Finance is about money and people, never one without the other.

People have biases. Some are driven by numbers and are better positioned to work with big sets of repetitive data, others prefer a more open-ended approach and are less driven by a process. Subtle differences in what one is solving for will meaningfully affect investment outcomes.

In high-quality companies with relatively little debt, the incremental financial performance – alpha – comes from anticipating the rating agencies’ actions and the markets’ reaction to their communication. The time and mental capacity spent on considering those exogenous variables always competes with the fundamental research. For the well-diversified portfolio of high-grade companies to outperform, one needs to be able to analyse many borrowers simultaneously and to anticipate how their stories might land with investors at large.

The analysis of borrowers in distress changes almost entirely; it pivots on the endogenous conditions. Balance sheet strength, liquidity, and legacy commitments – together with the small print which governs them – will define the operational capacity, which is available to implement the necessary remedies. Investors’ mistakes here can be lethal, and with a low margin for error, having a quality management team with the ability to execute is critical.

Equity analysis is not that different from a distressed credit. It is mainly endogenous to the companies’ fundamentals, but with an added focus on future growth and a pinch of optimism.

Then, there is also the space in between – companies for which endogenous and exogenous considerations matter in equal measure. They are the lower quality, so-called high yield, or junk bonds. In this space, companies’ primary focus is to remain viable, or going concern, long enough to be able to secure new funding. The refinancing of old debt can come with additional equity – IPO or stronger player – or without, in the form of leveraged buyouts. Some businesses achieve this by growing and reducing leverage others do it by shrinking and cutting costs. Those that do not survive are sold for parts, which invites a different set of investment consideration and skill.

Security analysis is at the core of all lending, and lending is a people’s business.

For the research to drive investment performance, it is imperative to match the best talent – people and technology – with the right opportunity. It is easier said than done. Most asset managers seek comfort in numbers by making their analysts cover companies across many sectors, geographies, and capital structures. This optically pleasing narrative promotes endless synergies and points to a plethora of potential relative value opportunities, making marketing easy for firms with vast resources.

But having armies of analysts is not always a differentiator. When organised poorly, inundated with meaningless administrative tasks, ill-equipped with technology, and undermotivated, people will always choose to survive first before they can perform. Groupthink tendencies inevitably creep in and analysts lean more towards what is conventional and expensive over the more idiosyncratic opportunities with better upside potential.

Three foundational pillars can help firms organise better.

First is the vision.

It can be expressed through a robust and dynamic fundamental framework, which is thematic and agile, able to adapt to the rapidly changing world. Such a framework can offer immeasurable benefits but is impossible to implement in an operationally complex environment. Without a framework underpinning all research, the efficacy of investment decisions is no better than a flip of a coin. Useful litmus test on the existence of such frameworks is the following question: ‘Have your security analysis and research process changed in the last twenty years, and if so, how?’

Second is establishing the right culture.

An environment that can facilitate the exchange of ideas, retribution-free brainstorming, transparency, and which assigns individual accountability and promotes meritocracy. It is also the culture of robust risk management, which acknowledges the learning merits of a mistake, but limits its impact on the portfolio. Those who argue that establishing the right culture should come before the fundamental framework are probably also right.

Execution is the third.

Ability to successfully match the talent with opportunity is a soft, but tremendously important managerial skill. It is hard to come by or develop leaders who combine obsession with markets and the inner drive for performance with a profound sense of acknowledgement of people. Human resources and investment teams rarely interact, and seldom managers actively connect self-development and mental hygiene with the high-performance environments.

Incentives matter and they drive behaviours, both personal and of the team. The individual performance always contributes to the overall success of the group. Multitasking by playing different instruments may be appealing as a street act, but it would detract from the quality of a musical piece performed by an orchestra. Finding the right balance between specialisation and teamwork is crucial. Analysts in the early stages of learning might contribute best in sectors where informational content is plentiful, and the consequences of a single mistake are limited. The more experienced analysts self-actualise differently, their value-added is higher when looking at companies with more asymmetric risk profiles.

Solid vision and framework, an authentic culture with the focus on performance, and a razor-sharp execution enable good chemistry between the talent and opportunity. In this context, the sustainable investment performance hinges on the combination of intellectual honesty, perpetual curiosity about people, equitable attribution, and the courage to innovate to facilitate all of the above.

Finance is always about money and people, never separate.

© 2020 GOALSFIRST LTD.

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