Machiavellian Investing – Part One

May 15, 2011

This is the first of a three-part series on Machiavellian investing.  How, you might ask could Niccolò Machiavelli, who died in 1512, tell us anything about investing in 2011?  The short answer is that Human nature has not changed.  Niccolò was famously skeptical about human nature and I have found that a good dose of Machiavellian skepticism is essential for distinguishing genuine from sham investment opportunities.

Princes of Commerce

Niccolò Machiavelli’s best known work, The Prince, provides advice for the princes of Renaissance Italy.   Today we have very few princes, at least in the realm of politics.  We do not believe that personal, autocratic rule is a good way to govern a country, but in business we believe that totalitarian rule is essential.  In fact, a CEO is a close modern equivalent of a Renaissance prince.  For that reason, Machiavelli’s advice to princes applies directly to CEOs. 

“How one lives is so far distant from how one ought to live, that he who neglects what is done for what ought to be done, sooner effects his ruin than his preservation; for a man who wishes to act entirely up to his professions of virtue soon meets with what destroys him among so much that is evil.”

CHAPTER XV—CONCERNING THINGS FOR WHICH MEN, AND ESPECIALLY PRINCES, ARE PRAISED OR BLAMED

This implies that, even if he wanted to, a CEO cannot be virtuous.   He must be at least as faithless, greedy, deceitful, and ruthless as his competitors.  In contemporary America (following the S&L meltdown, the dot com scandal, and the mortgage crisis), competition in the arena of corruption is especially intense. 

In practice he seldom has to worry about his reputation, because he will never be wanting for excuses.  

“Therefore it is unnecessary for a prince to have all the good qualities I have enumerated, but it is very necessary to appear to have them. And I shall dare to say this also, that to have them and always to observe them is injurious, and that to appear to have them is useful; to appear merciful, faithful, humane, religious, upright, and to be so, but with a mind so framed that should you require not to be so, you may be able and know how to change to the opposite.”

CHAPTER XVIII — CONCERNING THE WAY IN WHICH PRINCES SHOULD KEEP FAITH

In other words, CEO’s by the nature of their job must be not only mendacious but hypocritical.   That is not to say that CEO’s are insincere.  Like most people, CEO’s convictions tend to follow their interests.  That is, they believe what it is in their interests to have other people think they believe. 

Since we assume that CEO’s are profoundly mendacious, we modern Machiavellians, base our approach to investing on profound skepticism.

As a starting point, we Machiavellian, skeptical investors are on the lookout for CEO mendacity, which takes the form of corporate public relations, advertising, and lobbying.  Corporate communications deliberately, cunningly, and persistently promote a self-serving view of reality in which nothing but interference comes from the government, all good things in life flow from business, and CEO’s are heroic figures who direct their corporations with all the decisive bravado of kings leading their troops into battle. Of course, the CEO’s critical role in leading these goodness-giving corporations fully justifies their salaries. We can dismiss this corporate propaganda straight off.

However, not only must we be incredulous of CEO propaganda, we must be skeptical of the rhetoric of people who depend on the good will of CEO’s or the corporations they control.  This includes politicians whose election depends on corporate contributions to their campaigns and more importantly, on the absence of corporate contributions to their opponent’s campaigns. 

We must also include among those who depend on CEO’s good will, mass news/entertainment media, and the financial press.   There is no such thing as the liberal media. Media companies are big businesses and they are not the only employers in the world that cannot get their employees to do what they want.  The financial press depends heavily (for its raw material) on access to corporate executives and depends on corporate advertising in their publications.

Rating agencies derive their income from the same firms that they rate. Hence their ratings are likely to be reliable only when the value of the financial instruments they rate is unimportant.  On the other hand, in a case, such as the mortgage-backed securities that became the toxic assets of the recent mortgage crisis and the ensuing great recession, their ratings are likely to be not just worthless, but actively misleading.    

Brokerage company analysts also have deep conflicts of interest in the ratings they give corporate equities.  Analysts cannot afford to give a bad rating to a company with whom their employer has a lucrative investment banking relationship.  This conflict was at the heart of the dotcom bust and caused such analysts as Henry Blodget to be banned from the securities industry.

Furthermore, brokers are in the business of making commissions on trading stocks.  Successful investors are not active traders.  However, if an analyst’s recommendations did not promote active trading, he would not be serving the interests of his employers.  We can therefore expect analysts’ advice to be biased in favor of exaggerating trends, both positive and negative.  In fact, this is exactly what we see.  Analysts alternatively churn out scary stories (which promote panic selling), and enthusiastic reports on new investment opportunities (which prompt greedy buying). 

