The Magic Words of Money Management Part I – “proprietary”
Whether you’re a small retail investor or a huge institution, money managers are going to try to use a variety of magic words that are designed to entice you into placing your capital in their care. These words have been carefully chosen because they tend to tip the scales and induce the amateur and professional alike to invest. I know this stuff works because I’ve had my fair share of success deploying the vocabulary. In order to be an informed consumer, you need to know what these words really mean, so that you’ll develop the appropriate level of skepticism.
|Riverside Review (1999)|
We will examine two typical pitches: in the first, a traditional stock or bond manager, or a hedge fund will try to wow you; and in the second, a private equity or real estate manager will whispers sweet nothings – at least they are sweet nothings to investors.
Okay, here’s the first pitch, “we’ve developed proprietary investment models that enable us to excel at selecting securities.”
The manager is telling you he has a secret formula. This statement is effective because it’s supposed to inform you that he’s doing something special. The beauty of the manager’s assertion is that you’re blocked from asking meaningful questions. You might say, “How does your investment process work?” The manager will smile and say, “I’d love to tell you, but our process is proprietary. We have to protect our competitive advantage.” He’ll then tell you how much time and effort went into building those models; he’ll toss out some jargon (e.g., multi-factor model, decile rankings, dynamic weighting) and the impressive credentials of his colleagues. Even in situations where I’d signed a confidentiality agreement with the manager, I faced this stonewall. At times I’d plead with the manager and remind him that I’d sworn in blood to reveal nothing. The manager would say nothing, but his eyes would say, “trust me.” Invest purely on the basis of trust? I don’t think so.
The truth is that very little in money management is truly proprietary. Dozens of managers are analyzing the same factors using very similar models. However, if they were to drop the word “proprietary” the potential investor would quickly realize that there’s nothing special going on. The lesson: you shouldn’t invest with anyone who hides behind “proprietary” and won’t explain how his investment process works. And, you shouldn’t accept an answer that is filled with jargon.
Next we’re pushing our shopping cart down the specialty aisle, looking for a private equity or real estate manager. He’s going to say something like: “We have developed a “proprietary” pipeline of deals, which enables us to buy companies (or real estate) cheaply.” The manager is trying to convince you that he’s got an advantage from the very beginning of the investment process because he can buy companies (or real estate) below their fair value and therefore create an instant profit. Sounds enticing, doesn’t it? Before he’s leveraged the company, and made all those operational changes that are going to create value, he’s trying to infer that we’re already in the black. Normally I’d advise that you walk away from any manager making this claim, but since they all make the claim we just have to live with the fib. Every now and again, a manager can get his hands on a cheap deal, especially if he can induce the management to back his bid (not very nice for the existing shareholders, but then again investing isn’t meant to be nice [it's not meant to be evil either]). However, for the most part auctions, investment bankers, and competitors will make sure there aren’t very many bargains.
The lesson is to tune out this part of the pitch and doodle in your notebook until the manager moves onto the next part of his presentation, because proprietary deal flow is like a subatomic particle that only appears fleetingly.
Fortunately for investment managers, many investors want to believe that there is some magic in an investment process or deal pipeline, so the Power Point presentation or prospectus is going to use the word proprietary. With the other magic words that I’ll discuss in subsequent posts, they will raise money from investors.