Friday, September 14, 2012

Grantham & Buffett: "Career Risk" & "The Institutional Imperative"

Jeremy Grantham had this to say about what he calls "career risk" in his April 2012 letter:

"The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples' money. The prime directive, as [John Maynard] Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority 'go with the flow,' either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest."

He also talked about "career risk" in part 2 of his January 2011 letter:

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Investment professionals certainly had to wrestle with
"career risk" head on during the dot-com bubble. At the time, more than a little conviction and willingness to appear very wrong for quite a long time was necessary. Some pros rightly resisted the herd and were promptly rewarded with client redemptions.

Unceremoniously dumped as investors chased the "new paradigm".

Supposedly, those that weren't buying the hottest tech stocks just didn't "get it" or at least that's what much of the herd seemed to be thinking. Well, there was no new valuation paradigm. Many transformative companies were created (and plenty less so) but, either way, valuations went to ludicrous extremes. Only after the fact (and, unfortunately for some money managers, after the money had left) is it usually clear who really "gets it".*

This likely helps to explain something Warren Buffett pointed out in the 1978 Berkshire Hathaway (BRKa) shareholder letter:

"...in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks."

Jeremy Grantham happens to be describing a specific investment industry dynamic but, even if not precisely the same, it is not unlike something more generalized that Warren Buffett has covered from time to time.

What he calls
"the institutional imperative".**

From the 1989 Berkshire shareholder letter:

"My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative."

Basically, in Buffett's view, the imperative is a powerful tendency to imitate peer companies, at times rather foolishly, on things like acquisitions, executive compensation, expansion plans or whatever else.**

He described it in the 1990 Berkshire shareholder letter this way:

"...the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so."

Buffett makes it clear he considers the power of "the institutional imperative" to be rather substantial. In fact, so much so that Berkshire Hathaway has been deliberately set up to minimize its influence. Also, he prefers to invest in companies that seem to have an awareness of the problem.

Adam

Long position in BRKb established at lower prices

Related posts:

Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline

* And it's not like having money drain out of a fund (or funds) doesn't create its own return sapping headaches for a professional money manager. Part of the brilliance of Berkshire Hathaway is how it is designed to prevent this problem and, in fact, benefit from it.
** Check out the Mistakes of the First Twenty-five Years section of the 1989 Berkshire shareholder letter (the section is near the end of that letter) for more background on this.
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