I just finished reading a 144-page document from the Committee of European on ways to prevent market abuse.
The paper discusses myriad ways regulators can browbeat listed companies into following disclosure rules. Basically, it's 144 pages on how to force people to tell the truth.
Here's the ultimate truth on market regulation. It can't be done.
We have insider-trading rules that require company officials to report their personal buying of stock in the companies they own and run. We want to know if the CEO is driving the stock up, or blowing out his holdings ahead of bad news.
This is good in theory. Except that sophisticated company managers simply set up offshore accounts and run up or blow out of their companies without their name ever appearing. This happens all the time.
So we implement more rules. We spend millions on regulatory firepower to increase monitoring and prosecution. We produce huge reports like the one I mentioned. Making it ever more complicated for companies to list and stay listed.
Here's a revolutionary idea. Why don't we instead just invest our money with honest people?
We increasingly leave the matter of honesty up to regulators. Hoping that rules will force all companies to behave in an appropriate way (at least some minimum standard of appropriateness).
A much more effective approach is for investors to take it upon themselves to analyze the honesty of the management teams they're buying into.
Too often, investment analysis stops at the project level. Analysts (even professional ones) will spend hours and countless pages breaking down a company's operations, cash flow, costs, projected earnings, business risks, etc.
And yet the same analysis will contain nearly no appraisal of the people involved. Except maybe a cursory overview of past projects the team has been involved in.
This is like buying a house after just looking at the outside. You can't simply assume that what's behind the walls will be as good as the facade. Window-shopping for mansions is not good practice.
Incompetent or dishonest people can suck value from a project, no matter how attractive it is from a technical slant. (And conversely, good people can sometimes patch the holes in a faulty project. Or if not, they can source a better project using their expertise and contacts.)
But analyzing people is not straightforward. MBA students don't get trained in spotting honesty. It's a "soft science", and so it often gets ignored.
But just because it's esoteric, doesn't mean it can't be done. The best investors I've had the fortune to observe always, always make an assessment of management's concern for shareholder value (along with other qualities like technical excellence and industry knowledge) when they analyze a company for potential investment.
There's of course some heavy-duty psychology that goes into this. But not all of the tests are complicated.
As one very successful fund manager once told me, "Always give management a chance to lie to you. And see if they do."
Funny as it may sound, another quality I've come to look for as a proxy for honesty is love.
Love of the business, the science, the work at hand. The best mining executives are the ones who will talk endlessly (if allowed to) about the mines they've visited, the great projects they've seen. Who are clearly energized by the pursuit of knowledge about their field. Their eyes don't quite light up, but you know this kind of enthusiasm when you seen it.
These are the kind of people who would be pained to do things the wrong way. It just goes against their grain. They want to build something, and they want it done properly, almost to an obsessive-compulsive degree.
Of course, this is just one of many tests that go into the tapestry of an overall assessment. But it's one that becomes easy after you talk to enough management teams. You can see who's in it to make something great, and who's just going through the motions until you reach for your checkbook.
If you can do this kind of "people analysis" (or can find investment managers who can), regulation suddenly becomes a lot less critical. After all, it's not important that most companies are honest. It's important that the few you put your money with are.
By. Dave Forest
Disclosure: No positions