warwick business school the vital role of trust in investing “fido ergo emo” richard taffler...

Warwick Business School

The vital role of trust in investing“fido ergo emo”

Richard Taffler FSIPProfessor of Finance and Accounting


CFA Society of the UK MasterclassBNY Mellon Centre

March 4th 2014

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 paradoxCFA 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 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



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?



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?



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)



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)



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



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



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”



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”



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…”



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”



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?



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?



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?



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 17


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



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?



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



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!



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 22


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)



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?



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?


warwick business school the vital role of trust in investing “fido ergo emo” richard taffler...

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