Would your advisor save you from yourself?
Advising successful people is fraught with challenges. But chief amongst those difficulties is challenging the view of your client – especially when you are challenging them for being human. Success is often built on the virtues of common sense wisdom: an aptitude for a particular industry, hard work, risk management and, as always, a little luck. However, successful people are still human and researchers are constantly learning more about our inherent flaws.
One researcher who has been awarded a long list of top accolades for his work in this field is Dr Daniel Kahneman, including a Nobel Prize for Prospect Theory. Dr Kahneman, in partnership with Dr Amos Tversky, was the first to document a coherent theory explaining that when making financial decisions people do not consider a choice in isolation, but rather people consider the impact a choice has on their starting wealth. This was the first theory to explain why people choose to buy both insurance (risk averse behaviour) and lottery tickets (risk taking behaviour). Dr Kahneman and Dr Tversky realised that people are willing to be a little poorer for the chance to be rich, but will seek protect themselves from being flat broke.
So what human flaws affect business owners and managers?
There are three broad reasons why people reach the wrong conclusion in relation to a business:
- Misalignment of incentives
- Cognitive biases
- Emotional biases
In this newsletter we want to focus on emotional biases – and some famous examples of where value has been destroyed
Most business owners and managers have seen first-hand the impact of misaligned incentives. You might consider that employees using a helicopter to take a short journey, well serviced by roads and public transport, at company expense, to be an example of misaligned incentives.
Humans also have well known biases in terms of how we analyse large sets of information and attempt to answer complex problems. However, it is often possible to explain a mistake with a more thorough analysis and avert a poor judgement with minimal fuss.
What are the signs that you are making an emotional judgement?
Most of us can think of CEOs who have acted out of hubris. One of our favourite examples is that of Jean-Marie Messier. Jean-Marie undertook a staggering array of acquisitions during his eight years as Chairman/CEO of Vivendi (at one stage Vivendi Universal), with transactions worth almost $100 billion. Here are some warning signs that could have alerted investors to the problems:
- Jean-Marie sought exorbitant remuneration relative to other Vivendi employees. As an example, he made Vivendi provide him residence in a $17.5m apartment in New York. He also negotiated for his wife to be provided a chauffeur in his severance package.
- Jean-Marie transformed a water and utility business into an entertainment and media conglomerate, owning such assets as USA Networks and Universal Studios. Had he already forgotten the lessons of Japanese conglomerates from the 1980s?
- Jean-Marie Messier initially referred to himself as J2M (J-deux-M), but as things went along, he became J6M – Jean-Marie Messier, Moi-M me, Maître du Monde (myself, master of the world) – and that became the title of his auto-biography.
- The media loved to flatter Jean-Marie, with coverage including a TIME magazine cover.
- Vivendi stock had been caught up in the dot com bubble of the late 1990s.
By 2002, Vivendi lost approximately 80% of its market value and Jean-Marie was fighting claims of embezzlement and fraud.
J6M obviously made some mistakes, but is there any evidence that emotional biases systematically destroy value?
Fortunately for us, Mathew Hayward and Donald Hambrick, both of Columbia University, conducted a study into 94 companies to statistically test for the effects of hubris [Explaining the Premiums Paid for Large Acquisitions: Evidence of CEO Hubris, 1997]. Here are some highlights:
- The better the recent performance of a firm, the higher the premium paid for an acquisition - certainly Vivendi’s stock price run-up fits with this result.
- The greater the recent media praise for the CEO, the larger the premium paid for an acquisition. So if you see yourself on the cover of TIME, you may need a reality check.
- The higher the CEO relative pay to the next highest paid executive, the higher the premiums paid for an acquisition.
- Board independence was also a significant factor but the results were more subtle. However, having independent board members and an independent chairperson did appear to help.
Don’t shoot the messenger
Toro Liberty does not seek to run your business. However, we are there to support you with our analysis and assist you with complex decisions about your business. And this means that sometimes – simply as part of doing our job – we may need to save you from yourself. If that happens, just remember, it’s not personal, it’s just human.