Finally, we must also be somewhat skeptical of those who depend for their livelihood and prestige on the high reputation of some industry or of business in general.  Some level of skepticism must extend to the business education establishment. 

All of the above-mentioned dependent groups have conflicts of interest and when it comes to business and economics, the things they say (and sincerely believe) are likely to be, in some important respects, self-serving rubbish.  

A Corrective

To compensate for pervasive mendacity, we Machiavellians challenge certain core tenants of corporate propaganda and adopt investment assumptions that compensate for them.

Myth:  In America economics is dominated by the Free Market.

Skeptical Assumption: There is no such thing as THE Free Market.  There are many markets and few of those markets are free either in the sense that they are open or highly competitive.  Barriers, such as high capital requirements, prevent new competitors from entering most markets.  Most real markets are oligopolies, that is, they have only a few sellers but many buyers.    For example, oil exploration and producing, auto manufacture, and health insurance are oligopoly markets.

In oligopoly markets, competition tends to be tame and limited to a few non-essential areas.  In a free market, all firms are price-takers, that is, they take the price as something that is given by the market, not something that they can influence.  However, in an oligopoly, individual firms’ actions can and do influence prices.  Further, they can and do cooperate by simple tit-for-tat reciprocity.  No firm wants to set off a destructive price war and for that reason price wars are rare.  Competition on price or quality is rare.  In real markets, firms tend to compete only in peripheral areas such as advertising or style.   

Myth: There are laws of economics, and it is silly to try to circumvent them.

Skeptical Assumption: Economics is not an independent scientific discipline analogous to physics.  Rather it is a special, albeit, important branch of political and social thought.  The “laws” of popular economics expressed by corporate executives, politicians, and business press is predominantly propaganda.

Myth: Corporate managers are highly skilled decision makers.

Skeptical Assumption:  Management is neither a science nor legitimate branch of knowledge (such as is the study of the law or even of numismatics).  Rather, management is a combination of institutional politics, industry expertise, and bookkeeping.  The idea that there is something like management skill in general, apart from its practice in specific industries, is a convenient myth that justifies astronomical executive salaries. 

Myth: New products come from visionaries in corporate marketing departments.

Skeptical Assumption:  New products come ultimately from new scientific knowledge.  This new knowledge comes from basic research, much of it at universities, which are funded by government.  We discover what we can discover, not what we want or need.  Corporations’ interest or effort in discovering new products is not fundamentally important. 

Big investment opportunities are simply applications of new scientific discoveries.  However, even when we find a promising application for a new scientific breakthrough, government programs (such as DARPA and NIH) are often a critical first step in commercializing the application.  Examples include mainframe computers with core random access memory, biotechnology advances such as mapping the human genome, and the Internet.

Myth: CEOs are heroic leaders

Skeptical Assumption:  Corporate leaders can do harm, but can do little good.  Corporate executives’ primary skills are political, not managerial.

Myth: The financial services industry spurs economic growth by developing innovative financial products.

Skeptical Assumption:  Financial innovations are suspect.  Commerce (as opposed to industry) does not lend itself to innovation.  On the contrary, we view a new financial instrument, or an innovative financing method as a harbinger of fraud.    

Myth:  Most corporations are honest, above board, and serve the best interests of the shareholders.

Skeptical Assumption: Corporate governance is almost completely a facade.  A corporation’s board of directors is seldom independent of the CEO.  The position of CEO and Chairman are often combined.  The Board of Directors has no source of financial information that is independent of management (as it would for example if the CFO reported directly to the Board). Share holders have no means of nominating Board members that are independent of management.  Management compensation is poorly supervised, and compensation programs reward management for creating short term profits (or the appearance of profits) at the expense of long term value. 

Implications

The above assumptions imply that in evaluating a company’s prospects for success and the prospects for your investment in that company’s shares, factors internal to that company are not likely to be critically important.  Furthermore, a business’s success has little to do with dynamic management, cleaver marketing, innovation, and its financial strength.  Many of the things that stock analysts do (e.g. analyzing financial ratios, making spreadsheets, and extrapolating future earnings based on management guidance) are of little value.  In the last three financial crises, stock analysts were the last to know.  In many cases, analysts were recommending the shares of companies that were later found to be insolvent. 

More important in predicting a company’s success is its positioning with respect to political trends, demographics, and scientific research done at universities and government laboratories. 

Part 2 of this series will examine some political and technical trends that are important and will continue to be important for the next 3 to 5 years.  Part 3 will pick some companies that, based on these trends, are likely to be winners and losers.

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