This post was originally published on October 13, 2016.
With just a few weeks to go until Election Day, this year's political spectacle continues to provide jaw-dropping media fodder on a daily basis. While the idea of vitriolic debate is not a new concept in the context of U.S. politics, the current cycle is notable because of the unusually intense amount of energy both major party candidates have focused on the other's moral character and integrity as opposed to matters of actual governance and policy. While I don't want to use this forum to opine on who our next chief executive should be, I do think this backdrop offers a good reason to pause and ask ourselves: does integrity really matter? Should integrity matter in business and investing?
Theodore Roosevelt once recounted a tale from his time spent cattle-ranching on the western plains of the United States. At the time, no fences divided one rancher's property from another. The unwritten code of the land dictated that any unbranded animal belonged to the rancher on whose land the animal was found. One day Roosevelt was riding on a neighbor's lands with a recently hired cowboy when they came across an unmarked yearling. The cowboy made preparations to apply Roosevelt's brand to the animal and when Roosevelt told the cowboy that the calf should be branded as his neighbor's the cowboy replied, "That's all right, boss; I know my business. I always put on my boss's brand." Roosevelt stopped the cowboy and told him to return to the ranch, collect his pay and leave; Roosevelt would no longer be requiring his services. When the cowboy protested that he was acting to his employer's benefit, Roosevelt replied:
"Yes, my friend, and if you will steal for me you will steal from me."
Roosevelt's tale is a poignant account that highlights the importance of trust in interpersonal relationships. Anytime that we engage in a relationship where we must rely on another individual, we must trust them to act with our best interests in mind, even when we are not around. For a parent, one of the most important acts of trust is investing faith in a childcare provider. Whether it is a nanny or babysitter at home or a teacher at school, we trust these individuals to guard our most precious treasures, our children, with their lives. In this context, it is of course perfectly natural that we would not hire for this role any individual that has a history of excessive vice (drug or alcohol abuse, intemperate behavior, criminal record, sexual abuse, etc.). Similarly, when we seek out a spouse most of us generally apply similar screens for character and integrity. How many marriages work out well in the long-term in the absence of integrity?
The question then becomes, should it be any different in business? As a purely hypothetical exercise, let's pretend that a friend approaches you to start a small business together. The proposition would involve both of you investing a sizeable amount of cash at the outset and both of you would have the ability to access the business's accounts and assets, i.e., write checks and withdraw cash from the bank. Your friend is very clever and has a sharp mind for business having proven able to make money in other past ventures. However, this person also has a heavy drinking habit and is known for their fondness of gambling at the casinos. Your other friends also seem to think that this person has struggled with drug addiction in the past.
Before you decide whether or not you would want to make the investment, I would first challenge you to ask yourself, would you trust this person to watch your children for an evening? If you passed away, would you trust this person to care for and raise your children in your absence? If the answer to these questions is no, and you don't feel that you can entrust this person with caring for your children's lives, why would it be okay to entrust them with your children's college savings?
There are many people who treat stock market investing as some sort of abstract game of mere numbers, regressions and probabilities. Many of the tools of the trade certainly fit the notion. There are countless brokerages, websites and publications that are willing to sell investors sleek looking software tools with blinking green and red numbers and fancy charts that make it all look and feel like a table game in Las Vegas. Yet a stock is not just an abstract amusement. A stock is a tangible investment of money into a business. That business is run by actual human beings who make decisions that have real-world implications on what becomes of the shareholders' money. When we buy a stock, we are explicitly endorsing the issuer's management and employees with our trust and faith. We are entrusting them with our property, our capital, and hoping that they will be responsible stewards of that capital. The decisions these people make will ultimately impact whether or not we can pay for our children's education, fund our retirements, or contribute to our philanthropic causes. If these individuals are wise in their judgments and measured in how they conduct themselves, we have nothing to fear. If they are foolhardy and profligate, we could lose everything. Bearing this in mind, is it unreasonable to hold a CEO in whom we invest to a different standard of character and integrity than the babysitter with whom we entrust with our children's lives?
Perhaps all of this sounds like an unrealistically idealistic set of rhetorical criteria to apply to the world of business and finance. After all, haven't there been plenty of examples of unsavory characters who have made their investors plenty of money in spite of their character flaws? The answer, I believe, is yes in the short run; but any assumptions about such a proposition's sustainability over a long-term horizon is inherently purely speculative. The world seems to have a funny way of eventually revisiting karmic retribution on unscrupulous actors. One doesn't have to think too long to come up with an instructive list of examples of immoral individuals who ended up losing or stealing massive sums of wealth.
A prime example is the recent case of Valeant Pharmaceuticals. Up until recently, many on Wall Street lauded former Valeant CEO Michael Pearson as a wunderkind executive who applied exceptionally rational decision making to the often irrational business of making and selling drugs. Investors believed that Pearson would be able to use his management consultant expertise to generate excess returns by buying inefficient companies and improving their profitability. Pearson went on a prolific buying spree sucking up dozens of drug companies through acquisitions. Citing the low returns usually generated on research and development at most pharmaceutical firms, Pearson would typically shutter the labs of the firms he acquired and lay off the research staff. Instead, he focused on harvesting the benefits of drugs already on launched by his targets. He and his team would aggressively raise the prices of the drugs they acquired, in some cases by more than 500%.
The scheme worked well for a number of years and, at its peak, Valeant reached a market capitalization of $90 billion. However, the company became the target of negative news stories and, subsequently, political attention. The company's aggressive pricing practices came to light as did aggressive accounting treatments and questionable drug cost reimbursement practices. As his empire crumbled, Pearson was excused from the company to take a medical leave and stories circulated that he had struggled with alcoholism. Myriad lawsuits and investigations have ensued and the company has faced increased regulatory pressure. The share price has tumbled more than 90% from its peak wiping out over $80 billion in shareholder wealth in the process.
Valeant was not the first time the world saw value destruction of such massive proportion. There are older cases like Enron, Worldcom, and Bernie Madoff; and let us not forget the entire subprime mortgage crisis that caused the great recession in 2008. In each of these examples, unscrupulous individuals at the core of these organizations engaged in ethically questionable if not criminal behavior. Investors may have made out well in the early years of each scam, but the ultimate results were utterly catastrophic. Anyone who thinks that they can "ride the wave" on such gambles and time their exit at the top is playing a risky game indeed.
I spend a lot of time studying the integrity of a company when researching potential investments. I tend to focus a lot of attention on how the firm treats its customers and employees and what kind of impact its activities have on its community. I try to view the world from other stakeholders' shoes: would I want to be an employee, customer or supplier of this company? Abusing customers or employees might be good for shareholders in the short-term, but over the long run it is not a sustainable business practice and the ultimate comeuppance could be disastrous. Be wary of those who will steal for you, for ultimately they may steal from you.