Institutional Investment: Good Ideas – Few And Far Between by Cook & Bynum
Good ideas are rare. Investors are best served by focusing on areas where they have real insights and competitive advantages, and avoiding making decisions simply for the sake of “doing something.”
In the world of institutional investment, which tends to think very, very big, I’ve recently found myself extolling the virtues of small. I’ve been telling the Giants I work with to think about a set of assets that they understand deeply and to work to shrink the number of decisions they have to make, the number of relationships they have to manage, the number of people they oversee, the number of line items in their portfolio, the number of external managers they use and so on and so forth. I have two main reasons for thinking these increasingly small thoughts: 1) past academic research says small organizations rock big ones; and 2) present-day evidence tells me that most Giants are woefully underresourced, which means they should be doing less and doing it better. So, let me dig into each of these to help explain what I’m on about.
First, academic research clearly illustrates that as investment organizations get larger in terms of assets, their investment performance suffers. It’s reasonable to assume that this lapse stems from the difficulties in deploying large sums of capital in illiquid markets. However, a seminal 2004 paper showed that performance is affected in large part because of the diseconomies that go along with large organizations in terms of the bureaucracy. The authors demonstrated that certain types of “soft information” do not easily find purchase or have sway in the context of a large organization; that the great ideas based on soft information — i.e., the insights you get from boots on the ground — are slow to disseminate among management teams, hindering their ability to make informed decisions on a timely basis. The punch line is this: Big organizations with lots of people and administration tend to underperform small organizations, especially in illiquid assets, due to hierarchies.
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… I’m suggesting that “thinking small” means Giants should hold a concentrated set of assets that they understand deeply (as opposed to holding many assets they barely understand). Most Giants are overdiversified in terms of almost every risk I can think of. Instead, they should focus on opportunities where they can excel and seek to drop those assets where they can’t. As Warren Buffett has said, “Wide diversification is only required when investors do not understand what they are doing.”
The big question, then, is how these organizations might mobilize small thinking into their investment and operational strategies. For instance, why not establish a set of quantitative targets for the key areas that can creep up in size, such as “line items in a portfolio” or number of investment personnel you have on staff per line item? If you are a $100 billion Giant, why not put an absolute cap of 300 line items and 30 talented and highly compensated investment professionals? Also, since long-term investors may only turn over 10 to 20 percent of their portfolios per year, you’d only need 30 to 60 good ideas per year. In the context of 30 talented people, that’s totally doable. So rather than filling hundreds of desks with people around the world collecting information, small-thinking institutional investors could hire a handful of world-class people and provide them a mandate to go out and find the best opportunities – directly, themselves, or indirectly, through managers – and execute. Take Berkshire Hathaway as a not unreasonable example: The company may employ 330,000 across all of its entities, but Berkshire corporate, which makes all the investment decisions, runs with fewer than 30 people.
To think small, Giants will need an internal team with a culture of excellence and accountability in which individuals accept and embrace the risks that come with this approach. They will also need a Board that truly understands and supports this strategy, which will inevitably put strains on the organization when short-term volatility comes into play. Even if these two factors are unlikely to manifest in most public pensions, I’m beginning to think this is still the right path for future institutional investment success. To borrow the wise words of Kunu, “The less you do . . . the more you do.”
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