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Psycho-Investing – The importance of Desperation.
Students of the financial markets have long considered psychology to be an important factor. The emotions: fear and greed are often referred to as the major determinants of market behavior.
Those who have attempted to use psychology in the investment arena have mostly concentrated on the sentiment and behavior of investors. The psychology of corporate executives whose decisions and actions can greatly impact the values of the securities issues by the companies they head has not received much attention.
In the fixed-income markets, “character” has always been one of the C’s of bond investing. Some texts suggest evaluating the five C's of credit when making credit decisions: character, capacity, capital, conditions and collateral. Some add a sixth “C” for context as in the context of the business.
The “character” of the executives of a company refers to their honesty but also incorporates what credit- market participants call the “willingness to pay”. As to basic honesty, there does not seem to be any way that an individual investor can detect dishonest corporate executives. Even the most sophisticated audit firms, banks, brokerage houses and institutional investors were taken in by executives at companies like Parmalat, Worldcom and Enron to name a few.
Attempting to assess the mental state of corporate executives from publicly available information is probably not useful for detecting frauds. However, When investing in distressed securities the attitude of corporate executives can be extremely important information. Furthermore, the enactment of SEC Regulation FD means that individuals now have considerable opportunities to assess the mental state of corporate executives.
Regulation FD provides that whenever a company or a senior officer acting on its behalf, intentionally discloses material non-public information to certain persons outside the company, it must simultaneously disclose such information to the public. With the advent of the Internet, the practical effect of Regulation FD is that almost all meetings and conferences at which any senior executives speaks to any persons outside the company are Webcast.
Just having access to information that provides insight into the attitudes of executives of a company is not enough, the key is to know what to look for.
Recent examples of where decisions by corporate executives had tremendous impact on the values of securities suggest that significant profits could have been obtained by investors who paid attention to the attitudes of corporate executives. By examining these examples, patterns can be observed by which insight as to the probable behavior of executives of a company can very valuable investment tools.
What are we looking for?
The first thing to consider when attempting to use executive attitudes as investment tools is what behavior would be positive for the securities in question and what behavior would not be. Again, it should be emphasized that this technique is a relatively short-term tool. This is not a matter of trying to find talented or even brilliant executives of a company and invest based on the expectation that the talent or brilliance will result in superior performance. Rather, this investment technique concentrates on distress situations where one course of action by the management of the company will likely cause one set of outcomes for the securities of the company, while another will have quite different results.
We have found that it is the returns on the bonds and preferred securities of distressed companies, which is most significantly impacted by behavior that insight into the attitudes of executives of a company can predict.
Generally, a distressed corporation either files for bankruptcy or it does not. The returns on the bonds and preferred securities of a company bought when a significant risk of bankruptcy has depressed the price of the securities can be enormous, if the company avoids bankruptcy.
The ideal situation for this investing technique is where it can ascertained that the decision make usually the CEO has the ideal attitude. The ideal attitude that we are looking for might be called one of “purposeful desperation”. We want a CEO who desperately wants to keep the company going because he believes in the future of the company.
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