I invest in a lot of insurance companies.? It is the industry I know best.? When I worked for a hedge fund as an insurance analyst, they called me the weatherman.? I subscribed to a wide variety of services on hurricanes, but I eventually concluded that the forecasts of major hurricane analysts have a bias, and the best thing to do is to look at the error versus the forecasts, because when the error goes to the left, it tends to go further to the left, and vice-versa for the right.? In this case, the storm Irene is rightward biased versus the forecasts.
That’s why I said this two days ago.? It’s easy to panic over hurricanes, but harder to analyze the situation and suggest that the estimate are wrong.
At worst, I think Hurricane Irene will clip the easternmost point of North Carolina at worst, and very possibly miss the US entirely.? Little risk to the insurance industry.
This book was surprisingly good, and ambitious.? It takes on the short-term nature of our business culture in many areas:
The nature of the problem is that the owners no longer work for the corporations, and so managers run companies for shorter term objectives.? Owners would care more about the survival and long run profitability of the firm.
Much of the financial crisis stemmed from managing for the short-term, as financial institutions moved from a originate-to-hold to an originate-to-sell model.
Corporations focused on meeting quarterly earnings estimates, possibly to the exclusion of longer-term profitability improvements.
Investment managers manage for the short run as they try to beat indexes in the short run rather than over the long term.? Investors pulling money in the short term influences that.
The book then takes on these problems, and proposes solutions:
Create the proper long-term incentives for all parties: Executives, Line managers, and Employees.? I think he gets it right.? Make them long-term, and relative to a proper market index.? Or do it on a book basis, but make the hurdles reflect the cost of capital.
Communicate to the external world that you are no longer going to play the short-term game, like Berkshire Hathaway.? No more earnings guidance, and no more pseudo-earnings guidance where the analysts get enough to publish their estimates.
Most boldly: adopt new accounting principles that revolve around free cash flow, not earnings.? Make balance sheets probabilistic.? (even as an actuary, I don’t think we are ready for that, good as it would be)
Incent investment managers properly.? This is probably the weakest part of the book, because the problem of incenting investment managers properly is probably impossible.
Finally, how to make money.? Concentrate your investments, and if you are a good investor, you will make money over the index.
Now, some of these insights are truisms: sure concentrate your investments, and if you have good insights, you will do well.? Duh.? Most professional managers don’t have good insights, but they aren’t dropping out, and their investors are sticky enough.? That will be hard to change.
But creating longer term incentives for managers and realizable goals for workers are significant ideas.? I have argued for these for some time.? At my fellowship admissions course for the Society of Actuaries, I remember arguing with a consultant over these ideas, where she told me that longer-term incentives were unrealistic.
In a similar vein much of the book argues that you should think like a life actuary (my words, not the author’s).? Discount over the long term, taking into account interest rates and likelihood of the cash flows occurring.? I can heartily back that idea, though I wonder how well the average professional would deal with the concept.? Imagine a new income statement that has a pessimistic, realistic, and optimistic scenarios, and has ranges for accrual items off of that.? I would enjoy that, but the average investor would blanch at the complexity.
Average professionals, much less investors, don’t do well with probability? They want a point estimate and that is human nature.? Are we trying to create the NEW CAPITALIST MAN here?
Maybe, and I actually like the effort, though I think it won’t amount to much. Eliminating self-interest is very difficult; channeling it is another matter.
Quibbles
The book uses the exact same quote from Peter Bernstein on pages 54 & 130… come on, you can do better than that.? Where is the editor?
Beyond that, if you are going to rework the income statement, then differentiate between investment capital expenditures, and maintenance capital expenditures.
I think the proposed excess return versus shortfall ratio is flawed.? Under your definition, a manager who beats once by a lot, and loses often by a little, but loses versus the index overall would look good.? I think it is better to just look at long term returns versus the index, and consider Buffett’s dictum, “I would rather have a noisy 15% than a smooth 12%.”
Full disclosure: The publisher sent me a copy of the book for free.
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