The vital role of trust in investing
“fido ergo emo”
Richard Taffler FSIP
Professor of Finance and Accounting
Warwick Business School
CFA Society of the UK Masterclass
BNY Mellon Centre
March 4th 2014
Warwick Business School
CFA Masterclass 4 March 2014
1
Overview
• The emotional need to trust to be able to invest
• Why fund managers really need to trust
• Why do we really meet management?
• The investment case for meeting management?
• Measuring firm trust and management quality
empirically
• The real reason for corporate contact: a paradox
Warwick Business School
CFA Masterclass 4 March 2014
2
Data sources and research method (Fund
Management: An Emotional Finance Perspective, Tuckett
and Taffler, CFA Institute, 2012)
• Analysis of depth interviews in 2007 with 50
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active fund managers internationally
− average assets under management = $10bn
Mean interview duration = 70 minutes
39 traditional fundamental managers and 11
“quants”
Mean portfolio management experience 15 years
Two-thirds had outperformed their benchmarks
over the previous 3 years
Warwick Business School
CFA Masterclass 4 March 2014
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Fund managers – an emotional
finance perspective?
• Expected to outperform on a consistent basis
• Work under extreme pressure and competition
• Swamped by conflicting information
• Have to enter into emotional relationships with
investments which can easily let them down
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Have to rely on subjective judgment and intuition
Investment outcomes are often unpredictable
Under constant threat if they underperform
How do fund managers manage to generate the
conviction to invest?
Warwick Business School
CFA Masterclass 4 March 2014
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The need to be able to trust
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Investment and trust are synonymous
Worry and trust are the most salient emotions
Trust -> vulnerability
Needing to trust what management tell you and
the anxiety of being misled
• Needing to trust their ability to execute
─ but how do you know they can and will?
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CFA Masterclass 4 March 2014
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What is trust?
• Trust permeates all human relationships
• 46,000 academic articles on trust in the last 25
years
• Trust involves giving discretion to, relying on, or
being vulnerable to another under conditions of
uncertainty” (Shapiro, 2012)
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CFA Masterclass 4 March 2014
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What is trust? (cont…)
• Trust is a function of [both] the trustee’s
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perceived ability, benevolence and integrity and
of the trustor’s propensity to trust (Mayer et al.,
1995)
− it has to be given in advance of the outcome
“The basis of trust …is the feeling of confidence
in another’s future actions and also confidence
concerning one’s own judgment of the other.”
(Barbalet, 2009)
Trusting provides an “illusion of control” (Pixley,
2004)
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CFA Masterclass 4 March 2014
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You have to be able to trust
to invest!
• Investment outcomes are often
unpredictable
− leads to anxiety and potential stasis
• The ability to trust when “not knowing” ->
the conviction to commit
• Trust “trumps” anxiety and leads to action
• Trust links the present and the future
− it “creates” desired future outcomes
Warwick Business School
CFA Masterclass 4 March 2014
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Making a call on management
• Bedrock of active fund management
• Company management mentioned > 10x on average
• Judging/ reading quality of management
fundamental to virtually all our fund managers
• Over 40% directly stressed the key importance of
making a call on management
− often repeatedly
• Ability to do this -> key competitive advantage
• Trusting management to deliver is the sine qua non of
the investment process
Warwick Business School
CFA Masterclass 4 March 2014
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Investing in management
(some typical quotes)
• “Ultimately … what you are backing is
management, management, management…”
• “One good example of our edge is the access we
get to management…”
• “It’s got to be great management for us to own
it”
Warwick Business School
CFA Masterclass 4 March 2014
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Investing in management
(some more quotes)
• “The quality of management is the single most
important thing”
• “I like to find companies where, you know,
management is doing the heavy lifting as
opposed to me [laughs]”
• Only one dissenting voice in 39 interviews
‒ “ I try not to talk to managers … I think there
are grave dangers … I look at hard numbers,
that’s my favourite resource”
Warwick Business School
CFA Masterclass 4 March 2014
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The need to trust
management (some typical quotes)
• “It’s all about kicking the tyres and the whites of
their eyes…”
• “Its just sitting across the table from the guys
and you are making a judgment about their
honesty, integrity, and their ability”
• “Yeah, it’s very simple. The first and foremost
thing is to find out whether you trust the guys…”
Warwick Business School
CFA Masterclass 4 March 2014
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The need to trust
management (some more quotes)
• “But I need a management team that I can trust
and believe in”
• “I just have to know that the management team
when I sit across the table is going to create value
for us”
• “It’s a bit of a ‘sniff test’….. Management contact is
one of those things where I think often we do it to
make ourselves feel better”
Warwick Business School
CFA Masterclass 4 March 2014
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Why is meeting management so vital?
• “We don’t think there is any substitute for meeting
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management”
The need to “like” and trust
Confidence -> conviction to commit -> invest
Delegating (alleviating) uncertainty to feel better?
‒ “projecting” your unconscious anxiety on to firm
management to perform for you
What is the empirical relationship between liking
and trusting a management team and investment
returns?
Are meetings information or performance driven or
for more psychological reasons?
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CFA Masterclass 4 March 2014
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Putting a price on meeting management
• The “cash for access” story
• Company access ranked 4th out of 12 categories in the II
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survey of what the buy side wants form the sell side
Around 35% (25%) of broker income in the US (UK) comes
from providing management access (around $1.25bn.)
