Investing is more about integrity

What makes a business worth lending to or investing in? People often think in terms of cash flows, assets, profits, and so on. But character may play an even bigger role.

Here is a famous exchange between Samuel Untermyer, Counsel to the US House of Representatives, and the legendary banker J. P. Morgan, during a testimony before the Congress in 1912.

Untermyer : Is not commercial credit based primarily upon money or property?

Morgan : No, sir. The first thing is character.

Untermyer : Before money or property?

Morgan : Before money or anything else. Money cannot buy it… a man I do not trust could not get money from me on all the bonds in Christendom.

Bill Gross, co-founder of PIMCO, the world’s largest bond investor, in a recent interview with Becky Quick of CNBC discussed an important lesson that he had learnt from three incidents in his life that took place between 1974 and 1975.

The first one was concerning two reputable, smart and intelligent gentlemen, named Warren Buffett and Charlie Munger, who were looking to borrow $10 million for their company called Berkshire Hathaway.

On the face of it, at that time, Berkshire was a strange-looking company which owned a dilapidated industrial complex in north-east US; sees candy stores in California and Blue Chip stamps, which was into a declining business of discount coupons. Although the people definitely seemed worthy of funding, PIMCO chose to pass up the opportunity by evaluating the company alone.

Evaluating opportunities

A few months after that, Bill happened to visit a small town in Arkansas called Bentonville to evaluate another opportunity with a company called Walmart. He was floored by the spirit of the founder, Sam Walton, and the trust Sam enjoyed with the local community. Sam had come down to pick him up on arrival in a pickup truck along with his entire family, including his dog. They drove him around the town, showed him the Walmart stores, introduced him to the local community, and explained to him their desire to expand their business in other States within the US — such as Iowa, Ohio and so on.

But again, Bill decided to pass up the opportunity second-guessing the idea and what was then a dingy-looking business, although he felt that the people were of very high character and reputable. He felt that the assets and property weren’t sound enough.

Later that year, Bill was evaluating another opportunity with a company called Itel, which was in rail car leasing. The company folk took him to the rail yards, where he was pleased with the size and quality of assets made of real steel.

He became convinced that these assets were very stable and could be banked on, as they would never go away. Then they took him to their headquarters in downtown San Francisco — a 30-storey building with a view of the Golden Gate Bridge, with wonderful interiors, thick carpeting, well dressed executives and secretaries.

After looking at the impressive package if it all, Bill finally decided to invest in the company. Within six months, the company was bankrupt.

Business based on trust

Much later when Bill was reading about J. P. Morgan, he recognised the common thread to his three mistakes, which included both errors of commission and omission.

Morgan basically argued that “Lending is not based on money or property; lending is based on character — on character first sir”, during the landmark congressional testimony in the early 1900s.

Bill then realised what he had missed — the importance of people and their character — since a financial transaction is primarily based on trust and trust alone. He had earlier chosen to rely on the flash, which only resulted in him losing money.

Ever since, PIMCO has not forgotten this key lesson and Bill continues to hang the portrait of J. P. Morgan along with the famous saying on the wall in his office.

Bill claims that it is in fact this lesson that he learnt in the eighties — the importance of character as opposed to property or collateral — that held him in good stead when he chose to avoid investing in subprime.

The broader implication of character is the value system and governance within organisations.

There’s a very pertinent lesson to be learnt here for businessmen, entrepreneurs, corporate executives and investors alike.

Today there are many companies which seem to believe that profit comes directly from raising equity at unreasonably high valuations and not something that gets generated after deploying capital judiciously for generating revenues and after paying out all expenses including taxes.

Value system

Taking off from Buffett, in my opinion, over the short term, the market may behave like a voting machine and reward companies/individuals with flash, but over the long term — and I am talking about organisations that have survived many generations — a strong value system is vital for surviving and thriving in the world of business.

Those that retain it like the Tatas go on, while those that lose it somewhere along the way, a la Lehman, collapse.

Of course, the underlying assumption is that the political and legal framework provides an even playing field for companies/individuals with character — whether it does or does not is another subject altogether!

I’ll conclude with another saying by Warren Buffett — “I look for three things when hiring people. The first is personal integrity, the second is intelligence, and the third is a high energy level. But, if you don’t have the first, the other two will kill you.”

(The author is a business consultant. Feedback can be sent be >perspective@thehindu.co.in )