Strolling through London's streets today, I witnessed a pedestrian's phone getting snatched in broad daylight. It’s not my first encounter with street crime, so I took a detour, clutched my phone like it was the last piece of chocolate, and gave everyone the side-eye. This episode made me think about the concept of trust more deeply.
Trust isn't just a feel-good concept; it is the foundation of every interaction, decision, and market exchange. It fosters collaboration and efficiency, supports autonomy and loyalty, and boosts investor confidence. Trust and confidence are intrinsically linked—both derive from the Latin root "con-fidere," meaning "to trust together."
Trust is also a key part of our investment process. Unlike many investors who primarily focus on building trust in their financial models, we concentrate on evaluating the trustworthiness of management. We adopt a cynical approach, stress-testing the trustworthiness of management by assessing their capital allocation decisions and the language they use when describing risks and opportunities. Instead of meeting with management directly to assess their trustworthiness, we observe their actions from a distance. We believe this approach helps limit our biases, as CEOs tend to be charismatic storytellers. A key part of our investment process also focuses on understanding the general mood of investors regarding a company, whether trust is building or breaking.
The following piece unpacks the underlying principles that guide us to find trustworthy management.
Trust Issues: The CEO Edition
CEOs are the foundation of trust in any organization. Their decisions and transparency can make or break the company's reputation and investor confidence. Unfortunately, the incentive structure for many CEOs often encourages them to prioritize near-term profits and delay admitting to building problems in the business. Admitting to problems early can damage their credibility and the company share price, leading CEOs to delay or downplay issues in hopes of resolving them quietly.
Investors, however, need to trust management as they have to rely heavily on indicators released by management to make investment decisions. When key indicators start to disappoint and deviate from the story management has been selling, trust issues between investors and management start to build.
Trust Issues: Add Data + AI And Stir...?
As an investor, one can either trust management to do their job or not. Without trust, it is common to fixate on gathering as much information as possible to maintain oversight. With today’s abundance of data, more and more investors are tempted by this approach. Predictive analytics, algorithmic trading tools, sentiment analysis, and similar technologies make it look very attractive, giving investors a sense of control. And now, with AI in the mix, everyone thinks they have a crystal ball…
However, this can also make it easy for investors to overlook their own limitations, leading them to spend disproportionate amounts of time crafting detailed models. This approach is a massive time sink as relying on an information advantage means endless chasing of information - tons of meetings with management, experts, customers, etc. Many investors view these tasks as worth their time, convinced their models will outperform those made by others. Having lots of information and following a complex model gives many investors a sense of mental comfort in uncertain times - no stone has been left unturned. Although more uncomfortable, our method avoids the temptations of over-precision and instead uses a few heuristics (hence Heuristik Capital…) to cut through the noise and focus on key information.
Our Method: Trusting Only When the Stars Align
We live in a complex system with lots of difficult-to-forecast interactions and feedback loops. We think it is impossible to predict the future with any meaningful degree of accuracy. Instead, we focus on finding business models and environments with lower inherent risks, which reduces the need for predictions. Lower-risk business models help mitigate CEO risk, which isn't a silver bullet, but it does help: it's smarter to trust a solid business model that gives a CEO the time and resources to react to change than trusting management based on a narrow prediction of the future state of the world.
How We Determine whether the Stars Align:
The strength of the business model: does it have rare features that position it well to grow revenue or profitability; does it have resilient features that can fend off competition and make it through a market downturn
The state of the competitive environment: is capital crowding in and potentially resulting in lower future profitability; are the rules of success changing as customer preferences shift or regulators step in
The overall direction of of risk: is management’s strategy going according to plan and are they allocating capital effectively; is investor confidence building or breaking
Having a robust business model and lower-risk environment are necessary but not sufficient conditions for us to build trust in management.
Our Method: Decoding Trust
We certainly use data to evaluate a company’s performance and management; however, we believe that data becomes truly powerful when combined with an assessment of management trustworthiness.
How do you build trust with a person? We think this comes down to observing how someone’s words and actions align, and the consistency of their actions over time. This is exactly what we also do with management.
Questions we typically ask ourselves when reading earnings transcripts:
Are they upfront about mistakes and explain adverse events thoroughly? Are they clear and consistent about what is inside their control and what is not?
Do they strike realistic plans which they then go on to meet or beat? Do they allocate capital effectively against those plans?
Do they fixate on near-term growth at the cost of long-term shareholder value?
Transparency can upset investors when news is worse than they were expecting. But for us, it often builds confidence. Mark Zuckerberg and Meta is a good example. In October 2022, Meta’s share price fell 25% following weaker revenues and an investment splurge on the metaverse and virtual reality. The results shook investor trust in Meta. Following this, Zuckerberg understood the need to build back investor trust - growth plans were reset, and speculative investments behind the metaverse were cut. Management language in the transcripts matched this change; instead of communicating an abundance of growth, a more conservative and cautious strategy was put forward and consistently followed quarter by quarter.
We expect CEOs to make mistakes – they are humans tasked with making difficult decisions under uncertainty. This is why we look for business models that can help mitigate the damage that comes, either when a CEO makes a mistake or when risks outside management’s control realize and blow plans off course. Zuckerberg’s changes have resulted in a business model and growth plan better aligned with its environment. Investor confidence has been slowly rebuilding, and it is a story we continue to watch.
Finding transparent management also brings other positives for a business: it allows for a positive feedback loop within its own culture. A trustworthy CEO sets a precedent for the entire organization, fostering a culture of openness and accountability. This culture, in turn, can attract top talent, as employees prefer to work in environments where they feel their leaders are honest and transparent. It also reassures investors that the company is managed with integrity, potentially leading to a more stable and loyal shareholder base. For example, Netflix, under the leadership of Reed Hastings, has cultivated a culture of freedom and responsibility, as detailed in the book "No Rules Rules." Their culture promotes honesty, openness, and high performance, attracting top talent who thrive in an environment of trust and autonomy that leads to the long-term success of the company.
Conclusion
We believe that blending quantitative signals with qualitative assessments of how management communicates and reacts to change gives us a good indication of whether management is trustworthy or not, and whether the investment case is coming under strain.
While we don’t like to say we trust CEOs blindly, we prefer to invest in CEOs we don’t have reasons to distrust. Being skeptical of a good story and not being tempted by the illusion of knowledge is critical to help navigate a noisy marketplace where oftentimes all that glitters is not gold.
The topic of trust in investment is a big one, and part of behaving as trustworthy managers for our clients is holding ourselves accountable to the same standards we expect from the companies we invest in. I would therefore like to explore the importance of trust between clients and asset managers, as well as within an investment team – but that’s a topic for my next post.
Stay tuned, and in the meantime, be wary of smartphone snatchers, and even more so, smooth-talking CEOs!
- Afaf
Disclaimers:
This blog post is provided for informational purposes only and does not constitute investment advice, financial advice, or any other type of advice. The information contained herein is not intended to be a substitute for professional advice, including but not limited to investment or financial advice. The content presented in this blog post reflects the personal views and opinions of the authors at Heuristik and it may not necessarily represent the views of any other individual or entity.
Investing in financial markets involves risk, including the risk of loss. Past performance is not indicative of future results. Before making any investment decisions, it is important to conduct thorough research and consider seeking advice from a qualified professional, such as a licensed financial advisor or investment manager.
Heuristik is not a registered investment advisor, broker-dealer, or financial institution. We do not endorse or recommend any specific investment products, services, or strategies.
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a.auf@heuristikcapital.com