The Characteristics of Successful Investment Firms

Dr. Charles D. Ellis, CFA THE RECIPE FOR INVESTMENT SUCCESS It should, in theory, really be quite easy to develop a first-rate professional firm. We all know the recipe. Get top people. Have a clear purpose. Have high professional standards. Take a long-term view. Always remember that clients come ahead of the firm. Always remember that the firm comes ahead of the individual. And always remember, as an individual, that professional commitments come ahead of the financial rewards. Maintain discipline at all times, and you shall succeed. As Mr. Morgan put it, "Run a first class business in a first class way." The recipe is the same one for successful management that Marvin Bowers of McKinsey & Co. wrote about in his book, The Will to Manage. The title says it all. There wasn't anything unusual about what the management of any really good company was doing. They had the same recipe every other management had, but they were doing it. That made all the difference. David Ogilvy has written a third book, Ogilvy on Advertising. It's fun to read, has lots of pictures-and a good deal of real insight. He discusses five great advertising agencies, and comes to the conclusion that the principal factor required for success was-and is-persistence.
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and the business goals of an investment management organization, and that these two spheres work against each other. This can certainly be true. There's no doubt that they will be in direct conflict if either is mediocre. Any semi-good professional commitment or semi-good business goal will sooner or later corrode any organization. But there is no conflict between really good business goals and really good professional goals- if each strives for excellence and if the respect for both is sufficient. For example, it is only business strength that gives professionals the independence of mind and sureness of purpose that allows them to do firstrate professional work. Only professional independence is likely to result in the really good work that is needed to make a really good business. There is no conflict as long as each is truly strong. Most organizations, however, find it very hard to achieve and sustain excellence in both areas. It is a matter that requires much attention. The culture or the climate of the organization must always favor the professional dimension. When in doubt, lean toward the professional side. There must be that kind of favoritism. The Importance Of Strategic Considerations It's my belief that fees are one of the most powerful forces in the success or failure of an investment management organization. The fee level you set determines the market you will serve. Once you have chosen the market you will serve-which you do when setting your fees-you can then identify the key factors for success, the rules of the game in that market. Then you can organize to be successful in that particular kind of market. For example, if you choose to charge high fees, you must intend to be a high-value-adding organization. In strategy, clarity and simplicity are clearly critical. Most organizations are uncomfortable identifying what they will not do. It is not what you are willing to do, but what you will not do that most clearly defines what you really are.

One of the problems with identifying great and successful investment management firms is that most organizations doing very well now will not be doing very well 10 years from now. Most of the organizations we admired most 10 years ago are not those we would put on our shortest list of the great successful firms today. I have no answer for you as to why that should be the case-except that we are a very humane and human business. There is nothing quite so temporary as success in an intense, dynamic, "people" business like ours. The Professional Dimension/Business Goals Conflict Many observers believe there is a basic conflict between the professional goals

Peter Drucker has a good deal to say on this. It can be easily summarized. Focus your attention on areas of excellence; as professionals, do those things that you do quite well and try not to waste time doing the other things in which you are only moderately good. The internal focus should be on the things at which you are really good; the external focus should be on the major opportunities, the truly extraordinary opportunities. With regard to the formation of business strategy, it is my belief that many organizations fail to recognize that it is a completely different line of work from their investment management activity or their routine business administration. I would urge going to a different environment-in a different time frame- taking two or three or four days away from your offices, and clearly separated from your regular work. Otherwise, you're almost sure to have the time-urgent decisions drain away what time you have for those things that might be more important. Identifying The Big Decisions We never take too much, or even sufficient, time for the big decisions. I don't mean those big decisions that are abundantly evident and show themselves with great force and drama. We recognize these decisions-whether tremendous problems or great opportunities - and they do get our time. Instead I mean those soft, delicate, subtle, avoidable, easily postponed decisions on basic policy and strategy that can and will lead to very hard decisions later on if they are not attended to when "soft." The "soft" decisions are not easy. They are very difficult because they are the things of basic value: the selection of young people and the training, coaching, hope and trust that you put in them; decisions on which areas of development to give special emphasis; on the quality of the commitment you will make to your clients. It is in these areas of "softness" that all the really important decisions will be made, and they cannot be made wisely and well in the press of our daily activity. Strategy formation is not planning. It is my strong belief that planning is a negative function. Planning can be very useful, but it is negative in the sense that its whole intention is to eliminate

errors, reduce uncertainty, and avoid mistakes. If we were so good that we could plan the right things ahead two or three years, wouldn't we simply do them now? Firms that are successful do understand the value of a planning discipline, but it's a discipline against negatives. Our People And Our Communications
It was said earlier today, it will be said tomorrow, it will be said every time we get together: the most important part of a very successful organization is firstrate, high-caliber people. However, most of us do not give enough time and attention to the truly first-rate young people in our organizations. It is difficult to give them the environment they need; and difficult to give them the attention they want. First-rate people are so wonderfully rare that if we find them and bring them into our organizations, we should give them everything they need to flourish.

