The Bedrock of Due Diligence? Skepticism and “Cracking the Narrative”
There’s a classic scene in the 1976 Watergate drama All the President’s Men when Robert Redford, playing reporter Bob Woodward of The Washington Post, tells his secret source, Deep Throat, “The story is dry”:
Bob Woodward: The story is dry. All we’ve got are pieces. We can’t seem to figure out what the puzzle is supposed to look like. John Mitchell resigns as the head of CREEP, and says that he wants to spend more time with his family. I mean, it sounds like [garbage], we don’t exactly believe that . . .
Deep Throat: No, heh, but it’s touching. Forget the myths the media’s created about the White House. The truth is, these are not very bright guys, and things got out of hand.
Bob Woodward: Hunt’s come in from the cold. Supposedly he’s got a lawyer with $25,000 in a brown paper bag.
Deep Throat: Follow the money.
Bob Woodward: What do you mean? Where?
Deep Throat: Oh, I can’t tell you that.
Bob Woodward: But you could tell me that.
Deep Throat: No, I have to do this my way. You tell me what you know, and I’ll confirm. I’ll keep you in the right direction if I can, but that’s all. Just . . . follow the money.
Now what, you may ask, does this have to do with due diligence?
It’s simple: Anyone conducting due diligence and manager selection should watch All the President’s Men, according to Tom Brakke, CFA, principal of tjb research and a highly respected author on the topic of assessing the quality of the due diligence capabilities of an organization. Due diligence, Brakke believes, is one of the most important and yet most overlooked aspects of investment practice today.
(Brakke also recommended Spotlight, the true story of how reporters for the Boston Globe uncovered the decades-long child molestation scandal and cover-up within the Roman Catholic Archdiocese of Boston. Both films are about the power of investigative journalism.)
Why these movies? Because, at its heart, due diligence is “an investigative process where you’re trying to ferret out new information,” Brakke told delegates at the 2016 CFA Institute Wealth Management Conference in Minneapolis. “It’s discovery.”
To take the point one step further, if you are a research analyst performing the due diligence, your job, like that of Redford’s character, is to “figure out what the puzzle is supposed to look like.”
Brakke framed the responsibility in this way: “When we think about due diligence, it really starts from a standard of care that we have for our clients, a responsibility to investigate and pursue rigorously the investments that we choose on their behalf, and that naturally leads to a process of documentation that goes along with that.”
He continued, “Unfortunately what’s also happened is we’ve developed a culture of documentation, that when people talk about due diligence in manager selection, often they’re talking about collecting the available information that’s out there to make a decision. That leaves out the most important part of due diligence, which is discovery.”
Brakke, who writes frequently about due diligence on his blog, the research puzzle, urged the audience not to focus on performance chasing but to rather dig deep into the structure of the organization.
“You need to focus much, much, much more on non‑investment functions,” he said.
Most standard due diligence evaluations focus on the three Ps: philosophy, process, and people.
“You’re used to seeing them, we talk about them all the time,” Brakke explained. “My question is this, Where do you get the information from, about these three? The asset managers themselves? Isn’t that convenient? These firms have become narrative creation machines.”
While these narratives are necessary, the problem is that “they go largely uncontested on the qualitative side, because not enough time and attention is spent on it,” Brakke said. “An analyst’s job is to crack the narrative.”
He cautioned would-be truth seekers not to be swayed by the tale the company wants to tell.
Brakke said the story must be yours, not that of the firm.
“The narrative creation machine has two parts, really,” Brakke explained. “The first is just talking about what’s going on in the world in terms of investments — the investment ideas, portfolios, all the sorts of things that naturally come out of working in an asset management organization. My question to you is, Which is more important to you? The investment value of that, or the communications value of that?”
Brakke noted that it’s the communications value that is more important, “because these are really smart people talking about important things, and you can take what they have to say and use it for your own purposes and with your own client.”
“What I would urge you against is to not get hung up on what they say from an investment standpoint, because you’re going to chase your tail,” Brakke said. “Somebody’s going to be hot, and then they’re going to be cold, and ebb and flow. There’s really no consistency to it, and you end up spinning your wheels and diverting you from what’s really the purpose of due diligence, and that’s to understand the organization.”
How does a research analyst do this? By being skeptical. “That’s the bedrock of this process, skepticism, and it’s that part that’s in short supply in a lot of cases,” Brakke said. (For more words of wisdom, take a look at his book, Letters to a Young Analyst.)
Brakke reminded delegates that investment organizations are, well, organizations. “We get tripped up because we focus on investments. That’s not what’s important. It’s the organization.”
He added, “The typical anthropologist off the street could go into an investment organization and do a better job of due diligence than most people who go into investment organizations do, because they’re looking at how they’re put together. They’re looking at the connective tissue, and oh, by the way, they don’t go to the chief to ask about the tribe. They talk to the tribe. That’s what we don’t end up doing, and that’s why due diligence in the field is as good as it gets.”
It’s important to focus on the how, not the what.
“Investment people love to talk about ‘the what.’ That’s what they do. So every time they try to talk about the what, you pull them back. You put it in context. ‘Tell me the how? Who is involved? How was that decision made? Did you use any outside sources of information? What made you want to do that versus this?'” Brakke said.
“Always focus on the how. Don’t sit there and talk to them about what’s going to happen in Russia or the election,” he explained. “That’s useless. Craft the narrative, and remember: Everything is connected. The littlest piece of information is important in the mosaic. The littlest piece of information sometimes can get you to where you need to go.”
In general, he added, when you’re doing due diligence, make sure it’s on your terms, not the firm’s.
“Don’t ever walk into a room, and it’s their agenda that’s driving the thing,” he said. “It’s your agenda. Don’t listen to presentations or pitches. You can get all of that information in advance. It’s a waste of time. Get to the Q&A. Focus on what you want to do. Have a plan to do that, but be willing to walk away from that plan. Too often due diligence is, ‘Oh, I’ve got to get back, and I’ve got to fill out this due diligence report from my visit.’ That’s not due diligence. That’s documentation. Follow the trail. That’s due diligence. Learn about the whole organization.”
If you don’t understand the organization’s weaknesses, you shouldn’t be investing because they’re there, Brakke said. “You just need to know where they are.”
One of the best ways to gather information is by talking to people and doing old-fashioned field work, or what one would call “shoe leather reporting” in journalism. “Try to get out of the normal channels, and talk to people individually when you can,” Brakke said, “because it’s much better than talking to people in groups.”
In sum, tie the “what” to the “how,” crack the narrative, and remember: Everything is connected.
The best due diligence is “field work,” Brakke said. You’ve got to “have the mentality of [Bob] Woodward and [Carl] Bernstein in trying to track down the case.”
The CFA Institute Wealth Management Conference is an annual event covering tools and strategies important to private wealth management, including financial planning, practice management, and client relationship management. The CFA Institute Wealth Management 2018 Conference will be held in Los Angeles, California, on 28–29 March.
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