Overview

1. The vital role of trust in investing“fido ergo emo”Richard Taffler FSIPProfessor of Finance and AccountingWarwick Business SchoolCFA Society of the UK MasterclassBNY Mellon CentreMarch 4th 2014 CFA Masterclass 4 March 2014

2. 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 CFA Masterclass 4 March 2014

3. 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 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 CFA Masterclass 4 March 2014

4. 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 • 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? CFA Masterclass 4 March 2014

5. The need to be able to trust • 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? CFA Masterclass 4 March 2014

6. 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) CFA Masterclass 4 March 2014

7. What is trust? (cont…) • Trust is a function of [both] the trustee’s 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) CFA Masterclass 4 March 2014

8. 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 CFA Masterclass 4 March 2014

9. 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 CFA Masterclass 4 March 2014

10. 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” CFA Masterclass 4 March 2014

11. 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” CFA Masterclass 4 March 2014

12. 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…” CFA Masterclass 4 March 2014

13. 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” CFA Masterclass 4 March 2014

14. Why is meeting management so vital? • “We don’t think there is any substitute for meeting 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? CFA Masterclass 4 March 2014

15. Putting a price on meeting management • The “cash for access” story • Company access ranked 4th out of 12 categories in the II 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? CFA Masterclass 4 March 2014

16. 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 asked” (IR manager) • “ a time-consuming investment in theatrical self-presentation” • “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? CFA Masterclass 4 March 2014

17. Direct parallels with the job interview – a behavioural minefield? • 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? CFA Masterclass 4 March 2014

18. Research evidence on the investment case for meeting management? • Private 1-1 meetings at brokerage house 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 CFA Masterclass 4 March 2014

19. Research evidence on the investment case for meeting management? (cont…) • Similarly corporate site visits in China only 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? CFA Masterclass 4 March 2014

20. Valuing trust as an intangible asset (a pilot study) • How does the market value firm trust empirically? • Issues of information asymmetry, adverse selection and 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 CFA Masterclass 4 March 2014

21. 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! CFA Masterclass 4 March 2014

22. 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) CFA Masterclass 4 March 2014

23. 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) CFA Masterclass 4 March 2014

24. 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? CFA Masterclass 4 March 2014

25. Some takeaways • Emotion is integral to investing • The purpose of trust is to allow you to invest • it alleviates unconscious anxiety by delegating this (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? CFA Masterclass 4 March 2014