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The Softer Side of Value Investing
Article available in Spanish here.
You can listen to a professional narration of this article below:
I’ve been with IMA since August 1997. I started as an analyst, then transitioned to being a portfolio manager and CIO. Then in 2011 I became IMA’s unofficial CEO and in 2013 official CEO. The most important lesson I’ve learned running IMA is the importance of people and culture.
As a young analyst I did not have much appreciation for people and did not really think about IMA’s culture. I have a feeling this is true for most young analysts. When you are starting out, you are focused on things that are quantifiable – return on capital, return on equity, various growth rates and valuation metrics. You can look backwards and analyze numbers and then you can model them going forward.
Even when you mature as an analyst and start spending time on the company’s competitive advantages, you are still thinking about abstracts like the firm’s distribution strategy versus its competitors, the stickiness of customers, the size of the potential market, etc.
I don’t want to dismiss the importance of these factors. But as I started to manage people, after many painful experiences I realized that the success of IMA as an investment manager and a business was tied to people – human capital. Great employees push you forward; not so great ones drag you down.
Then there is culture. Let me tell you two stories.
In 2008, Michael Conn, IMA’s co-founder, was CEO of the company. IMA’s operational folks were reviewing investment management agreements, comparing them to the fees that were actually encoded in our portfolio management (billing) system. They found that one account was mistakenly miscoded. IMA had been overcharging a client for 20 years. The difference in any particular quarter was not grotesque, but over the 20-year period it had added up to a large sum. Let me remind you that this happened during the financial crisis; the market was quickly melting down.
Once the operations folks brought this problem to Mike, he said, there is only one thing to do, let’s calculate the interest accrued over this time period and refund the client the fee with interest. Mike called the client and apologized for the mistake. The fee was refunded. That was it.
And then there is another story.
When I took over running IMA we had no marketing strategy. Mike’s original partner, Merv, was the marketer. IMA’s marketing went away when Merv retired in the early 1990s. I was running the firm and I had to come up with a marketing strategy. My education was in finance, not in marketing. I experimented a lot.
Let’s pause and fast-forward. Today we do only very passive marketing and no sales. People subscribe to my articles. When the need to hire a money manager arises, prospective clients reach out to us (this usually happens after they’ve read my articles for years). We ask them to read our 31-page brochure. We don’t employ a salesperson. I am a horrible salesman and hate selling. Only after they read this brochure, I’ll get on the phone with them and answer their questions for about 20 minutes. That’s it.
When I became CEO back in 2013, one of my not so brilliant ideas was to do cold calls. I was not going to do cold calls myself; I hired an assistant, Slavcho, who lived in Macedonia. His task was to call prospects and ask if they want to have a call with me.
I thought Slavcho might face some awkward conversations – “Hi, my name is Slavcho, would you like to schedule a call with Vitaliy?” Too many Eastern European names in one sentence. I asked Slavcho, how would you feel about going by “Steve” instead. He didn’t care. In fact, he kind of liked Steve.
One day Slavcho calls me and says “Vitaliy this guy John is going to call you. I told him that I was born in Macedonia and moved to San Diego ten years ago. I went to college in LA and then moved to Denver.” I was confused. I couldn’t understand what was happening. Slavcho said, “Well, you didn’t want people to know that I live in Macedonia, so I created a cover story.”
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I was shocked and embarrassed. This was a wakeup call for me.
What had just happened was completely on me. I had inadvertently asked my subordinate to lie. My little white lie almost created a culture of deception at IMA. I told Slavcho that from now on he could use his real name and if anyone asked, just tell them the truth. (I ended the cold calling idiocy a few months later).
In contrast, Mike’s behavior taught everyone at IMA a lesson of integrity. Not just when it’s convenient but when it hurts. (Mike had to forgo his paycheck during the financial crisis.) My inadvertent behavior threatened to turn good people into liars. The little things management does matter. As a parent I learned that my kids pay much closer attention to my actions than to my words. I don’t want to be condescending and compare employees to kids. But I was an employee once. I paid more attention to what the management did than what it said. Yes, management actions matter a lot more than their words.
Warren Buffett told a story about an insurance company where people were screamed at by senior management when they brought bad news. They stopped bringing bad news. Nothing good happened to that company.
The culture in most companies, especially small ones, comes from the top. People emulate the management (rather than just the founder and CEO). Culture is what people do when no one is watching. It is the mutually agreed set of principles that aligns everyone’s behavior. But it is much more than that. It is a positive, negative, or inert charge. A positive charge makes the sum of individuals in the company exceed their mathematical sum. It is synergistic. A negative charge, caused by a sluggish bureaucracy or internal power struggles, causes friction and ultimately harms business performance. An inert charge neither adds nor subtracts.
And there is one more thing – incentives. During the 2021 annual Berkshire shareholder meeting Warren Buffett was asked if Berkshire would insure Elon Musk’s trip to Mars, to which Buffett replied, “Sure; it will depend on price.” Then he thought some more and added, “There will be one price if Musk is on board the ship, and another if he is not.” It is programmed into our genes to put our self-interest above that of others. It would be impossible for Elon Musk to care more about the safety of a ship taking strangers to Mars than about one carrying him and his family.
If you have great people and a healthy culture and add proper incentives, a company is unstoppable. When management owns a lot of shares in the business, they will behave like owners; they’ll have skin in the game. They won’t do acquisitions or overpay for them just to grow the size of the company. Their interests will be aligned with those of the other shareholders.
Being CEO of IMA made me a better investor. Today, when we analyze companies, in addition to doing everything else we’ve done before, we also think a lot about the management that runs them, their culture, and incentives. In fact, if I look at my biggest investment mistakes in the past, most of them have one thing in common: bad management.
Life is so much easier when companies you own have a great culture and are run by top-notch, properly incentivized management teams with skin in the game.
Life is definitely too short to own companies run by bad management. Warren Buffett said that he’d like to own “businesses that an idiot could run, because one day they will be.” I can definitely see this being true in the past. I am not sure if it is true today. The rate of change is much different today.
Some businesses can definitely withstand more abuse by management than others. But there is no business great enough that it can withstand endless abuse by management. I am thinking about Microsoft as I am writing this. Under Steve Ballmer, Microsoft’s culture decayed. Toxic HR policies turned the internal culture within the company into a version of the Hunger Games. Microsoft was setting cash on fire with mindless acquisitions. Microsoft’s business was so strong (it was a monopoly) that Ballmer didn’t kill it, but we don’t know where Microsoft would be if the new CEO hadn’t changed the company’s course and revitalized its culture. Companies with wide moats are not impervious to destruction by management; it just takes longer for them to die.
Today I’d like to share with you Concerto for Two Pianos by German composer Max Bruch (1838-1920). Max Bruch is well known for his first violin concerto, which probably ranks in the top three most-performed violin concertos. This concerto for two pianos sounds refreshingly different from other piano concertos from the classical and romantic eras. Parts of it sound like a requiem (a hymn for the repose of the souls of the dead), and then there are bursts of optimism that sound almost like themes from an American Western movie. The piece often sounds like it was written by multiple composers.
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Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to email@example.com.
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