last issue of Bloomberg Businessweek; a story about an asset management firm’s $4 million investment in China Agritech. The article was fun to read as it became a game of underlining with red pen the red-flags and missteps of a failed due diligence process. (How nerdy, right? And always so much easier in hindsight.) The great value of the article was the expensive lesson we, the investment community, get to hopefully learn on the cheap: conduct thorough, thoughtful, and objective due diligence on each and every company, manager, and investment opportunity.

Without developing a case-study, what are a few due diligence lessons gleaned from the article?

1. Check SEC and other regulatory filings. A two minute search of China Agritech’s April 2010 10-k reveals their financials did not include auditor attestation. A reason to dig a little deeper.
2. Check who’s making the investment decisions. The article as an example, a 29 year old new employee (the son/grandson of the asset management firm founders), who wears frayed khakis and rumpled shirts to work, without an investment background (but a solid masters degree in global affairs), is able to make a $4m investment on behalf of the firm. How is this even possible? Was this investment recommendation not screened by an investment committee for reasonable basis? If your managers do not have a process to screen investment recommendations, ask why while you take your money out fast.
3. Know what you’re buying. An profitable environmentally friendly company that feeds China. Sounds great! The “fundamentals” may even look good but sorry, that isn’t the end of the research or due diligence. In the example of Agritech, a look at the initial SEC filing in February 2002 reveals quite clearly a shell company, warranting second looks and critical eyes to all other aspects of diligence, especially red flags.
4. Guided tours are nice but not the best. Arranging a due diligence trip through the manager or company itself is not the best way to get a clean, clear, and unbiased look at operations. Good research requires a deep dig, including conversations with customers, auditors, and other relevant parties. Yes, this applies to screening managers as well.
5. What are other people saying. Don’t believe everything that you read. That’s true. Yet in the investment world, there’s nothing wrong with looking around at other research and arguments that don’t mesh with yours. It will challenge your position, potentially making your argument stronger if you can objectively demonstrate the reasoning behind your position.
6. Examine the big picture. Even if the water seems warm, there is nothing wrong with getting in slowly. Fundamentals are great, the company strategy is great. Does that mean it is a good idea to take a 2% position in a company who has unaudited financials and short ratio of 25%+? Risky business… why not strategize to take a 2% position, but execute over time while you further validate your investment? Sometimes it is not just what you invest in, but the strategy of how you do it that matters.

Monday Morning Memo: Book Review “Against the Gods: The Remarkable Story of Risk” by Peter Bernstein

Part story, part study on the concept of risk, Against the Gods, by Peter Bernstein, is a thoughtful and eloquent review on the history of risk and risk management through human history. While it is not a recent publication (1998), the book presents relevant basis and discussion on modern risk topics and the underpinnings of risk in financial markets and everyday life. A best seller in its day, it is still a quality and worthwhile read for any financial professional.

Monday Morning Memo: Investment Management Services, Value-Added or Commodity?

What makes investment management services valuable to the average retail investor? As an adviser, this key is a tremendous asset to any professional financial practice. Valued services typically trigger customer loyalty (if customer service is also a highlight of the product/service being offered) and have a tendency to carry desirable profit margins. Whereas services or products that are commodities are normally bought on a low-cost basis, all other things equal. So how can a financial professional providing investment services ensure they deliver value-added investment services and not a commodity?

The most simple solution to creating value-added investment services is in strategy and process. As an investment professional, customers expect you to be something more than a stock or fund picker. If professional investment fund selection is based upon fund-family or Morningsar ratings, guess what?, it becomes a commodity. Anyone can do that, even your customer. To truly add value, as a professional you need to develop and articulate an investment strategy and a process by which you monitor and manage that strategy. It is the professional knowledge, expertise, and its ongoing application that is valued by customers; it’s what builds customer loyalty and what they pay for. There are other advantages to providing value-added investment services – it’s called differentiation.

When engaging new customer prospects or retaining current customers, articulating the application of your professional expertise and the process by which you monitor and update your customers’ investment strategy sends a strong message of professional knowledge and competency. It also signals to your customers you are delivering something of value. Aside from the obvious benefits, how does this benefit you as an adviser? Believe it or not, it sets you apart – not only in strategy, but in offering. Not all financial advisers offer investment management services of such a caliber. Combined with the other skills and practices setting you apart, investment  management may become a large differentiator for your financial practice.

At IPS we look to provide support, training, and consulting services to you to help you create an efficient and value-added investment services offering.  We don’t directly work on marketing or market positioning (although we know quite a bit about it!), but for more information on differentiation, check out the recent post we contributed to the FPA Practice Management Center. There is an outline and guide to market positioning. How can you differentiate? Do you want to add investment management services to your core differentiation strengths?

An Alternative Regulatory Organization for RIA’s?

The Committee for the Fiduciary Standard is advocating the development of an SRO for RIA’s. Is this a good idea? This article by Elizabeth McBride on RIABiz takes a deeper look.

The challenge with a separate SRO for RIA’s and B/D’s is that many advisors and reps are dually registered. Would two regulating authorities make compliance a greater challenge and burden? Would it force a distinction between practices?

Monday Morning Memo: “The Regulation of Brokers, Dealers, Advisors and Financial Planners”

This article published in the Review of Banking and Financial Law, by Tamar Frankel, law professor at Boston University, provides a legal perspective of the fiduciary duty of the financial industry and its representatives. It is an interesting legal perspective arguing the fiduciary duty is already an obligation of the financial services industry, as a whole, though not yet a legal one for all parties.

The article discusses the limitations inherent in disclosure and conflict of interest as well as challenging the legal statutes created in the 1930′s and 1940′s as out of date. The result is an interesting and thoughtful read on the evolution of the investment and investment advisory industry.

The key question is, beyond individual advisors, should the industry as a whole be subject to fiduciary duty?

Monday Morning Memo: Fiduciary News, FI360 Fund Rankings

FI360, a nonprofit dedicated to investment fiduciary responsiblity and excellence has issued their mutual fund/etf fiduciary ranking report (data as of 12/31/2010). It is an interesting read. Their description of their ranking system does not offer the clarification you would expect, but it provides enough basis to view the data and gain insight (and perhaps trigger a review of your portfolio).

Interesting to note that Schwab and Vanguard are the only major discount fund providers within the top 25 rankings. At the very top? Oakmark.

How to be a Duck

“If it looks like a duck and quacks like a duck – it’s a duck.” As worn out as this adage may be, it remains valid. So, for those who are under fiduciary appointment, and therefore obligation, it is possible you have been told “Ok, you are a fidudiary. You must act in the best interest of the (fill in the blank).” That’s like being told you are a duck and then given a picture of a duck. Do you then know how to BE a duck?

Being in a fiduciary capacity is not the same as acting as a fiduciary and doing what fiduciaries must do. There are many resources available to fiduciaries to help them understand the required fiduciary actions: meetings, reviews, due diligence, etc. However, most of these books, articles, websites, classes, and consultants are only “show and tell”. Show and tell is helpful, and to some extent educational as it is the who, what, when, where, and why of fiduciary obligation. Yet, it fails to teach the fundamentals of doing the fiduciary duty – the how.

How do you do due diligence? How do you perform reviews? How do you insure the IPS is in alignement with the portfolio and objectives? How do you manage the fiduciary process? How do you know if you are doing it right?

“How” questions only get answered with training and exprience, not just education. The key is to consult fidicuary resources that do more than educate on the fiduciary process, but help you learn the in’s and out’s of how to best perform your fiduciary duty.