Investment Wisdom

69. Wesco Financial Annual Meeting 2005: Lessons Learned – Part 2 – Points 7-12

Excellent Book: Charlie Munger For All Seasons

Point 7. Should Accounting Firms Do Only Audit? Also, Combination of Flaws From Accounting Firms and Investment Banks Can Lead To A Big Mess

Accounting firms and investment banks had reached a near bottom. The combination helped messes like Enron to happen. In the accounting business, you’ve had a change – it’s been separated from the consulting business.

There’s another temptation: building buildings. You can save a lot of money by pouring less concrete, which is why buildings in Latin America often fall down. People will yield to temptation if they’re not carefully checked, so we have regulations and the building commissioners actually have to be present when the concrete is poured. By and large, [the result is that] the building record is pretty good in the U.S. Building inspectors and permitters are like judges – they are paid a salary. In accounting, we’re not going to treat them like building permit issuers – limit them to just checking things. We let them do consulting for tax shelters, etc. I was for it all the way along because for the most part they could do these things and the behavior was pretty good. But four or five years ago, this changed and pretty much every major accounting firm was selling fraudulent tax shelters and were participating – at least one partner was – in accounting fraud. They have thrown out those partners, in some cases reluctantly, but in any case they’re gone and the accounting is way better.

Whether we should have gone all the way and only let accounting firms do audits is an interesting question. I like accounting firms – we’ve had good service. But given all the temptations, I don’t know if it wouldn’t be best to make them do only audits. If we have another wave of scandals, CPAs will be asked to choose between certifying the accounts of publicly traded corporations vs. other activities. They hate it – checking the accounts is very boring; other work is more interesting, so they won’t be able to attract good people [to the profession].

The investment banks were just unbelievable. If you want to be really horrified, those of you who haven’t already read FIASCO [The Inside Story of a Wall Street Trader, by Frank Partnoy], the account of the derivatives trading desk at Morgan Stanley, it will turn your stomach.

I recommend the new book by Kurt Eichenwald, Conspiracy of Fools [about the Enron scandal]. He takes some liberties, like what the guy was thinking as he got on the elevator, but I don’t think the gist is wrong. The title is right: Conspiracy of Fools. A lot of this was delusion.

But the thing that is sickening is the investment bankers – but lawyers and accountants behave badly too. It’s good to rub your nose in it. If you can’t stand it all at once, then do it in bursts. If you throw up in between episodes, that’s OK too. (Laughter)

Some of these faults ought to be judged as they are in the church – as mortal vs. venial. The sin of smoothing of earnings was so widely done by so many people that we have to accept it as a venial sin. But now we’re changing the category, and we should. I think

we should think long and hard before we smooth the achievement record. I think a lot of smart people have decided “I’m not going within 10 miles of this whirlpool that can suck you down, break you up and spit you out.” Some people who only had small sins are going to get clobbered. But overall the prosecutorial discretion has not been abused.

However, once people are disgraced, pay a fine, etc., what’s the point of beating up a guy who’s half dead? Once he’s disgraced, do you need to stomp on him?

I don’t want to suggest that all of the puffery and folly is over, however. Now they wear tailored suits, but there’s a good bit of the old Mark Twain culture in those suits.

Part of it is from people who shrink from doing unpleasant things. Who hasn’t? It’s terribly unpleasant to fire someone. Or how do you tell someone not to go into a field [of business] with lots of money to be made because it smells? Or if their incomes are going down, there’s huge pressure to invent some products to keep their income up.

That’s why Warren doesn’t lay people off when our home-grown insurance company volume goes down.

There’s been ghastly behavior in the sale of annuities. The idea of shifting an old lady from one annuity to another to make a commission – you laugh, but it happens. The trouble is always with us. At the cost of being sickened by all the scandal, I think the behavior is getting better.

Point 8. Hedge Funds Results: You Need To Verify

I don’t know what will happen with hedge funds. They now have $1 trillion and all of them are on margin. History would indicate a certain percentage will lie about their results if they have any discretion whatsoever, and will try to cover up market errors if they can. I can confidently predict scandals. It will always be thus.

If you rise high in a corporation or elsewhere in life, you have a duty to be an exemplar – you have a duty to take less than you deserve, to set an example. [And By The Way, Jack Welch Was Underpaid When He Was Chairman and CEO of GE.]

The corporate governance thing, as it affects compensation, I do not think is getting improved. They [CEOs] will accomplish the same old thing, helped by clever lawyers. People will just get more sophisticated in the way they do it.

