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Leithner & Co. stoutly resists – indeed, is intended to resist – what psychologist Irving Janis called “groupthink” and what Warren Buffett has dubbed “the institutional imperative.” This is the tendency, which is particularly marked during “booms” and “busts,” is endemic within cohesive small groups and is often present in a more diffuse form in large organisations, to imitate others’ behaviour – no matter how demonstrably silly or self-destructive that behaviour might be. To resist the institutional imperative is, when applied to the allocation of capital, to ignore the crowd, embrace Emersonian self-reliance and invest on the basis of reason and enduring value rather than emotion and current popularity.
This process does not eliminate errors. Nor will the assets so selected necessarily generate superior results for their owners. The composition of a portfolio of assets selected on the basis of value rather than popularity will, however, generally differ markedly from the portfolios of most institutional investors (which, despite their varying labels and often substantial fees charged, tend to greater or lesser extents to resemble an index such as the ASX200, Small Ordinaries Index, etc.). The “value” portfolio will tend to be conservative but unconventional; that is to say, it will tend to comprise solid (on the basis of their financial statements and past operating results) but not prominent companies in what many would regard as “unfashionable” industries. Further, the construction and maintenance of such a portfolio tends to corroborate the results of an exhaustive analysis, conducted by Tweedy, Brown LLC and entitled What Has Worked in Investing. That analysis justifies a policy of buying investment assets whose fundamentals are sound but, for whatever reason, currently out of favour (see also Benjamin Graham and David Dodd, Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960).
Of Lemmings and Investment-by-Committee
Lemmings are small rodents, native to Scandinavia, which periodically and inexplicably commit mass suicide. Every so often, high rates of breeding and low rates of mortality cause the population of lemmings to rise sharply. As their ranks swell, they begin to migrate and become bold, aggressive and reckless. Although some die from starvation or accidents, large numbers reach the sea. Once there, they swim from shore until they die of exhaustion.
Although the consequences of their errors harm others more than themselves, major institutional investors sometimes act like lemmings. As Mr Buffett has emphasised, they respond regularly, sometimes spectacularly and usually foolishly to the behaviour of their peers. Indeed, wild swings of the prices of financial assets, such as those experienced recently in Australia, have relatively little to do with the panic of “Mums and Dads” and much to do with the actions of major investment institutions. These actions are not caused by poor intelligence; rather, they stem from “the institutional imperative” that pervades large organisations and the “groupthink” that plagues the decisions of committees.
Mr Buffett wrote in his 1989 Letter to Shareholders “my most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’ In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.”
Mr Buffett elaborated “for example: (1) as if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialise to soak up available funds; (3) any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
John Meynard Keynes, the influential British economist and custodian of the investments of King’s College, Cambridge, described the fundamental nature of these phenomena in The General Theory of Employment, Interest, and Money (Prometheus Books, 1936, 1997, ISBN: 1573921394). “[Most] investors may be quite willing to take the risk of being wrong in the company of others, while being much more reluctant to take the risk of being right alone.” Peer pressure and group dynamics, in other words, prompt us to do things as members of a group that we would never countenance as individuals.
Within business organisations, decisions tend to be made by teams or committees; and the larger the organisation the greater the grip of the committee. Teams and groups, in turn, encourage and insidiously enforce conformity to certain norms of thought and behaviour; and in so doing they frown upon individuality and creativity (see in particular the thought-provoking article Groupthink and You by Karen de Coster and Brad Edmonds). Apart from the King James Bible, it is debateable whether any formally constituted committee has contributed anything of lasting significance to Anglo-American civilisation. Within a closely-knit group, then, standard practice (whether it is sensible or not) tends to be rewarded; and independent thinking (no matter how firmly justified by logic and evidence) that gainsays the consensus and challenges the group’s cohesion is discouraged and sometimes punished.
Accordingly, what investment managers in large organisations seem to fear most is not so much the possibility of being wrong but the possibility of being out of step with their colleagues and competitors. For these managers, in other words, the risk to their careers is much more salient than the risk to their clients’ wealth. Given these incentives and disincentives, to adhere closely to the consensus and thereby to fail conventionally is a rational and sensible route. As Mr Buffett reminds us, “lemmings as a group have a bad reputation, but no individual lemming has ever been ridiculed or received a bad press.” And as Lord Keynes recognised seven decades ago and the quarterly “performance tables” of the managed fund industry reaffirm today, “investment is a field where plaudits tend to go to those who are conventionally unsuccessful, rather than to those who succeed by unconventional means.”
Exhibit #1
The Australian Financial Review (2 February 2000) provided an excellent example of the institutional imperative and the disastrous decisions it can beget. Within a month of the crest of the tech mania, in an article entitled “Experts Name Six Strong Buys”: “one of the most successful research houses in identifying the small cap technology winners of 1999 … put its cards on the table and outlined its picks for 2000. Technology stocks are feeling the pinch at the moment,” said the article, “but this broker is confident the outlook remains bright. It does warn, though, that many will fall by the wayside this year as their business models are found wanting. [The broker] has run the ruler over Australian listed growth companies, weeding out the pure internet plays with questionable business models to identify six strong buys … A strong buy sets a price growth target of a minimum 25 per cent over a 12-month period. Underpinning this is a resolute belief that the world is experiencing a technology boom rather than just a bubble.”
What were its recommended “strong buys”? All were market darlings at that time: Catuity at $16.00; Energy Developments at $9.52; Powerlan at $1.39; Protel International at $4.80; Solution 6 at $12.42; and Sausage Software at $5.40. How well did these experts’ picks fare? Alas, the expectation that capital gains of a “minimum 25 per cent” within a year would occur – and the assumption that these capital gains could be realised – have not quite eventuated. If one had bought at these recommended prices then one would have incurred quotational losses of 26% by December 2000 and of 79% by June 2002.
...continued in Part II
 
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