Successful firms have a tremendous consistency on basic values. The really "interesting" discussions seldom take place-because they are not needed. The organization that has deep agreement on the most important philosophical matters does not have "interesting," crisis discussions. The best firms will enrich that consistent set of core values with a wonderful diversity of experience and orientation, ways of thinking and articulating, and personalities-all with deep mutual respect. It is out of that kind of common weal that an aristocracy of talent is likely to come forth. I think that the matter of size and market liquidity is a false issue for most investment management organizations. There are some for which it would be right to say that market considerations would put constraints on their ability to manage money. But most investment management organizations are not constrained externally. They are constrained, instead, by their internal difficulties, largely their difficulties of communication. Consider, for a moment, the German U-boat fleet, which in the early part of the Second World War was dreadfully successful. Much as the AmericanBritish navies would like to say that they defeated the U-boats, the reality is

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that the V-boats defeated themselves. The reason is that the V-boat command was in Berlin. The original concept was that all V-boats would look for cargo ships, and if they found a ship they would radio back to Berlin, and Berlin would decide where every V-boat should go. When Germany had only 50 or 60 V-boats, that system worked very well. When they got to 400 or 500 Vboats, the deluge of data piling into Berlin so exceeded Berlin's capacity to process and organize the data that headquarters' decision making could not keep up with the demand. This same problem of data over-load is characteristic of investment management firms that are in trouble. The enormous volume of data can overwhelm decision making and make it seem impossible to find time to think. It is a curious reality of our profession that the investment management community in the Vnited States is now spending $2 billion a year inducing a group of highly-motivated, very competent individuals largely located in Wall Street to supply investment managers with further excesses of data. Two billion dollars is a very large amount of money. Successful firms protect their decision makers from the tyranny of data and find ways to control the flow of information coming into their organizations. They make sure that the research is working for them-not the other way around. It does no good to play the horse to someone else's Lady Godiva.

Getting Bigger vs. Getting Better Growth and expansion are entirely different from one another-even though in the investment field, we tend to talk about growth as though it were expansion and about expansion as though it were growth. Expansion is getting bigger. Growth is getting better. Getting bigger almost necessarily means that you will have fewer wonderful people joining your organization in larger numbers. It almost necessarily means that you will be doing more things for more customers. As you expand the volume of work, there is a grim tendency to enter lines of work that are less value-adding and to serve smaller clients. As the margin of value added declines, so does the margin of profit-but both are hidden in the short run by expansion's increase in total profits. Expansion is almost always a decline in quality offset by a rise in quantity. Growth is getting better. Doing more difficult, more valuable things-often for more substantial and demanding clients. I'm for getting better - for growth. The great enemy of growth is expansion. Peter Drucker, once again, says that the easiest way to get hold of first-rate resources that can be put to work on first-rate opportunities is to stop doing things that aren't worth doing. Stop doing things you don't do well and devote the liberated resources to things with which you could succeed greatly. Tenure, Turnover And Structure Optimizing the balance between common commitment and diversity recommends average tenure of professionals between four and six years. To calculate average tenure, take all the years of everyone in your organization and divide it by the total number of people. Ideally, it will to be somewhere between four and six years. If it is less than that, people don't know each other well enough to really work together effectively. Beyond six years, they know each other too well and stop listening and stop thinking. This leads naturally to a desire for low turnover. All the really successful

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For internal communication, the great problem is adding people. As you add people arithmetically, their relationships go up geometrically. There is a rapid progression toward decisions that are social or political, rather than objective and fact-founded; decisions that are made with inadequate reflection because so much time is spent talking; and decisions without clear-cut accountability. Direct, simple, short lines of communication are wonderfully powerful. One of the great organizations in the history of the world, the Catholic Church, has only four levels of communication between God and the average parishioner. That's a model communication system. Most of us can't say we're very close to it. The closer we get to simple, clear, direct communication, the greater our chances to succeed.

