The Benchmark Is Not Your Friend

Over 40 years of investing, I have been asked one question more than any other: can you beat the benchmark?

I have never found it to be the most interesting question.

The more interesting question is this: do you know what your money is actually doing in the world? Not what return it generated. What it is doing. Who it is funding. What it is building. And what it might be destroying.

In 2007, a conversation at a conference in Mumbai changed the way I thought about this. It lasted less than five minutes. It has stayed with me for nearly twenty years.

It was 2007. Everyone was caught up in the BRIC (Brazil, Russia, India, China) fairytale that India will be a superpower. Reality was suspended as stock market indices and real estate prices rocketed towards nirvana. As always, the infinite power of an Excel sheet allowed any 5th standard student to project India's GDP is on a path of estimated 8% perpetual growth and, voila , we have a superpower.

Past experience has proven that Excel sheets are easy to manipulate. Generating real movement in a, diverse economy requires planning, policy and persistent policing and monitoring to ensure that the assumed 8% rate of growth in GDP in an spreadsheet becomes a reality. With apologies to those who believed that speeches and Excel sheets lead to economic growth, we did a simple calculation: how many power plants were estimated to go operational in that 2007 to 2010 period to, literally, power the rate of growth on the pathway to being a superpower? The answer was: in 2007 India was building just enough power to charge all mobile phones once a day. No extra power for running the factories that were being built to manufacture steel and cement or to power the new refrigerators and air-conditioners that we may buy for our new home.

As a passenger in a car trying to get from A to B, I may have to face the hurdles of traffic jams caused by VVIP movement, potholes, overturned trucks or morchas. But eventually I will get from point A to point B, though the journey may take 3 hours or 6 hours or 12 hours. Unlike a car, power cannot crawl slowly along an electric line: it is a binary outcome; it is either available or it is not available. Hence, we knew there was not enough power to fuel the assumed reality of the BRIC mania of 2005 to 2008 and markets were running on hope and hype.

It was in this environment of the hype of BRIC trumping reality that I was invited to be a keynote speaker for a real estate conference. I was slated as Keynote Speaker #2; the Keynote Speaker #1 was the late Sam Zell, a legendary real estate investor fondly known as "the grave dancer" for his ability to identify severely distressed real estate opportunities and turn them into a goldmine. Sam Zell built Equity Office Properties into one of the largest owners of office real estate in the world and sold his enterprise for US$39 billion to Blackstone in 2007 *. This was months before the Global Financial Crisis in 2008, which was caused by the thuggery of Wall Street firms and resulted in the economic displacement (and death) of tens of thousands of families across the world.

As is the norm at such conferences, I was seated next to Sam Zell ahead of our Keynote Address. I knew who he was and told him how honoured I was to share the stage with him. He gave me a disarming smile and asked me what I do. I explained in a few minutes that we were long term "value" investors and we evaluated risks before we invested the money of our clients. He squinted his piercing eyes "You don't manage money", he whispered, "you manage capital. Money has no notion of risk; it only seeks return. Capital understands you need to assess risk and set your return objectives accordingly."

That was a Eureka moment for me. We were trained by Tom Hansberger, the founder of Templeton, Galbraith and Hansberger, in the style of value investing. The four years I spent managing the Vanguard International Value Fund honed our inherent philosophy to ensure we always work in the best interests of the clients, but I had never heard the clear distinction between money and capital whispered with such conviction.

Understanding what capital means in theory is one thing. Living by it is another. Let me give you an example that has nothing to do with finance.

How many parents wake up every morning wishing that their son is a successful drug dealer or a pimp? "Dhyaan sey suno, aaj bahut maal bechna aur jyaada paisa banana. Mera aashirvaad hai! Khush raho, beta!"

How many parents want their children to be The Baddest Biggest Black Sheep of them all?

Not many. And certainly, no sane parent will wish this for their children.

Most of us would want our children to be educated from a well-known college and then marry someone like them from a respectable family.

How many parents tell their family priest to "find us a girl from a family which has made money from kidnapping, murder and bootlegging for my son - and by the way my son is a drug dealer and a pimp; it will be a perfect match"?

There are limits to what business activities we will publicly be comfortable with proclaiming and being associated with.

But how many of us will take those same moral principles to our investment portfolio?

How many of us will say that I refuse to invest in this company because I know that it sells tobacco which will end up killing hundreds of thousands every year? Or I refuse to invest in this company because I know that this group owns governments and manipulates government policy which, in the long run, will be detrimental to the interests of society and will eventually come back to haunt me and hurt me?

In every economy from the US to Japan to South Korea to Indonesia there were a select few families who, at different points in time over the past century, controlled government policy. When the music stopped and the economies collapsed into depression the damage was widespread. We have read about the impact of the Great Depression in the US in the 1930s; we have witnessed the collapse of Japan in the 1980s and its fabled Lost Decades; we have witnessed the chaebol in South Korea and the extent of corruption that was laid bare after the Asian Crisis in 1997, and we have seen the slow rot of the corruption during the licence raj economy of India that culminated in our near-bankruptcy as a nation in 1991.

When an economy or a country implodes, society is at risk. Nothing is safe and no matter how much money one may have, danger lurks at every corner.

The challenges for many of us who value values - and look beyond the reported profits are this angst over "performance against the index".

The competition are the benchmarks. Clients want to know if we can "outperform the benchmark?" The benchmark indices compiled by stock exchanges and approved agencies have purely quantitative criteria: (a) what is the market cap of the company? (b) what is the daily trading volume? and (c) is more than 25% of the shares issued by the company available for the public to buy on a stock exchange? It is a bit like comparing your child who works with a reputed firm for a respectable salary and has a steady job with the neighbour's son who peddles drugs in the day time and maybe a hitman for the local mafia don in the night. Were the Colombian drug lords to apply for listing on a stock exchange, chances are they would make it to the Top 3 stocks by market cap in an index.

Morals are subjective. And every religion has their own rules on what morals, behaviour or habits are acceptable or unacceptable. But there are some things that most of us, across most religions and most cultures, can agree on. A company that corrupts governments. A business built on addiction. A promoter who treats minority shareholders as an afterthought. These are not grey areas that one should overlook - but strictly avoidable characteristics which should eliminate the possibility of any company finding its way into your investment portfolio.

Furthermore, a poorly governed company can take decades to implode. A company went from being involved in everything from real estate, to airlines, to TV and media, to finance to politics. It took a while to implode. Were it a listed stock it would have been in every Index and owned by every mutual fund. There are Similar other entities out there in many indices. No one has any idea if they will implode (they may transform into fabulously governed companies), or when they will implode. Until they do, the benchmark indices that include them are what any allocator of capital, as Sam Zell labelled us, is measured against. It is a bit like how you will compare your son to the neighbour's son who is "doing so well, you should learn from him", until that neighbour's son is whisked away one night never to be seen again. And then you hug your son and hold on to him and never wish to let go.

We don't have any desire to manage your money.

If you wish to double your money every few years, please go somewhere else.

We manage and allocate capital. Long term. Patient. Capital.

Yes, we will take measured risks and recognise that the more risk we take we endeavour that higher should be the returns we make.

And, unlike the manufacturers of benchmarks and indices, we will screen companies and managements to ensure your capital is treated with respect and, as a minority shareholder, you are entitled to your proportional shares of profits.

The simple rule of investing capital is: assess the risk before you invest to reduce the probability of losing capital - and then compound that capital at a steady rate over decades.

This is what we understand. This is what we have done. This is what we will continue to do.

*Source: Behindthedeals article date: 28-12-2016

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