Such access must be very valuable!
Going rate of $20,000 for a CEO and $15,000 for a CFO
Average brokerage house conference with management
access generates around $750,000 in incremental revenues
Is management access private information driven (illegal)
‒ or by the fund manager’s emotional need to have to
trust to be able to invest when outcomes are
unpredictable?
Warwick Business School
CFA Masterclass 4 March 2014
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Private face-to-face meetings
from the other side (Roberts et al. , AOS, 2006)
• Very skilled at playing the game
• Intense preparation and very carefully rehearsed
‒ ”[we] run through every Q&A we think is likely to be
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asked” (IR manager)
‒ “ a time-consuming investment in theatrical selfpresentation”
“The careful cultivation of looks and gestures and
interpersonal ‘chemistry’ “ to generate confidence in and
“liking”/ trusting of management
Carefully crafted sound bites along with the fear of unfair
disclosure ensures that managers stay on script
How does drawing inferences from “body language”
relate to future financial performance?
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CFA Masterclass 4 March 2014
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Direct parallels with the job
interview – a behavioural minefield?
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Is meeting management potentially dangerous?
Key role of personal attractiveness?
Initial information presented dominates?
Decisions (unconsciously) made in the first minute?”
followed by search for confirmatory evidence?
Attribution bias – inferences about future performance
based on interview behaviour in a highly artificial situation?
Clone error?
Being impressed by being agreed with and flattered?
Inevitably a highly biased interaction
‒ Confusing “liking” with validity? (representativeness)
‒ implicitly designed to generate the trust and conviction
for fund managers to be able to invest?
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CFA Masterclass 4 March 2014
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Research evidence on the
investment case for meeting
management?
• Private 1-1 meetings at brokerage house
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conferences -> contemporaneous significant
changes in institutional ownership, increased
turnover and abnormal returns
Roadshow private meetings -> increased 3-day
trading volume, institutional holdings and
abnormal returns
But little or no evidence of superior investment
performance in the longer term as a result of
private meetings
Warwick Business School
CFA Masterclass 4 March 2014
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Research evidence on the
investment case for meeting
management? (cont…)
• Similarly corporate site visits in China only
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associated with contemporaneous increased
trading and price movements but again no
longer term impact
Sell-side analyst private interaction with
management does not improve their earnings
forecasting ability
Do fund managers need to meet management
to be able to trade despite little or no
investment value?
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CFA Masterclass 4 March 2014
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Valuing trust as an intangible
asset (a pilot study)
• How does the market value firm trust empirically?
• Issues of information asymmetry, adverse selection and
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moral hazard
Trust and firm cost of capital?
US computer software and hardware sectors 2005-2010
Trust = f(set of 6 measures)
‒ abnormal ‘large’ CEO stock exercise
‒ securities fraud and litigation cases
‒ auditor change
‒ accounting restatements
‒ board size shrinkage
‒ aggressive earnings management
Warwick Business School
CFA Masterclass 4 March 2014
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Valuing trust as an intangible
asset (a pilot study) (cont…)
• Cost of capital regressed against trust, and control
variables
• The higher the level of trust the lower the cost of capital
(required returns)
• Ceteris paribus, a high trust firm has a cost of capital 3%
lower than a low trust firm!
• Trust has clear market value!
• Caveat: very preliminary study but encouraging results
“trust” is potentially measurable!
Warwick Business School
CFA Masterclass 4 March 2014
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Full circle: is management
quality value relevant?
(Agarwal, Taffler and Brown, JFQA, 2011)
• Is management quality an intangible asset?
• Can we measure the market value of good management
empirically?
‒ how does it relate to firm performance?
• Management Today’s “Britain’s Most Admired Companies”
annual survey
‒ 1990 to 2007
‒ 10 largest firms in 25 industry sectors
‒ average of 226 listed firms a year
‒ firms ranked on 9 indicators of firm quality by their peers
(highly correlated)
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CFA Masterclass 4 March 2014
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Full circle: is management
quality value relevant? (preliminary
findings)
• High quality of management firms (QM) are large
‘glamour’ stocks with strong prior returns and
earnings performance
• Management reputation inversely related to
subsequent stock returns
‒ badly managed firms appear to outperform well
managed firms (by > 4% in the following year)
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CFA Masterclass 4 March 2014
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Full circle: is management
quality value relevant?: (main findings)
• Consistent with markets being informationally efficient no
difference in subsequent risk adjusted stock returns
• Cost of equity increases as management quality falls (4-6%)
• Well managed firms have more stable earnings and higher
profitability that persist over time
• A one decile increase in QM increases median firm predicted
market value by 4%!
• Good management is a valuable resource of the firm
‒ but is management quality already in the price?
Warwick Business School
CFA Masterclass 4 March 2014
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Some takeaways
• Emotion is integral to investing
• The purpose of trust is to allow you to invest
‒ it alleviates unconscious anxiety by delegating this
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(projecting) on to firm management
The real reason to meet and assess management is
psychological not information driven
‒ inherently a biased interaction
‒ only indirectly a marketing story
No evidence access to management has any investment as
opposed to emotional value
Firm trust and management quality measurable empirically
‒ but are these already in the price?
Warwick Business School
CFA Masterclass 4 March 2014
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