organizations, other than those that are very new, have low turnover. In some cases it can mean reaching out to find extraordinarily talented new faces that will help bring your average tenure down into that four to six year zone. The great silent enemy of a vibrant, effective strategy is its structure. The reason is that strategy, created to meet a market's requirement, needs a structure for implementation. As soon as the structure is in place, however, it strives to wrest control of the organization away from strategy. Structure almost always wins. Structure resists change. It holds onto the familiar past and keeps us from advancing toward our future with a bold contemporary strategy, if it can. Beware the normal tendency toward the "Peter Principle". Don't take your best investment manager and make him a not-very-good organization manager. Keep the best investment achievers, if you are lucky enough to have them, free to invest. Try to make it possible for them to invest 100% of the time. There are many more good general managers than there are good investment managers in this nation. I don't think it's possible to be a good business manager and a good investment manager simultaneously, because the basic talents that lead to great success in an investment manager are not likely to lead to great success in an organization manager. Compensation Now-And Later Compensation is the great driving force in any organization's strategy. It is not just the financial compensation that's important; and most particularly, it's not the current-dollar compensation. Do you have distributive justice? If everybody knew exactly what everybody was being paid, would it make good sense to them? The best test of that is, I think, one every organization ought seriously to consider: total disclosure of compensation policy. It will cause those who make the decisions to make them with great care. Fair play is the essential factor in compensation. Without fair play, no organization will be successful for long. Beyond current compensation, there is a looming problem for the most successful

of the independent investment management firms. In many of these firms, a great confrontation will come between three generational groups. One group will say, "We started this firm. We were here when there was no one here. We did the first pieces of business. We took all the risks. It's ours." The next group will say, "The first arrivals may have started this company, but it wasn't much when we got here. We are the ones who brought in the really big accounts. We are the ones that made the really important strategy moves. We are the ones that made it a really successful business. It is ours." And the third generation will say, "We are the future. We are doing all the really good research and we are moving into more and more client relationships. If you lose us, the future will be rough. The firm should be ours." Those generations will not be more than ten years apart. Investment organizations that are part of a large organization all too often have their pay patterns set by the pattern designed for the parent company's other-usually larger and more important- business. This can cause a distressing mismatch between the firm's internal compensation and the norm in the market. In one form or another, most investment organizations are struggling with success. Many are so successful that their major problem will be living with that success. In some cases, very successful firms have a benevolent major owner who is increasingly distributing the ownership-and matching the rising expectations of the young. Other firms have a complete disclosure policy or equitable sharing - equal pay to all partners. Most firms do not enjoy such blessed conditions. Stature, respect, acceptance and recognized importance are vital aspects of compensation. There certainly ought to be no one in the investment management business inadequately compensated today. The pay is, frankly, spectacular. The prospects are even more charming. But there are people who will be unhappy because they are not treated with the respect as professionals that they are entitled to. In successful organizations there is a high level, even a surplus, of respect, recognition, and admiration among the

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professionals. There is, also, quite a lot of pride-that same kind of pride that goes with being a good athlete. There is a total dedication and desire to be very good. The Power Of Good Ideas And Good Clients Most of us go to work every day. We put in ten or more hours reading and talking about routine and making unimportant, perhaps even useless, decisions day after day. Only once or twice a year is there something really worth doing. Most of us are too busy to notice. Great organizations must have the ability to recognize a great idea, grab hold of it and embrace it in a powerful way. Knowledge is not a constant. Insight is certainly not a constant. Big ideas of real value seldom come along. The best investment management organizations seem to be reasonably good at pausing reverently before those good ideas and exploiting them. An important dimension of successful investment management organizations-true of great organizations in many fields-is having great clients. If you have clients you do not enjoy or admire, or clients that do not expect much of you, you should seriously consider terminating the relationship with them. They will hold you back. If you have great clients, wonderful clients, reach out to them and ask them to demand even more of you. The great role of the client is to challenge you to be the very best you can be. Appraising "Success" What makes for successful firms? Business success in investment management is not hard to come by. Fees are high. Costs are relatively modest. Technological risks are minimal. Foreign competition is not consequential. Growth comes easily. Customers are often docile. Competition is benign. Demand exceeds supply. It's a wonderful, easy place to have a business success. In terms of professional success, however, I would ask some questions. First, how many of the really important developments in investment management have come from within - from

within your own organization or from within our profession-as opposed to coming from outside? Have we, as a profession, truly contributed to our national society? Have we added net value? I confess to having some genuine doubts. If you took all the fees paid to all the investment managers, added up all the transaction costs incurred by these managers, and then compared the total to the riskadjusted returns on the portfolios, which would be larger? Have we truly advanced young people in their professional development? Have we succeeded in educating our clients, particularly with regard to the importance of setting long term policies on asset mix and risk levels? Have we taught them how to avoid odd-lotting? I suspect that, on those dimensions of professional success, we're not yet very successful. In the long run, however, satisfying the real and legitimate needs of clients will be the best part of our professional success. Leadership is the final characteristic of successful firms. To become excellent a firm needs strong leadership-not an individual, necessarily, but ideally a group of leaders-committed to an idea of real value and able to take the time needed to pursue that idea. Venture capitalists say they don't want to invest in small companies. They want to invest in small companies in big businesses. It is my belief that the successful investment management organizations of the future will be those whose people want to invest their careers in relatively small enterprises that engage in important work on challenging problems for great clients. It's a wonderfully difficult field in which we are engaged. Fortunately, it is an easy place to make a business success and, therefore, we will be well paid. The really interesting questions are how to make a professional success. On that, I don't think we have the answers. I'm not even sure we have the questions. It is our largest challenge.