Perhaps a semi-public place like the NYSE will behave better, but the ordinary corporation will continue to escalate compensation. The key officers appoint the directors and then the directors decide how much the officers make. And then the officers increase the compensation of the directors, etc. You look around the table and nobody else is objecting. There are psychological pressures tending to gross abuse.

That’s not to say that all CEOs are overpaid. In my opinion, Jack Welch was underpaid for what he did at GE. But if you rise high in a corporation or elsewhere in life, you have a duty to be an exemplar – you have a duty to take less than you deserve, to set an example. This goes all the way back to Athens. The Athenians were like today’s United Jewish Appeal.

Public duty was not optional. Civilized man had a duty to act as an exemplar – and this was not a minor duty; it was a major duty of life. This is not mentioned by compensation consultants. (Laughter)

Point 9. Code Of Ethics: Apply Conduct Unbecoming an Officer

This should change. When I was an officer in the military, we had a rule called Conduct Unbecoming an Officer. It was not specific, but it said there were certain ways to behave as an example for others. I don’t see why we shouldn’t have this for our corporate executives. I would argue the CEO of Boeing was removed for Conduct Unbecoming an Officer. Messing up the email system of a corporation with hot and dirty email is Conduct Unbecoming an Officer. I would love to see the SEC make it explicit: “We hereby exercise our authority and say that there will be a new standard for officers of public companies called Conduct Unbecoming an Officer.” The lawyers would scream though – it’s not specific enough.

But if we ask our military officers, who risk their lives and risk being maimed [to adhere to this standard], then why can’t we ask this of some guy making $2 million per year? (Applause) Well that’s corporate governance. It’s certainly been interesting to watch as these messy stories unfurl.

  1. If a well-trained orangutan can see certain serious financial problems and the people in authority chose to ignore, what do you expect?

Oh, I’d say this: if you read the Eichenwald book on Enron, if there’s one issue to highlight, it’s that Arthur Andersen and the SEC allowed them to use Wall Street accounting to account for long-term contracts. It’s one of the worst things. A well-trained orangutan could see what it would lead to, but the SEC and the accountants lay down. This was 90% of the problem.

When accountants lie down, they are failing civilization in a truly important way. There’s no reason that people so secure – there are only four firms and they’re all the same, so it doesn’t do any good to fire them – can’t do better than they do. They’re secure and it’s terrible publicity, so there’s no reason the accounting can’t be better.

10. Harvard and Yale’s Investment Successes Have Unintended Impact

There’s $1 trillion in hedge funds and private equity is 3-4 times larger. Private universities have fixed-income departments, private equity for mid-stage investments, masses of complicated math to track risk in each class and how to judge each class, etc.

So far, it’s worked beautifully for Harvard and Yale – they got into some good things. But I feel about Harvard and Yale the way I feel about my own career: I feel that by getting rich in the way I did, I think my own example has hurt my own country. I think that Harvard and Yale have caused every charitable foundation to act in the same way. I think it has pernicious effects on civilization.

  1. Too Many Brains Going Into Money Management Is Not A Good Thing

It’s my guess that something like 5% of GDP goes to money management and its attendant friction. I define it broadly – annuities, incentive pay, all trading, etc. Nobody else has used figures that high, but that’s my guess. Worst of all, the people doing this are among the best and the brightest. Hundreds and thousands of engineers, etc. are going into hedge funds and investment banking. That is not an intelligent allocation of the brainpower of the civilization.

While we’re doing this, in Korea at Samsung, they have a meeting every day at 11 pm to review the day. Well, who is going to win if our brainpower is going into hedge funds and theirs is having a meeting at 11 pm? But nobody is talking about this. These people are honored. If people talk at the country club, one person might say, “Boy, my daughter is getting married to a hedge fund manager.” They’re making heroes.

My daughter is an art dealer and she says that most of her business is selling to hedge fund managers. If you make $100 million, why not have a fancy apartment and two Chagalls? You can’t get this [kind of money] elsewhere, so it goes on.

  1. Leverage is a Dangerous Thing That Can Lead To Real Mess

The action, the trading, the amount of credit… And to get good returns, the hedge funds need more use of credit. Of course, the firms that are extending the credit are the investment banks. If there’s any great wave of running for the exits, those people will get out fast. Unless the Federal Reserve decides to protect hedge funds, you could have a real mess.