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A brief discussion period immediately followed this presentation.

Mr. Ellis: One thing that I know is very much on your minds concerns"The Loser's Game". Do I still believe in it? The answer is affirmative.
Let me tell you why. The reason is you. The talent in this business is too great. There is no reasonable hope that such a wonderful group of talents could leave sufficiently large errors in plain view for me or anyone I know to find them and exploit them, if they manage consequential amounts of money. Question: Would you be more explicit about the details of the conflict you find between business and professional success? Mr. Ellis: For investment managers the easy, quick business profits are so great that it is difficult to justify striving to be really good at the professional dimension. Those organizations that are most successful at the professional dimension-the development of really clearlyarticulated, mature, supported and achievable concepts of investment management-typically are not financially motivated in that work. The attitude that is brought to bear is one seeking fulfillment in the professional dimension, rather than seeking to make a business success of it. That gets into a dangerous conflict when the business success starts to roll. It is easier for us to count the jelly beans than achieve the more subtle things that have to do with professional excellence. It's easy to accept business that we really ought to let pass by. It's easy to accept the growth in business or the expansion in business that requires us to add people to undertake more of what we are doing successfully. I watch outside our field. Look at the great management consulting firms. There are so few that have done first-rate work for very long. The greatest failure in the consulting field is certainly Booz, Allen & Hamilton, which at the beginning of the Second World War was the largest, best regarded and probably the most capable consulting firm in the country. Sometime in the 1950s it was controlled by a group of people who cared more about running it as a business. They ultimately took it public and it failed badly as a public company. It was bought back by

people who had been there as professionals. They are still in the process of rebuilding that organization. During that same time, McKinsey & Company went from being a fairly small, inconsequential management consulting firm to being clearly the consistently best firm. I believe the reason is that the people at McKinsey have closed down a series of their activities. They've really backed away from businesses that do not lend luster to the professional integrity of the firm. It has to be a business they are proud to do, or they won't do it. Ogilvy & Mather has an interesting requirement: to take on any new client, first the new client has to be in a different field than present clients. Sometimes a lot of imagination is required to get differences between kinds of consumer goods companies! Then it also has to look like it would be interesting and challenging work. It must be strongly sponsored by a senior member in the organization who wants to do the work. I think that's one of the reasons they're so successful in their business. The clients they add are added from a professional point of view. Am I being helpful? Let me just identify what I think is the most professional decision I have ever heard. Peter Drucker's book, The Concept of the Corporation- written in the middle 1940s about General Motors Corporation and very unpopular with the company- explains how in the late 1930s their senior management came to the judgement that the world was moving towards a great and difficult war. And if there would be a war, there would be a shortage of talented, skilled labor. So they began to search in 1938 for areas in which there were large populations of skilled labor. They deliberately put their plant locations, to the extent they could, in those centers of talent. In late 1939 or early 1940 the executive committee of that corporation proposed to the board of directors-and the proposal was accepted-that if there was a war they would take no contracts of any kind, including military work, if some other company could do that work. They would only take, as manufacturing assignments, those things that no one else could do. That was one of the reasons that this nation was so enormous-

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mously successful at staffing its military capability. General Motors was able to do things that we really needed to have done. Listen to Vladimir Horowitz talk about his musical performances. Every year he eliminates two or three pieces he has mastered because they are starting to become almost easy. He takes on something he thinks might be very difficult. For a wonderfully long period he has been first-rate by keeping himself tested and challenged. The great professional of our field is clearly Ben Graham. I didn't get to know Ben until he was an older man. He was 77 when I first met him. What a thrilling experience it was to watch him sit in a room with the lions and tigers of the performance period. Twenty investment geniuses and old Ben Graham. Ben was the one that had the largest number of new ideas, was the most interested in the ideas of others, and was the least sure about the ones he had. In his last two years he was involved with a slide rule and an ancient typewriter. With his delightful Spanish

companion talking with him and encouraging him, he was trying to reinvent investment management. The Renaissance of Value, published by The Financial Analysts Research Foundation, was a preliminary report on the work that he'd been doing. He thought that he had found another way to outperform the market. That, I think, is where great professionalism comes from. It's an inner drive; when you find it, support it and nurture it in any way you can. Jack Hogge asked today, "What should you do if you can only do one thing?" A good answer is one that was given, "I hope to tell each person working for me exactly how I think they are doing, always." My own answer would have been, "I hope to find wonderful talent," because there's so little more we can do after we've done that. The wonderful talents are the geniuses behind all the really successful firms. The extremely successful firms are the ones who don't mess this up. They give talent the room to do first-rate work and encourage it. That's a very delicate process.

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